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- Hidden Action or Hidden Information? How Information Gathering Shapes Contract Design
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- Hidden Actions, Moral Hazard and Contract Theory
This is a problem encountered when one party knows more than the other party in the contract. In particular, it addresses how information differences between buyers and the sellers information asymmetry can cause market failure. These differences are the underlying causes of adverse selection Situation in which a person with higher risk chooses to hedge the risk, preferably without paying more for the greater risk.
Hidden Action or Hidden Information? How Information Gathering Shapes Contract Design
In economics , moral hazard occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk knowing that its insurance will pay the associated costs. A moral hazard may occur where the actions of the risk-taking party change to the detriment of the cost-bearing party after a financial transaction has taken place. Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk and has a tendency or incentive to take on too much risk from the perspective of the party with less information.
One example is a principal-agent problem , where one party, called an agent, acts on behalf of another party, called the principal. If the agent has more information about his or her actions or intentions than the principal then the agent may have an incentive to act too riskily from the viewpoint of the principal if the interests of the agent and the principal are not aligned.
According to research by Dembe and Boden,  the term dates back to the 17th century and was widely used by English insurance companies by the late 19th century. Early usage of the term carried negative connotations, implying fraud or immoral behavior usually on the part of an insured party. Dembe and Boden point out, however, that prominent mathematicians who studied decision-making in the 18th century used "moral" to mean "subjective", which may cloud the true ethical significance in the term.
The concept of moral hazard was the subject of renewed study by economists in the s,   beginning with economist Ken Arrow,  and did not imply immoral behavior or fraud. Economists use this term to describe inefficiencies that can occur when risks are displaced or cannot be fully evaluated, rather than a description of the ethics or morals of the involved parties.
Rowell and Connelly offer a detailed description of the genesis of the term moral hazard,  by identifying salient changes in economic thought, which are identified within the medieval theological and probability literature. Their paper compares and contrasts the predominantly normative conception of moral hazard found within the insurance-industry literature with the largely positive interpretations found within the economic literature.
Often what is described as "moral hazard[s]" in the insurance literature is upon closer reading, a description of the closely related concept, adverse selection. In , William J. This move was criticized by former Fed Chair, Paul Volcker and others as increasing moral hazard. Economist Paul Krugman described moral hazard as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.
Lending institutions need to take risks by making loans, and the riskiest loans usually have the potential for making the highest return. Taxpayers, depositors, and other creditors often have to shoulder at least part of the burden of risky financial decisions made by lending institutions.
Many have argued that certain types of mortgage securitization contribute to moral hazard. Mortgage securitization enables mortgage originators to pass on the risk that the mortgages they originate might default and not hold the mortgages on their balance sheets and assume the risk. In one kind of mortgage securitization, known as "agency securitizations," default risk is retained by the securitizing agency that buys the mortgages from originators. These agencies thus have an incentive to monitor originators and check loan quality.
They are similar to the "covered bonds" that are commonly used in Western Europe in that the securitizing agency retains default risk. Under both models, investors take on only interest-rate risk, not default risk.
In another type of securitization, known as "private label" securitization, default risk is generally not retained by the securitizing entity. Instead, the securitizing entity passes on default risk to investors. The securitizing entity, therefore, has relatively little incentive to monitor originators and maintain loan quality.
During the years leading up to the subprime mortgage crisis , private label securitizations grew as a share of overall mortgage securitization by purchasing and securitizing low-quality, high-risk mortgages.
Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private-label securitizations and performed far better in terms of default rates.
Economist Mark Zandi of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis. He wrote that "the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined.
Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards. Moral hazard can also occur with borrowers. Borrowers may not act prudently in the view of the lender when they invest or spend funds recklessly.
For example, credit card companies often limit the amount borrowers can spend with their cards because without such limits, borrowers may spend borrowed funds recklessly, leading to default. Securitization of mortgages in America started in at Salomon Brothers and where the risk of each mortgage passed to the next purchaser instead of remaining with the original mortgaging institution. These mortgages and other debt instruments were put into a large pool of debt, and then shares in the pool were sold to many creditors.
