Moral Hazard and Compensation for Income Losses: Results from an Experiment

Compensation for income losses may create a problem of double moral hazard: the party at risk may not undertake any risk-reducing effort, and if the extent of the loss suffered is unobservable to the party liable for compensation, the size of claim may be exaggerated. This paper uses experimental methods to investigate the effort and reporting decisions of an individual subject to the risk of a monetary loss. We find that the decision to over-report the loss suffered is sensitive to the probability of obtaining compensation, as intuition suggests. However, most subjects chose to expend effort ex ante although it would have been rational not to do so.