Probability of a fire with a fire prevention program

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Reference no: EM131278338

A firm has purchased fire insurance for its main factory. The probability of a fire in the factory without a fire prevention program is 1%. The probability of a fire with a fire prevention program is 0.1%. If a fire occurred, the value of the loss would be $900,000. A fire prevention program would cost $100 to run, but the insurance company cannot observe whether or not the fire prevention program has been implemented at no cost.

1. Why does moral hazard arise in this situation? What is its source?

2. Can the insurance company eliminate the moral hazard problem? If yes, how this problem be eliminated? If not, explain why it cannot?

Reference no: EM131278338

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