I’m not sure if Economic Thinking Thursday will become a series or not, but I’ve been looking for opportunities to write about the role that basic economic thinking can play in looking at society and the firm. Today’s example comes from this article, namely the following quote:
“We recognize that moral hazard is a real and significant concern” in the Troubled Asset Relief Program, Timothy Massad, acting assistant secretary for financial stability, said in a hearing before a House Oversight Committee panel today. “But to suggest that it is TARP’s main legacy is to ignore the facts, and to confuse the response to a crisis with the need to address the causes of the crisis.”
Moral Hazard “occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.” Critics of TARP often allege that it created an environment in which financial institutions are insulated from risk.
The purpose of this post is not to determine whether or not TARP creates moral hazard. Instead, I want to focus on how exposure to risk–and being shielded from it–can affect organizational behavior. Taking too much (or unprincipled) risk can destroy value. However, taking too little risk leaves value on the table. It seems that people are more likely to sacrifice value (perhaps because the unseen loss appears better than one that is seen).
Firms, by their very nature, shield employees from risk. If an employee makes a bad deal, they are unlikely to be personally liable for the losses related to that deal (assuming that the deal was legal and that the employee was authorized to make the deal). Aware that employees still tend to be too risk averse, some firms take extra steps to shield employees from risk. They encourage experimentation, forgive disciplined failure, and give disproportionally large incentives for risks that pay off.
Your Challenge: Using the definition of moral hazard, the example from the article, and your knowledge of the subject, discuss the role of moral hazard in understanding how firm might encourage and/or discourage risk aversion.