Moral hazard

Moral hazard is the incentive of a person to use more resources than he otherwise would have used, because someone else will provide these resources, against his will, and is unable to immediately sanction this expropriation.

Conventional theory

Conventional economic theory explains moral hazard as a consequence of the fact that market participants are unequally well informed about economic reality. In other words, it results from "asymmetries of information" and the theory of moral hazard is therefore considered to be a part of the economics of information. The other condition is the separation of ownership and control.

In a co-ownership, if one co-owner of a swimming pool cannot effectively monitor the activities of his fellow-owners, the latter have an incentive to swim without cleaning up, repairing the fences and so on, thus increasing their own (monetary and psychic) income at his expense. In the Principal-agent problem, when the principal cannot effectively monitor the activities of his agent, the latter has an incentive to increase his own (monetary and psychic) income at the expense of the former.

For example, automobile insurance, creates a moral hazard for drivers; it creates an additional incentive for risky driving because other insurance clients will pay a part of the costs of the driver's accidents. Similarly, in the presence of unemployment insurance, an unemployed person has an additional incentive to stay unemployed because other people will pay at least a part of his living expenses. Or, in the presence of health insurance, insured people will have an additional incentive to engage in risky activities or lifestyles because others will pay at least a part of the treatment in case of illness or accidents.

Employees can be subject to moral hazard to the extent that they can reduce their efforts without fearing reduced pay. Debtors may be subject to moral hazard if they believe they can squander the money without negative consequences when they turn out to be incapable of paying back. Certain auditing firms have been subject to moral hazard when they sold consulting services to the very companies they were supposed to audit (for example, in the Enron case). A central bank can produce moral hazard in the banking community if the commercial bankers perceive the central bank as a lender of last resort. The IMF can produce moral hazard among debtor governments. Taxpayers are said to be subject to moral hazard if they can evade high-tax regions, and so on. Similarly, in the literature on public choice and constitutional political economy, governments and parliaments are often portrayed as agents prone to moral hazard, whereas the voters are the less informed principals.

External links

• Moral hazard on Wikipedia
• Economics 101: Moral Hazard (video), a short video lesson on the concept from the Center for Freedom and Prosperity