Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAP. 15] THE ECONOMICS OF INFORMATION 345
well as benefiting from the franchise good will and advertisements in return for a franchise fee, a fraction of the
outlet’s revenues, and the responsibility to abide by the franchise rules on quality, cleanliness, operating hours,
etc. By enforcing these rules, the franchise ensures quality in all of its outlets.
Thus, while an area resident could conceivably find a better buy at a local retailer because of his knowledge of
the area, a traveler who is not familiar with the area is happy to pay a little more at a national franchise outlet to
ensure consistent quality wherever he happens to be. If the franchise were unable or unwilling to regularly
inspect its outlets and close those that do not uphold its standard of quality, it would soon lose its value. Thus, a
franchise provides a signal of quality.
THE PROBLEM OF MORAL HAZARD
15.15 (a) What problem can arise for General Motors by providing a 50,000-mile guarantee for its new automobiles
sold? (b) How can GM reduce this problem?
(a)
(b)
The problem that can arise for GM by providing a 50,000 miles guarantee for its new automobiles sold is that
of moral hazard. That is, since GM pays for any breakdown on the new automobiles sold, buyers will not be as
careful to avoid costly breakdowns.
GM could try to reduce the moral hazard problem by demanding regular tune ups and requiring the buyer to
bring their automobiles to a GM dealer as soon as any sign of problem arises.
15.16 An insurance company is considering providing fire insurance for $120,000, $100,000, or $80,000 to
the owner of a house with a market value of $100,000. (a) How much insurance is the company
likely to sell for the house? Why? (b) If the probability of a fire is 1 in 1000, what would be the
premium charged by the company?
(a)
(b)
The insurance company is likely to provide only $80,000 insurance to the owner of the house in order to
reduce the problem of moral hazard. In fact, if the insurance company allowed the owner of the house to purchase
insurance for $120,000, it would actually encourage that the house will go up in smoke because in that
case the owner would collect more than the value of the house from the insurance company.
If the probability of a fire is one in one thousand, the insurance premium would (1/1000)($80,000) ¼ $80 per
year plus the cost of operation (including the opportunity costs) of the insurance company for an insurance
policy for $80,000.
15.17 What is the relationship between moral hazard and externalities?
Moral hazard arises whenever there is an externality (i.e., whenever an economic agent can shift some of
its costs to others). Then the economic agent will not be as careful to avoid a possible loss. This increases the
probability of a loss and the amount claimed for reimbursement from the insurance company.
PRINCIPAL-AGENT PROBLEM
15.18 From your school library, get the September 11, 2000 issue of BusinessWeek and read Dean Foust’s
article on “CEO’s Pay: Nothing Succeeds like Failure” on p. 46 and indicate some of the abuses in
the use of golden parachutes discussed in the article.
In his article, Dean Foust remarked “failure has never looked more lucrative”. For example, in August 2000,
Proctor & Gamble gave Durk Jager, its just-ousted CEO, a $9.5 million bonus even though he had been at P&G less
than one-and-half years and P&G stock had fallen by 50% during his tenure. Also in 2000, Conseco Inc. gave a
$49.3 million going-away gift to CEO Stephen Hilbert, who practically bankrupted the company with his ill-fated
move into sub-prime lending. Similarly, Mattel gave a parachute package worth nearly $50 million in severance pay
to Jill Barard, its departing CEO.