Moral Hazard - Economic Theory

Economic Theory

In economic theory, moral hazard is a situation where the behavior of one party may change to the detriment of another after the transaction has taken place. For example, a person with insurance against automobile theft may be less cautious about locking their car because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently than how it would if it were fully exposed to the risk.

According to contract theory, moral hazard results from a situation in which a hidden action occurs. Bengt Holmström said this:

It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome.

Moral hazard can be divided into two types when it involves asymmetric information (or lack of verifiability) of the outcome of a random event. An ex-ante moral hazard is a change in behavior prior to the outcome of the random event, whereas ex-post involves behavior after the outcome. For example, in the case of a health insurance company insuring an individual during a specific time-period, the final health of the individual can be thought of as the outcome. The individual taking greater risks during the period would be ex-ante moral hazard whereas lying about a fictitious health problem to defraud the insurance company would be ex-post moral hazard. A second example is the case of a bank making a loan to an entrepreneur for a risky business venture. The entrepreneur becoming overly risky would be ex-ante moral hazard, but willful default (wrongly claiming the ventured failed when it was profitable) is ex-post moral hazard.