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A Course in Microeconomic Theory$
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David M. Kreps

Print publication date: 2020

Print ISBN-13: 9780691202754

Published to Princeton Scholarship Online: May 2021

DOI: 10.23943/princeton/9780691202754.001.0001

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Moral hazard and incentives

Moral hazard and incentives

(p.576) (p.577) Chapter Sixteen Moral hazard and incentives
A Course in Microeconomic Theory

David M. Kreps


This chapter discusses the problem of moral hazard. In the problem of moral hazard, one party to a transaction may undertake certain actions that (a) affect the other party's valuation of the transaction but that (b) the second party cannot monitor/enforce perfectly. A classic example here is fire insurance, where the insuree may or may not exhibit sufficient care while storing flammable materials. The “solution” to a problem of moral hazard is the use of incentives — structuring the transaction so that the party who undertakes the actions will, in their own best interests, take actions that the second party would (relatively) prefer. For example, fire insurance is often only partial insurance so that the insuree has a financial interest in preventing a fire.

Keywords:   moral hazard, transaction, valuation, fire insurance, incentives, partial insurance, financial interest

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