11
Chapter 20:
The Problem of
Moral Hazard
1
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Summary of main points
• Moral hazard refers to the reduced incentive to
exercise care once you purchase insurance.
• Moral hazard occurs in a variety of circumstances:
Anticipate it, and (if you can) figure out how to
consummate the implied wealth-creating
transaction (i.e., ensuring that consumers continue
to take care when the benefits of doing so exceed
the costs).
• Moral hazard can look very similar to adverse
selection—both arise from information asymmetry.
Adverse selection arises from hidden information
about the type of individual you’re dealing with;
moral hazard arises from hidden actions.
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Summary of main points (cont.)
• Solutions to the problem of moral hazard center on
efforts to eliminate the information asymmetry
(e.g., by monitoring or by changing the incentives
of individuals).
• Shirking is a form of moral hazard.
• Moral hazard in loans: Borrowers prefer riskier
investments because they get more of the upside
while the lender bears more of the downside. The
problem is worse for borrowers who have nothing
to lose.
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Introductory anecdote:
TripSense
• In 2004, the Progressive Direct Group of Insurance Companies
introduced TripSense – a service that provided a free device to
record mileage, speeds and times driven in a vehicle.
• Progressive then used this information to offer discounted
renewal policies to customers who drove fewer miles at slower
speeds during non-peak hours.
• This helps the insurance company solve two problems.
Adverse selection, from the last chapter, and moral hazard,
the focus of this chapter.
• The decision of how frequently, how far, or how fast to drive is
equivalent to choosing your probability of having an accident.
• The cost of having an accident goes down when you buy
insurance.
• Drivers respond to this reduced cost by “choosing” to have
more accidents. This is called “moral hazard.”
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Introduction: Moral hazard
• Once you have insurance, the cost of an accident is
reduced, which also reduces the cost of the risky
behavior.
• This is the problem of “moral hazard” and exists in
many contexts, not just in the market for insurance.
• Moral hazard and adverse selection are closely
related problems. Both,
• are caused by information asymmetry:
moral hazard results from hidden actions; while adverse
selection results from hidden information
• The cost of managing both problems can be reduced
by reducing uncertainty (gathering more information).
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Moral Hazard in Insurance
• To illustrate moral hazard, lets return to the bicycle
insurance example of chapter 19.
• Suppose that bike owners stand a 40% chance of theft
when parking their bike on the street overnight.
However, if the bike owner exercises care (locks the
bike), the chance of theft is reduced to 30%.
• Suppose the cost of taking care (buying a lock) is $5.
• For uninsured bike owners, the benefit of exercising
care is (0.40 - 0.30)($100) = $10 and is greater than
the costs of exercising care, $5.
• Moral hazard suggests that once customers purchase
insurance, they exercise less care because there is less
incentive to do so.
• Is this really the case?
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Moral Hazard in Insurance
(cont.)
• In our example,
• The cost of bike theft is reduced when an insurance
policy is purchased.
• Sp, the consumer stops taking the extra time to lock up
the bicycle every night once she buys insurance.
• The probability of theft then increases from thirty back
to forty percent.
• The insurance company anticipates this moral hazard,
and now charges $45 for every policy it sells.
• If you do NOT anticipate that the probability of theft
will increase from 30% to 40%, you will lose money on
the insurance you sell.
• In other words, anticipate moral hazard and protect
yourself against it.
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Creating wealth with moral hazard
• Moral hazard can also represent an unconsummated
wealth-creating transaction.
• This opportunity exists because the benefits of taking
care are bigger than the costs of taking care.
• But how can the insurance company induce the bike
owner to take care?
• If the insurance company could observe whether the
customer was exercising care, then it could lower the
price of insurance to those taking care.
• This is exactly what Progressive’s MyRate/TripSense
system tries to do.
• It could also purchase the lock for the bike owner.
•
Note that these kinds of prevention and wellness
programs do NOT reduce health care costs.
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Moral Hazard or Adverse
Selection?
• To distinguish between moral hazard and adverse
selection, ask whether:
• Information is hidden (adverse selection) or the action is
hidden (moral hazard)
• The problem arises before a transaction (adverse
selection) or after (moral hazard)
• Discussion: Give a moral hazard and an adverse
selection explanation for each the following:
• Drivers with air bags are more likely to get into traffic
accidents.
• Volvo drivers are more likely to run stop signs.
• At all-you-can-eat restaurants, customers eat more
food.
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Shirking as moral hazard
• Because it’s difficult to monitor an employee’s actions after
they are hired, employers anticipate shirking.
• Problem: What commission rate is required to induce hard work?
• Suppose the benefit of working hard is the higher probability of
making a sale, e.g., probability of a sale rises from 50% to 75%.
• The cost of working hard is $100
• To induce hard work, (0.25) x (Commission) > $100, i.e., the
commission must be bigger than $400
• Unless the contribution margin on the item is at least $400, you
can’t afford to pay a $400 commission. You make more money by
letting the salesman shirk, i.e., it doesn’t pay to address the moral
hazard problem.
