moral hazards - mishaal kirpalani

Moral Hazards

By Mishaal Kirpalani

Asymmetric information

This is when one party does not have as much information about the product as the other. This leads to a kind of market failure.

Examples

·      Buyer has more information than the seller

In health insurance, the buyer knows how bad or good his health actually is while the insurance company knows only a limited mount of information from the buyer’s medical reports

·      The seller has more information that the buyer

In real estate businesses the seller has a lot more information about the property he is selling but he would like to sell it for a high value and therefor will withhold valuable information from the buyers. Information like neighbourhood criminal activities or the structural integrity of the building.

Moral hazards

Moral hazards occur because of asymmetric information. This is when a buyer or seller changes their behaviour after the purchase of the product. This is also he principal agent problem

Examples

·      When the buyer changes behaviour

Taking the previous example of insurance, we can see that the buyer knows his own bad or good habits. After successfully purchasing insurance, the buyer will or can change his/her behaviour because he knows that he is insured

·      When the seller changes behaviour

When a person buys a second hand car and the deal is made and the delivery date is set, the seller would drive his/her car recklessly as it is not their property anymore and they do not have to pay for damages

Solutions

·      Private insurance companies charge higher insurance rates just in case their buyers behaviour changes. The also have ‘out of pocket payments’ where the buyer must pay some money as well when claiming his/her insurance. This ‘out of pocket payment’ acts as an incentive for people to not be reckless.

·      Information through government or other sources also helps as the buyer is more aware of what he/she is buying

·      Incentive also works as a solution. An office worker who is hired can change his work habits after being hired and his employer cannot know what he is doing at all times. However, if he is paid well, he will work his best not to lose his job.

Citations

http://www.econport.org/content/handbook/Imperfect-Information/asymmetric.html

http://www.econport.org/content/handbook/Unemployment/Comparing/MoralHazard.html