A friend of yours tells you she has an idea for a new product. She believes that once the prototype is built she can sell the rights to the product for $250,000. The problem is she needs $20,000 to build the prototype and she only has $5,000. She asks you to invest $15,000 in the idea and she will give you 75% of whatever amount she obtains when she sells the rights. You have the money available but should be reluctant to provide the money. Why?

Question

What will be an ideal response?

Answer 1

Your reluctance should come from the problem of moral hazard. It is true that if she sells the prototype for $250,000 you stand to gain $187,500, less your initial investment of $20,000 for a net gain of $167,500 and your friend gains $62,500, less her initial investment of $5,000 for a net gain of $57,500. On the other hand, if her idea isn't good, or she fails to build the prototype, and the project is worth $25,000 she stands to lose only $57,500. You stand to lose $167,500. This is a moral hazard problem since your friend will be the one controlling the success or failure of the project.