How Information Asymmetries Can Lead to Moral Hazard and Hidden Actions
In consideration of the emerging trends in economics, there exists a significant difference between executive compensation contracts and other forms of compensation contracts (Goldberg & Idson, 1995). Executive compensation contracts refer to a contractual situation whereby high-level employees such as managers are remunerated with strict dependence on their results as output. This implies that with poor company performance, these kinds of employees shall receive poor or low payment. Similarly, better company performance is also associated with better or high remuneration. This mode of operation was originally introduced to minimize challenges associated with agency problems since executives as high-level employees shall not be exposed to over-payment as remuneration. Finally, this contributes to the calmness of the shareholders.
On the other hand, asymmetries in information refer to the uneven dissemination of information to various stakeholders of a company or organization during the realization of duties by managers (Binks et al, 1997). In actual scenario, it is concerned with decisions that surround company transactions where certain parties are exposed to more and better information than other stakeholders. This imbalance of transactional information is usually associated with dishonesty and unethical insider deals through trades by the high-level managers during the realization of their duties. In the long run, information asymmetries are often associated with moral hazards, unethical and hidden actions that aim at generating more personal income to the involved parties or stakeholders. This literature shall, therefore, focus on identifying and explaining various ways through which information asymmetries stand a possibility of leading to moral hazards and hidden actions.
Moral Hazards and Hidden Actions
During situations involving moral hazards, one of the parties that are involved in the mutual contractual agreement avails misleading or dishonest information to the other involved party. In some circumstances, one of the said parties may change their mode of conduct or behavior after formalizing the agreement since they possess a belief that they can never be exposed to consequential measures for their actions. This mode of conduct can be summarized by the logic that suggests that during situations whereby an employee or chief executive officer of a company is not directly impacted by the cost of a risk, they tend to behave in a manner that results in more exposure to the risk. Similarly, the nature of this behavior is usually dependent on the level of the benefit obtained from the behavior of the employees.
In most common cases, moral hazards are usually witnessed when the CEO of a company possesses a conflicting interest that is different from that exhibited by the shareholders or owners. Nevertheless, this moral misconduct is mostly evident during situations whereby the actions and conduct of a CEO are not frequently monitored by the shareholders. Besides CEOs being the main subject behind moral hazards resulting from information asymmetries, there exist various levels of moral hazards and hidden actions that are exercised by different parties within organization management and they include:
Principal to Agent Moral Hazard
This scenario presents owners of the company as the principal whereas agents are the managers who run the business on behalf of the business owners as a result of their skills and talents. This moral hazard is initiated by the action of the company owners assigning managerial tasks to the managers with the idea that managers shall deliver their duties about their interests. On the contrary, the managers possess a shift of interest since they mainly concentrate on actions that contribute towards maximizing their compensation. This behavior of self-satisfaction possessed by the managers is founded by human behavior which suggests that when human beings are left to function independently, they get motivated towards maximization of personal needs. This offers the most appropriate explanation of this moral hazard.
In a physical scenario, when managers are assigned the duties of running a company by the owners under limited supervision or attachment to the daily operations of the company from the owners, the managers deviate from their original goal and engage in activities that increase their income through the utilization of the company resources. This mode of conduct may eventually result in a conflict as the interests of the owners shall now not be achieved as outlined by the goals of the engagement. This behavior is encouraged by the existing asymmetries in information between the two contracting parties.
Principal to Principal Moral Hazard
This type of moral hazard results from the existence of conflicting interests between major and minor owners of a company. Major owners refer to a group of shareholders who possess the majority of the company shares whereas minor owners are shareholders who have fewer shares. Major owners are usually associated with the managerial advantage of which relates to the voting power hence making them capable of passing decisions that are more beneficial to them than the minor owners. Additionally, as a result of their superiority, the major owners enjoy access to more information relating to the operation of the company which in some cases possesses an influence on their decisions at the expense of minor owners.
As a result of this moral misconduct by the major owners, conflict of interest arises between major and minor owners. This mode of moral and hidden misconduct is common in companies or organizations which concentrate ownership on a few individuals as evident from companies that are owned by families. Finally, minority owners find it difficult to advocate or champion for their interests.
Principal to Creditor Moral Hazard
This involves moral misconduct that exists between owners of a company and the company creditors as the financiers. It is witnessed from the actions of the business owners during situations when they invest in more risky projects due to the higher returns associated with such risks. Additionally, the business owners may decide not to disclose information relating to such increased risks to the creditors to prevent objections of the action. This hidden action by the owners negatively affects the creditors since it increases the finance cost as it decreases the outstanding debt value. Upon the success of the unethical action, business owners enjoy extremely large amounts of profits whereas the creditors suffer from the negative effects of fixed interest rates. Similarly, creditors suffer more during situations where the risky project fails since a significant portion of the losses shall be shared by both the owners and the creditors.
Information asymmetry forms the primary cause of moral hazards and hidden unethical mode of actions by stakeholders of most companies. To reduce the negative impacts of moral hazard and hidden actions by managers and company stakeholders, there is an emerging need of minimizing the underlying factors that encourage information asymmetry. This brings about the concept of reducing agency costs. Agency costs relate to conflicts between company owners and the managers of the company as a result of contradicting interests. The majority of public companies suffer a lot from this practice since the “agent” puts more focus on his or her financial obligations before the interest possesses by the “principal”. Agency costs are finally realized through agents utilizing the company’s resources to satisfy their financial interests and the costs incurred by the principal towards limiting the agent’s focus to the interests of the shareholders.
According to Xiang et al (2012), some of the techniques adopted by the business owners to maintain the focus of agents towards the realization of shareholders’ interests include the introduction of incentives in terms of cash, payment of bonuses during the achievement of outlined organizational goals and allowing management salaries to be company’s partial shares. Generally, the costs associated with these techniques form the agency costs. Successful implementation of an appropriate compensation plan aids in the reduction of agency cost which finally becomes cheaper than the costs associated with management satisfying their financial interests.
In conclusion, to achieve a general company’s success and a balance in satisfaction of company stakeholders’ interests, all stakeholders of the company should perform their duties with utmost honesty and adherence to business ethics. This involves engaging in business activities that do not negatively affect the financial obligations of the company, both shareholders i.e. major and minor shareholders, creditors, and managers in general. Through this concept, moral hazards and hidden course of actions by various business stakeholders can be minimized or avoided.
References
Binks, M. R., Ennew, C. T., & Reed, G. V. (1992). Information asymmetries and the provision of finance to small firms. International small business journal, 11(1), 35-46.
Goldberg, L. G., & Idson, T. L. (1995). Executive compensation and agency effects. Financial Review, 30(2), 313-335.
Xiang, P., Zhou, J., Zhou, X., & Ye, K. (2012). Construction project risk management based on the view of asymmetric information. Journal of construction engineering and management, 138(11), 1303-1311.