Moral Hazard
What is Moral Hazard?
Moral hazard occurs when one party takes greater risks because they do not bear the full consequences of those risks, often due to insurance or government protection.
This happens after a transaction, such as when people drive recklessly because they have car insurance. It leads to market inefficiency because behavior changes in ways that increase costs for others. Governments may respond with co-pays or monitoring to reduce the incentive to take excessive risks.
Moral Hazard: a worked example
A driver who garages his car faces expected accident costs of 4,800 dollars a year. Parking on the street saves him 800 dollars a year in fees and walking time but raises expected accident costs to 8,400 dollars. With no insurance he bears the whole increase, 8,400 - 4,800 = 3,600 dollars, which swamps the 800 dollar saving, so he keeps using the garage. Give him full coverage and the insurer pays every claim, so his share of the extra 3,600 is zero and the 800 dollar saving wins: he parks on the street. Add 10 percent coinsurance and he bears 0.10 x 3,600 = 360 dollars, still less than 800, so the street keeps winning. Raise coinsurance to 25 percent and he bears 900 dollars, more than the 800 he saves, and the car goes back in the garage.
The mistake students make with moral hazard
Because the label contains the word moral, students describe the problem as dishonesty and reach for insurance fraud as their example. Deliberate fraud sits at the far end of the idea, but the concept mainly covers ordinary self interested responses to a changed incentive, where the private cost of a risky choice has fallen even though the cost to society has not. Name the cost the protected party stopped paying, then name the behavior that became cheaper. Nothing in that pair of steps requires anyone to break a rule.
Moral Hazard questions
What is an example of moral hazard?
A tenant whose landlord pays the heating bill leaves the windows open in winter, because the extra fuel costs the tenant nothing. Other standard cases include a policyholder who stops setting the burglar alarm after buying theft cover, a clinic ordering extra tests when an insurer settles the invoice, and a bank funding riskier loans because it expects public support if those loans sour. Each involves a party whose own cost of a careless choice has shifted onto someone else.
How is moral hazard different from adverse selection?
Moral hazard concerns a hidden action taken after the contract is signed, so a remedy has to change what the covered party wants to do: deductibles, coinsurance, monitoring, or a no claims discount. Adverse selection concerns a hidden type that exists before anything is signed, so its remedy has to change who signs, through screening questions, inspections, or automatic enrollment. One quick test: ask whether the problem would vanish if the contract were handed to a randomly chosen person. If yes, you are looking at selection.
How do deductibles and copayments reduce moral hazard?
Deductibles and copayments put part of every loss back onto the insured party, restoring a private cost to careless behavior. If a policy covers only 80 percent of a claim, a 4,000 dollar repair still leaves the driver paying 800 dollars, so precautions that had become pointless are worth taking again. The design trades protection against incentives, since heavier cost sharing sharpens care but leaves the buyer carrying more risk, which is why insurers rarely push it to the extreme.
Related terms
Common comparisons
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