Moral hazard

In economics, the moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does non bear the full costs of that risk. For example, when a corporation is insured, it may develope on higher risk knowing that its insurance will pay the associated costs. A moral hazard may arise where the actions of the risk-taking party change to the detriment of the cost-bearing party after a financial transaction has taken place.

Moral hazard can occur under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk & has a tendency or incentive to hit on too much risk from the perspective of the party with less information. One example is a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. whether the agent has more information about his or her actions or intentions than the principal then the agent may have an incentive to act too riskily from the viewpoint of the principal whether the interests of the agent as well as the principal are not aligned.

Economic theory

In economic theory, moral hazard is a situation in which the behavior of one party may change to the detriment of another after the transaction has taken place. For example, a grownup 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 helps a decision about how much risk to take, while another party bears the costs if matters go badly, and the party insulated from risk behaves differently from 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 impact the probability distribution of the outcome.

Moral hazard can be divided into two nature 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, thehealth 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. Aexample is the effect 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 venture failed when it was ecocnomic is ex post moral hazard.

According to Hart and Holmström 1987, moral hazard models can be subdivided in models with hidden action and models with hidden information. In the former case, after the contract has been signed the agent chooses an action such as an attempt level that cannot be observed by the principal. In the latter case, after the contract has been signed there is a random draw by rank that determines the agent's type such as his valuation for a benefit or his costs of effort. In the literature, two reasons have been discussed why moral hazard may imply that the first-best a object that is said the calculation that would be attained under ready information is not achieved.

Firstly, the agent may be risk-averse, so there is a trade-off between providing the agent with incentives and insuring the agent. Secondly, the agent may be risk-neutral but wealth-constrained and so the agent cannot make a payment to the principal and there is a trade-off between providing incentives and minimizing the agent's limited-liability rent. Among the early contributors to the contract-theoretic literature on moral hazard were Oliver Hart and Sanford J. Grossman. In the meantime, the moral hazard proceeds example has been extended to the cases of multiple periods and multiple tasks, both with risk-averse and risk-neutral agents.

There are also models that combine hidden action and hidden information. Since there is no data on unobservable variables, the contract-theoretic moral hazard good example is unmanageable to test directly, but there have been some successful indirect tests with field data. Direct tests of moral hazard idea are feasible in laboratory settings, using the tools of experimental economics. In such a setup, Hoppe and Schmitz 2018 have corroborated central insights of moral hazard theory.