Moral Hazard

Overview

"Moral hazard" refers to a situation in which one party becomes involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other. The party insulated from risk behaves differently than it would if it were fully exposed to the risk. Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard can occur when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

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History

The term "moral hazard" originates from the insurance industry. Insurance companies were concerned that protecting their clients from risks (like fire, or car accidents) might lead them to behave in riskier ways (like smoking in bed or not maintaining their car properly). This is because they know the cost of their reckless behavior will be borne by the insurance company. In this context, the insured individual is said to have a "moral hazard".

Economic Theory

In economic theory, moral hazard is a situation where the behavior of one party may change to the detriment of another after a financial transaction has taken place. It is a situation where a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently than it would if it were fully exposed to the risk. Moral hazard can be divided into two types: ex-ante (before the event) and ex-post (after the event).

Ex-Ante Moral Hazard

Ex-ante moral hazard is a change in behavior prior to the outcome of a random event, or in anticipation of being insured. For example, if a person has theft insurance on their car, they may be less likely to lock it, or more likely to park it in a high crime area. The insured party has the possibility to behave in such a way as to make the insured event more likely.

Ex-Post Moral Hazard

Ex-post moral hazard is a change in behavior after the outcome of a random event, or after being insured. For example, after a person has had a car accident and the car has been repaired, they may be less careful about driving or maintaining the car, because they know that any damage can be repaired at the insurer's expense. The insured party has the possibility to behave in such a way as to make the insurer bear a larger cost than necessary.

Examples of Moral Hazard

Moral hazard can occur in various sectors and situations, including insurance, finance, and law. For example, in the financial industry, a lender may take on risky lending knowing that if it fails, the cost will be borne by the borrower or the government. In the legal field, a lawyer may take on a risky case knowing that if he loses, the cost will be borne by the client. Similarly, in politics, a politician may take on a risky policy knowing that if it fails, the cost will be borne by the public.

Mitigation of Moral Hazard

There are several ways to mitigate moral hazard, including financial incentives, contractual obligations, and monitoring. Financial incentives can be used to align the interests of the parties. For example, a deductible in an insurance policy can reduce moral hazard by making the insured party bear some of the cost of loss. Contractual obligations can be used to limit the behavior of the insured party. For example, an insurance policy may require the insured party to install a security system. Monitoring can be used to reduce information asymmetry. For example, a lender may monitor the borrower's financial situation.