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Effects of changes in preferences in moral hazard problems

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  • Jung, Jin Yong

Abstract

This study examines the effects of changes in an agent's preferences over income and effort on the principal's costs. The incentive cost is fundamentally affected by two factors: the income-effort marginal rate of substitution at the first-best wage, and the degree of absolute risk aversion around it. Thus, a resulting increase in the first-best wage has mixed effects because both factors are altered simultaneously. When the limited liability constraint does not bind and if the utility is concave with respect to the inverse of the marginal utility, a decrease in the marginal rate of substitution, an increase in the degree of risk aversion, and an increase in the first-best wage will raise both incentive and agency costs. However, when the constraint binds and if the marginal rate of substitution at the minimum payment decreases, an increase in the degree of risk aversion and an increase in the first-best wage will raise agency cost. Even if the first-order approach is not valid, the results still hold under the log-submodularity of the marginal cost.

Suggested Citation

  • Jung, Jin Yong, 2022. "Effects of changes in preferences in moral hazard problems," Journal of Economic Theory, Elsevier, vol. 205(C).
    • Handle: RePEc:eee:jetheo:v:205:y:2022:i:c:s002205312200117x
    DOI: 10.1016/j.jet.2022.105527
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    References listed on IDEAS

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    More about this item

    Keywords

    Moral hazard; Agent preferences; Incentive cost; Agency cost; Wealth effects;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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