PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
Moral Hazard
• Once you have insurance, the cost of an accident is
reduced, which also reduces the cost of the risky behavior,
which results in riskier behavior
• The problem of moral hazard 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
• Adverse selection results from hidden information
• The cost of managing both problems can be reduced by
reducing uncertainty (gathering more information)
Econ 5313
TripSense
• In 2004, the Progressive Direct Group of Insurance
Companies introduced TripSense – a service with a free
device to record mileage, speeds and driving times
• Progressive 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 both adverse
selection and moral hazard problems
• The decision of how frequently, how far, or how fast to
drive is affects 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.”
Econ 5313
Bicycle Insurance
• To illustrate moral hazard, lets return to the bicycle
insurance example from adverse selection
• Suppose that bike owners have 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
Econ 5313
Bicycle Insurance
• Would insured owners take the same care?
• Once customers purchase insurance, they exercise less
care because someone else “owns” the loss
• Is this really the case?
• Drivers respond to this reduced cost by “choosing” to have
more accidents
• This is called moral hazard
• The term was coined by the insurance companies long before
economists started studying it
• To insurance companies, consumers were at hazard of acting
“immorally”
Econ 5313
Bicycle Insurance
• The cost of bike theft is reduced when an insurance policy
is purchased
• So, 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 30% to 40%
• 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
• Anticipate moral hazard and protect yourself against it
Econ 5313
How do you treat a rental?
• Seinfeld: Car Rental
• Days of Thunder: Racing with rented cars.
Econ 5313
Health Care
• Example New heart medicines are wonder drugs
•
•
•
•
1980: 50% of all deaths from heart disease
2010: 25% of all deaths from heart disease
So, … benefit of diet and exercise is smaller
Result, people “choose” to be obese
• Example The health benefits of exercising are no longer
high enough
• Many “choose” to under-invest in exercise
• A solution – A company sponsored “Wellness” program
• When costs change, anticipate behavioral changes
Econ 5313
Profit Opportunity
• 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
• Or it could purchase the lock for the bike owner
Econ 5313
Which is Which?
• To distinguish between moral hazard and adverse
selection, ask:
• Are there hidden characteristics (adverse selection) or are there
hidden actions (moral hazard) ?
• Is the problem is pre-contractual (adverse selection) or postcontractual (moral hazard)?
• Often both are present and attempts to solve one also
solves the other
Econ 5313
Which is Which?
• What are the moral hazard and adverse selection
explanations for each the following?
• Drivers with air bags are more likely to get into traffic
accidents
• Are we safer on net?
• Volvo drivers are more likely to run stop signs
• My first car was a death trap and I drove accordingly
• At all-you-can-eat restaurants, customers eat more food
• Locate far from college students
Econ 5313
Shirking on the Job
• Because it’s difficult to monitor an employee’s actions
after they are hired, employers anticipate shirking
• 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) × (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
Econ 5313
Shirking on the Job
• 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 monitor the salesperson’s behavior?
• Expected benefit of inducing hard work is the increased
probability of making a sale 25% times the margin
• If the item’s margin is at least $200, then it pays to monitor the
worker
• There is a tradeoff between incentive pay and monitoring
Econ 5313
Shirking on the Job
• The company could also pay $50 more for a worker that
has a reputation for working hard, whether or not she is
being monitored
• Solution to a moral hazard problem may be to address it
as an adverse selection problem
• A reputation for working hard without monitoring is
valuable to both companies and workers
• Does moral hazard injure only employers and not
employees?
• If firms anticipate moral hazard, they will be less willing to
hire; or lower the compensation – both are harmed
Econ 5313
Consultants
• 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
• What solutions are there to this problem?
• Quite often, none
Econ 5313
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
Econ 5313
Lending
• Bank’s expected payoff is $30 = 0.5×$60 + 0.5×$0
• Borrower’s expected payoff is $20 = 0.5×$40 + 0.5×$0
• 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
• Same $50 expected return overall
Econ 5313
Lending
• Here the borrower receives more if the investment pays
off, $47 = 0.05×$940 + 0.95×$0
• So the bank receives a smaller payoff, $3 = 0.05×$60 +
0.95×$0
• The lender prefers the less risky investment because she
receives a higher expected payoff
• But, the borrower prefers the riskier investment
Econ 5313
Lending
• 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 exists 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
Econ 5313
Lending
• 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
• It also leads to the complaint that banks lend money only
to those who don’t need it
Econ 5313
The 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
• When the value of assets fall by more than 10% 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
• Companies that are “too big to fail,” such as AIG, take
bigger risks because they know the government will bail
them out
Econ 5313
The Financial Crisis
• Bailing out homeowners also causes moral hazard
• Foreclosure bailouts helps irresponsible homeowners who
made risky investments
• Responsible borrowers wouldn’t need the bailout
assistance
• The bailouts end up hurting responsible borrowers two
ways:
• Those who were less cautious are now getting to keep their risky
investment while taxpayers (responsible borrowers) pay for the
bailouts
• Also the new rules favoring borrowers tend to increase the cost
of making loans … to responsible borrowers
Econ 5313
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
• Truck parked in front of the same suburban house every
Thursday afternoon for an hour
• Driver was having extra-marital affair
• A number of drivers were fired
•
… and divorced
Econ 5313
Extended Warranties
• Your product fails about 2% of the time
• Some customers purchase the extended warranty you
offer in which you will replace the product if it fails
• Would the warranty price be 2% of the product price?
• Your product fails about 2% of the time on average, but is
lower for careful users. You could face both adverse
selection and moral hazard issues:
• Careless users are more likely to purchase
• Insured users will exercise less care
• In either case, the claim rate will exceed 2% and you will
lose money
Econ 5313
More Business Examples
• Example Taxi pricing
• Rate per mile versus fee plus rate per mile
• Example Timber contract from earlier chapter
• Fee for all trees or per tree
• Example Garment Industry
• Hourly versus piece rate
• Example Royalty rate for books, TV shows, movies
• Percent of revenue or profits?
• Example Social Worker at adoption agency
• Salary versus bonus for placement
Econ 5313
•
•
•
•
•
•
•
Some Policy Examples
Example Anti-lock brakes
Example Seatbelts
Example Improved football helmets
Example Hernia belts
Example Hiker’s locator beacons
Example Improved parachute ripcords
Example Doctor’s prescriptions
Econ 5313
•
•
•
•
•
•
•
•
From the Blog
Chapter 20
Medicare reimbursement
Oregon health insurance experiment
Reverse deductible
DC Teacher Incentives
Stock brokers
Physician Induced Demand
Fly Straight
Econ 5313
Main Points
• One aspect of asymmetric information is moral hazard in
which people’s behaviors change when their actions are
not observable
• This means assets are stuck in low value uses which
means … a potential profit opportunity
• Moral hazard problems emerge in the financial sector
because it is easy to misuse other people’s money
• Employee shirking is an example of moral hazard
• One solution to moral hazard is to collect more
information and monitor behavior better
• Another solution is to design the contract to better align
the incentives of the better informed party