Moral Hazard

Imagine you take your car in to the shop for routine service and the mechanic says you need a number of repairs. Do you really need them? The mechanic certainly knows more about car repair than you do, but it’s hard to tell whether he’s correct or even telling the truth. You certainly don’t want to pay for repairs you don’t need. Sometimes, when one party has an information advantage, they may have an incentive to exploit the other party. This type of exploitation is called moral hazard, and can happen in many situations — a taxi driver who takes the “long route” to get a higher fare from a tourist, for example. In this video, we cover moral hazard and what is known as the principal-agent problem.

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- [Tyler] Previously, we discussed
asymmetric information

and how that can cause
adverse selection in markets.

In this video, we'll tackle
how asymmetric information

can lead to moral hazard.

Let's start with an example.

Imagine you're buying
a bottle of water.

You probably have
a pretty good idea

of what you're getting, H2O,
especially if you've bought

the same brand of water before.

The information that the seller
and the buyer have

is pretty close to equal.

But things get more complicated
if you're dealing

with something
like repairing your car.

The mechanics says you need
a Johnson rod.

Do you? Do you even know
what a Johnson rod is?

The mechanic knows a lot more
about car repair than you do,

and that makes it hard to know
whether the mechanic is correct

or even telling the truth.

You might end up paying
a lot of money for car repairs

you don't really need.

This is another example
of asymmetric information

where one party to an exchange
has more or better information

than the other party has.

As we'll see, asymmetric
information can challenge markets

and sometimes cause them to fail.

When one party to an exchange
has an information advantage,

they may have an incentive
to use that advantage

to exploit the other party,
and that temptation to exploit

is called moral hazard.

The car repair problem
is just one example

of asymmetric information
and moral hazard.

A taxi driver has more information
about the roads

than does a tourist.

He may take a longer route
in order to get a higher fare.

A restaurant owner knows more
about the safety of his restaurant

than does his insurance company.

He might choose
to skimp on sprinklers

if he's got fire insurance.

An employee knows
what he's been working on all day

whereas the manager
maybe does not.

The employee might choose
to goof off rather than do his job.

These examples highlight a concept
called the principal-agent problem.

Often when you hire someone,
that person has more information

than you do.

Indeed, that's often why
you pay to hire them.

In the case of your car,
you are the principal

and the mechanic is your agent.

Your incentive
is to get your car fixed

and not waste too much money.

His incentive might be
to get as much money

out of you as possible.

Given that he has information
about cars that you don't,

he can lie to charge more.

In this case there
are conflicting incentives,

and you don't have
the information to know

a good deal from a bad deal.

Ideally, you would like
to align the incentives

of the mechanic with yours,
so you don't get swindled.

That is at least, in principle,
how you can solve

a principal-agent problem.

No one likes to be ripped off,
but the problem of moral hazard

runs deeper than just the rip-off.

The bigger problem
is that the potential for a rip-off

means that a transaction
maybe less likely to occur

in the first place.

If you know the mechanic
may recommend more service

than is necessary,
you might, for instance,

pass on some recommended
precautionary repairs

and just wait
until your car breaks down.

Of course, that can be inefficient.

You’d prefer to perform
that preventive maintenance

and not break down unexpectedly.

But because
of asymmetric information,

you can't trust your agent,
the mechanic,

and so you pass on those repairs
for fear of being ripped-off.

So we can see that asymmetric
information can impede trade

and limit the great benefits
of specialization through markets.

So what can we do?

Well, take a moment
to think about this,

and perhaps you can anticipate
some of the solutions

we'll discuss in the next video.

- [Narrator] If you want
to test yourself,

click “Practice Questions.”

Or, if you're ready to move on,
just click “Next Video.”

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