Thursday, April 1, 2010

Risk and Moral Hazard

I recently was teaching about risk, and we discussed moral hazard and adverse selection. That's probably what put the concepts into my mind. Then I was watching the movie Joe vs. the Volcano which starred Tom Hanks and Meg Ryan. It hit me. Here's an example of how "knowing" the future can affect our choices. Specifically, Tom Hanks' character, Joe, is told he has an incurable disease. He is then approached by a multi-millionaire to take on a dangerous mission - one which would end with him throwing himself into a volcano. All his expenses are covered. He immediately begins making decisions and taking risks that he previously wouldn't have taken - moral hazard.

Take a look at it and let me know if you agree.


Ronald Rutherford said...

I could be wrong and you are using moral hazard correctly but it seems that Tom Hanks still is fully exposed to his risks he bears. The more correct seems to fall under adverse selection that he willingly takes on more risks for immediate gains knowing that something bad will happen. Just as people that know they are bad drivers are more likely to carry insurance or unhealthy individuals may choose the best insurance policies as insurance agents can not discriminate or simply asymmetrical information.

You are right about changing behaviours of course.

Ron Rutherford

Tim Schilling said...

You may be right. I understood moral hazard as a situation where one party is induced to take on more risk than they normally would. Such as this definition in Wikipedia:

If I look at the definition in Investopedia,
I see where you are probably right.

My first exposure to the concept came when I was working at the Fed, and we were discussing the combination of an extension of FDIC coverage with the wider opportunities first offered under the Depository Institutions Deregulation and Monetary Control Act.

Thanks for your insight.

Tim Schilling said...

One more thing to help clarify my understanding of moral hazard.

I have frequently heard the term used to describe depositors under a deposit insurance system. The argument goes that moral hazard arises because the depositors know their losses are covered. Consequently, they are not careful in "overseeing" the bank and the bank escapes the market discipline that would be present if depositors faced the full value of their losses.

I hope that clarifies my understanding.