• If there is no solution, there is no problem!
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Shirking as Moral Hazard (decision tree)
Salesperson
Shirk (cost = $0)
Work Hard (cost = $100)
EV = [.5C + .5 × $0] – $0 = .5C
EV = [.75C + .25 × $0] – $100 = .75C – $100
Make sale
No sale
Make sale
No sale
(probability = .50)
Earn commission = C
(probability = .50)
Earn commission = $0
(probability = .75)
Earn commission = C
(probability = .25)
Earn commission = $0
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Shirking (cont.)
• Another potential solution is to try to get a better indicator of
effort than sales.
• Suppose that by incurring costs of $50, you could observe whether
the sale person was working hard.
• Would it be profitable to hire someone to monitor the
salesperson’s behavior?
•
•
Expected benefit of inducing hard work is the increased
probability of making a sale (twenty-five percent) times the
margin.
If the item’s margin is at least $200, then it pays to monitor the
worker.
• The company could also pay $50 more for a worker that has a
reputation for working hard, whether or not she is being
monitored.
• Remember: A reputation for working hard without monitoring is
valuable to both companies and workers.
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Shirking (cont.)
• Moral hazard injures both parties to a transaction.
• If firms anticipate moral hazard, they will be less
willing to transact; or put a lower value on the
transaction.
• Example: A consulting firm is paid on an hourly
rate.
• Given the rate structure, and the inability of the
client to monitor what the consultant is doing, the
client expects the consultant to shirk by billing more
hours than the client would prefer, or by working on
projects that are valuable to the consultant but not
the client.
• Are there solutions to this problem?
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Moral Hazard in Lending
• Banks face a moral hazard in loans: borrowers who are least
likely to repay loans are the most likely to apply for them.
• Example: a $30 investment opportunity arises. The
investment has a 50% chance of a $100 payoff and a 50%
chance of a $0 payoff
• The bank offers a $30 loan at 100% interest based on the
expected value of the investment.
• If the investment pays off, then the bank gets $60, if the
investment fails the bank gets $0.
Bank’s expected
payoff is $30 =
(.5)($60) + (.5)($0)
Borrower’s expected
payoff is $20 =
(.5)($40) +
(.5)($0)
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Moral hazard in lending (cont.)
However, after the loan is made, the borrower
“discovers” a different investment.
• This second investment pays off $1000 but only has a 5%
probability of succeeding.
• Here the borrower receives more if the investment pays
off, so the bank receives a smaller payoff, $ 3 = (.05)($60)
+ (.95)($0)
• The lender prefers the
less risky investment
because she receives
a higher expected
payoff. But, the
borrower prefers the
riskier investment.
•
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Moral hazard in lending (cont.)
• Moral hazard is a problem for both the lender
and the borrower in this situation.
• If the bank anticipates moral hazard they will be less willing to
lend, or demand a higher interest rate.
• This incentive conflict is only made worse when the borrower
can put other people’s money at risk.
• Borrowers take bigger risks with other people’s money than they
would with their own.
• To control this, lenders must find ways to better align the
incentives of borrowers with the goals of lenders.
• Banks sometimes do this by requiring borrowers to put some of
their own money at risk.
• This is why banks are much more willing to lend to borrowers who
put a great deal of their own money at risk, but it also leads to
the complaint that banks lend money only to those who don’t
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Moral hazard in financial crisis
• Regulators try to reduce the costs of moral hazard by
requiring banks to keep about 10% of their equity in case
depositors want their money back.
• But when the value of assets fall by more than 10%, (as they
did in 2008) banks become insolvent and the risk of moral
hazard increases.
• In late 2008, the US treasury guaranteed short-term loans to
help banks make riskier loans – if loans payoff, the bank
profits; but if they fail, taxpayers cover the loss.
• A better solution may have been to simply give the banks more
equity. The govt. would own equity and thus share in the
upside gain, i.e., should the loans payoff.
• Companies that are “too big to fail,” such as AIG, take
bigger risks because they know the government will bail
them out.
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Moral hazard in 2008 (cont.)
• Bailing out homeowners also causes moral hazard.
Foreclosure bailouts helps irresponsible homeowners
who made risky investments that they couldn’t
afford; responsible borrowers wouldn’t need the
bailout assistance.
• The bailouts end up hurting responsible borrowers.
• Those who were less cautious are now getting to keep
their risky investment while taxpayers (including those
cautious borrowers) pay for the bailouts.
• AND, the new rules favoring borrowers increase the cost
of making loans. So responsible borrowers who had no
part in the real estate collapse pay the higher loan
rates caused by new regulations; AND pay for the
bailout.
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Extra anecdote: Driver Tracking
• Regional phone company using GPS to track
driver location
• Designed to deploy repairmen more efficiently.
• Used to investigate slow response time
• Led to surprising conclusions on source of problem
(drivers having extra marital affairs)
• Example of moral hazard
• Similar to adverse selection (but post-contractual
or “hidden action”)
• Caused by same information asymmetry
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.