Moral hazard

What is moral hazard?

Moral hazard is an incentive problem that can arise when one party’s actions affect another party’s outcomes and those actions are difficult to observe or contract on. It includes choices about effort and prevention, not only deliberate risk-taking.

Economic model

Holmström (1979) analyzes privately chosen actions in risk-sharing arrangements. Providing insurance can weaken incentives to prevent a loss; leaving more risk with the decision maker can strengthen incentives but reduce insurance protection.

A policyholder taking less care after obtaining insurance illustrates the possible incentive change. It does not imply that every insured person behaves this way or that their actions are morally blameworthy.

Limits

Monitoring, contract terms, and shared costs can change incentives, but have costs and limits of their own. The design problem is a tradeoff: preserving useful protection while keeping an incentive to take care.

Adverse selection concerns hidden information about parties or products before an agreement.