Moral Hazards - Week 5 Flashcards
When do problems arise in Moral Hazard?
Problems arise when:
1. There is a conflict of interest in a relationship (e.g., in contracting)
- Personal utility of decision marker (agent) conflicts with the objectives of the principal (contractor)
- Example: when managers (agents) make decisions that affect the wealth of shareholders (principals)
- The principal (employer) cannot monitor agent’s effort but can observe output
- The state of the world is not observable to the principal - there is no 1-to-1 relationship between effort and output because the state of the world varies randomly - exogenous risk that impacts on output
What is a moral hazard?
A moral hazard is when a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event
A scenario in which moral hazard occurs (mechanic)
A car mechanic is hired by the hour to fix a car, the owner of the car is concerned that the mechanic will take a lot of long tea breaks but claim that the problem was complicated
Consequences of Moral Hazard
- An informed person takes advantage of a less informed person through an unobserved action
- E.g., employees may put less effort into work - if they are not monitored by an employer
- Or insured individuals may engage in more risky behaviour such as reckless driving - Moral hazard also alters market efficiency to allocate resources
The Principal-Agent problem
The Principal-Agent Problem arises when one person (the Principal) hires another (the Agent) to perform a task, but there’s an information imbalance between them.
Key Terms:
Agent:
The person hired to achieve the Principal’s goal (e.g., an employee).
Has more information and is considered the informed party.
Principal:
The person who hires the Agent (e.g., an employer).
Has less information and is at an informational disadvantage.
Core Issue:
The Principal cannot fully monitor or verify the Agent’s actions, leading to potential problems like moral hazard
What are the goals of the principal in the Principal-Agent problem?
The principal is usually the employer/shareholder/owner
They’re goals are to:
Maximise the value of the firm/to maximise their wealth, to reduce their costs
What are the goals of the agent in the Principal-Agent problem?
The agent is the mechanic/manager/worker
They’re goals are to:
- Minimise effort
- Maximise job security
- Avoid failure
- Enhance reputation
- Maximise pay/earnings
Reducing moral hazard: fixed free contract
Employer Sets Profits as Priority:
Employers design the fixed wage to maximize their profits:
Profits=Revenue−Costs
Revenue depends on the worker’s effort and external factors (“state of the world”).
Employers incentivize workers indirectly by setting a competitive fixed wage.
Worker Balances Effort with Utility:
TotalUtility = U(wage) - U(effort)
The fixed wage motivates workers to balance their effort with the benefits they gain from the wage.
If they don’t work hard enough, the employer might replace them, so workers still put in effort to maintain their job security.
How do contingent contracts reduce moral hazard?
Definition:
Contingent contracts tie payoffs (rewards or payments) to certain conditions, such as:
Actions taken by the agent (e.g., worker effort).
State of nature (e.g., external factors like weather).
Firm’s profit, output, or revenue.
Types of Contingent Contracts:
State-Contingent Contracts:
Pay depends on external factors (e.g., weather in farming).
Encourages fairness when outcomes are beyond the agent’s control.
Profit-Sharing Contracts:
Pay is a fraction of the total profit (e.g., bonuses tied to company earnings).
Aligns the agent’s goals with the firm’s success.
How it works:
Agents are incentivized to perform better because their payoff depends on measurable outcomes.
Aligns the interests of both parties, reducing the risk of agents shirking responsibility.
Monitoring to reduce moral hazard
Eliminates asymmetric information problem:
- Both the employee and the employer know how hard the employee works
Performance bond - an amount of money that is forfeit to the principal if the gent fails to complete certain duties or achieve certain goals.
Used in rental market
e.g., landlords require tenants to post security deposits to ensure that they will not damage an apartment
What are efficiency wages and how are they a solution for moral hazard?
Efficiency wage: wage that a firm will pay to an employee as an incentive not to shirk (slack off)
E.g., Ford motor company in 1914
- Increased wages led to improved efficiency
- Attracted better workers - led to increased productivity and profits
What are the consequences of supplier moral hazard in health care?
Supplier-Induced Demand (SID):
Doctors may recommend treatments, procedures, or tests that go beyond what is medically necessary. This is called supplier-induced demand (SID).
Example: Recommending unnecessary diagnostic tests or follow-ups.
b. Increased Costs:
The use of more services (often expensive ones) increases overall healthcare costs.
For example, doctors may prescribe costly medications or suggest high-tech medical procedures, even when cheaper options would suffice.
c. Inefficiency in the System:
Healthcare resources are used inefficiently because the demand is higher than what is socially optimal (what is truly needed for good health outcomes).
How does consumer moral hazard arise in health care markets?
Consumer moral hazard arises because insurance reduces the cost of consuming health care at the point of consumption. As the cost of consumption falls, the cost of being ill is reduced. Therefore the risk of being ill is reduced so individuals are more likely to take risks with their health through health related (bad) behaviour such as smoking, participating in dangerous activities and exercising less. Increased use of health services raises overall healthcare costs in the form of higher premiums or taxes. This is socially inefficient because resources are spent unnecessarily.
Provide 3 examples of insurance based arrangements that can resolve consumer moral hazard health insurance markets and how they do this.
The insured person needs to pay some of the fraction of the cost of the service/procedure, so called ‘out-of-pocket’ expenditures. Examples are: co-payments, coinsurance and deductibles.
- Co-payments: This is a flat fee that the insured person pays for a service or prescription.
For example: paying £10 for each prescription even if the prescription costs £50 or £100) - Coinsurance: The insured person pays a percentage of the total cost of the healthcare service
- Deductibles: A fixed amount of money that the insured person must pay ‘out-of-pocket’ before the insurance begins to cover costs.
For example: If your deductible is £500 and your medical bill is £1000, you pay the first £500 and the insurance pays the rest.
How does supplier moral hazard arise in health care provision and what are the likely consequences?
Provider moral hazard derives from the infrastructure of modern health care, where a third party pays for the health care provided by the doctor. The payer may have different priorities to either the doctor or patient and systems will reflect the payer’s utility/objective function.
Doctor’s know more about healthcare than patients (e.g., which treatments are necessary). This allows doctors to recommend treatments or procedures without the patient fully understanding whether or not they are needed. The patient is less concerned about getting additional treatment as they no longer need to pay for it. Also doctors may be paid of a fee-for-service basis, meaning they earn more money by providing more treatments or tests. Hence, doctors may recommend treatments that go beyond what is medically necessary. This increases the overall cost of the healthcare.
