Chapter 20: Moral Hazard

How to calculate the optimal bonus to prevent a moral hazard:

Bonus x change in % normal and extra efforts = cost of extra effort

What is moral hazard a problem of?

Hidden action

What is adverse selection a problem of?

Hidden information

Moral Hazard

When the act of insuring an event increases the likelihood that the event will happen (i.e. Banks bail out by the government)

What are some examples of moral hazards?

1) Not installing a smoke alarm because you have fire insurance 2) Being rough on the clutch in a rental car when you would be careful in your own 3) Being careless as a doctor because you have malpractice insurance

Moral hazard in lending

We can also characterize moral hazard as an incentive conflict between a lender and a borrower. The lender prefers the less risky investment because she receives a higher expected payoff. The borrower prefers the more risky investment for the same reason. This is because borrowers take bigger risks with other people's money than they would with their own.

Shrinking

a type of moral hazard caused by the difficulty or cost of monitoring employees' behavior after a firm has hired them. Without good information, ensuring high levels of effort becomes more difficult.