A company has purchased fire insurance for its main factory. The probability of a fire in the factory without a fire-prevention program is 0.01. The probability of a fire in a factory with a...

A company has purchased fire insurance for its main factory. The probability of a fire in the factory without a fire-prevention program is 0.01. The probability of a fire in a factory with a fire-protection program is 0.001. If a fire occurred, the value of the loss would be $300,000. A fire prevention program would cost $80 to run, but the insurance company cannot costlessly observe whether or not the prevention program has been implemented.

(a) Why does moral hazard arise in this situation? What is its source?

(b) Can the insurance company eliminate the moral hazard problem? If so, how? If not, explain why not.