Moral Hazard

Moral hazard is a situation in which one party takes on more risk because they do not bear the full consequences of that risk. It occurs post-contractually — the behaviour change happens after a contract or insurance arrangement is in place — in contrast to Adverse Selection, which arises pre-contractually from hidden types.

Examples from the lectures: an insured driver parking in unsafe locations or driving recklessly knowing damages are covered; insured individuals scheduling unnecessary medical tests; banks engaging in riskier lending when a government bailout is anticipated; an employee on a fixed salary exerting less effort because pay is not tied to performance. The common thread is that transferring risk also transfers the incentive to avoid risk. See Topic 1 — Asymmetric Information for the full treatment.

When to use

Invoke moral hazard whenever a contract that shifts risk from one party to another also reduces that party's incentive to behave carefully. It is the central friction in principal–agent problems and contract design: the principal needs to structure incentives (performance pay, deductibles, co-payments) so the agent still exerts appropriate effort even though risk has been transferred.