Moral Hazard

Moral Hazard is the idea that, under certain circumstances, individuals will alter their behaviour and take more risks. Moral hazard can occur if

  1. There is information asymmetry. Where one party holds more information than another. For example, a firm selling sub-prime loans may know that the people taking out the loan are liable to default. But, the bank purchasing the mortgage bundle has less information and assumes that the mortgage will be good.
  2. A contract affects the behaviour of two different agents. In some cases, two parties face different incentives. If you are insured then you may have less incentive to take care against risks. For example, if a country knows it will receive a bailout from the IMF, then it may feel less incentive to reduce debt. Moral hazard is particularly a problem in the insurance market because when insured, people may be more liable to lose things.

Definition of Moral Hazard:

The risk that a person has the incentive to take greater risks before the completion of the contract.

“any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” [1]

– Paul Krugman

Examples of Moral Hazard

1. Insurance and consumer behaviour

If your bike is not insured you will take great care to avoid it getting stolen. You will lock it carefully. However, if it becomes insured for its full value then if it gets stolen you do not really lose out. Therefore, you have less incentive to protect against theft. This becomes a situation of asymmetric information. The insurance company may assume you will look after your bike, but you may know that you won’t.

In these cases an insurance firm faces a dilemma.

  • When your bike is uninsured, it has say a 10% chance of getting stolen. Therefore, if the bike is worth £1,000. The cost of insurance would be based around £100.
  • However, once insured, the bike may now have a 30% chance of getting stolen. Therefore, if the insurance firm charges £100 based on the 10% risk, it will lose out.
  • This could lead to a missing market. The insurance firm doesn’t want to insure bicycles because people change their behaviour.

2. Moral hazard and Sub Prime Mortgages

In the case of the sub-prime mortgage market. Lenders faced a situation of moral hazard. They were able to sell on any mortgage they lent to other financial institutions. Because there was strong demand from other people, and because other banks were taking on all the risk, the mortgage companies had less incentive to check the mortgages could be repaid. Therefore, there was a big growth in sub-prime mortgage lending with inadequate checks made.

3. Bank Bailouts and Moral Hazard

If a manufacturing company goes bankrupt, the government will not intervene. Therefore, they have an incentive to avoid taking unnecessary risks. However, generally governments feel they have to bailout banks to prevent a collapse in confidence in the banking industry. Therefore, banks may change their behaviour and take more risks. Sometimes people argue we shouldn’t bailout banks because this creates future moral hazard. If we always bail them out, they will repeat the risky mistakes later.

4. Fiscal and Monetary Union

It is argued that membership of the Euro can cause a type of moral hazard. A country in the Euro may assume that if it gets into difficulties, other countries will bail it out. Therefore, they may allow debt to grow. For example, when Greece joined the Euro, it benefited from low interest rates because it was in the Euro. This encouraged them to keep borrowing, until markets realised too late, that they actually had high debts.

Overcoming Moral Hazard

1. Build in incentives. The insurance firms needs to provide incentives so that you still want to insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first £50 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place.

2. Penalise bad behaviour. The government could bailout banks, but penalise those responsible for making the reckless decisions. In the case of Greece, bailout funds are being given very reluctantly and with conditions to reform and pursue austerity.

 

Readers Question on Moral Hazard. – can it be when information is complete, when information is asymmetric, when information is biased against the consumer or is it when information is exaggerated. can you help be with this question please?

Two parties may have good information, but the presence of a contract changes peoples behaviour, e.g. in the case of insurance. In that sense the information isn’t really complete because the insurer isn’t aware the contract will change peoples behaviour. Exaggerated or asymmetric information can all lead to moral hazard.

Worth being aware of adverse selection. Adverse selection occurs when there may be a bad choice of products due to asymmetric information.

See also:

[1] Krugman, Paul (2009). The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company Limited. ISBN 978-0-393-07101-6.

9 Responses to Moral Hazard

  1. Carlo Jr February 19, 2013 at 2:58 pm #

    when would a moral hazard occur, can it be when information is complete, when information is asymmetric, when information is biased against the consumer or is it when information is exaggerated. can you help be with this question please?

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