13. Moral Hazard

1. 13. Moral Hazard • Moral Hazard: agent has incentives to do things that are bad for the principal. • Cash in the hat. Put in 1 or 3. Player 2 can match. If opponent matches, player 1 doubles investment. • In original formulation, can’t put in 3 as will have -3 utility.

2. Sequential game • Borrower/lender – moral hazard if borrower had incentive to do things which are not in the interest of the lender. • In insurance, solution is deductible. Otherwise, I might not be willing to lock my car. They want to reduce the temptation to do something harmful to the other player. • Incentives – align goals of CEO with goals of company. • Piece rates – amount paid depends on outcome. Causes people to work harder – creates incentives. • employees – I get the same no matter what I do

3. Smaller piece of a bigger pie may be better – $ in hat Change in what player 1 takes may be better for both.

4. Commitment Strategy Saxtons/Normans Run away for Normans is removed if you burn the boats You are changing the decisions of others by eliminating your choices. If you didn’t change their behavior, it wouldn’t be worth it. Crucial the other side knows Backward induction is key idea

5. 14. Cournot Duopoly – move in turns • Recall, Cournot – only decision is how much to produce • What if firm 1 announced what it would produce? If opponent responds with a best response, – if firm1 produces less, firm 1 could win as prices would go up. • Need commitment - sunk cost can help. • If we have a spy in our midst (and know the spy exists), it is as if the firm being spied on now has the first move. • Sequential is not really about timing – but its about information. Who knows what and who know what others know.

6. Stackelberg Model. So how do we want to think about this? A natural question to bear in mind is, assuming we're in this world of quantity competition, is it an advantage to get to move first, to set one's quantity first? Or is it an advantage to be able to wait, see what the other firm has done, and then respond? • leader (goes first) follower (goes second) • Leader must know the follower observes his actions • Follower must have no means of committing to an action before the leader moves. (If he did, he would be a leader.)

7. Stackelberg Model. So how do we want to think about this? A natural question to bear in mind is, assuming we're in this world of quantity competition, is it an advantage to get to move first, to set one's quantity first? Or is it an advantage to be able to wait, see what the other firm has done, and then respond? • Having fewer options (burning boats) helped you. First mover advantage • Having higher costs helped you. BECAUSE the other player knew more, he adjusted his actions.

8. Nim At seats. Game is called Nim. Sometimes games have a first mover advantage and sometimes they have a second mover advantage. Nim: Two players. Two piles of stones. Move sequentially. Player picks a pile and removes some (1-n) of stones. The person who gets the last stone wins. Strategy: If the piles have the same number, want to be second. If the piles are unequal, want to be player 1. If they have different numbers, make them equal. Once the piles are equal, the other player can't do anything.