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What is Moral Hazard?
Moral hazard occurs when one party engages in risky behaviour or makes decisions knowing that another party bears the consequences of those risks. It arises from asymmetric information and misaligned incentives.
Definition
Moral hazard is a situation where individuals or organizations take greater risks because they do not fully bear the costs of those risks.
Key Takeaways
- Occurs due to unequal information and shifted responsibility.
- Common in insurance, finance, and employment relationships.
- Can lead to inefficient or irresponsible decision-making.
Understanding Moral Hazard
Moral hazard emerges when the person making a decision is protected from the risk’s negative consequences, often leading them to behave less cautiously. This problem is widespread in insurance markets—for example, individuals with full coverage may take fewer safety precautions.
In financial markets, moral hazard played a significant role during the 2008 financial crisis. Banks engaged in risky lending because they expected government bailouts if things went wrong.
Organizations mitigate moral hazard through monitoring, incentive alignment, contracts, deductibles, co-payments, and performance-based compensation.
Formula (If Applicable)
No specific formula applies, but economic models address:
- Principal–Agent Problem
- Information Asymmetry
- Incentive Design
Real-World Example
If an employee’s performance is not monitored but they receive the same pay regardless of effort, they may exert less effort—creating moral hazard due to lack of accountability.
Importance in Business or Economics
Moral hazard affects economic efficiency, financial stability, and organization performance. Policymakers design regulations, incentives, and monitoring systems to reduce moral hazard in markets and institutions.
Types or Variations
- Ex-Post Moral Hazard: After a contract is signed.
- Ex-Ante Moral Hazard: Before a contract is signed.
- Financial Moral Hazard: Risky financial behaviour due to safety nets.
Related Terms
- Principal–Agent Problem
- Adverse Selection
- Information Asymmetry
Sources and Further Reading
- Investopedia – Moral Hazard: https://www.investopedia.com/terms/m/moralhazard.asp
- OECD – Behavioural Economics: https://www.oecd.org
- Federal Reserve – Economic Research: https://www.federalreserve.gov
Quick Reference
- Risk-taking increases when one party doesn’t bear full consequences.
- Common in insurance, finance, and labour markets.
- Managed through incentives, monitoring, and contract design.
Frequently Asked Questions (FAQs)
What causes moral hazard?
Information asymmetry and misaligned incentives.
Can moral hazard be eliminated?
Not completely, but it can be reduced with proper incentives and oversight.
Is moral hazard always bad?
Not necessarily, some risk-taking is beneficial, but unchecked moral hazard can lead to systemic issues.
