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selling lemons. As a result, more sales occur and dealers can command higher
prices for their used cars.
Finally, in the face of adverse selection, it can be very valuable to establish a
good reputation: a used- car dealership will often advertise how long it has been
in business to show that it has continued to satisfy its customers. As a result, new
customers will be willing to purchase cars and to pay more for that dealers cars.

Moral Hazard
In the late 1970s, New York and other major cities experienced an epidemic of
suspicious fires that appeared to be deliberately set. Some of the fires were probably started by teenagers on a lark, others by gang members struggling over turf.
But investigators eventually became aware of patterns in a number of the fires.
Particular landlords who owned several buildings seemed to have an unusually
large number of their buildings burn down. Although it was difficult to prove,
police had few doubts that most of these fire-prone landlords were hiring professional arsonists to torch their own properties.
Why burn your own building? These buildings were typically in declining
neighborhoods, where rising crime and middle- class flight had led to a decline
in property values. But the insurance policies on the buildings were written to
compensate owners based on historical property values, and so would pay the
owner of a destroyed building more than the building was worth in the current
market. For an unscrupulous landlord who knew the right people, this presented
a profitable opportunity.
The arson epidemic became less severe during the 1980s, partly because insurance companies began making it difficult to overinsure properties, and partly
because a boom in real estate values made many previously arson-threatened
buildings worth more unburned.
The arson episodes make it clear that it is a bad idea for insurance companies
to let customers insure buildings for more than their valueit gives the customers some destructive incentives. You might think, however, that the incentive
problem would go away as long as the insurance is no more than 100% of the
value of what is being insured.
But, unfortunately, anything close to 100% insurance still distorts incentivesit induces policyholders to behave differently than they would in the
absence of insurance. The reason is that preventing fires requires effort and
cost on the part of a buildings owner. Fire alarms and sprinkler systems have
to be kept in good repair, fire safety rules have to be strictly enforced, and so
on. All of this takes time and moneytime and money that the owner may not
find worth spending if the insurance policy will provide close to full compensation for any losses.
Of course, the insurance company could specify in the policy that it wont pay
if basic safety precautions have not been taken. But it isnt always easy to tell how
careful a buildings owner has beenthe owner knows, but the insurance company does not.
The point is that the buildings owner has private information about his or her
own actions, about whether he or she has really taken all appropriate precautions.
As a result, the insurance company is likely to face greater claims than if it were
able to determine exactly how much effort a building owner exerts to prevent a
loss. The problem of distorted incentives arises when an individual has private
information about his or her own actions but someone else bears the costs of a
lack of care or effort. This is known as moral hazard.
To deal with moral hazard, it is necessary to give individuals with private
information some personal stake in what happens so they have a reason to
exert effort even if others cannot verify that they have done so. Moral hazard
is the reason salespeople in many stores receive a commission on sales: its

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A long-term reputation allows an

individual to reassure others that
he or she isnt concealing adverse
private information.
Moral hazard occurs when an
individual knows more about his or
her own actions than other people
do. This leads to a distortion of
incentives to take care or to exert
effort when someone else bears the
costs of the lack of care or effort.

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PA RT 9

FAC TO R M A R K E TS A N D RISK

A deductible in an insurance policy

is a sum that the insured individual
must pay before being compensated
for a claim.

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hard for managers to be sure how hard the salespeople are really working,
and if they were paid only a straight salary, they would not have an incentive
to exert effort to make those sales. As described in the following Economics
in Action, similar logic explains why many stores and restaurants, even if they
are part of national chains, are actually franchises, licensed outlets owned by
the people who run them.
Insurance companies deal with moral hazard by requiring a deductible:
they compensate for losses only above a certain amount, so that coverage is
always less than 100%. The insurance on your car, for example, may pay for
repairs only after the first $500 in loss. This means that a careless driver
who gets into a fender-bender will end up paying $500 for repairs even if he
is insured, which provides at least some incentive to be careful and reduces
moral hazard.
In addition to reducing moral hazard, deductibles provide a partial solution to the problem of adverse selection. Your insurance premium often
drops substantially if you are willing to accept a large deductible. This is an
attractive option to people who know they are low- risk customers; it is less
attractive to people who know they are high -riskand so are likely to have
an accident and end up paying the deductible. By offering a menu of policies
with different premiums and deductibles, insurance companies can screen
their customers, inducing them to sort themselves out on the basis of their
private information.
As the example of deductibles suggests, moral hazard limits the ability of the
economy to allocate risks efficiently. You generally cant get full (100%) insurance
on your home or car, even though you would like to buy it, and you bear the risk of
large deductibles, even though you would prefer not to. The following Economics
in Action illustrates how in some cases moral hazard limits the ability of investors
to diversify their investments.

