Moral Hazard

Moral hazard refers to situations where a party takes on riskier behavior because they’re shielded from the consequences. It often occurs in insurance, finance, and healthcare, potentially leading to market inefficiencies and higher costs. Strategies exist to mitigate it.

Definition of Moral Hazard

Moral hazard is 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.

Information Asymmetry

At the heart of moral hazard is an imbalance of information, also known as information asymmetry. One party has more or better information than the other, leading to actions that may not be in the best interest of the uninformed party.

Insurance and Moral Hazard

One of the most common examples of moral hazard involves insurance. When a party is insured, they may take greater risks because they know they are protected from the potential costs of those risks.

Consequences of Moral Hazard

If unchecked, moral hazard can lead to a range of negative outcomes including market failures, increased costs for certain parties, and general economic instability. For instance, during the 2008 financial crisis, several large financial institutions made risky investments knowing that they were “too big to fail” and would likely be bailed out by the government.

Mitigation Strategies

There are strategies to mitigate moral hazard, including deductibles in insurance policies, copayments, and regulation. These strategies aim to align the interests of all parties involved, incentivizing behavior that is less risky or damaging.

Adverse Selection and Moral Hazard

Moral hazard is often mentioned alongside adverse selection, another concept related to information asymmetry. While moral hazard involves changes in behavior due to shifts in risk exposure, adverse selection refers to a situation where high-risk individuals are more likely to select into insurance, driving up costs for the insurer.

Moral Hazard in Public Policy

Beyond insurance and finance, moral hazard can arise in a number of public policy contexts. For example, if a government routinely bails out failing businesses, companies may engage in riskier behavior knowing they have a safety net.

Signaling and Screening in Moral Hazard

To manage moral hazard, the uninformed party can use techniques like signaling and screening. Signaling involves the informed party sending a message to demonstrate its type, while screening involves the uninformed party using mechanisms to reveal the informed party’s type.