Moral hazard happens when a person or group takes more risks because they do not have to pay for the full consequences of their actions. This often occurs after an agreement is signed or insurance is purchased, as the protected party no longer feels full responsibility for potential losses.
Essentially, people tend to be less careful when someone else covers the costs.
Key Characteristics:
- Occurs after a transaction or contract is made.
- The insured person has less motivation to avoid problems.
- It creates a conflict where individual interests go against the common good.
Examples of Moral Hazard:
- Car insurance: Someone might drive more recklessly if they know the insurance company will pay for damages.
- Health insurance: People might take fewer steps to stay healthy if their medical bills are fully covered.
- Bank bailouts: Banks might make dangerous investments if they believe the government will save them from failure.
Why It Matters:
- It causes higher costs for companies, which leads to more expensive premiums for everyone.
- It can hurt society if risky behavior negatively impacts other people.
- It can make certain insurance markets impossible to maintain without government rules.
Common Solutions:
- Deductibles and co-payments: Making the insured party pay for a small part of the loss keeps them careful.
- Rewards: Giving bonuses to people who do not file claims.
- Monitoring: Using contracts to track performance and ensure responsible behavior.
Connection to Information Problems:
- Moral hazard is a form of asymmetric information, meaning one side has more knowledge or control than the other.
- It involves hidden actions, where an insurer cannot see real-time behavior.
- It is linked to the principal-agent problem, where a person authorized to act for another does not act in their best interest.