Business Case Studies & Business Publications

Moral Hazard and Incentive Design

Sun, Bo

Technical Note

Moral Hazard and Incentive Design

Sun, Bo

GEM-0240 | Published June 12, 2025 | 8 Pages Technical Note

Collection: Darden School of Business

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Learning Objectives

This technical note establishes the concept of moral hazard and explores how to manage moral hazard in business contexts. Moral hazard—the misalignment of incentives that occurs when decision-makers do not fully bear the consequences of their actions—represents a common challenge across diverse business relationships. The note begins by establishing the theoretical foundation of moral hazard within the principal-agent framework, explaining how information asymmetries and misaligned incentives can lead to suboptimal outcomes in business decision-making. A significant portion of the note examines real-world solutions, including incentive compatibility mechanisms, risk-sharing arrangements, and monitoring systems. The note provides detailed coverage of executive compensation design, showing how companies balance risk allocation, incentive provision, and talent retention through combinations of base salaries, performance bonuses, and long-term equity instruments. Advanced students will benefit from the mathematical appendix, which formalizes the optimal contracting problem under moral hazard using constrained optimization. This material is well suited for MBA courses in managing economic uncertainty, managerial economics, and corporate governance.

Identify moral hazard; analyze incentive design; explain risk-sharing trade-offs that arise between agents and principals; and evaluate real-world incentive mechanisms that mitigate moral hazard.