moral hazard
SUMMARY
Moral Hazard in Equity Contracts: The Principal-Agent Problem
The separation of ownership and control involves moral hazard, in that the managers (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do.
Tools to Help Solve the Principal-Agent Problem
Production of Information: Monitoring Stockholders engage in a particular type of information production, the monitoring of the firm’s activities: auditing the firm frequently and checking on what the management is doing.
Government Regulation to Increase Information Governments have laws to force firms to adhere to standard accounting principles that make profit verification easier. They also pass laws to impose stiff criminal penalties on people who hide and steal profits.
Financial Intermediation Venture capital firms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses.
Debt Contracts It is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. There is a reduced need to monitor managers and the contract is more attractive than the equity contract.
QUESTIONS
4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets and hence making them operate better. Standard accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to understate profits, thereby reducing the principal-agent (moral hazard) problem.
QUANTATIVE PROBLEMS
4.
Expected loss with full insurance without a seawall 400,000×0.02=8,000 with a seawall 400,000×0.005=2,000
with partial insurance without a seawall 300,000×0.02=6,000 with a
Moral Hazard in Equity Contracts: The Principal-Agent Problem
The separation of ownership and control involves moral hazard, in that the managers (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do.
Tools to Help Solve the Principal-Agent Problem
Production of Information: Monitoring Stockholders engage in a particular type of information production, the monitoring of the firm’s activities: auditing the firm frequently and checking on what the management is doing.
Government Regulation to Increase Information Governments have laws to force firms to adhere to standard accounting principles that make profit verification easier. They also pass laws to impose stiff criminal penalties on people who hide and steal profits.
Financial Intermediation Venture capital firms pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses.
Debt Contracts It is a contractual agreement by the borrower to pay the lender fixed dollar amounts at periodic intervals. There is a reduced need to monitor managers and the contract is more attractive than the equity contract.
QUESTIONS
4. Standard accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets and hence making them operate better. Standard accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in financial markets. In addition, they make it harder for managers to understate profits, thereby reducing the principal-agent (moral hazard) problem.
QUANTATIVE PROBLEMS
4.
Expected loss with full insurance without a seawall 400,000×0.02=8,000 with a seawall 400,000×0.005=2,000
with partial insurance without a seawall 300,000×0.02=6,000 with a