Preprint A361/2005
The trade-off between incentives and endogenous risk
Marcos Tsuchida | Araujo, Aloisio | Moreira, Humberto
Keywords: Incentives | Endogenous risk | Moral hazard models
Negative relationship between risk and incentives, predicted by standard moral hazard models, has not been confirmed by empirical work. We propose a moral hazard model in which a risk-averse agent can control the mean and variance of the profits. The possibility of risk reduction allows the agent's marginal utility of incentives to be increasing or decreasing in risk aversion. Positive relationship between risk and incentives is found when both marginal utility of incentives and variance are decreasing in risk aversion. Similar results are found if risk aversion is not observable and adverse selection precedes moral hazard.