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Moral Hazard

Why It Matters

Insurance changes behavior. Bailouts change behavior. Any risk-sharing arrangement confronts this problem. The structure is: I take actions, you bear consequences, and you can't see what I do.

The Key Move

Identify post-transaction hidden action. Ask: how does the party's behavior change when they don't bear full consequences of their actions? What would they do differently if they bore the full cost or had to act in public?

Classic Application

Insurance. Insured drivers drive less carefully. Insured homeowners invest less in fire prevention. The problem isn't that bad drivers buy insurance (that's adverse selection) - it's that insurance makes drivers worse. Coverage changes behavior.

Surprising Application

Corporate limited liability. When downside is capped but upside isn't, excessive risk-taking is rational. Heads I win big, tails the company goes bankrupt but my personal loss is limited. This explains some financial crisis dynamics - bankers had moral hazard.

Failure Modes

  • Confusing moral hazard with adverse selection - hidden action (moral hazard) vs hidden type (adverse selection)
  • Over-relying on monitoring - it's costly and often incomplete
  • Ignoring that incentive pay creates its own distortions - it can induce gaming and risk-taking
  • Treating all behavioral changes as moral hazard - some are legitimate responses to changed circumstances
  • Assuming moral hazard is always bad - some risk-sharing despite moral hazard is still beneficial

Go Deeper

Holmstrom's papers on moral hazard and optimal contracts. Arrow's work on medical care and moral hazard.