Louisa is an avid cyclist who is currently working on her business degree. She normally rides an

$800 bike to class. If Louisa locks her bike carefully—locks both wheels—the chance of theft for the term is 5%, but this careful locking procedure is time consuming. If she is less careful—just quickly locks the frame to a bike rack—the chance of theft is 20%. Louisa is risk averse and is considering buying theft insurance for her bike. There are two types of insurance. With full insurance, Louisa pays the premium and gets the full $800 value of the bike if it is stolen. Alternatively, with partial insurance, Louisa receives only 75% of the bike’s value, $600, if the bike is stolen. Which contract is more likely to induce moral hazard problems? To break even on consumers like Louisa, what price would the risk-neutral insurance company have to charge for full insurance? If we observe Louisa buying partial insurance what can we say about the trade-off between moral hazard and efficient risk-bearing.

4. Monitoring to Reduce Moral Hazard