User:Aely-Aronoff/sandbox

My evaluation of the Moral hazard page:

It has a C-class rating presently.

The intro portion is quite bad - it has four sentence-paragraphs. The first three basically say the same thing about being shielded from risk and having an information asymmetry. Additionally, the first three only talk about moral hazard as it relates to insurance, which is the toy example. However, the fourth paragraph adds that moral hazard can occur in principal-agent problems.

The first subsection is an "Example," which talks about the moral hazard of originators of subprime loans. It has NO CITATION, although it is a good example of moral hazard.

Under the "Finance" subsection, there is another definition of moral hazard, more discussion on subprime loans (perhaps that needs its own section?), a brief interlude on moral hazard with borrowers and then a return to subprime loans! The section also has some small grammar errors.

Under the "insurance industry" subsection, there is some good text on moral hazard in the insurance industry (though the citations are sparse), then a brief aside on the financial and banking industries (that doesn't belong there), and then a return to the discussion on insurance industries which re-introduces the concept as if we didn't just read a paragraph on it. These two subparts of the insurance discussion need to be combined. The latter part elaborates on two kinds of behavioral change from getting insurance (again, no clear citation), and then concludes with a sentence on how insurers reduce moral hazard (again, no clear citation). Overall, the section has good content, but needs to be re-jiggered to be clearer and have better citations.

Finally, the section on "Economic theory" isn't really coherent. It brings up a couple of past papers but doesn't explain them clearly. It also reiterates a lot that was mentioned before it.

My sources for improving the Moral hazard page:

A History of the Term "Moral Hazard" - https://www.jstor.org/stable/23354958 Cite

The Logic of Moral Hazard: A Game Theoretic Example - https://www.jstor.org/stable/252498 Cite

Moral Hazard in Health Insurance - www.jstor.org/stable/10.7312/fink16380 Cite

After the Bailout: Regulating Systemic Moral Hazard Essay - https://heinonline.org/HOL/Page?handle=hein.journals/uclalr57&id=185&collection=journals&index=

How did moral hazard contribute to the 2008 financial crisis? - https://www.investopedia.com/ask/answers/050515/how-did-moral-hazard-contribute-financial-crisis-2008.asp

MORAL HAZARD AND THE CRISIS - https://www.newyorker.com/business/james-surowiecki/moral-hazard-and-the-crisis

Too Big to Fool - https://heinonline.org/HOL/P?h=hein.journals/mnlr102&i=793

The Financial Crisis Inquiry Report - https://www.govinfo.gov/app/details/GPO-FCIC

Original lead section

In economics, moral hazard occurs when someone increases their exposure to risk when insured, especially when a person takes more risks because someone else bears the cost of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk.

Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard can occur when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

My lead section

In economics, moral hazard occurs when an actor has an incentive to increase their exposure to risk because they don't bear the full costs of those risks. For example, when a person is insured, they may take on higher risk knowing that their insurance will pay the associated costs of that risk. A moral hazard may occur where the actions of the risk-taking party may change to the detriment of the cost-bearing party after a financial transaction has taken place.

Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk and has a tendency or incentive to take on too much risk from the perspective of the party with less information. One example is a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. If the agent has more information about his or her actions or intentions than the principal does then the agent may have an incentive to act too riskily (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

My addition to History of the term

The concept of moral hazard was the subject of renewed study by economists in the 1960s, beginning with economist Ken Arrow, and then did not imply immoral behavior or fraud. Economists use this term to describe inefficiencies that can occur when risks are displaced or cannot be fully evaluated, rather than a description of the ethics or morals of the involved parties.

Connection to financial crisis of 2007-08

Main article: Financial crisis of 2007–08

Many scholars and journalists have argued that moral hazard played a role in the 2008 financial crisis, since numerous actors in the financial market may have had an incentive to increase their exposure to risk. In general, there are three ways in which moral hazard may have manifested itself in the lead up to the financial crisis.

• Asset managers may have had an incentive to take on more risk when managing other people's money, particularly if they were paid as a percentage of the fund's profits. If they took on more risk, they could expect higher payoff for themselves and were somewhat shielded from losses because they were spending other people's money. Therefore, asset managers may have been in a situation of moral hazard, where they would take on more risk than appropriate for a given client because they didn't bear the cost of failure.
• Mortgage loan originators, such as Washington Mutual, may have had an incentive to understate the risk of loans they originated because the loans were often sold to mortgage pools (see mortgage-backed securities). Because loan originators were paid on a per-mortgage basis, they had an incentive to produce as many mortgages as possible, even if they were risky. Because these institutions didn't expect to hold on to the loans until maturity, they could pass on the risk to the buyer of the loans. Therefore, mortgage loan originators may have been in a situation of moral hazard, because they didn't bear the costs of the risky mortgages they were underwriting.
• Third, large banks may have believed they were "too big to fail." That is, because these banks were so ingrained in the US economy, the federal government would not have allowed them to fail in order to prevent a full-scale economic crash. This belief may have been shaped by the 1998 bailout of Long Term Capital Management. "Too big to fail" banks may have believed they were essentially invincible to failure, thus putting them in a position of moral hazard: they could take on big risks - thus increasing their expected payoff - thinking that the federal government would bail them out in the event of a major failure. Therefore, large banks may have been in a situation of moral hazard, because they didn't bear the costs of a catastrophic collapse.

Notably, the Financial Crisis Inquiry Commission (FCIC), tasked by Congress with investigating the causes of the financial crisis, cited moral hazard as a component of the crisis, arguing that many factors, including deregulation in the derivatives market in 2000, reduced federal oversight, and the potential for government bailout of "too big to fail" institutions all played a role in increasing moral hazard in the years leading up to the collapse.

Others have argued that moral hazard could not have played a role in the financial crisis for three main reasons. First, in the event of a catastrophic failure, a government bailout would only come after major losses for the company. So even if a bailout was expected it wouldn't prevent the firm from taking losses. Second, there's some evidence that big banks weren't expecting the crisis and thus weren't expecting government bailouts, though the FCIC tried hard to contest this idea. Third, some have argued that negative externalities from corporate governance were a more important cause, since some risky investments may have had positive expected payoff for the firm but negative expected payoff to society.

Numerical example

A graphical representation of moral hazard in health insurance.

Consider a potential case of moral hazard in the health care market caused by the purchase of health insurance. Assume health care has constant marginal cost of $10 per unit and the individual's demand is given by $Q=20-P$. Assuming a perfectly competitive market, at equilibrium, the price will be $10 per unit and the individual will consume 10 units of health care. Now, consider the same individual with health insurance. Assume this health insurance makes health care free for the individual. In this case, the individual will have a price of $0 for the health care and thus will consume 20 units. The price will still be $10, but the insurance company would be the one bearing the costs.

This example is shown graphically at the right. The blue line represents the downward sloping marginal benefit curve. The orange line represents the constant marginal cost curve without insurance. The green star is the market equilibrium. When the individual is insured, the marginal cost curve shifts down to 0, leading to a new equilibrium at the yellow star.

This example shows numerically how moral hazard could occur with health insurance. The individual consumes more health care than the equilibrium quantity because they don't bear the cost of the additional care.