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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.
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02:39
Jesse Neumann
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Chapter 22
Frontiers of Microeconomics
How Markets Work
Topics for Further Study
Introduction
04:00
Each of the following situ…
01:05
The term "moral hazar…
we were discussing principles, agents, asymmetric information and moral hazards. And were given three examples A BNC within age. We would like to identify who is the principal. Who is the agent. Why there might be asymmetric information in the situation and how what is being described may work to prevent Or two solve this problem of moral hazard. So part a here, let's see. We're told that tenants are required to pay security deposits to landlords. So what we can see here is that the landlord is the principal there, the one providing the service which is their property, whatever it is and the tenant is going to be the agent that is the person renting from them. Now we may see asymmetric information in this case because the landlord is not going to always be aware of what the tenant is doing within their property. The landlord isn't always there keeping an eye on them. So we may see um certain things, maybe, maybe there's property damage going on that the landlord isn't aware of. So that's where we may see asymmetric information. However, this idea of a security deposit is what is working to remedy this whole issue of moral hazard. Because if this tenant who is the agent chooses to go against these goals of the landlord, the principle by damaging the property, well then the tenant is going to have to pay that security deposit. So the security deposit works to prevent them from acting it controversial. Conversely, to what the landlord would like part B. Here, we're told that top executives are given the option to purchase stock from the firm in the future. So in this case, these top executives are the agents within the firm, the firm and its owners being the principal, and we'll receive asymmetric information here is that these agencies, top executives, They are expected to work towards the goal of firm. However, they may have some ulterior motives. But what is done to prevent that is by giving them the option to purchase stock, meaning that these top executives will be better off if they choose to work in the way in which the firm would like them to. So if they choose to do something that the firm or the principal doesn't want or something that isn't in its best interest and the top executives are going to be hurt in the future by getting stock at a lower value. Whereas because they're given this option, it's this idea of an incentive that will hopefully push them to work in the best interests of the firm. And the principal part c here is saying that customers receive discounts from insurance companies if they install anti theft devices in their car. So in this case, what we're seeing is that these insurance companies are the principal. Whereas we have these customers who are the agents now, the insurance companies, their goal is to pay out as little as possible, right? They don't want to have to pay out. And that's what these anti theft devices do. Because if a person's car is stolen, will the insurance company is likely going to have to pay out for that, Which means they're going to lose some money. So the anti theft devices work to prevent that from happening. And this asymmetric information information comes into play because the insurance companies aren't aware of what the customers are doing with their cars every day, where they're parking them, who they're around. So this idea of theft, it could be very possible. But the anti theft devices work to protect the interests of the principle in this case.
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