Moral Hazard in Economics: Definition & Examples

Moral Hazard in Economics: Definition & Examples
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  • 0:00 What Is a Moral Hazard?
  • 1:06 The Origin of Moral Hazard
  • 2:37 Examples of Moral Hazards
  • 4:43 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Learn what a moral hazard is and why they exist between individuals and businesses. Find out some common examples of moral hazards and discover where the term was first used.

What Is a Moral Hazard?

Have you ever heard of someone maxing out their credit cards and then filing for bankruptcy protection? Maybe you had a friend who was driving carelessly, or parked very close to another vehicle, and when questioned, said, 'Don't worry, I have insurance.' In each of these situations, a moral hazard existed.

A moral hazard is a situation where a person or business will have a tendency to take risks or alter their behavior, because the negative costs or consequences that could result will not be felt by the person taking the risk. Simply stated, the financial cost or consequence will be felt by someone else.

For example, that person who maxed out their credit cards knew he would not have to pay for all the additional debt he was bringing on when he made the decision to file for bankruptcy protection. The credit card companies would simply have to take those charges as a loss since they wouldn't collect payment. The friend driving the vehicle carelessly was shifting all of the risk to his insurance company to pay for his poor decisions in how he parked or drove his car.

The Origin of the Moral Hazard

The term 'moral hazard' originated in the insurance industry. Insurance companies realized that by protecting their clients from things like fire or car accidents, they might be encouraging risky behavior, such as smoking indoors, not wearing seat belts, or speeding. The problem then arises that with higher potential claims, the insurance company will have to charge higher premiums. A moral hazard usually exists in one of the following two situations:

Lack of shared information - This is where one party has more information that is important to a contract or outcome. For example, a firm selling investments in a company may know that there is a good chance the firm won't make it another two years based on some recent non-disclosed projections. The people investing with less information assume the company is in good shape and the future is bright.

Principal-agent problem - In some cases, two parties face different incentives. When an agent (an insurance broker, real estate agent, financial advisor, or accountant) is not in alignment with the principal (the person they are representing), moral hazards can exist. For example, an insurance broker may know that his client really only needs $100,000 of coverage to meet her needs, but he gets a special bonus on all policies over $150,000, so the agent recommends the bigger policy. Or a real estate agent might recommend a house because she needs a sale, but not share with the new home buyer that there are recent crime issues in the neighborhood.

Examples of Moral Hazards

Let's look at some more examples of moral hazards.

Dental Insurance and Brushing Habits

If you are not insured, you may take extra time to floss and brush twice a day, knowing that you can't afford to have teeth or gum issues. However, if you soon get dental insurance through a new job, that dental work becomes more affordable and you have less financial incentive to stay on top of things.

The insurance company assumes you still do a good job of brushing and flossing, but you know that you might not take care of your dental hygiene as much. You'll just let the dentist fix it! You have information the insurance company does not, and if the insurance company doesn't figure this out over time, they risk not charging a high enough premium and going out of business.

Sub-Prime Mortgages

This is one of the most classic examples of a moral hazard. In the last several years, it would have been hard to watch the news, read the newspaper, or take business classes without running across the topic of these bad mortgages and their effect on the housing market and economy.

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