Moral hazard
Moral hazard is the inefficiency from hidden action after a contract: the insured take fewer precautions, banks expecting bailouts take more risk, and hard-to-monitor employees shirk — a principal–agent problem. Unlike adverse selection (hidden characteristics before contracting, e.g. the market for lemons), it concerns behaviour afterwards. Remedies include deductibles and co-insurance, incentive pay (Holmström, 1979), monitoring and regulation.
Frequently asked questions
- Moral hazard vs adverse selection?
- Adverse selection: hidden traits before; moral hazard: hidden actions after.
- Is it about bad morals?
- Economists see it as an incentive problem.
References
- Arrow, K. J. (1963). Uncertainty and the welfare economics of medical care. American Economic Review, 53(5), 941–973.
- Pauly, M. V. (1968). The economics of moral hazard: Comment. American Economic Review, 58(3), 531–537.
- Holmström, B. (1979). Moral hazard and observability. Bell Journal of Economics, 10(1), 74–91.