A company has purchased fire insurance for its main factory. The probability of a fire in the…

A company has purchased fire insurance for its main
factory. The probability of a fire in the factory without a fire-prevention
program is 0.01. The probability of a fire in a factory with a fire-protection
program is 0.001. If a fire occurred, the value of the loss would be $300,000.
A fire prevention program would cost $80 to run, but the insurance company
cannot costlessly observe whether or not the prevention program has been
implemented.

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(a) Why does moral hazard arise in this situation? What
is its source?

(b) Can the insurance company eliminate the moral hazard
problem? If so, how? If not, explain why not. 

 

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