Moral Hazard Model of Asymmetric Information

Introduction to Contract Theory and Auctions

Assymetric Information

Moral hazard model

The moral hazard model of asymmetric information applies to a variety of spheres. This essay will focus on using the model, to critically review a TV series, to which the mentioned model of asymmetric information is applicable. The paper aims to show gained knowledge of the contracts theory. A television series, “Lie to Me,” revolves around the use of psychology, to solve criminal cases. This essay will assume that the contracted agent is the hero of the series, while the party taking the risk is the population of the city which may fall prey to the criminals the agent has to work with. Different types of criminals are viewed as risks. The main antagonist of the series, Cal Lightman, is an expert in psychology, and the relationship between facial expressions and what they stand for. These skills allow him to understand if he is being lied to or not. Moreover, he can distinguish and decipher the involuntary body language, to reveal the thoughts of that person. Regarding asymmetric information, Lightman is using his analytical skills, yet does not bear the risk a criminal presents to the general public. In several cases, he had to face master liars, who were adept at controlling their physiology and even use it to their advantage. In respect to the risk, the series finale demonstrated how the hero of the series failed to understand the motives of a maniac murderer, the trust credit he had gained over the solved cases, allowed him to state the criminal is innocent, all of this based solely on his presumptions. Later in the series, the maniac which was set free, went on a killing spree, murdering over thirty innocent victims. This shows the ex-ante type of moral hazard, the psychologist made a decision, prior to the commitment of a crime.

The solutions to the moral hazard issue are applied to the mentioned turn in the series, firstly, the decrease in the asymmetricity of the specific information. In most cases, Cal Lightman was the only party that knew what a certain facial expression stood for. However, a master liar criminal, knowing the assumptions Lightman would make from the body language he was shown, manipulated the antagonist into thinking that he is innocent. The essay aims to prove that the actions of Cal Lightman would be more cautious and professional if he were the one who could be harmed in the process. An ex-post moral hazard would be a biased view on assumed criminals, due to the mistake Lightman had made.

In general, the moral hazard issue in economic theory can be applied to a variety of processes. The judicial system, for example, could prove to be more efficient, if the judge was at direct risk of being affected by the criminal he had set free. It also explains the revival of the judicial jury procedure, the jury represents the general public, who are the possible victims of a crime.

The main flaw of the moral hazard contract theory is the inability to view the hidden actions of the working agent, actions which may be essential to the work, yet cannot be readily judged or observed. For example, the risk an investor takes when investing in the actions of a certain agent, is hard to evaluate. The positive investment results of the agent, only mitigate the risk of the investor up to a certain extent, since factors which are outside the control of the agent could come into play.^[1] Best solutions that are applied to the moral hazard contracts is the incentivization of the agent, to show best results possible. These incentives can work through both positive incentives, e.g., bonuses for achieved profit, or negative, e.g., fines, for extensive losses. It is important to hold to find a balance in this approach since an abundance of incentives can prove to be just as bad as an excess. This is self-evident in the insurance and financial businesses. Insured people, tend to take higher risks, insurance providers have attempted to negate such carefree risk approach by increasing starting costs of the insurance and increasing the monthly/annual cost, if this approach continues.^[2] The causation is explainable, the burden of the insurance lies with the provider. In the financial sector, moral hazards are common when a higher risk may provide more profit, individually to the contracted agent, while it is the lender, who bears the possible losses of the involved risk.