If a firm borrows a large sum of money, it may engage in particularly risky investments knowing that if the investments succeed, the firm will make lots of money, while if the investments fail, the firm can declare bankruptcy. This is an example of:
A) risk taking.
B) adverse selection.
C) poor decision making.
D) Ricardian equivalency.
E) moral hazard.

Question

Quizplus · Accepted Answer

This scenario is an example of moral hazard, which occurs when one party takes on more risk because they are insulated from the consequences of their actions due to a contractual arrangement. In this case, the firm is taking on risky investments because they know that if they fail, they can declare bankruptcy and the lenders will suffer the consequence, not them.

If a Firm Borrows a Large Sum of Money, It