1)What is a moral hazard? Illustrate with an example.

2)

A principal-agent problem is most likely to arise when

a. a new music school is inaugurated in a town.

b. a homeowner appoints a gardener to maintain his lawn.

c. a homemaker buys fresh fish from a local fishmonger.

d. a company outsources its tax computation to a consultancy.

e. a teenager requests his hairstylist for a new hairstyle.

1)Moral hazard relates to a risk that an individual or firm enters into knowing that another party will be held accountable for the loss if it occurs; thus, they fail to come up with ways of avoiding the risk. This is most common in loan and insurance contract where borrowers and insured parties engage in risky operations, knowing that someone else will be responsible for their treacherous actions.

An example of a moral hazard is when one fails to protect his home property from fire by putting in fire extinguishers because they know that an insurer will be responsible since he or she has paid for full home insurance cover.

2)

• A principal-agent problem is most likely to arise when b. a homeowner appoints a gardener to maintain his lawn.

When a principal-agent problem arises when (1) a principal hires an agent to act on his/her behalf; (2) the principal cannot perfectly observe the actions of the agent; (3) the agent can take actions that better his/her own interest at the cost of the best interest of the principal.

When a homeowner appoints a gardener, the homeowner is the principal, and the gardener is the agent. The gardener is acting on behalf of the homeowner by taking care of the lawn. But the gardener can shrink without the homeowner's knowledge, which hurts the best interest of the homeowner. Thus this represents a situation of the principal-agent problem.