# Don't punish yourself for bad luck

_The following text first summarizes the standard moral-hazard model. Afterwards, I point out that it implies that you always get punished for bad luck. The third part is completely speculative: I speculate on how you should behave towards yourself.  
_  
**A brief summary of a moral-hazard setting**  
  
A Moral Hazard situation occurs when someone takes too much risk, or does not reduce it enough because someone else bears the cost.  
  
The following situation is a typical textbook example. A worker works for a firm, and her effort influences the probability that the firm has high revenue. The worker can exert high or low effort, the firm's revenue can be high or low, and low revenue is more likely when effort is low, but can also occur when effort is high. Moreover, the worker has to get a wage that compensates her for forgoing whatever else she would do with her time.  
  
Suppose the firm would, in principle, be willing to compensate the worker for high effort (which means that we assume that the additional expected revenue gained from high effort ist at least as high as the additional wage needed to make the worker willing to exert high effort). Because workers are usually assumed to be risk-averse, the firm would take the risk of low revenue and the worker gets a wage that is constant in all states of the world.  
  
However, now also suppose the firm cannot directly observe the effort - this constitutes a situation of asymmetric information, because the worker can observe her own effort and the firm cannot. Then the firm cannot condition the payment on the worker's effort. It also cannot just conclude that the worker exerted low effort by observing low revenue, because we assumed that low revenue can also occur when the worker exerted high effort.  
  
The second-best optimal solution (that is, the best solution given this information problem) is to condition payments on the revenue - and thus, on the result instead of the effort to get it. The worker gets a higher wage when the firm has high revenue. Thereby, the firm can design the contract such that the worker will choose to exert high effort.  
  
In this setting of asymmetric information, the worker gets the same expected utility as in the setting with symmetric information (in which effort could be observed), because the firm still has to compensate her for not doing something else. But because the worker now faces an uncertain income stream, the expected wage must be higher than if the wage were constant. (Thus, the firm has a lower expected profit. If the loss to the firm due to the high-revenue wage premium is severe enough, the firm may not even try to enforce high effort.) The asymmetric information precludes an optimal arrangement of which economic agent takes the risk.  
  
**  
You'll get punished for bad luck**  
  
At this point, note that the way that the firm offers a higher wage when it has high revenues and a lower one when it has low revenues is a matter of framing. The firm may for example say that it wants its workers to participate in its success, and therefore pay a premium.  
  
Vocabulary of "punishment", by contrast, may not be popular. Also, it seems wrong to call the low wage a punishment wage. Why? Because the optimal contract makes the worker exert high effort, and a low revenue will NOT indicate that the worker idled.  
  
So that is the irony of the situation: An optimal contract punishes you for bad luck, and for nothing else. At the same time, the worker would be more likely to get "punished" if he idled, because low revenue would then be more likely. The threat of punishment for a bad result is exactly what makes the worker exert high effort to at least make the bad results unlikely.  
  
**Optimal contracts in your brain?**  
  
Suppose you feel a bit split between two "agents" in your brain. One part of you would like to avoid working. The other part would like you to exert high effort to have a good chance of reaching your goals.  
  
You cannot pay yourself a wage for high effort, but you can feel good or bad. Yet the kind-of-metaphorical implication of the moral-hazard optimal-contract model is that you should not punish yourself for bad luck. There are random influences in the world, but if you can see (or remember) how much effort you exerted, it does not make sense to give yourself a hard time because you were unlucky.  
  
On the other hand, maybe you punish yourself because you lie to yourself about your effort? If you have created such an asymmetric-information situation within yourself, punishing yourself for bad luck is a seemingly rational idea. But keep in mind that it is only second-best optimal, under the assumption that this asymmetric information indeed exists. If so, think of ways to measure your effort instead of only your outcome. If you cannot do it, consider whether forcing yourself to exert high effort is really worth it. Solve the problem that actually needs to be solved, and respect the constraints that exist, and none that do not.