Give an example of the potential for moral hazard that exists in the following relationships: (a) a film actress and her agent; (b) a employee hired by a large firm to manage one retail location; and (c) a college student and a professor.

Question

What will be an ideal response?

Answer 1

(a) The agent might have a motivation to make his client a "star" because managing stars builds a reputation and leads to other big clients as well. However, it could be that the types of things that will make her a star in the short run are not good for the actress's career in the long run. (b) The goal of the manager is not necessarily to maximize the firm's profit; it might be simply to have a stress-free life and happy employees. In this case, the manager might have an incentive to, for example, create a work schedule or store policies that make employees happy at the expense of the firm's profit. The manager might, for example, overschedule employees because they all want "more hours," or schedule too few employees on holidays. (c) The most obvious example of the actions of a student that are unobservable to a professor is cheating. It might be a stretch, but cheating and plagiarism do impact the benefit that the professor gets from the transaction. If enough students cheat, it might eventually be revealed that students of the institution don't learn enough, and the institution could lose its accreditation, and the professor could lose her job. If the professor knew the student was cheating, of course, she would not participate in the transaction.