The Trade-Off Between Incentives and Endogenous Risk

Brazilian Review of Econometrics vol. 27, pp. 193-198

26 Pages Posted: 30 Sep 2013

See all articles by Aloisio Araujo

Aloisio Araujo

Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finan├žas

Humberto Moreira

Fundacao Getulio Vargas (FGV)

Marcos H. Tsuchida

Getulio Vargas Foundation (FGV)

Date Written: January 2, 2007

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 supply more effort in risk reduction. If the marginal utility of incentives decreases with risk aversion, more risk-averse agents prefer lower-incentive contracts; 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.

Keywords: Incentives, non-monotone contracts, single-crossing property

JEL Classification: D82, M52

Suggested Citation

Araujo, Aloisio and Moreira, Humberto and Tsuchida, Marcos H., The Trade-Off Between Incentives and Endogenous Risk (January 2, 2007). Brazilian Review of Econometrics vol. 27, pp. 193-198 , Available at SSRN: https://ssrn.com/abstract=2330815

Aloisio Araujo (Contact Author)

Getulio Vargas Foundation (FGV) - FGV/EPGE Escola Brasileira de Economia e Finan├žas ( email )

Praia de Botafogo 190/1125, CEP
Rio de Janeiro RJ 22253-900
Brazil

Humberto Moreira

Fundacao Getulio Vargas (FGV) ( email )

R. Dr. Neto de Araujo 320 cj 1307
Rio de Janeiro, Rio de Janeiro 22250-900
Brazil

Marcos H. Tsuchida

Getulio Vargas Foundation (FGV) ( email )

R. Dr. Neto de Araujo 320 cj 1307
Rio de Janeiro, Rio de Janeiro 22250-900
Brazil

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