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Chapter 17 The Problem of Moral Hazard COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South- Western are trademarks used herein under license.

Chapter 17 – Take Aways 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 even 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.

Chapter 17 – Take Aways 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. Borrowers prefer riskier investments because they get more of the upside while the lender bears more of the downside. Borrowers who have nothing to lose exacerbate this moral hazard problem.

Review of Chapter 16 Risk aversion creates demand for insurance  Insurance moves risk to a higher-valued use Adverse selection is pre-contractual or “hidden information” problem caused by asymmetric information  Problem is that only “poor” risks get to buy insurance Lessons of adverse selection  It occurs; anticipate it  Sometimes you can consummate the unconsummated wealth creating transaction by screening or signaling Screening or signaling is effort to solve problem by revealing information to less informed party

Anecdote: Driver Tracking Regional phone company using GPS to track driver location  Designed to realize higher efficiencies  Used to investigate slow response time problems  Led to surprising conclusions on source of problem Example of moral hazard  Similar to adverse selection (but post-contractual or “hidden action”)  Caused by same information asymmetry

Moral Hazard in Insurance Action lowers the probability of theft to  Benefit = ( )$100=$10 > costs of exercising care, $5.  BUT, moral hazard means that once customers purchase insurance, they exercise less care because there is less incentive to do so Discussion: What is the unconsummated wealth-creating transaction?

Moral Hazard in Insurance (cont.) In our example  The consumer stops bringing the bicycle inside  The probability of theft increases from thirty to forty percent  The insurance company loses $5, on average, for every policy it sells. Moral hazard disappears if the asymmetry of info disappears

Moral Hazard Lessons First Lesson: anticipate moral hazard  In bicycle example, realize you need to price insurance at $45 Second Lesson: you may be able to consummate the unconsummated wealth creating transaction by gathering info to remove the information asymmetry

Moral Hazard vs. Adverse Selection Distinguishing between the two explanations  Hidden information (adverse selection) vs. hidden action (moral hazard)  Problem arises before a transaction (adverse selection) or after (moral hazard) Discussion: Persons with air bags are more likely to get into traffic accidents. Discussion: Volvo drivers more likely to run stop signs. Discussion: All-you-can-eat restaurant, more food is consumed

Shirking as Moral Hazard

Shirking (cont.) What commission is required to induce hard work?  Benefit of work > cost of work  0.25(Commission) > $100  Commission > $400  Unless margin on the item is at least $400, you can’t afford to pay $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’s no solution, there’s no problem!

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 was monitored.  Reputation for working hard without monitoring is valuable to the company as well as the worker.

Shirking (cont.) Moral hazard injures both parties to a transaction Discussion: Consulting firms and moral hazard Solutions?

Moral Hazard in Lending Discussion: Bank loans?  Moral Hazard Less-Risky InvestmentMore Risky Investment

Alternate Intro Anecdote Once you have auto insurance, you are likely to drive more miles and even do so in a more reckless manner Insurance companies try to anticipate this type of behavior and price policies accordingly; however, their estimates are imprecise. The Progressive Direct Group of Insurance Companies has come up with a unique solution. With TripSense, drivers agree to use a device that records mileage totals, speeds driven, and the times when the vehicle is driven. Progressive uses this information about driving habits to calculate the renewal discount the customer can receive Participants save an average of 12 to 15 percent on their premiums.