Public Bail-out Projects and Moral Hazard

Abstract

It often happens that a public bail-out project ends up with ineffective spending. In our opinion, most problems relating to public spending stem from moral hazard or hidden action. Depending on the incentive scheme, the problem can be either exacerbated or reduced. In this paper, we will suggest an incentive scheme for resolving the moral hazard problem from the perspective of strategic information transmission. Prior to the decision of a bail-out project, a government and firms play a game of communication using messages. That is, a firm signals its own capabilities and the government updates its belief of the firm’s true capabilities after receiving the signal. According to our analysis, the game leads to a paradox such that, when a firm is allowed to indirectly indicate its own capability rather than be forced to tell the truth (i.e. confess), total payoffs for both players can be increased in preventing serious moral hazard.