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
(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.