Moral hazard occurs when one person receives the benefits of an action or decision but is able to contractual shift the cost of the action to another. In particular, the person making the decision changes behavior after an agreement is reached and the change in behavior is unknown to the other person.
Moral hazard is commonly seen in the insurance industry. An insurance provider agrees to pay benefits to a customer in the event of an illness, accident, or other detrimental event based on expectations of the customers behavior. However, moral hazard results if the customer then changes behavior after the agreement has been finalized. For example, a driver might take more risks (speeding, ignoring traffic signals, etc.) with insurance than without. This change in behavior is not known by the insurance provider.
This problem arises due to asymmetric information, which is when different people have different information. Asymmetric information occurs because even though information is beneficial it is costly to acquire. Some people are bound to find it more beneficial or less costly to acquire information than do others. They know more, others know less. When insurance providers know less than their customers, then moral hazard is likely to result.
Insurance: Shifting RiskTo illustrate the moral hazard problem, let's first consider the provision of insurance. Insurance is a service that transfers the risk of large losses from an individual to a larger group, a group typically represented by an insurance provider. This transfer of risk is undertaken in exchange for a premium payment. That is, the individual agrees to incur a small guaranteed loss (the premium) but avoids incurring a less likely but much larger loss.
For example, a person pays an automobile insurance premium each month (guaranteed), but shifts the (slight) risk of a major expense associated with an accident to the insurance provider.
The insurance provider spreads this slight risk of a large expense for one person over a large group, the vast majority who pay the premium but do not incur the expense. Suppose, for example, that insurance is provided to 100 people and one member of this group is involved in an accident that incurs a cost of $20,000. The insurance provider spreads this $20,000 expense over the 100 people by charging each a premium of $200.
The key is that the insurance provider knows that 1 of the 100 customers will incur the $20,000 expense, it just doesn't know which specific person it will be.
Changing BehaviorMoral hazard occurs when insured members of the group modify their behavior after the premiums are paid and the insurance provider agrees to incur the expense. More importantly, the change in behavior also changes the likelihood that the insurance provider will incur an additional expense.
Suppose, once again, that automobile insurance is provided to 100 people with the expectation that 1 of the group will incur an accident related expense of $20,000. Now suppose that members of this group, knowing that they are protected from incurring the $20,000 expense, choose to drive less safely (speeding, disobeying traffic signals, etc.).
This change in behavior increases the likelihood that more than 1 person in the group will incur an accident related expense. The insurance provider might then incur the cost of a second $20,000 accident. Because the insurance provider is unaware of this change, moral hazard results.
Private and PublicWhenever insurance services are offered, moral hazard is a distinct possibility. If risk is transferred from individuals to larger groups, individuals are likely to change behavior and undertake greater more risks. This change in behavior applies to both private sector insurance, as well us insurance offered by the public sector.
Private insurance, of course, includes that for health, automobile, property, and life, all commonly purchased by consumers through profit-motivated private businesses.
Public insurance is even more wide ranging. In fact, one of the key roles of government is to be the "insurance of last resort." Several noted government insurance programs include Medicare, Medicaid, unemployment compensation, welfare, Social Security, and bank deposit insurance, all provided through assorted government agencies. However, the tax-paying public also looks to government should other unexpected losses or problems arise, such as natural disasters, foreign invasions, or economic calamities.
Whether or not the government sector has formal policies, programs, or agencies in place to deal with such unexpected losses, the public expects an insurance-type shifting of loss from individuals to the larger group (tax-paying citizens). Should a hurricane, tornado, flood, or earthquake occur, the public expects government to help out those adversely affected. Should a large profit-seeking airline, bank, automobile company be on the verge of bankruptcy, then the government sector is expected to provide assistance.
The downside of such government actions is the emergence of moral hazard. If a large company knows that it can take risks that might generate large profits, but government is there to bail out any losses should the risk not pay off, then moral hazard occurs. If a worker knows that lackluster effort can make a job easier, but government is there with welfare or unemployment compensation should employment cease, then moral hazard occurs.
Screening: A Possible SolutionThe problems caused by moral hazard can be lessened through screening. Screening is the attempt by those with limited information to identify indicators suggesting more complete information. An insurance company might try to overcome the problems of moral hazard by screening individuals who are more likely to undertake risky behavior from those less likely. For automobile insurance, traffic tickets is often used as a screening indicators. Of course, screening can also be inaccurate. A good driver, with a low risk of an accident, might have the same number of traffic tickets as a bad driver.
Related ProblemsMoral hazard is one of three problems arising from asymmetric information. The other two are adverse selection and the principal-agent problem.
- Adverse Selection: Adverse selection occurs when an inefficient, bad, or adverse outcome of a market exchange results because buyers and/or sellers make decisions based on imperfect information. This commonly results in a market that exchanges a lesser quality good, what is termed the market for lemons. Because buyers have less accurate information about the quality of goods, they are likely to offer a lower price, which discourages sellers from offering higher quality goods.
- Principal-Agent Problem: The principal-agent problem is a disconnection or conflict between the goals and objectives of the "principal" and those of the "agent" authorized to represent the principal. The problem arises because the principal does not have accurate information about the behavior of the agent. This problem is common in corporations, when the owners (principals) hire managers (agents) to run the company. The agents, however, might make decisions that benefit themselves (higher salaries, fringe benefits) that are unknown to and not in the best interests of the owners (profit).
MORAL HAZARD, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: April 6, 2020].