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What is the Moral Hazard Problem? | Economics Definitions
Moral Hazard Explained
The moral hazard problem is a concept in Economics that you might need to know of. It is a cause of market failure due to information failure.
Moral hazard occurs when there is asymmetric information between two parties. It occurs when the behaviour or actions from one party changes after an agreement is reached between two or more parties.
One example of moral hazard is from the car insurance industry. Once somebody has agreed a product and price with an insurance company, they are insured against risk. This might mean that the driver is willing to take more risks, simply because they are insured. Such a risk might be speeding or not checking twice when turning a blind corner. Without insurance, people would certainly be less likely to take risks. Why does the driver become more risky once the insurance agreement is reached? It is because of asymmetric information; it is because the driver knows that the insurance company cannot monitor their driving. This is why some insurance companies make you fit a tracking box in your car.
Another example of moral hazard is when banks are too big to fail, so they are willing to take more risks. The banking sector is a vital part of the economy, and if this were to fail, the government would likely bail them out. Even without an insurance contract written out, banks know that it’s highly likely the government will not let them fail, as it would cause too much distress to the economy.
Another example of moral hazard exists between employer and employees. When an agreement is reached prior to employment, both sides of the agreement may express ideas about the specifics of a job role. However, once a person is employed, the moral hazard problem may cause an employee to show up late for work, shirk off when the manager isn’t there (because the employee is protected by an employment contract). The same applies in the case of the manager - the manager may place excessive workloads on employees because he/she knows their employee needs their job.
For an interesting read about the information failure problem, try ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ by George Akerlof.
Some more facts about the moral hazard problem
Adverse selection and the moral hazard problem are both terms used in economics, risk management and insurance to describe situations where there is an imbalance of information which causes an information market failure
Moral hazard refers to when actions change for whatever reason after an agreement has been reached.
People’s actions may change due to being insured, or even a feeling of being insured (being able to get away with it)
Moral hazard is different to adverse selection. Moral hazard occurs when somebody’s actions change after an agreement is made. Adverse selection occurs before the agreement is made, where there is an imbalance of information between two parties - this leads to wrong business decisions being made.
The Moral Hazard Problem and Adverse Selection Problem are both part of information market failure
Moral hazard should not be confused with adverse selection (another type of information failure)
Both moral hazard and adverse selection problem stem from the asymmetric information problem
Find out more about the adverse selection problem
Find out more about imperfect information market failure here
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