Chapter 20:
The Problem of Moral Hazzard
Managerial Economics: A Problem Solving Appraoch (2nd Edition)
Luke M. Froeb, luke.froeb@owen.vanderbilt.edu
Brian T. McCann, brian.mccann@owen.vanderbilt.edu
Website, managerialecon.com
COPYRIGHT © 2008; Slides prepared by Lily Alberts for Professor Froeb
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Slides prepared by Lily Alberts for Professor Froeb
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.
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.
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.”
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).
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?
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.
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.
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.
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!
Shirking as Moral Hazard (decision tree)
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.
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?
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)
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.
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 need it.
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.
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.
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
1. Introduction: What this book is about
Managerial Economics
2. The one lesson of business
Table of contents
3.Benefits, costs and decisions
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7.Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19.The problem of adverse selection
20.The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
20