Do you remember Claire who wasn’t having much luck with online dating? Well, I’m pleased to say she’s met an eligible bachelor, they’ve been seeing each other for a while and she asked him to move in with her...
…Unfortunately, as the eligible bachelor (let’s call him Fred) settled in, he started to let things slip. Dirty socks weren’t making their way into the laundry basket, tea bags were left on the coffee table and date nights turned into pizza nights in. Needless to say, Claire isn’t pleased.
Any economist would spot the problem instantly. It’s moral hazard, another issue, arising from imperfect information between the parties, which comes up after a contract is signed or a deal is made. Moral hazard is essentially an incentive problem - the agent isn’t compelled to do the right thing after the deal.
Think of buying a policy to insure your bike against theft: once your bike is insured, you become more careless and would not think twice about leaving it outside the pub in Soho. If someone cuts the lock and takes your bike, an insurance company will pay you to get a new one.
Another example is a new hire who has a great CV, makes all the right noises during the interview, gets hired and then spends most of her time at work planning her wedding.
Fortunately, her employer Alex studied economics and included a probation clause in her contract. He also offered her a relatively modest base salary and a highly attractive sales commission, which means that she is incentivised to delegate wedding planning to her fiancé and focus on making sales calls.
Insurance companies weren’t born yesterday either and they always include an excess penalty in their contracts so that policy holders don’t get into the habit of making claims and take greater care instead.
These examples seem obvious but how many times did you hire a contractor: a builder to do some work in your house or a photographer to take memorable snapshots at your wedding only to get frustrated with the time it was taking to fit the new kitchen in or to get your photos… A penalty clause for late delivery might be a good idea next time.
Claire isn’t an economist so it’s only fair to give her some advice. You can override the moral hazard problem by putting incentives in place. I’ll let you get creative here but do make sure it’ll be costly for Fred not to pick up his socks.
…Unfortunately, as the eligible bachelor (let’s call him Fred) settled in, he started to let things slip. Dirty socks weren’t making their way into the laundry basket, tea bags were left on the coffee table and date nights turned into pizza nights in. Needless to say, Claire isn’t pleased.
Any economist would spot the problem instantly. It’s moral hazard, another issue, arising from imperfect information between the parties, which comes up after a contract is signed or a deal is made. Moral hazard is essentially an incentive problem - the agent isn’t compelled to do the right thing after the deal.
Think of buying a policy to insure your bike against theft: once your bike is insured, you become more careless and would not think twice about leaving it outside the pub in Soho. If someone cuts the lock and takes your bike, an insurance company will pay you to get a new one.
Another example is a new hire who has a great CV, makes all the right noises during the interview, gets hired and then spends most of her time at work planning her wedding.
Fortunately, her employer Alex studied economics and included a probation clause in her contract. He also offered her a relatively modest base salary and a highly attractive sales commission, which means that she is incentivised to delegate wedding planning to her fiancé and focus on making sales calls.
Insurance companies weren’t born yesterday either and they always include an excess penalty in their contracts so that policy holders don’t get into the habit of making claims and take greater care instead.
These examples seem obvious but how many times did you hire a contractor: a builder to do some work in your house or a photographer to take memorable snapshots at your wedding only to get frustrated with the time it was taking to fit the new kitchen in or to get your photos… A penalty clause for late delivery might be a good idea next time.
Claire isn’t an economist so it’s only fair to give her some advice. You can override the moral hazard problem by putting incentives in place. I’ll let you get creative here but do make sure it’ll be costly for Fred not to pick up his socks.
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