Question

05) Examples of market responses to moral hazard (hidden action) problems include: 1. Paying salespeople on commission (percentage of sales) rather than a set salary. 2. Insurance companies only offering policies with partial insurance for losses (large deductibles or paying only a percentage of the loss). 3. Offering sports stars contracts that only renew for the next year after the athlete has achieved a "good year" this year. O A) 1 only OB) 2 only O C) 3 only OD) 1 and 2 only OE) 1, 2 and 3.

Answer 1

Moral hazard refers to a situation where the asset owner doesn't have any incentive to protect the asset because the loss of asset is covered by insurance so for example, if the goods are secured, the owner is not careful whether he has taken care of fire safety at the storage space because even if the goods catch fire, they are insured and the monetary value will be recovered.

Now what we require here is a response to moral hazard of a situation that prevents people from having an inclination of moral hazard.

• So paying sales people on commission ensures that they get sales. If they get a fixed salary they wont be eager to sell more and may get complacent. So this is a response to moral hazard
• Partial insurance also gives the incentive to take care of not incurring the loss that is beyond the covered limit. So this is a response to moral hazard
• If a sports star doesn't have a good year his contract wont be renewed so that means that the sports star can't intentionally under perform because he would want to secure the contract. So this is a response to moral hazard
• Therefore the correct answer is option E which states that all statements are true.