ECONOMICS IN ACTION
FRANCHISE OWNERS TRY HARDER

Erik Freeland/Corbis

hen Americans go out for a quick meal, they often end up at one of the
fast-food chainsMcDonalds, Burger King, and so on. Because these
are large corporations, most customers probably imagine that the people who
serve them are themselves employees of large corporations. But usually they
arent. Most fast-food restaurantsfor example, 85%
of McDonalds outletsare franchises. That is, some
individual has paid the parent company for the right
to operate a restaurant selling its product; he or she
may look like an arm of a giant company but is in
fact a small-business owner.
Becoming a franchisee is not a guarantee of success. You must put up a large amount of money, both
to buy the license and to set up the restaurant itself (to
open a Taco Bell, for example, cost $1.1 million to $1.7
million, excluding land or lease costs, in 2010). And
although McDonalds takes care that its franchises
are not too close to each other, they often face stiff
competition from rival chains and even from a few
truly independent restaurants. Becoming a franchise
owner, in other words, involves taking on quite a lot
of risk.
But why should people be willing to take these
risks?
Didnt we just learn that it is better to diversiFranchise owners take on a lot of risk but at the same time are
fy, to spread your wealth among many investments?
incentivized to succeed.

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The logic of diversification would seem to say that its better for someone
with $1.7 million to invest in a wide range of stocks rather than put it all
into one Taco Bell. This implies that Taco Bell would find it hard to attract
franchisees: nobody would be willing to be a franchisee unless they expected
to earn considerably more than they would as a simple hired manager with
their wealth invested in a diversified portfolio of stocks. So wouldnt it be
more profitable for McDonalds or Taco Bell simply to hire managers to run
their restaurants?
It turns out that it isnt, because the success of a restaurant depends a lot
on how hard the manager works, on the effort he or she puts into choosing the
right employees, on keeping the place clean and attractive to customers, and
so on. Could McDonalds get the right level of effort from a salaried manager?
Probably not. The problem is moral hazard: the manager knows whether he or
she is really putting 100% into the job; but company headquarters, which bears
the costs of a poorly run restaurant, does not. So a salaried manager, who gets
a salary even without doing everything possible to make the restaurant a success, does not have the incentive to do that extra bitan incentive the owner
does have because he or she has a substantial personal stake in the success of
the restaurant.
In other words, there is a moral hazard problem when a salaried manager
runs a McDonalds, where the private information is how hard the manager
works. Franchising resolves this problem. A franchisee, whose wealth is tied up
in the business and who stands to profit personally from its success, has every
incentive to work extremely hard.
The result is that fast-food chains rely mainly on franchisees to operate their
restaurants, even though the contracts with these owner-managers allow the
franchisees on average to make much more than it would have cost the companies to employ store managers. The higher earnings of franchisees compensate
them for the risk they accept, and the companies are compensated by higher
sales that lead to higher license fees. In addition, franchisees are forbidden by the
licensing agreement with the company from reducing their risk by taking actions
such as selling shares of the franchise to outside investors and using the proceeds
to diversify. Its an illustration of the fact that moral hazard prevents the elimination of risk through diversification.

CHECK YOUR UNDERSTANDING

20-3

1. Your car insurance premiums are lower if you have had no moving violations for several

years. Explain how this feature tends to decrease the potential inefficiency caused by
adverse selection.
2. A common feature of home construction contracts is that when it costs more to con-

struct a building than was originally estimated, the contractor must absorb the additional
cost. Explain how this feature reduces the problem of moral hazard but also forces the
contractor to bear more risk than she would like.
3. True or false? Explain your answer, stating what concept analyzed in this chapter

accounts for the feature.

