“In economics, moral hazard occurs when an individual has an incentive to increase their exposure to...

“In economics, moral hazard occurs when an individual has an incentive to increase their exposure to risk because they do not bear the full costs of that risk. For example, when a person is insured, they may take on higher risk knowing that their insurance will pay the associated costs.”

One of the topics of chapter 10 is market power and concentration. In the current economic crisis, many large firms will receive governments “bailouts.” What is your opinion of the possibility that government “bailouts” will only increase moral hazard of large firms that are “too big to fail.”

Expert Solution

Moral Hazard is a critical concept of economics. It clearly defines the fact that irrational behaviour may take place and a person may be able to take larger risks, if they believe that the risk would not affect their actions. The example of insurance here is correct. So long as a person has car insurance, they are less worried if their car is damaged because they are aware that major part of the costs is covered.

Similarly, in the current environment as the COVID 19 has created greater issues for the private sectors, a bailout package by the government may make them continue with reckless activities such as production of those goods and services which may not be needed. Or to continue pursuing certain costs which are avoidable and should not be allowed for a firm’s profit. For example, it is said that corporations use expenses as a technique to evade taxation. Therefore, if the government was not to give such bailout packages, companies would be forced to reduce some of the unnecessary expenditure.

Thus, we find evidence in the fact that the bailout package may lead to a critical moral hazard of companies becoming complacent and irresponsible towards their expenses as they would know that governments would help them in paying off a large portion of the added expenses. Some may also seek loans at lower interest rates and this may increase bad debts for the society at large.

Please feel free to ask your doubts in the comments section.

Rahul Sunny answered 7 months ago

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