How does Imperfect Information cause Moral Hazard


I understand what Moral Hazard is (people taking risks because they won’t be the ones paying the costs if it goes badly), but I don’t understand what it has to do with Asymmetric/Imperfect Information

In: Economics

The big issue is how moral hazard interacts with insurance under imperfect information. Moral hazard is a problem in insurance because people are more likely to take risks once those risks are covered by insurance. However, this wouldn’t be important if the insurance company could perfectly observe the risks each person takes. In that case, all insurance could be fairly priced by charging higher premiums to the people who took more risks. If information is imperfect, the insurance company must settle for pricing based on what it can observe, which allows some people to take risks it can’t observe.

Asymmetric info arises in the situation where a company is run by a separate person than the company is owned by. The director has all the information about the potential for future projects, income and expenditure etc.

Now the moral hazard here arises because a director could benefit personally from running a company badly in order to boost short term metrics, and therefore their bonuses. By providing limited imperfect information to shareholders who need to back the decision they can steer the decision to benefit themselves instead of the shareholders.

ROCE (Operating profit/Capital Employed) is a good example here, if a director is targeted by ROCE the director will attempt to avoid investment heavy projects which provide a long term boost in profits, but would increase the capital employed, thereby decreasing the metric they are rewarded by. By providing limited data on the availability of investment options the director can persuade the investors they’ve made a good decision.

Another fairly common area is in investments. If you leave your money with an investment professional to invest with commissions based on the investment performance (think investment banks who trade their own and potentially client’s monies and give their star traders huge bonuses) The individual traders get rewarded for taking more risks to achieve a higher return but the downside is paid by the bank/client. You or the bank, frequently cannot subject every trade decision to scrutiny and rely on the trader’s greater knowledge of the market.