Question

What is the problem of moral hazard?

Short answer

Moral hazard is the risk that an individual protected from consequences will behave differently than if exposed to those consequences. For instance, an insured person might drive recklessly, knowing the insurance company will cover the costs. This leads to increased claims for insurers and potential harm to others. Moral hazard can create market inefficiencies and negatively impact society; thus, regulatory measures and monitoring mechanisms are needed to address information asymmetry and risk-sharing issues.

Step-by-step solution

Define Moral Hazard

Moral hazard refers to the risk that an individual or party, protected from the negative consequences of their actions, will behave differently than if they were fully exposed to the consequences. In other words, the party with more information about their actions has an incentive to take advantage of the other party, who bears the cost of those actions.

Provide an Example

A common example of moral hazard includes a person with insurance coverage. Suppose a person has car insurance which covers all repair costs in case of an accident. Since the insured person knows they will not bear the full financial cost of an accident, they may be more likely to engage in risky driving behavior, such as speeding or driving recklessly. The insurance company, on the other hand, would have to cover the cost of the accident, despite not having full information about the insured person's driving habits.

Explain the Consequences

The consequences of moral hazard can be significant. For the insured person in our example, risky driving behavior increases the likelihood of an accident, which can lead to damage, injuries, or even fatalities. For the insurance company, the problem of moral hazard results in an increased frequency of claims, which leads to higher costs. To address this issue, insurance companies might charge higher premiums, offer limited coverage, or implement strict rules and monitoring to reduce the chances of moral hazard occurring.

Discuss the Implications

The problem of moral hazard has broader implications for society as well. Risky behavior, enabled by the reduced consequences for the individual, can result in harm to others or in a reduction of overall welfare. In our car insurance example, the risky driving behavior might cause accidents that harm other drivers or pedestrians. Furthermore, moral hazard can create market inefficiencies, as it distorts incentives and pricing structures, which ultimately affects consumers and businesses alike. To mitigate moral hazard, regulatory measures, and monitoring mechanisms need to be implemented to address the underlying information asymmetry and risk-sharing issues that give rise to this problem.