One should worry about the problem of moral hazard when

Question

BlackTom AI · Accepted Answer

Question: One should worry about the problem of moral hazard when

Option 1: 'differentiating with a rival firm.' Differentiation strategies with rivals are about competitive positioning and market gaps, not primarily about the incentives and risk-sharing that create moral hazard within a principal–agent relationship. This choice targets competition analysis rather than internal incentives that lead to hidden action problems.

Option 2: 'solving the game of Prisoner’s Dilemma.' The Prisoner’s Dilemma illustrates strategic miscoordination and the tension between individual rationality and collective welfare, but moral hazard in principal–agent settings is specifically about hidden actions due to asymmetric information and incentive design, not the abstract dynamics of a one-shot game. While related in spirit, this option doesn’t pinpoint the classic source of moral hazard in compensation design.

Option 3: 'designing salesforce compensation.' This is the classic context where moral hazard arises: when a principal (employer) cannot perfectly observe effort or effort quality by the agent (salesforce), and compensation schemes can alter incentives. If compensation does not align with effort or outcomes, salespeople may shirk or undertake unobserved activities. Therefore, worry about moral hazard is precisely tied to how compensation is structured to align incentives and share risk.

Option 4: 'designing a screening mechanism.' Screening mechanisms are typically used to deal with adverse selection, i.e., information asymmetry before engagement, to reveal private information. They address problems of hidden information at the outset rather than hidden actions after engagement. While related to incomplete information in contracts, moral hazard specifically concerns post-contract behavior, making this option less directly about moral hazard.

In summary, the question targets the settings where incentive misalignment and unobservable effort can occur, and among the choices, designing compensation for a salesforce is the most direct illustration of moral hazard concerns. The other options either deal with competitive strategy, game-theoretic coordination without the employment contract focus, or adverse selection concepts rather than post-contract moral hazard.

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One should worry about the problem of moral hazard when

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