Solutions to Moral Hazard

What are some solutions to moral hazard? We could try to make information less asymmetric — meaning both parties have similar information, making it harder for one party to exploit the other. We could also try to reduce the incentive of the agent to exploit their information advantage. Online ratings and reviews on Yelp, Angie’s List, or Amazon, for instance, incorporate both of these solutions. The reviews give you more information about a product or service and close the information gap between buyers and sellers. In addition, sellers’ incentives change, as they now have to think about their reputation. They likely won’t want to exploit you if they know it will result in a negative online review.

What are some other approaches to modifying the incentives of those with an information advantage? One approach is to split the diagnosis of a problem from the actual work that needs to be done — for instance, home inspectors don’t fix the problems they identify during their inspection. Another approach is to alter the payment structure to change incentives. For instance, a lawyer is less likely to run up their hours when payment is contingent on winning your case as opposed to the number of hours they work on the case. Ethics also plays a role. Doctors swear to the Hippocratic Oath, which provides them an incentive to not exploit their information advantage. As you can see, there are many solutions to addressing moral hazard.

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- [Tyler] In the previous video,

we discussed how
asymmetric information

can lead to moral hazard,

which can lead
to people being ripped off,

which in turn can lead
to markets breaking down.

Now, there are two types
of potential solutions

to moral hazard problems.

First, since the problem
is asymmetric information,

you can try to make
information less asymmetric.

If both parties
have similar information,

then one party cannot
so easily exploit the other.

Second, if you can't get rid
of the information asymmetry,

you can try to reduce the incentive
of the agent to exploit

his or her informational advantage.

One example
that you're already familiar with

works along both
of these dimensions:

user ratings.

You can get ratings
for businesses at sites

such as Yelp and Angie's List,

and for products
at places such as Amazon.com.

Reviews give you more information
about a product or service,

and they help balance
the information

between buyer and seller,

thereby mitigating issues
of moral hazard.

Additionally, the existence
of these review sites

changes the incentives
for the sellers.

In our previous example
of the auto mechanic

we sketched out how your incentive
to get your car repaired

might conflict
with the mechanic's incentive

to milk you for extra money.

However, the mechanic also
has to think about her reputation,

which is what leads
to future business.

Previously, you might have told,

well, just a few friends
that you got ripped off.

Now, today, you can write
an online review

and reach a much larger audience,
maybe thousands of people.

A mechanic's online reputation
is important to her success

and provides an incentive
for her not to try to exploit

her informational advantage.

While review sites are great,
the market is continually evolving,

and some sellers try to fight back

by faking or manipulating
reviews or ratings.

There's some obvious examples,

like favorably reviewing
your friend's book on Amazon

if your friend reviews yours.

But there are more
subtle examples as well.

For instance, some universities
invite lots of applicants,

knowing they will reject them,

just hoping to boost
their rating for exclusivity.

Reviews are more trustworthy
if they come from third parties

who do not have incentives
to bias the review

one way or the other.

The magazine Consumer Reports,
for example,

has a reputation
for honest reporting

because it's a non-profit
and it accepts no advertisements

and no funding
from commercial sources.

But there's another problem --

it's hard to exclude people
from produced information.

Information is also
what we call nonrival --

nonexcludable and nonrival.

Do those property sound familiar?

Yes, information
has the characteristics

of a public good.

Click to go back
and review if you need.

It's hard for Consumer Reports
to keep the information it provides

to only those people
who buy the magazine.

If you hear that Consumer Reports
says that brand X of television

is the very best,

well you might use that information

even if you didn't buy
the magazine and pay for it.

In this case, we would say
that you are free riding,

using the benefits
of their research

and testing without contributing
to paying the costs.

Free riding is a problem, however,
not because it's unfair or unjust,

but because it means
that information provision

may be under-provided
in the first place.

As a result, there are fewer
trustworthy third parties

reviewing products and services.

So, review sites help solve
moral hazard issues

by both balancing the information
between buyer and seller,

and reducing the incentives
for the more informed party

to exploit
an informational advantage.

There are other approaches

that work solely
by modifying the incentives

of those people
with the informational advantages.

Let's take two examples

that might seem
completely different,

but are actually, conceptually,
pretty similar:

house inspections,
and second opinions from doctors.

When you buy a house,
you typically get a home inspector

to check out the house
and identify potential problems.

By law in many states,

these home inspectors
cannot also sell services

to fix any problems
they've identified.

This changes their incentives.

No longer do they have the incentive

to overstate
potential problem issues

to inflate the bill.

Similarly, when you go to a doctor
for a second opinion,

that doctor is simply
diagnosing the problem,

but not doing the actual treatment.

Just like with the home inspector,

this eliminates the incentive
to run up the bill.

Both of these examples
split the diagnosis of the issue

from the actual work
to address the problem.

So while the information
is still asymmetric,

there is less of an incentive
to exploit that asymmetry.

By the time you're ready
to fix the issue,

this separate diagnosis by an expert

allows you to have
much more information.

Maybe now, almost as much
as the service provider in some ways.

This video has covered
the various solutions

to moral hazard issues

in situations
of asymmetric information.

In the next video,

we'll take up
a different kind of response

to the asymmetric
information problem,

namely signaling.

See you then.

- [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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