Module 11.2 Moral Hazard Lecture

Adverse Selection and Moral Hazard

• Adverse Selection: A situation where one party in a transaction has more information than the other, often leading to suboptimal market outcomes.

  • Example: In insurance markets, individuals at higher risk are more likely to seek insurance, leading to higher overall risk for the insurer.

Understanding Moral Hazard

• Definition: A situation where one party engages in riskier behavior after a transaction because they do not bear the full consequences of that behavior.

• This leads to an increase in risk-taking due to the reduced marginal cost of those actions.

• Moral hazard typically occurs after the transaction has been completed.

Example in Insurance Markets

• National Flood Insurance Program:

  • The government provides insurance in areas where private companies refuse to insure at reasonable rates.

  • Homeowners may become less cautious about building in flood-prone areas because they are insulated from the full costs of potential damages.

  • This creates a subsidy for risky behavior.

• Personal Example:

  • The speaker recalls a time mountain biking with a friend who had temporary health insurance.

  • With coverage, the friend felt emboldened to engage in risky behavior, knowing that the financial consequences of an injury would be mitigated.

  • This reflects how insurance induces people to change their behavior, increasing overall risk.

Moral Hazard Beyond Insurance

• Moral Hazard in Labor Markets:

  • Principal-Agent Problem: Occurs when a principal (e.g., someone hiring a tutor) hires an agent (the tutor) whose actions are not fully observable.

  • Asymmetric Information: The principal cannot see how hard the agent works or their level of expertise, leading to potential underperformance by the agent.

  • Example: A student hiring a tutor does not know if the tutor is truly effective, risking poor outcomes due to the tutor's lack of motivation to work hard without oversight.

Aligning Incentives

• To counteract moral hazard:

  • Contracts can be structured with incentives that align both parties’ interests.

  • Performance-Based Contracts: Bonuses for tutors based on student performance can incentivize them to work harder and provide better quality tutoring.

  • Such strategies aim to ensure tutors (agents) are motivated to perform to the best of their abilities to achieve mutual success.

Applications of Personnel Economics

• The field of Personnel Economics studies how to best align incentives between employees (agents) and employers (principals) to reduce moral hazard.

  • Strategies may include:

  • Above Market Wages: Providing higher pay to attract more dedicated workers.

  • Firing for Underperformance: Establishing stringent consequences for poor performance to deter shirking.

• Implications: Broad applications of moral hazard can be seen in various everyday interactions, influencing both economic theory and practical workforce management strategies.