Moral hazard

This article describes a market failure situation, i.e. a situation where the rational pursuit of self-interest by individual agents leads to an outcome that fails a Pareto optimality criterion.|See a list of market failures

Definition

Moral hazard refers to a situation where a market transaction empowers one of the parties to the transaction to take an unobservable action that is more beneficial to that party than earlier, and more harmful to the other party than earlier.

For instance, an insurance contract empowers the insured to behave more riskily, bearing a smaller fraction of the total cost of risky behavior, while passing the added cost to the insurer. If deliberate risk-taking is hard to distinguish from genuine problems that the insured person may encounter, a situation of moral hazard is created.

Moral hazard is an example of asymmetric information leading to a market failure.

Conditions for moral hazard

One of the parties can take single-handed action without being observed

It is necessary that one of the parties to the transaction should be able to single-handedly take action that cannot be observed, or identified, by the other party. If the party's actions can easily be observed by the other party, then the original contract could include clauses that forbid such action, or impose penalties for such action.

The action harms the party less than before

For the situation to pose moral hazard, the party taking the unobservable action should either be benefited, or be harmed less than the extent to which that person was harmed before the transaction. In the case that the unobservable action is a net benefit for the party, the party has a strong incentive to engage in the action. But even in situations where the cost of the action is simply reduced, the party may be tempted to undertake more risky behavior. For instance, health insurance may not make people desire becoming sick, but it may make people slightly more careless about their health. Similarly, financial insurance may make people and institutions less risk-averse and thus may increase the possibility of financial problems.

The action hurts the other party more than before

The other party to the transaction must lose in some way from the action. For instance, in the case of insurance, the insurer loses from risky behavior, because it increases the probability that the insurer will have to pay up.

Alternative explanations for apparent moral hazard

Adverse selection

Further information: Adverse selection versus moral hazard

Moral hazard is often confused with adverse selection. Adverse selection is another example of how asymmetric information leads to a market failure. The difference is that adverse selection occurs when one of the parties has more information than the other prior to the transaction, while moral hazard occurs when one of the parties is able to take unobservable actions after the transaction.