Moral Hazard

Updated Jan 8, 2023

Definition of Moral Hazard

Moral hazard is a situation in which one party has an incentive to take risks because the costs of those risks are borne by another party. That means it describes a situation in which one party is encouraged to act in a way that is not in the best interest of the other party.

Example

To illustrate this, let’s look at the example of an insurance company. The company offers car insurance to its customers. That means it agrees to cover the costs of any damages to the customer’s car in case of an accident. Now, if the customer knows that the insurance company will cover the costs, they actually are incentivized to take more risks while driving. That means they may drive faster, drive more recklessly, or even drive while intoxicated. Simply because they know they won’t have to cover the costs should they damage their car. This behavior is not in the best interest of the insurance company because it increases the likelihood of an accident and, thus, the costs for the company.

Why Moral Hazard Matters

Moral hazard is an important concept in economics and finance. It is closely related to the concept of asymmetric information, which describes a situation in which one party has more information than the other. In most cases, this information asymmetry leads to a situation in which one party is incentivized to take more risks than the other. That means moral hazard can lead to inefficient outcomes and can even cause market failure. Therefore, it is important to be aware of this phenomenon and take steps to mitigate it.