David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 12 Risk and information
want to pay for a lazy worker. However, you do not know with certainty if the worker you are hiring is
going to be productive or not. On the other hand, the worker knows himself and knows ifhe is productive
or not. In this case, there is asymmetric information, since one party (the worker) has more information
about an important characteristic of the transaction (his productivity) than the other party (you, as the
owner of the company). Why is this related to risk and uncertainty?
You are uncertain about the productivity of the worker and in the case of them being unproductive you
face the risk of paying someone who does not contribute to the profits of the company. The existence of
asymmetric information creates the possibility of opportunistic behaviour: the informed individual benefits
at the expense of the less-informed individual.
In the case of asymmetric information we distinguish between two possible cases:
1 Moral hazard (or hidden action) In this case the uninformed agent cannot observe a particular action
of the informed individual. For example, a worker may put little effort into performing his job if it is
difficult for the employer to monitor him. The problem of moral hazard is also known as the principalagent
problem, where the principal is the name we give to the uninformed individual and the agent is
the informed one.
2 Adverse selection (or hidden information) This is the case where the uninformed individual does not
know about an unobservable characteristic of the informed individual. For example, a person who wants
to buy life insurance has more information about his own health than does the insurance company.
In the following sections we discuss the two cases in the context of the insurance market.
Moral hazard
Insurance companies calculate the statistical chances of particular events. They work out how many cars
are stolen each year. Since different thefts are largely independent risks, we expect insurance firms to pool
the risk over many clients and charge low premiums for car theft.
Sitting in a restaurant, you remember that your car is unlocked. Do you abandon your nice meal and rush
outside to lock it? Not if you know the car is fully insured against theft. If the act of insuring changes the
odds, then we have the problem of moral hazard. The informed individual (the insured) has an incentive
to engage in risky behaviour; in this case, by not making the effort to minimize the chance of having his
car stolen.
Statistical averages for the whole population, some of whom are uninsured and take greater care, are no
longer a reliable guide to the risks the insurance company faces and the premiums it should charge. Moral
hazard makes it harder to get insurance and more expensive when you do get it.
Insurance companies insure your car or house only up to a certain percentage of its replacement cost. They
take over a big part of the risk, but you are worse off if the bad thing happens. The company gives you an
incentive to minimize the chance of the bad thing happening. By limiting moral hazard, the insurance
company pays out less frequently and can charge a lower premium.
Why are CEOs paid so much?
II
The compensation received by chief executive officers ( CEOs) of large banks has featured
prominently in the news in the past couple of years. As a result of the credit crunch some
troubled large banks were rescued using taxpayers' money. Nevertheless, those large banks continued to
provide large bonuses to their CEOs. US President Barak Obama once described such large bonuses as
'shameful' and the public appears outraged each time one is announced in the news.
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