An employer wants to make sure the firm performs very well this year and, as a result, decides to tie employees’ entire compensation for the year to be 5% of whatever after-tax profits are at the end of this year. Further, she promises to pay that same dollar amount of compensation to the employees in perpetuity (for as long as they remain with the firm in future years) regardless of future after-tax profits.

Knowing this, employees decide to forego (ignore) any opportunities for new investment opportunities with many long-run benefits because they don’t want to incur a big cost (a reduction in after-tax profit) this year that will reduce their pay for future success with these projects that will not alter their compensation. The employer does not have enough information to distinguish whether the projects foregone this year were because employees truly estimated they were bad vs. good long-run investments. Thus, she cannot distinguish whether the actions by employees are good vs. bad performance this year.

Which term below BEST applies for the type of problem the employer is facing?

1. Symmetric uncertainty
2. Adverse-selection
3. Hidden-action or moral hazard
4. None of the above terms applies to the problem the employer is facing.

Answer rating: 100% (QA)

Hiddenaction or moral hazard EXPLANATION The employer is fa... View the full answer