Essay Sample on Moral Hazard Problems Within a Corporation

Introduction

Moral hazard refers to a circumstance in which an individual or an organization indulges in a risky event or investment or any other activity. It does so knowing that it has sought protection against those risks from another organization which will bear the blunt should the risks occur. The circumstance comes up where there is insufficient information shared between the two companies (Herbert, 2017). When the latter organization pays for the damages accrued by the former organization due to risky undertakings, then moral hazard problem arises.

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Therefore, the moral hazard problems arise in a situation in which the insured company undertakes activities that have high chances of causing damage because the damages will be paid for by the insurer. For instance, an individual who takes a loan whereby he knows that if he fails to pay, it is the guarantor who will be forced to pay it. The person, therefore, wastes the money instead of using it in a way that it would enable him to pay it back because he knows that his guarantor will pay the loan. When the guarantor pays for the loan, a moral hazard problem arises.

Moral hazard problems arise due to different causes which are discussed in detail below - the first cause of moral hazard adverse selection. It refers to a condition where one party in an insurance contract is at a disadvantage. The party with the upper hand has more accurate information on the deal made in the agreement than the other party (Wilson, 2016). Therefore, the organization with less data is disadvantaged in the contract, and it is taken advantage of by its partner.

Adverse selection arises from unsuccessful price signals which for instance, the company seeking an insurance cover lies about its level of risk exposure to avoid higher premiums. The company does not give accurate information to the insurer, and this makes the insurance company disadvantaged. The insurance company will charge the lying client in the same amount as other clients who have the same cover but at lower risks. The insured firm then undertakes its activity in the environment full of risks that will occur and be paid for by the disadvantaged insurer which is a moral hazard problem.

The second cause of the moral hazard problem is asymmetric information. It refers to a situation where one organization has more real knowledge about the risk than its partner in a contract. The organization with the more knowledge then changes its behavior after they have signed the agreement to be in such a way that it benefits from the risks that are insured for by its partner (Postlewaite, 2016). The unequal distribution of the material knowledge makes the transactions made in the contract unbalanced which leads to moral hazard problems.

For instance, one organization in a contract has information on how to enforce, and retaliate for breaches of the contract whereas the other partner lacks the knowledge or systems to do the same. In this situation, the insured has more knowledge about his activities and the risks they pose. The insurance company, on the other hand, lacks this knowledge if proper investigations are not carried out. The insured can breach the contract and pretend to be acting in its boundaries which gives them an advantage over the insurer who is bound by the agreement and cannot violate it. Therefore, this failure in the flow of information causes moral hazard problems.

The third cause of moral hazard problems is the principal-agent problem. It is also referred to as agency dilemma and occurs when a single entity or person is in a position to make major economic decisions on behalf of others in such a way that there is a significant impact (Delreux, 2017). The agent might, therefore, make decisions on behalf of other organizations for his interest. In this situation, the principal is motivated to act in such a way that the benefits accrued from a deal are personal and the damages collectively affect all the parties involved. Therefore, when an agent makes a bad decision for the company, but it has personal gains, it leads to moral hazard problems.

For example, in big companies, the board of directors acts as the agents and the shareholder's act as the principals. The board of directors makes the crucial decisions about the running of the company without involving the shareholders. When the board is corrupt, it makes decisions that benefit them whereas the damages proceed as losses to the shareholders which is a case of a principal-agent problem that builds up to a moral hazard.

Lastly, the moral hazard problem can arise from the tragedy of the commons. It refers to a situation where each organization is trying to reap the biggest benefits from a contract. The parties to the agreement, therefore, readily breach the contract and act outside its boundaries to disadvantage each other to enjoy more benefits (Brown, 2019). When one organization manages to disadvantage the other in the deal, there is a moral hazard problem.

Conclusion

The moral hazard problem refers to a situation in which two parties in a contract do not benefit equally from the deal because one is disadvantaged. In this situation, one organization accrues benefits whereas the other suffers damages and losses. The causes of this circumstance are adverse selection, asymmetric information, principal-agent problem, and the tragedy of the commons.

References

Hebert, B. (2017). Moral hazard and the optimality of debt. The Review of Economic Studies, 85(4), 2214-2252.

Wilson, C. (2016). Adverse selection. The New Palgrave Dictionary of Economics, 1-4.

Postlewaite, A. (2016). Asymmetric information. The New Palgrave Dictionary of Economics, 1-3.

Delreux, T., & Adriaensen, J. (Eds.). (2017). The Principal Agent Model and the European Union. Springer International Publishing.

Brown, C., & BLOCK, W. (2019). Free Market for the Environment. Economic Policy, 1, 116-125.