Moral Hazard Problem

Marty has been driving his Dad's 20-year-old beat-up car to work and school. To embarrass him, Biff, the local bully has challenged Marty to a car race. If Marty wins, he gets $1,000 but if he loses, he pays $1,000.

If Marty races using his Dad's old car, Marty guesses that Biff would win 8 times out of 10. This is embarrassing!Marty is willing to pay $100 to not race at all, just to avoid the humiliation.

Unknown to Biff, Marty's 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 Mom's car and use that in the race, Marty guesses that he will win 9 times out of 10.

There is a catch. Under racing conditions, Marty figures he has a 1 percent chance of a crash. Having an accident is independent of winning or losing. If Marty crashes his Dad's car, he will pay the $500 insurance deductible.If Marty crashes his Mom's car, the car will incur $200,000 in damage, but Luxury Cars Inc. is fully insured, with no deductible, so Marty would pay nothing out-of-pocket.

Marty needs to consider his options.

HINT: Review Notes 4A and 4B again before attempting this problem set. Note that payoff can be calculated by multiplying the likelihood (chance) of an occurrence by the dollar amount spent or earned on that occurrence and adding up all scenarios to determine the payoff (loss or gain).

Question 1

What is Marty'sexpected profit/gain (express as positive number) or loss (express as negative number) of not racing Biff?

Question 2

What is Marty'sexpected profit/gain (express as positive number) or loss (express as negative number) of Marty racing Biff using his Dad's car? Consider the potential of an accident in your calculation. Blank 1

Question 3

What is Marty's personal expected profit/gain (please express as positive number) or loss (please express as negative number) of racing Biff using his Mom's car? Consider the potential of an accident in your calculation. Blank 1

Question 4

What is the total expected profit/gain (express as positive number) or loss (express as negative number) of Marty racing using his Mom's car? Consider the potential for an accident. Blank 1

Question 5

So, what does Marty do?

a) Marty races using his Mom's car

b) Marty races using his Dad's car

c) Marty doesn't race Biff and is humiliated

d) Marty buys additional insurance and then races with his mom's car

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

The company knows everything about a driver's behavior behind the wheel and can also track their expensive cars if they are stolen.There is a $1,000 fee, to use a Luxury Car vehiclefor racing. The fee covers Luxury Cars' own insurance deductible if there is an accident or makes money for Luxury Cars if there is no accident.

Question 6

What is Marty's personal expected profit/gain (express as positive number) or loss (express as negative number)of Marty racing Biff using his Mom's car and paying the $1,000 racingfee? Blank 1

Question 7

What does Marty do now?

Marty races using his Mom's car

Marty races using his Dad's car

Marty doesn't race Biff and is humiliated

Marty buys additional insurance and races with his mom's car

Question 8

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

Monitor bad behavior

Restrict action sets

Provide an incentive contract to improve effort

Bond to align goals

Change ownership in outcomes to align goals

Question 9

Suppose that in order to get the keys to Ms. McFly's 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):

Monitoring bad behavior

Restricting action sets

Providing an incentive contract to improve effort

Bonding to align goals

Changing ownership in outcomes to align goals

Luxury Cars Inc. knows that its customers like to race, so it offers an advanced driver's education training program to improve driver's 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 Inc's deductible. Marty figures if he takes this course, his chances of beating Biff in his Mom's car rise to 99% and his chances of an accident fall to 0.001.

But there's still a problem. If his Mom catches him racing, he'll 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 he'll take the driver's ed course, cover Luxury Car Inc.'s accident fee, and take the family out to a $100 steak dinner following a win.

Question 10

What is Marty's payoff now?

$279

$379

$479

$579

$679

Question 11

What should Marty do now?

Marty races Biff with his mom's car, takes the driver's ed course and with 99% probability enjoys a steak dinner with his family

Marty races using his Mom's car but privately skips the driver's ed

Marty races using his Dad's car

Marty doesn't race Biff and is humiliated