17.10
Moral Hazard
Moral hazards arise due to information asymmetry between buyers and sellers in a market. This occurs when one party cannot monitor the actions of the…
A moral hazard arises because of an information gap in a transaction after the transaction has taken place. It happens because one party cannot observe the actions of the other party.
For example, many unobservable actions are performed after buying insurance or signing a job contract or a house renovation contract.
Consider Alex, who hires a home renovation firm to make improvements to his house. He pays the renovation firm for the services.
Alex can check a few of the improvements such as the new tiles on the floor, the lighting fixtures added to rooms, the replacement of cabinet doors in the kitchen, and the landscaping of the garden.
However, Alex cannot check a few things because he may not have the expertise, or it is difficult to observe such things. For example, electrical rewiring or plumbing work. Knowing Alex's limitations, the firm does not complete these tasks as agreed.
Moral hazard refers to this tendency of one party to act less diligently or to take on riskier behavior, knowing that the other party will bear the negative consequences of such actions.
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Q1: What is moral hazard and how does it differ from adverse selection?
Moral hazard occurs when one party cannot observe the actions of another after a transaction takes place, causing the unobserved party to act less diligently or take riskier behavior. Unlike adverse selection, which stems from information asymmetry before a transaction, moral hazard results from unobservable actions after the transaction. For example, an insured driver may drive more aggressively knowing repairs are covered.
Q2: Why can't a homeowner fully monitor a renovation contractor's work?
A homeowner can observe visible improvements like new tiles, lighting fixtures, and landscaping, but cannot check hidden work such as electrical rewiring or plumbing because they lack expertise or the work is difficult to observe. Knowing these limitations, contractors may not complete unobservable tasks as agreed, creating a moral hazard situation.
Q3: How does moral hazard increase costs for service providers and consumers?
When one party acts less cautiously because their actions are only partially observed, unnecessary costs arise for service providers. These providers then charge higher prices to all consumers to offset the increased expenses from moral hazard behavior, such as employees taking unwarranted medical leave or insured drivers filing more accident claims.
Q4: What are common examples of moral hazard in different markets?
Moral hazard occurs across multiple sectors including renovation contracts, insurance markets, job markets, and banking. In insurance, drivers behave more aggressively knowing repairs are covered. In employment, workers take medical leave when not sick, knowing unused days expire. These behaviors reflect the tendency to act riskier when consequences fall on others.
Q5: Why does information asymmetry create vulnerability for the observing party?
When one party's actions are not fully observable, the other party becomes vulnerable to behavioral changes that could result in financial consequences. The unobserved party may prioritize personal benefit over the agreement's terms, knowing the observing party cannot detect or prevent such actions, leaving them exposed to unexpected losses.
Q6: How does moral hazard relate to principal-agent relationships?
Moral hazard is central to principal-agent relationships where a principal hires an agent to perform work but cannot fully monitor the agent's actions. The agent may shirk responsibilities or take excessive risks knowing the principal bears the consequences. This information gap between principal and agent creates the conditions for moral hazard to emerge.
Q7: What role does expertise play in creating moral hazard situations?
Moral hazard intensifies when one party lacks the expertise to evaluate the other party's work. For example, homeowners cannot assess electrical or plumbing quality, making it impossible to verify whether contractors completed work properly. This expertise gap enables the unobserved party to reduce effort or quality without detection, deepening the moral hazard problem.