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
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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The video and the related questions indicate that moral hazard is a problem due to a) underinformed party being ripped off, b) underinformed party avoiding the exchange altogether out of the fear of a). I guess, strictly speaking, one should only consider b) an economic problem, while a) is a mere transfer. In other words, b) is truly inefficient, but a) is just unfair.
There is of course every reason to care about both as social scientists, but only b) is a genuine market failure. Just like we make that distinction elsewhere (e.g. in economics of crime; we do not say crime is a market failure), I wonder if it was not useful to make it in the context of asymmetric information as well.
This video about the moral hazard problem is more about the principle agent problem. Moral hazard problem is: Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other. An example would be a homeowner without insurance showing extra care and attentiveness because he has to pay for damages to the home. The homeowner installs high-tech burglar alarms and fire alarms. After the homeowner purchases insurance they no longer are as attentive and remove burglar alarms because the insurance company pays for the damages.