Moral Hazard

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.

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.

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.

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.

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.

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.

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.