PowerPoint Slides © Michael R. Ward, UTA 2014

Moral Hazard• Once you have insurance, the cost of an accident is

reduced, which also reduces the cost of the risky behavior, which results in riskier behavior

• The problem of moral hazard 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• Adverse selection results from hidden information

• The cost of managing both problems can be reduced by reducing uncertainty (gathering more information)

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TripSense• In 2004, the Progressive Direct Group of Insurance

Companies introduced TripSense – a service with a free device to record mileage, speeds and driving times

• Progressive 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 both adverse selection and moral hazard problems

• The decision of how frequently, how far, or how fast to drive is affects 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.”

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Bicycle Insurance• To illustrate moral hazard, lets return to the bicycle

insurance example from adverse selection• Suppose that bike owners have 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

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Bicycle Insurance• Would insured owners take the same care?• Once customers purchase insurance, they exercise less

care because someone else “owns” the loss• Is this really the case? • Drivers respond to this reduced cost by “choosing” to have

more accidents• This is called moral hazard

• The term was coined by the insurance companies long before economists started studying it

• To insurance companies, consumers were at hazard of acting “immorally”

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Bicycle Insurance• The cost of bike theft is reduced when an insurance policy

is purchased • So, 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 30% to 40%• 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

• Anticipate moral hazard and protect yourself against it

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How do you treat a rental?• Seinfeld: Car Rental• Days of Thunder: Racing with rented cars.

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Health Care• Example New heart medicines are wonder drugs

• 1980: 50% of all deaths from heart disease• 2010: 25% of all deaths from heart disease• So, … benefit of diet and exercise is smaller• Result, people “choose” to be obese

• Example The health benefits of exercising are no longer high enough• Many “choose” to under-invest in exercise• A solution – A company sponsored “Wellness” program

• When costs change, anticipate behavioral changes

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Profit Opportunity• 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

• Or it could purchase the lock for the bike owner

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Which is Which?• To distinguish between moral hazard and adverse

selection, ask:• Are there hidden characteristics (adverse selection) or are there

hidden actions (moral hazard) ?• Is the problem is pre-contractual (adverse selection) or post-

contractual (moral hazard)?

• Often both are present and attempts to solve one also solves the other

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Which is Which?• What are the moral hazard and adverse selection

explanations for each the following?• Drivers with air bags are more likely to get into traffic

accidents• Are we safer on net?

• Volvo drivers are more likely to run stop signs• My first car was a death trap and I drove accordingly

• At all-you-can-eat restaurants, customers eat more food• Locate far from college students

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Shirking on the Job• Because it’s difficult to monitor an employee’s actions

after they are hired, employers anticipate shirking• 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) × (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

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Shirking on the Job• 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 monitor the salesperson’s behavior?

• Expected benefit of inducing hard work is the increased probability of making a sale 25% times the margin• If the item’s margin is at least $200, then it pays to monitor the

worker

• There is a tradeoff between incentive pay and monitoring

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Shirking on the Job• The company could also pay $50 more for a worker that

has a reputation for working hard, whether or not she is being monitored

• Solution to a moral hazard problem may be to address it as an adverse selection problem

• A reputation for working hard without monitoring is valuable to both companies and workers

• Does moral hazard injure only employers and not employees?

• If firms anticipate moral hazard, they will be less willing to hire; or lower the compensation – both are harmed

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Consultants• 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

• What solutions are there to this problem?• Quite often, none

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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

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Lending• Bank’s expected payoff is $30 = 0.5×$60 + 0.5×$0 • Borrower’s expected payoff is $20 = 0.5×$40 + 0.5×$0

• 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

• Same $50 expected return overall

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Lending• Here the borrower receives more if the investment pays

off, $47 = 0.05×$940 + 0.95×$0• So the bank receives a smaller payoff, $3 = 0.05×$60 +

0.95×$0• The lender prefers the less risky investment because she

receives a higher expected payoff• But, the borrower prefers the riskier investment

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Lending• 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 exists 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

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Lending• 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• It also leads to the complaint that banks lend money only

to those who don’t need it

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The 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

• When the value of assets fall by more than 10% 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

• Companies that are “too big to fail,” such as AIG, take bigger risks because they know the government will bail them out

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The Financial Crisis• Bailing out homeowners also causes moral hazard• Foreclosure bailouts helps irresponsible homeowners who

made risky investments• Responsible borrowers wouldn’t need the bailout

assistance • The bailouts end up hurting responsible borrowers two

ways:• Those who were less cautious are now getting to keep their risky

investment while taxpayers (responsible borrowers) pay for the bailouts

• Also the new rules favoring borrowers tend to increase the cost of making loans … to responsible borrowers

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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• Truck parked in front of the same suburban house every

Thursday afternoon for an hour• Driver was having extra-marital affair• A number of drivers were fired• … and divorced

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Extended Warranties• Your product fails about 2% of the time • Some customers purchase the extended warranty you

offer in which you will replace the product if it fails • Would the warranty price be 2% of the product price?• Your product fails about 2% of the time on average, but is

lower for careful users. You could face both adverse selection and moral hazard issues:• Careless users are more likely to purchase• Insured users will exercise less care

• In either case, the claim rate will exceed 2% and you will lose money

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More Business Examples• Example Taxi pricing

• Rate per mile versus fee plus rate per mile

• Example Timber contract from earlier chapter• Fee for all trees or per tree

• Example Garment Industry• Hourly versus piece rate

• Example Royalty rate for books, TV shows, movies• Percent of revenue or profits?

• Example Social Worker at adoption agency• Salary versus bonus for placement

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Some Policy Examples• Example Anti-lock brakes• Example Seatbelts• Example Improved football helmets• Example Hernia belts• Example Hiker’s locator beacons• Example Improved parachute ripcords• Example Doctor’s prescriptions

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From the Blog• Chapter 20• Medicare reimbursement• Oregon health insurance experiment• Reverse deductible• DC Teacher Incentives• Stock brokers• Physician Induced Demand• Fly Straight

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Main Points• One aspect of asymmetric information is moral hazard in

which people’s behaviors change when their actions are not observable

• This means assets are stuck in low value uses which means … a potential profit opportunity

• Moral hazard problems emerge in the financial sector because it is easy to misuse other people’s money

• Employee shirking is an example of moral hazard• One solution to moral hazard is to collect more

information and monitor behavior better• Another solution is to design the contract to better align

the incentives of the better informed party

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