Moral Hazard Problem :

Marty has been driving his Dads old beat up car to work and school. To embarrass him, Biff, the local bully, has challenged Marty to a race. If he wins, he gets $1,000 but if he loses, he pays $1,000.

Using his Dads old car, Marty guesses that Biff would win 8 times out of 10. This is embarrassing! To Marty, avoiding the humiliation of not racing Biff at all is worth $100.

Unknown to Biff, Martys mom, Mrs. McFly, is CFO at Luxury Cars Inc. and she often drives home in the $625,000 company Ferrari. If Marty can secretly borrow his Moms car, Marty guesses hell win 9 times out of 10.

There is a catch. Under racing conditions, Marty figures he has a 1% chance of a crash. Using his Dads car, hed pay the $500 insurance deductible. Using his Moms car, hed do $200,000 in damage, but Luxury Cars Inc. is fully insured so Marty would pay nothing. Marty needs to consider his options.

Q. What is the payoff (please express as positive number) or loss (please express as negative number) of not racing Biff?

Q. What is the expected payoff (please express as positive number) or loss (please express as negative number) of Marty racing using his Dads car?

Q. What is the expected total payoff (please express as positive number) or loss (please express as negative number) of racing using his Moms car including an accident?

Q. What is Martys personal expected payoff (please express as positive number) or loss (please express as negative number) of racing using his Moms car?

Q. So, what does Marty do?

1. Marty races using his Moms car 2. Marty races using his Dads car 3. Marty doesnt race Biff and is humiliated 4. Marty buys additional insurance and races with his moms car

Now suppose that Marty overhears his Mom talking to his Dad, and she mentions that Luxury Cars Inc. has installed tracking devices in all their cars.

The company knows everything about a drivers behavior and can also track their expensive cars if stolen. If the cars are used for racing, theres a $1000 fee. This covers Luxury Cars own deductible if there is an accident, and actually makes money for Luxury Cars if there is no accident.

Q. What is Martys payoff (please express as positive number) or loss (please express as negative number) of racing using his Moms car and covering the racing fee?

Q. What does Marty do now?

1. Marty races using his Moms car 2. Marty races using his Dads car 3. Marty doesnt race Biff and is humiliated 4. Marty buys additional insurance and races with his moms car

Q. To solve the moral hazard problem of racing with its cars, Luxury Cars Inc. has used the tracking device to (choose the best answer):

1. Monitor bad behavior 2. Restrict action sets 3. Provide an incentive contract to improve effort 4. Bond to align goals 5. Change ownership in outcomes to align goals

Q. Suppose that in order to get the keys to Ms. McFlys car, Marty must turn his stereo and Xbox over to his Mom until the car comes back in good condition. This would be an example of (choose the best answer):

1. Monitoring bad behavior 2. Restricting action sets 3. Providing an incentive contract to improve effort 4. Bonding to align goals 5. Changing ownership in outcomes to align goals

Luxury Cars Inc. knows that its customers like to race, so it offers an advanced drivers education training program to improve drivers skills. Drivers who take this course pay $200 and if they race, there is no racing fee, only a $2,000 cost if the driver actually has an accident to cover Luxury Car Incs deductible. Marty figures if he takes this course, his chances of beating Biff in his Moms car rise to 99% and his chances of an accident fall to 0.001.

But theres still a problem. If his Mom catches him racing, hell still be grounded for a month, which is worse than not standing up to Biff. So, he discusses his problem with his Mom. Mrs. McFly is willing to loan her son her own car if hell take the drivers edu course, cover Luxury Car Inc.s accident fee, and also take the family out to a $100 steak dinner following a win.

Q. What is Marty's payoff now?

1. $279 2. $379 3. $479 4. $579 5. $679

Q. What should Marty do now?

1. Marty races Biff and with 99% probability enjoys a steak dinner with his family 2. Marty races using his Moms car 3. Marty races using his Dads car 4. Marty doesnt race Biff and is humiliated

Q. In addressing the moral hazard problem, the deal that Marty makes with his Mom, and taking her to dinner, is an example of (choose best answer):

1. Monitoring bad behavior 2. Restricting action sets 3. Providing an incentive contract to improve effort 4. Changing ownership in outcomes to align goals

Q. Suppose that Mrs. McFly really wants her son to win and so makes him an offer that if he wins by more than a car-length (with no accidents), then she will take the family out for dinner and Marty wont need to pay. This is an example of (choose best answer):

1. Monitoring bad behavior 2. Restricting action sets 3. Providing an incentive contract to improve effort 4. Bonding to align goals 5. Changing ownership in outcomes to align goals