The trade-off between incentives and endogenous risk

Marcos H. Tsuchida, Aloisio Araujo and Humberto Moreira ()

No 523, FGV EPGE Economics Working Papers (Ensaios Economicos da EPGE) from EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil)

Abstract: Standard models of moral hazard predict a negative relationship between risk and incentives, but the empirical work has not confirmed this prediction. In this paper, we propose a model with adverse selection followed by moral hazard, where effort and the degree of risk aversion are private information of an agent who can control the mean and the variance of profits. For a given contract, more risk-averse agents suppIy more effort in risk reduction. If the marginal utility of incentives decreases with risk aversion, more risk-averse agents prefer lower-incentive contractsj thus, in the optimal contract, incentives are positively correlated with endogenous risk. In contrast, if risk aversion is high enough, the possibility of reduction in risk makes the marginal utility of incentives increasing in risk aversion and, in this case, risk and incentives are negatively related.

Date: 2004-02-01
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Citations: View citations in EconPapers (5)

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Related works:
Journal Article: The Trade-Off Between Incentives and Endogenous Risk (2007)
Working Paper: The trade-off between incentives and endogenous risk (2004)
Working Paper: The trade-off between incentives and endogenous risk (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:fgv:epgewp:523

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