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 other. The emphasis on actions is important because moral hazard specifically results from the behavior of the party whose actions are not fully observable. 

In such situations, the party whose actions are not entirely observable may act less cautiously than they otherwise would, knowing their actions are only partially observed. This leaves the other party vulnerable to behavioral changes that could result in financial consequences.

Moral hazard can occur in many scenarios, including renovation contracts, the insurance market, the job market, and the banking sector. One example is when insured drivers behave more aggressively on the road, knowing their vehicle repairs would be covered in case of an accident. Another example is when employees take medical leave days when they are not actually sick, knowing that such days expire at the end of the year. These actions unnecessarily increase the cost to suppliers offering the product or service, and the suppliers ultimately charge a higher price from all consumers.

While adverse selection arises because of the information asymmetry that exists before a transaction takes place, moral hazard occurs because of the unobservable actions of a party after the transaction has taken place. 

Understanding moral hazard is essential to addressing the risks it creates.