It has been suggested that this may have caused the subprime mortgage crisis. Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along.
In a purely capitalist scenario, the last one holding the risk like a game of musical chairs is the one who faces the potential losses. In the sub-prime crisis, however, national credit authorities the Federal Reserve in the US assumed the ultimate risk on behalf of the citizenry at large.
Others believe that financial bailouts of lending institutions do not encourage risky lending behavior since there is no guarantee to lending institutions that a bailout will occur.
Decreased valuation of a corporation before any bailout would prevent risky, speculative business decisions by executives who fail to conduct proper due diligence in their business transactions. The risk and the burdens of loss became apparent to Lehman Brothers , which who did not benefit from a bailout, and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation , whose valuation plunged during the subprime mortgage crisis.
Many scholars and journalists have argued that moral hazard played a role in the financial crisis , since numerous actors in the financial market may have had an incentive to increase their exposure to risk. Notably, the Financial Crisis Inquiry Commission FCIC , tasked by Congress with investigating the causes of the financial crisis, cited moral hazard as a component of the crisis, arguing that many factors, including deregulation in the derivatives market in , reduced federal oversight, and the potential for government bailout of "too big to fail" institutions all played a role in increasing moral hazard in the years leading up to the collapse.
Others have argued that moral hazard could not have played a role in the financial crisis for three main reasons. First, in the event of a catastrophic failure, a government bailout would only come after major losses for the company. Second, there is some evidence that big banks were not expecting the crisis and thus were not expecting government bailouts, though the FCIC tried hard to contest this idea.
Moral hazard has been studied by insurers  and academics; such as in the work of Kenneth Arrow ,    Tom Baker,  and John Nyman. The name comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks like fire, or car accidents might encourage those clients to behave in riskier ways like smoking in bed or not wearing seatbelts. This problem may inefficiently discourage those companies from protecting their clients as much as the clients would like to be protected.
Economists argue that the inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions like smoking in bed or not wearing seat belts , allowing them to provide thorough protection against risk fire or accidents without encouraging risky behavior.
However, since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information.
Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information , rather than hidden actions.
The same underlying problem of non-observable actions also affects other contexts besides the insurance industry. It also arises in banking and finance : if a financial institution knows it is protected by a lender of last resort , it may make riskier investments than it would in the absence of the protection.
In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service, which would otherwise not be necessary. In those instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.
Two types of behavior can change. One type is the risky behavior itself, resulting in a before the event moral hazard. Insured parties then behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer.
After purchasing fire insurance, some may tend to be less careful about preventing fires say, by smoking in bed or neglecting to replace the batteries in fire alarms. A further example has been identified in flood risk management in which it is proposed that the possession of insurance undermines efforts to encourage people to integrate flood protection and resilience measures in properties exposed to flooding. A second type of behavior that may change is the reaction to the negative consequences of risk once they have occurred and insurance is provided to cover their costs.
That may be called ex post after the event moral hazard. Insured parties then do not behave in a more risky manner that results in more negative consequences, but they ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases.
For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. However, after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise. Sometimes moral hazard is so severe that it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume.
Thus, the insured have a financial incentive to avoid making a claim. Consider a potential case of moral hazard in the health care market caused by the purchase of health insurance. Now, consider the same individual with health insurance.
Assume this health insurance makes health care free for the individual. This example shows numerically how moral hazard could occur with health insurance. The individual consumes more health care than the equilibrium quantity because they don't bear the cost of the additional care. In economic theory, moral hazard is a situation in which the behavior of one party may change to the detriment of another after the transaction has taken place.
For example, a person with insurance against automobile theft may be less cautious about locking their car because the negative consequences of vehicle theft are now partially the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.
According to contract theory , moral hazard results from a situation in which a hidden action occurs. It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome. Moral hazard can be divided into two types when it involves asymmetric information or lack of verifiability of the outcome of a random event.
