Sex Scandals Create a Problem of Moral Hazard

Asymmetric information creates a moral hazard problem if one party in a transaction cannot observe the (possibly bad) behaviour of the other party. It was moral hazard that caused the sub-prime mortgage meltdown in the U.S. housing market, as those who owned the risky mortgages could not observe the decisions made by mortgage brokers—who were more than willing to dole out money (that wasn’t their own) to high-risk homeowners.

Moral hazard is also a problem in the world of celebrity sports figures. Would-be corporate sponsors can’t monitor the bedroom behaviour of the athletes they endorse. As a result, they risk having their brand tarnished if the celeb associated with it is caught in a sex scandal. (Sometimes, admittedly, a sex scandal helps the brand, but I suspect that effect is product-specific.)

The problem with moral hazard it is that it causes risk-averse firms to under-invest in sponsorship. If there was a way to solve the moral hazard problem—for example if firms could directly observe the behaviour of the star whose wagons they are hitched to—then sponsorship would increase and both players in the transactions (firms and celebrities) would be better off.  

I don’t know of a way to solve this particular moral hazard problem. The usual solution, government regulation, seems an unlikely candidate. There is a way, though, for the endorsing firm to reduce the risk created by the moral hazard problem; buy insurance that pays out if the person you endorse behaves badly. It’s called "disgrace insurance."

No surprise that there is sufficient demand to make providing disgrace insurance profitable. But I would love to know how it is priced by the insurance companies. I always thought that being an actuary would be a great job, and now I am absolutely sold on the idea. I can just see it: "Adshade, we want you to get out there and determine the probability that [name big sports celebrity here] will put his willy where he shouldn't!"

What fun. I wonder if they ask their wives.Big thanks to Kim Brooks who sent me this article, which led to this post.

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