People with higher deductibles on their auto insurance:
a. Generally drive more carefully
b. Pay lower premiums
c. Generally are wealthier

585

Quick Review
Private information can distort
incentives and prevent mutually
beneficial transactions from occurring. One source is adverse selection: sellers have private information
about their goods and buyers offer
low prices, leading the sellers of
quality goods to drop out and leaving
the market dominated by lemons.

Adverse selection can be reduced by

revealing private information through
screening or signaling, or by cultivating a long-term reputation.

Another source of problems is

moral hazard. In the case of insurance, it leads individuals to exert
too little effort to prevent losses.
This gives rise to features like
deductibles, which limit the efficient allocation of risk.

Solutions appear at back of book.

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586

Dan Kitwood/Getty Images

BUSINESS
CASE

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The Agony of AIG

AIG (American International Group) was once the largest insurance company
in the United States, known for insuring millions of homes and businesses and
managing the pension plans of millions of workers.
But in September 2008, AIG acquired a much more notorious reputation. It was
at the epicenter of the crisis sweeping global financial markets because major commercial and investment banks were faced with potentially devastating losses through
their transactions with AIG. Fearful that a chaotic bankruptcy of AIG would panic the
already distressed financial markets, the Federal Reserve stepped in and orchestrated
the largest corporate bailout in U.S. history, paying a total of $182 billion to satisfy
claims against AIG. In return, American taxpayers became owners of nearly 80% of
AIG. How did things go so wrong?
AIGs problems originated not in its main lines of businessproperty insurance
and pension managementbut in its much smaller financial products division,
which sold what are known as credit-default swaps, or CDS. A CDS is like an insurance policy for an investor who buys a bond. A bond is simply an IOUa promise
to repay on the part of the borrower (the person or company that issued the bond).
But any IOU carries with it the possibility that the borrower will default and not
pay back the loan as promised. So bond investors who wish to protect themselves
against the risk of default purchase a CDS from a company like AIG. Later, if the
borrower does default, then bond investors collect an amount equal to their losses
from the company that issued the CDSs.
During the mid-2000s, Joseph Cassano, the head of AIGs Financial Products
Division, sold hundreds of billions of dollars worth of CDSs. They were bought by
investors in mortgage-backed securitiesbonds created by combining thousands of
American home mortgages. As homeowners paid their monthly mortgages, the owners of the mortgage-backed securities received the interest earned on those mortgages.
For several years AIG earned billions in premiums from selling CDSs, making
the Financial Products Division its most profitable department. As its head, Cassano
benefited, too, earning a total of $300 million. And there were virtually no costs
involved because mortgage defaults were low and the Financial Products Division
was based in London. Its location meant that AIG was not required to abide by U.S.
insurance regulations to set aside capital to cover potential lossesdespite the fact
that AIG, the parent company, was headquartered in the United States. As Cassano
stated in 2007, It is hard for us . . . .to even see a scenario within any kind of realm
of reason that would see us losing $1 in any of those transactions. Cassano was
so confident that he prevented AIGs American auditors from inspecting his books,
leaving AIGs management and shareholders in the dark about the risk they faced.
Yet the hard-to-see scenario appeared in 2008 in cataclysmic form when the
U.S. housing market crashed. As mortgage defaults surged, investors in mortgagebacked securities incurred huge losses and turned to AIG to collect. But with no
capital to cover claims, AIG faced bankruptcy until the U.S. government stepped in.
The congressional investigation that ensued revealed that some investment
banks, such as Goldman Sachs, had made huge profits by putting together mortgagebacked securities with a high likelihood of default and then insuring them with AIG.
Despite an outcry, Goldmans claims were paid in full by the government because
their transaction with AIG was entirely legal.

QUESTIONS FOR THOUGHT

1. Did AIG accurately assess the default risk that it insured? Why or why not?
2. What did AIG assume about the probabilities of defaults by different homeowners in the

U.S. housing market? Were they wrong or right?

3. What are the examples of moral hazard in the case? For each example, explain who commit-

ted the moral hazard and against whom and identify the source of the private information.
4. Cite an example of adverse selection from the case. What was the source of the private

information?

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