Overview:

In economic theory, a moral hazard is a situation where a party will have a tendency to take risks because the costs that could result will not be felt by the party taking the risk. In other words, it is a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.

Example: You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishappening, like fire or burglary. Hence you will show extra care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any unforeseen event. But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

For this assignment, you will explore a corporate scandal that has occurred in the past 5 years. You will examine moral hazard and the relationship with excessive risk taking by management.

Action Items:

Q1. Read the following articles:

a. Economics and Moral Sentiments: The Case of Moral Hazard by Sheila C Dow Presented to the CES Workshop on ‘Facts, Values and Objectivity', Coimbra, March 2010

"The purpose of this paper is to develop the argument that sentiments (including moral sentiments) are endemic to the building of knowledge about the economy, as well as the functioning of the economy itself. This contrasts with the mainstream treatment of sentiment as separable from rationality, such that it is seen (if at all) as requiring an ex post modification of rational choice theory. The case of moral hazard is considered, first in its mainstream interpretation in terms of rationality, and then in terms of an alternative approach where knowledge and behavior are built on (moral) sentiments. The implications are drawn for how we understand the financial crisis, and the appropriate policy response."

b. Moral Hazard and Earnings Manipulation by Anton Miglo Advances in Economics and Business 1(2): 39-48, 2013. DOI: 10.13189/aeb.2013.010201

"We consider a principal-agent relationship, where the agent is subject to a double moral hazard problem (the choice of production effort and earnings manipulation). Since the agent cannot completely capture the results of his effort, the production effort is socially inefficient. The opportunity to manipulate earnings protects the agent against the risk of a low payoff when the results of production are low. Ex-ante, this provides an incentive for the agent to improve effort. Optimal contract trades-off social loss from earnings manipulation and improved incentives for productive effort. In equilibrium some degree of earnings manipulation can be optimal."

c. Reconceptualizing Corporate Boards

Should board members have to be "natural persons"? By M. Todd Henderson

"Corporations play a central role in our capitalist society and therefore corporate governance is a matter of vital public debate. Reformers argue that governance could be improved by requiring different types of executive compensation, changing election procedures, increasing independence requirements, or the like. Defenders of the status quo, on the other hand, counter that these reforms are unnecessary or even harmful and mistrust any one-size-fits-all solution."

Q2. Identify a corporate scandal that has occurred in the last 5 years.

Q3. Identify the moral hazard associated with this scandal.

Q4. Research the excessive risks that were taken by management that led to the scandal.

Q5. Reflect on possible solutions to mitigate the moral hazard.

Q6. Write a 2- to 3-page paper that includes the following sections. Include 1 to 2 resources besides your textbook. Format the paper according to the Academic Paper Guidelines.

a. Discusses the corporate scandal chosen and the moral hazard involved.
b. Discusses the excessive risk-taking by management.
c. Provides possible solutions to mitigate the moral hazard.