Moral Hazard Discussion
An agency theory is a contractual relation between an agent and a principle. An agency relation has a couple of problems. They are generally categorized into one of two forms: moral hazard or adverse selection. Moral hazard arises when a principal is unable to control the actions of an agent, and these actions have differential value to the agent as compared to the principal.
So what is an agency relation? It is an economic model of contractual relations or agreement between 2 or more individuals (agents) or group of individuals that are known as the principal. The agent is typically an employee of the principal hence the agency relation. the employee/agent has an incentive the shirk on the job to the detriment of the principal while the principal has an incentive to monitor the activities of the agent to minimize the cost to him/her.
Principal agency theory argues that the agent is risk averse while the principal is risk neutral. A risk averse individual is one who needs to be more than compensated for taking a risk, they would not bet equal bets on flipping of a coin. They might want to be paid more than a dollar for a bet on a fair coin toss and pay a dollar if they lose. A risk neutral individual will accept a dollar for each outcome and the third type of individuals are the risk seeker. These are individual who gets an excessive utility for the mere presence of the bet and therefore such a person will accept $0.90 for a head and pay a dollar for a tail or vice versa. these are the people that you would find in casinos and possibly in Future markets.
Principal agent theory applies to other situations besides an employee and employer relation. It applies to the corporate world as well. For example, is management of a company an agent or a principal. Of course, more important management is an agent for the shareholders, but management can behave in a way that is detrimental to the wealth of the shareholders. An example would be excessive travel booking, very expensive hotels ordering and so on. This increases the operating cost to the organization without adding any true benefit to the organization. In this case the shareholders are the principle they and have an incentive to “force management” to act in a way that is consistent with their welfare. This is known as monitoring cost and takes the form of the creation of a board of directors. The board of directors in essence monitor the behavior of management to make sure it is in alignment with the interest of shareholders Unfortunately many times the chairman of the board of directors is also the CEO of the company and such monitoring is really not done the way it should be.
Agency theory also extends to other situations such as bondholders and stockholders it is very possible that management the agent again behaves in a way that is to the benefit of the shareholders but not to the bond holders. Here’s an example, If management makes risky investment decisions and if the investment decisions lead up to profitable results the profits from that will accrue to the shareholders only if on the other hand the investment decision turned out to be to have a negative consequences the shareholders and the bondholders will also lose because now the company is not worth as much as it was worth before and the value of the bonds would decrease to some extent because the company is more risky now. but the value of the bondholders will not increase above its face value if the company does well. This is another example of a misalignment of an agent and principal.
Paper requirements: 2-page, APA format with at least 2 scholarly journal citations
• Did the bailouts help or hurt the economy?
• Do you support the idea of the government stepping in to help companies in trouble? Could this promote the moral hazard problem?
• Fully explain and support your response.