Game TheoryMoral Hazard Sandeep Gunjan Ashok Bhardwaj Khyati Bhola
What is moral “Hazard”?In economic theory, moral hazard refers to a situation in which aparty makes a decision about how much risk to take, while anotherparty bears the costs if things go badly, and the party insulated fromrisk behaves differently from how it would if it were fully exposed tothe risk.It is the form of • Post contractual opportunism • That arises because actions that have efficiency consequences are not freely observable (monitoring problem) • So the person taking them may choose to pursue his or her private interests at others’ expense
Moral Hazard Term HistoryAccording to research by Dembe and Boden, the termdates back to the 17th century, and was widely used byEnglish insurance companies by the late 19th century.Early usage of the term carried negative connotations,implying fraud or immoral behaviour (usually on the partof an insured party).
Moral Hazard Game Player 1 3 1 0 Player 2 0,0 Player 2 -3 3 1 -13,3 -1,1 1,1.5 3,2
Moral Hazard Example: InsuranceFor example, a person with insurance againstautomobile theft may be less cautious about lockinghis or her car, because the negative consequences ofvehicle theft are (partially) the responsibility of theinsurance company. Below are some more examplesof Moral Hazard:-• Fire Insurance• Term Life Insurance (?)• Health Insurance
Moral Hazard Example: FinanceMoral hazard also occur with borrowers. Borrowers may notact prudently (in the view of the lender) when they invest orspend funds recklessly.For example, credit card companies often limit the amountborrowers can spend with their cards, because without suchlimits borrowers may spend borrowed funds recklessly, leadingto default.
Moral Hazard Example: Politician• Elected people has public trust. Which can not be cannot usually be monitored much of the time.• They may pursue their personal interests rather than those of the public.
Moral Hazard Example: Management• Senior Management members may pursue their own goals of status, high salaries, expensive perks, and job security rather than the stockholders’ interests• They may push sales growth over profits.• They may treat themselves to huge staffs and corporate jets.• They may oppose takeovers that would oust them and increase the value of the firm.• Senior Management members may ignore the shareholder’s rightful claims, building executive offices that are not exactly Spartan by nature.
Illustration In the presence of uncertainty:Assign the risk to the better informed party. Efficiency and greater profits result.The more risks are transferred to the well-informed party, the more profit is earned. •9
Warning In the presence of uncertainty:Assign the risk to the better informed party. Efficiency and greater profits result. BUT If done imprecisely, may be better not to bother. •10