An ex ante moral hazard is a change in behavior prior to the outcome of the random event, whereas ex post involves behavior after the outcome. The individual taking greater risks during the period would be ex-ante moral hazard whereas lying about a fictitious health problem to defraud the insurance company would be ex post moral hazard. A second example is the case of a bank making a loan to an entrepreneur for a risky business venture.
The entrepreneur becoming overly risky would be ex ante moral hazard, but willful default wrongly claiming the venture failed when it was profitable is ex post moral hazard.
In the latter case, after the contract has been signed there is a random draw by nature that determines the agent's type such as his valuation for a good or his costs of effort. In the literature, two reasons have been discussed why moral hazard may imply that the first-best solution the solution that would be attained under complete information is not achieved.
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Issues also arise when companies have an incentive to become increasingly deferential to management that have ownership stakes. Common examples of this relationship include corporate management agent and shareholders principal , elected officials agent and citizens principal , or brokers agent and markets buyers and sellers, principals. In fact the problem can arise in almost any context where one party is being paid by another to do something where the agent has a small or nonexistent share in the outcome, whether in formal employment or a negotiated deal such as paying for household jobs or car repairs. The principal—agent problem typically arises where the two parties have different interests and asymmetric information the agent having more information , such that the principal cannot directly ensure that the agent is always acting in their the principal's best interest,  particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe see moral hazard and conflict of interest. Often, the principal may be sufficiently concerned at the possibility of being exploited by the agent that they choose not to enter into the transaction at all, when it would have been mutually beneficial: a suboptimal outcome that can lower welfare overall. The deviation from the principal's interest by the agent is called " agency costs ". The agency problem can be intensified when an agent acts on behalf of multiple principals see multiple principal problem.
Allocation, Information and Markets pp Cite as. As an extreme but standard example, a fire insurance holder may burn the property in order to obtain the insured sums. Arrow stresses that the complete set of markets required for first best efficiency often cannot be organized. The so-called Arrow-Debreu contracts which are needed would have to be contingent on states of nature. However, states of nature may not be observable either directly or indirectly, so that real contracts have to rely upon imperfect proxies. Take the overly simple fire insurance example.
Hidden characteristics are things that one side of a transaction knows about itself that the other side would like to know but does not. Hidden actions are actions taken by one side of an economic relationship that the other side of the relationship cannot observe.
Hidden Actions, Moral Hazard and Contract Theory
Economics Stack Exchange is a question and answer site for those who study, teach, research and apply economics and econometrics. It only takes a minute to sign up. Hidden information concerns characteristics that are unobservable by one side of the market. For example, a consumer's willingness to pay, a worker's productivity, the quality of a used car all fall under this category. The characteristics in question are typically assumed to be fixed or very costly to modify.
Economics Stack Exchange is a question and answer site for those who study, teach, research and apply economics and econometrics. It only takes a minute to sign up. Hidden information concerns characteristics that are unobservable by one side of the market. For example, a consumer's willingness to pay, a worker's productivity, the quality of a used car all fall under this category. The characteristics in question are typically assumed to be fixed or very costly to modify. Moral hazard concerns actions that are unobservable by one side of the market.
As the access to this document is restricted, you may want to search for a different version of it. Lewis, Tracy R. Epstein, Larry G. Zin, Leonidas Enrique de la Rosa, Cremer, J. Villeneuve, Bertrand,
Moral Hazard in Health Insurance. This history of moral hazard in health insurance shows that this concept is different from how moral hazard is understood in economics outside of health. Health economists are divided on their understanding and conceptualization of moral hazard in health insurance and we show that these divisions can be organized along two main questions: one on the nature of demand for health care and one on the nature of demand for health insurance. The former revolves around the ability of consumers to make informed choices and, as a consequence, how we value the health care services that are consumed. The latter revolves around the idea that utility of consumption is significantly affected by changes in health status, and that health insurance might work, as a result, as an income transfer across states of the world rather than as protection against financial risk.
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