Moral hazard
Someone takes less care, or more risk, because the cost of it falls on another party who cannot see what they are doing.
Often misread asLabelling anything that goes wrong under a contract as moral hazard, including an insurer who simply ended up with risky customers because its price attracted them.
How to see it
Hidden action: you cannot see what they do after you have agreed
Moral hazard is a problem about behaviour after a deal is struck. The informed party chooses something the other cannot observe, typically effort or care, and because outcomes only partly reflect that choice, the uninformed party cannot tell slacking from bad luck. The usual response is to pay on the observable outcome, which pushes risk onto the person taking the action.
The checkMoral hazard is hidden action after contracting; adverse selection is hidden type before it. Ask whether the problem would disappear if behaviour were observable but types stayed hidden. If it would, it is moral hazard.
Try itTwo insurance customers: one who was always a reckless driver and bought cover because the premium looked cheap for them, and one who starts leaving the car unlocked only after being insured. Label each. If both came out with the same label, the two problems have merged in your head.
Games that show it
Know these first
Easily confused with
Sources
- Holmstrom, B. (1979). Bell Journal of Economics 10(1), 74-91.
- Laffont, J-J. & Martimort, D. (2002). Princeton University Press.