Each of the following situations involves moral hazard

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Each of the following situations involves moral hazard

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Each of the following situations involves moral hazard. In each case, identify the principal and the agent and explain why there is asymmetric information. How does the action described reduce the problem of moral hazard?

a. Landlords require tenants to pay security deposits.

b. Firms compensate top executives with options to buy company stock at a given price in the future.

c. Car insurance companies offer discounts to customers who install antitheft devices in their cars.

Explanation & AnswerSolution by a verified expert

A
Here is a tip:
Asymmetric information exists when one party has more information than the other.

Explanation
The agent is a person performing a task on behalf of the principal. In this case, the landlord is the principal and the tenant is the agent.

Asymmetric information refers to the difference in knowledge between different people. In the case of the landlord and the tenant, the landlord does not know whether the tenant will keep the place safe and maintained, and whether the tenant vacates the place without prior information.

The security deposit helps mitigate this lack of information and the problem of a moral hazard. This is because in case the tenant destroys the property, or leaves without prior information, the security deposit will not be forfeited. Thus, the fear of forfeiture of the security deposit will induce the tenant to take care of the property and he will not leave the property without prior information. Therefore, requiring tenants to pay a security deposit will reduce the problem of moral hazard.

Verified Answer
The landlord is the principal and the tenant is the agent.

There exists asymmetric information because the landlord cannot be sure of how the tenant will treat the property and when the tenant might leave without any information.

A security deposit will ensure that the tenant takes care of the place and does not leave without prior information. It will reduce the problem of a moral hazard.

B
Here is a tip:
Asymmetric information exists when one party has more information than the other.

Explanation
The agent is a person performing a task on behalf of the principal. In this case, the firm is the principal and the top executive is the agent.

Asymmetric information refers to the difference in knowledge between different people. The firm cannot be sure whether the top executive will perform well and whether he/she will not shirk from responsibilities. This implies there is asymmetric information and the problem of a moral hazard exists.

The firm reduces this problem by providing the option of buying stock of the firm in the future at a set price because if the executive does not perform well or if he/she shirks, the stock price will go down. This will affect the executive negatively. On the other hand, if the executive does well, he/she will earn profit because the stock price will rise and he/she will be able to buy it at a predetermined price, which is lower than the current price.

Thus, it will reduce the problem of moral hazard.

Verified Answer
The firm is the principal and the top executive is the agent.

There exists asymmetric information because the firm cannot be sure of how the top executive will work and whether he/she will shirk from responsibility.

By giving the option of buying stock of the firm in the future at a set price, the firm ensures that the executive does not shirk and that he/she performs well. This will reduce the problem of moral hazard.

C
Here is a tip:
Asymmetric information exists when one party has more information than the other.

Explanation
The customers who buy insurance are the agents and the car insurance companies are the principal.

There exists asymmetric information because the car insurance companies cannot be sure whether the customer will take care of the car after the insurance, or whether he/she will indulge in careless activities such as parking the car at unsafe spots.

By providing a discount to the customers who install anti-theft devices, the car insurance companies will provide an incentive for the customers to buy the anti-theft device to avoid careless behaviour on the part of the customers. Installation of anti-theft devices will make the cars safer from thefts and will help mitigate the problem of moral hazard.

Verified Answer
The car insurance companies are the principal and the customers are the agents.

There exists asymmetric information because the car insurance companies cannot be sure whether the customers who buy car insurance will take precautions to prevent theft of their car.

By providing a discount to the customers who install anti-theft devices, the car insurance companies will ensure that the cars will be safe from theft. This will help mitigate the problem of moral hazard.

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