Solutions to Moral Hazard

In the previous video, we discussed how asymmetric information can lead to moral hazard, which can lead to people being ripped off, which in turn can lead to markets breaking down.

Now, there are two types of potential solutions to moral hazard problems. First, since the problem is asymmetric information, you can try to make information less asymmetric. If both parties have similar information, then one party cannot so easily exploit the other. Second, if you can't get rid of the information asymmetry, you can try to reduce the incentive of the agent to exploit his or her informational advantage. One example that you're already familiar with works along both of these dimensions: user ratings. You can get ratings for businesses at sites such as Yelp and Angie's List, and for products at places such as Amazon.com. Reviews give you more information about a product or service, and they help balance the information between buyer and seller, thereby mitigating issues of moral hazard.

Additionally, the existence of these review sites changes the incentives for the sellers. In our previous example of the auto mechanic we sketched out how your incentive to get your car repaired might conflict with the mechanic's incentive to milk you for extra money. However, the mechanic also has to think about her reputation, which is what leads to future business. Previously, you might have told, well, just a few friends that you got ripped off. Now, today, you can write an online review and reach a much larger audience, maybe thousands of people. A mechanic's online reputation is important to her success and provides an incentive for her not to try to exploit her informational advantage.

While review sites are great, the market is continually evolving, and some sellers try to fight back by faking or manipulating reviews or ratings. There's some obvious examples, like favorably reviewing your friend's book on Amazon if your friend reviews yours. But there are more subtle examples as well. For instance, some universities invite lots of applicants, knowing they will reject them, just hoping to boost their rating for exclusivity. Reviews are more trustworthy if they come from third parties who do not have incentives to bias the review one way or the other. The magazine Consumer Reports, for example, has a reputation for honest reporting because it's a non-profit and it accepts no advertisements and no funding from commercial sources. But there's another problem -- it's hard to exclude people from produced information. Information is also what we call nonrival -- nonexcludable and nonrival.

Do those property sound familiar? Yes, information has the characteristics of a public good. Click to go back and review if you need. It's hard for Consumer Reports to keep the information it provides to only those people who buy the magazine. If you hear that Consumer Reports says that brand X of television is the very best, well you might use that information even if you didn't buy the magazine and pay for it. In this case, we would say that you are free riding, using the benefits of their research and testing without contributing to paying the costs. Free riding is a problem, however, not because it's unfair or unjust, but because it means that information provision may be under-provided in the first place. As a result, there are fewer trustworthy third parties reviewing products and services. So, review sites help solve moral hazard issues by both balancing the information between buyer and seller, and reducing the incentives for the more informed party to exploit an informational advantage.

There are other approaches that work solely by modifying the incentives of those people with the informational advantages. Let's take two examples that might seem completely different, but are actually, conceptually, pretty similar: house inspections, and second opinions from doctors. When you buy a house, you typically get a home inspector to check out the house and identify potential problems. By law in many states, these home inspectors cannot also sell services to fix any problems they've identified. This changes their incentives. No longer do they have the incentive to overstate potential problem issues to inflate the bill.

Similarly, when you go to a doctor for a second opinion, that doctor is simply diagnosing the problem, but not doing the actual treatment. Just like with the home inspector, this eliminates the incentive to run up the bill. Both of these examples split the diagnosis of the issue from the actual work to address the problem. So while the information is still asymmetric, there is less of an incentive to exploit that asymmetry. By the time you're ready to fix the issue, this separate diagnosis by an expert allows you to have much more information. Maybe now, almost as much as the service provider in some ways.

This video has covered the various solutions to moral hazard issues in situations of asymmetric information. In the next video, we'll take up a different kind of response to the asymmetric information problem, namely signaling. See you then.