Ch.20: Problem of Moral Hazard

Moral Hazard vs. Adverse Selection

- Adverse selection arises from hidden information - Moral hazard arises from hidden actions

"Lessons 1 & 2" on Moral Hazard

- anticipate moral hazard and protect yourself against it - the problem of moral hazard represents and unconsummated wealth-creating transaction

"Lesson 3" of Moral Hazard

- both parties benefit if they can figure out how to address the moral hazard problem - the business person, say a consultant, can try to develop a reputation for not shirking

Solutions to Moral Hazard

- insurance companies can reward their clients for exercising appropriate behavior to encourage increased safety

Shirking

- type of moral hazard caused by the difficulty or cost of monitoring employees' behavior after a firm has hired them

Banking/Lending & Moral Hazard

-banks guard against moral hazard by monitoring behavior and by placing covenants on loans to ensure that the loans are used for their intended purpose ~ "Borrowers take bigger risks with other people's money than they would with their own." ~ Banks are much more willing to lend to borrowers who have a great deal of heir own money at risk

Moral Hazard

-caused by hidden actions that the insurance company is not able to observe -such actions are the result of the consumer feeling more protected by their insurance policy, and thus are more likely to engage in riskier behavior than they would without their insurance policy -"Moral hazard means that insured customers exercise less care because they have less incentive to do so."