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 FroebThomson 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 investmentbecause 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

20

1. Introduction: What this book is about2. The one lesson of business3.Benefits, costs and decisions4. Extent (how much) decisions5. Investment decisions: Look ahead and reason back6. Simple pricing7.Economies of scale and scope8. Understanding markets and industry changes9. Relationships between industries: The forces moving us towards long-run equilibrium10. Strategy, the quest to slow profit erosion11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing13. Direct price discrimination14. Indirect price discrimination15. Strategic games16. Bargaining 17. Making decisions with uncertainty 18. Auctions19.The problem of adverse selection20.The problem of moral hazard21. Getting employees to work in the best interests of the firm22. Getting divisions to work in the best interests of the firm23. Managing vertical relationships24. You be the consultantEPILOG: Can those who teach, do?

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