Information Economics
Moral Hazard
Insured against consequences, take more risk — economic problem in insurance, banking
Moral hazard occurs when one party takes more risk because they don't bear the full consequences. Classic example: insured drivers may drive less carefully (insurance covers damages). Originated in insurance industry. Major issues: bank bailouts (banks may take excessive risk if "too big to fail"), health insurance (might overuse healthcare), employment (workers may shirk if salary not tied to performance). Solutions: deductibles, copays, performance-based pay, monitoring, screening. Information asymmetry: principal (e.g., insurer) can't fully observe agent's (insured) actions. Foundation of: insurance design, banking regulation, principal-agent theory.
- DefinitionRisk-taking when not bearing full consequences
- OriginInsurance industry
- Famous examplesInsured drivers, bank bailouts, health insurance
- Information issuePrincipal can't observe agent's actions
- SolutionsDeductibles, copays, monitoring, performance pay
- FoundationPrincipal-agent theory; information economics
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Why moral hazard matters
- Insurance design. Deductibles, copays.
- Banking regulation. Capital requirements, supervision.
- Health policy. Healthcare spending.
- Corporate governance. CEO compensation.
- Welfare programs. Work disincentives.
- Environmental policy. Liability vs regulation.
- Game theory. Information asymmetry.
Common misconceptions
- Same as adverse selection. Different (selection vs behavior).
- Only insurance issue. Many domains.
- Implies people are immoral. Just rational responding to incentives.
- Easily eliminated. Information problems often persist.
- Always major. Sometimes minor.
- Just insurance industry. Banking, health, employment, etc.
Frequently asked questions
What's moral hazard?
Phenomenon: party takes more risk because someone else bears costs. Example: with car insurance, drivers may park less carefully (insurance covers theft) or drive faster (insurance covers accidents). Without insurance: full caution. With: reduced caution. Classic insurance industry concern.
How does it apply to banking?
"Too big to fail" issue. If government bails out banks during crisis: banks may take excessive risk knowing government will save them. Heads they win (profit); tails taxpayers lose. 2008 financial crisis: many banks bailed out. Encouraged future risk-taking. Solutions: regulations (Basel III), capital requirements, "living wills" for orderly resolution.
What's the principal-agent problem?
General framework. Principal hires agent to act on their behalf. Agent's incentives may differ from principal's. Agent has private information about effort or actions. Result: agent may not work in principal's full interest. Examples. Owner-CEO (CEO may shirk or self-deal); patient-doctor (doctor may overprescribe); insurer-insured (insured may take risk). Solutions: incentives, monitoring.
How does insurance handle it?
Several methods. (1) Deductibles: insured pays first portion; have skin in game. (2) Copays: portion of each claim paid. (3) Coinsurance: percentage of claim. (4) Premiums adjusted by behavior: safe drivers get lower rates. (5) Monitoring: verify claims, investigate suspicious. (6) Exclusions: not covering certain behaviors. Each: aligns incentives partially.
What's adverse selection?
Related but distinct. Not about behavior change but about who buys. People with hidden risk: more likely to buy insurance. Insurance pool: skews toward higher risk. Premiums rise; healthier people leave. Pool gets even sicker. "Death spiral." Solutions: mandatory enrollment (ACA), screening, group insurance. Akerlof's "lemons market" classic analysis.
How does this apply to health insurance?
Multiple issues. (1) Moral hazard: more healthcare use when insured. Studies: patients use less when paying more (RAND health insurance experiment). (2) Adverse selection: sick people more likely to buy comprehensive plans. (3) Provider issues: paid per service, may overprovide. ACA provisions: address some issues; debates continue.
What about employment?
Workers may shirk if compensation not tied to effort. Solutions. (1) Performance-based pay: bonuses, commissions. (2) Stock options: align with shareholders. (3) Monitoring: supervisors, time-tracking. (4) Reputation: long-term consequences. (5) Career concerns: future job market. Different industries balance differently.