that this estimate is highly uncertain; final cost could well be as low as $6 mil-
lion or as high as $7.5 million. Recognizing this uncertainty, the parties have
drawn up a cost-plus contract. That is, the firm will reimburse the builder for
all allowable costs, plus a provision for a normal rate of profit. The contract
also sets the completion date for two years from commencement of the proj-
ect, but this target is also uncertain.
Beyond the element of risk and uncertainty, the more subtle aspect of the
building contract is that the business firm is less well-informed about the con-
tractor’s likely capabilities and completion cost than the contractor itself. This
information asymmetry exposes the business firm to the risk of adverse selec-
tion. Some contractors will give honest estimates and others will low-ball—that
is, give an estimate below what they know the real cost will be. The cost-plus
contract attracts the low-ballers, who may in the end cost the firm more than
the honest contractors.
The business firm faces a second risk. Under the cost-plus contract, the
contractor is not responsible for any cost overruns and does not benefit from
any cost underruns. Thus, it has no incentive to complete the project at mini-
mum cost. It might instead indulge in various kinds of managerial “slacking”
or in the extreme case might pass questionable costs (or allocate undue fixed
costs) to the client. The presence of moral hazard means that the contractor
has an incentive to act in its own interests, not the client’s. Unable to monitor
perfectly the contractor’s actions (cost management, accounting practices, and
the like), the business firm is at risk to pay inflated costs.
In this example, the business firm faces the twin, but logically distinct, risks
of adverse selection and moral hazard. Here is the distinction:Adverse selection occurs when the agent (whose interests are at odds
with the principal’s) holds unobservable or hidden information.
Moral hazard occurs when an agent (whose interests are at odds with
the principal’s) takes unobservable or hidden actions.Generally speaking, adverse selection occurs at the time the agent enters
into a relationship, while moral hazard occurs after a relationship has been
established. At the outset, the agent is using his or her private information
to decide whether to enter into the relationship. Once in the relationship,
the agent decides which (unobserved) self-interested actions to take. For
example, a life insurance policy may attract those with serious health prob-
lems (adverse selection) and may cause those covered to begin to engage in
more risky behavior (moral hazard). Likewise, an employment contract may
attract lower-productivity employees (adverse selection) and give those work-
ers incentives to engage in self-serving actions at the expense of the
employer (moral hazard). As the next two examples show, the problem of
moral hazard is pervasive.588 Chapter 14 Asymmetric Information and Organizational Designc14AsymmetricInformationandOrganizationalDesign.qxd 9/26/11 11:03 AM Page 588