Moral Hazard

 a core concept in Economic Analysis and Atlas102

Concept description

The Economist (reference below) defines moral hazard as meaning that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.

Tyler Cowen (reference below, video on right) explains how asymmetric information could lead to moral hazard and the general challenges of the principal-agent problem.

Cowen describes the contents as:

“Imagine you take your car in to the shop for routine service and the mechanic says you need a number of repairs. Do you really need them? The mechanic certainly knows more about car repair than you do, but it’s hard to tell whether he’s correct or even telling the truth. You certainly don’t want to pay for repairs you don’t need. Sometimes, when one party has an information advantage, they may have an incentive to exploit the other party. This type of exploitation is called moral hazard, and can happen in many situations – a taxi driver who takes the “long route” to get a higher fare from a tourist, for example. In this video, we cover moral hazard and what is known as the principal-agent problem.”

In a second video (reference below, video on right), Cowen looks at solutions to moral hazard. He outlines it as follows:

“What are some solutions to moral hazard? We could try to make information less asymmetric –  meaning both parties have similar information, making it harder for one party to exploit the other. We could also try to reduce the incentive of the agent to exploit their information advantage. Online ratings and reviews on Yelp, Angie’s List, or Amazon, for instance, incorporate both of these solutions. The reviews give you more information about a product or service and close the information gap between buyers and sellers. In addition, sellers’ incentives change, as they now have to think about their reputation. They likely won’t want to exploit you if they know it will result in a negative online review. What are some other approaches to modifying the incentives of those with an information advantage?

• One approach is to split the diagnosis of a problem from the actual work that needs to be done – for instance, home inspectors don’t fix the problems they identify during their inspection.
• Another approach is to alter the payment structure to change incentives. For instance, a lawyer is less likely to run up their hours when payment is contingent on winning your case as opposed to the number of hours they work on the case.
• Ethics also plays a role. Doctors swear to the Hippocratic Oath, which provides them an incentive to not exploit their information advantage.

As you can see, there are many solutions to addressing moral hazard.”

Assessment questions

From http://www.mruniversity.com/node/318711, and http://www.mruniversity.com/node/318712, accessed 10 May 2016.

1. Identify which of the following situations are caused by moral hazard: Fred lives in an apartment above a restaurant, and his apartment always smells like burgers and fries. He has tried unsuccessfully to get the restaurant owner to remedy the problem.
   1. Caused by moral hazard
   2. Not caused by moral hazard
2. Maria is halfway to work before she realizes that she forgot to lock the back door. Because she has renter’s insurance, she decides it is not worth being late just to go home to lock the door.
   1. Caused by moral hazard 
   2. Not caused by moral hazard
3. Your friend, Paris, has super-rich parents who gave her an Audi for her 16th birthday party and have lavished her with luxury items throughout her entire life. She tells you that she has never felt the need to get good grades in school or succeed at a job because her parents provide her with everything.
   1. Caused by moral hazard
   2. Not caused by moral hazard
4. In the car repair market, moral hazard is a problem because
   1. The car owner might pay money for a repair or service that was not needed.
   2. The car owner might opt not to get a repair that was actually needed for fear of being ripped off. 
   3. The car owner has more information about the car’s status than the car mechanic.
   4. A & B only. 
   5. B & C only. 
   6. A, B, & C.
5. Identify whether the following scenario is meant to reduce moral hazard effects: Your car insurance has a high deductible (the amount that you have to pay out-of-pocket before insurance kicks in)
   1. Reduces moral hazard effects.
   2. Does not reduce moral hazard effects.
6. True or false: The under-provision of trustworthy third parties, such as Consumer Reports, reviewing products and services is an example of moral hazard.
   1. True
   2. False
7. You’d like to buy a new computer and so you are researching the best one to buy. Amazon reviewers rate a particular computer highly but Consumer Reports does not. Which product review site are you more prone to trust?
   1. Amazon
   2. Consumer Reports

Atlas topic, subject, and course

Asymmetric Information, Signaling, and Game Theory (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

The Economist, Moral hazard, Economics A-Z, at http://www.economist.com/economics-a-to-z/m#node-21529763, accessed 10 May 2016.

Tyler Cowen, Moral Hazard (4-minute video), Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/moral-hazard-adverse-selection, accessed 10 May 2016.

Tyler Cowen, Solutions to Moral Hazard (6-minute video), Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/solutions-moral-hazard-example, accessed 10 May 2016.

Page created by: Ian Clark, last modified 10 May 2016.

Image: Tyler Cowen, Minute 0.19 of Moral Hazard (4-minute video), Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/moral-hazard-adverse-selection, accessed 10 May 2016.