Answer to Question #104393 in Management for mary

Question

Consider a small coffee shop run by a manager who is also the owner. If this coffee
shop borrows money, why might a moral hazard problem still exist? Explain.

Answer 1

Moral Hazard in Financial Lending

The moral hazard concept traces its origin to insurance literature. Contemporary economists use the term to define loss-increasing behavior, which arises under insurance coverage. Moral hazard may also refer to an ex ante behavior that involves the consequences of insurance on risk-reducing incentives. These definitions suggest that moral hazard occurs when people or businesses lack the incentive to take care. A moral hazard may still occur in the coffee shop even if it is operated by the owner if he is involved in risky activities and decisions knowing that he or she has protection against such risks.

A moral hazard occurs in a financial market when the lender and the borrower have incomplete information about one another. The lending institution may fear that the borrower or coffee shop owner may engage in risky or undesirable activities that may hinder him or her from paying back the loan. For example, the coffee shop manager may act in a riskier manner if he or she knows that some third party will pay for his or her loan. The coffee house manager may also be subjected to moral hazard when he or she believes that he/she can misappropriate the money borrowed without prosecution if he or she turns out incapable to pay back.

As stated earlier, moral hazard may also arise due to a lack of adequate information between the bank and the coffee house manager. This may occur if the hotel manager does not enter into the contract in good faith by failing to provide accurate information about his or her property or credit capacity. Further, moral hazard may occur when the coffee house manager participates in unusual risks with a quest to earn profits before the agreement settles. These arguments show moral hazard includes any attempts by the coffee shop manager to act against the provisions of the loan contract. 

References

Hülsmann, G. D. What causes moral hazard? Retrieved from, https://mises.org/library/what-causes-moral-hazard

Rowell, D., & Connelly, L. B. (2012). A history of the term “moral hazard”. Journal of Risk and Insurance, 79(4), 1051-1075.