Do you ever think about why you make certain decisions in your day? For example, how well do you take care of your health when you have insurance? What about without it? You may not even realize it, but the way you make decisions is based on the information you have. In fact, this relationship is critical in economics! The concept of moral hazard is often talked about in finance, but it can be a bit confusing to understand. In simple terms, moral hazard refers to the problem that arises when people or institutions take on more risk because they know they will not bear the full consequences of their actions. In this article, we'll dive into the moral hazard definition and explore some moral hazard examples. We'll also examine how moral hazard can lead to a market failure and even a financial crisis!
Moral Hazard Definition
Let's go over the definition of a moral hazard. A moral hazard occurs when one individual knows more about their actions and is willing to alter their behavior at the expense of another individual. A moral hazard occurs when there is asymmetric information between two people — an agent and a principal. An agent is someone who performs a certain task for a principal; a principal is someone who receives the service from the agent.
Generally, for a moral hazard to occur, the agent needs to have more information about their actions than the principal does. This allows the agent to alter their behavior in order to benefit from the principal's lack of information. We can take a brief look at what the moral hazard problem may look like.
Let's say you're expected to work in the office for 9 hours a day. However, you know that you can get all of your work done in 3 hours and talk to your coworkers for the remaining 6 hours. However, your boss doesn't know this about you; your boss believes that you need 9 hours to complete your work for the day.
In this example, you are the agent, and your boss is the principal. You have information that your boss lacks — how productive you can be while working. If your boss did know about your productivity, you would not alter your behavior in the workplace out of fear of getting in trouble. However, since your boss doesn't know about your productivity, you are incentivized to work quickly so that you can get paid to talk to your friends at work.
As we can see, this example represents a moral hazard since you have information that your boss doesn't have. With this information, it is now in your self-interest to alter your behavior since your boss does not know how productive you are in the workplace. While this may be good for you, this yields an inefficient workplace since you could be working more than you actually are.
Moral hazard occurs when one individual knows more about their actions and is willing to alter their behavior at the expense of another individual.
An agent is someone who performs a certain task for the principal.
A principal is someone who receives the service from the agent.
Moral Hazard Examples
Let's look at some moral hazard examples. We will look at two examples in areas where moral hazard is common: the insurance market.
Moral Hazard Examples: Health Insurance
If you have health insurance, then you are insured for any sicknesses you get. If you know that you are insured and you believe that your insurance will fully cover any sickness, then you may be incentivized to engage in risky behavior. For example, you may care less about the foods you eat, or you may decrease how often you exercise. Why might you do this? If you know that you will be covered by your insurance for most sicknesses, then you will care less about taking care of your health. In contrast, if you were not insured, you would likely be more careful about the foods you eat and exercise more to avoid going to the doctor and paying a higher price.
In the example above, you are the agent, and the insurer is the principal. You have information that your insurer lacks — the risky behavior that you will engage in after having health insurance.
Moral Hazard Examples: Car Insurance
If you have car insurance, then you are protected (to a certain extent) from any damage to your vehicle or someone else's vehicle. Knowing this, you may be incentivized to drive a bit faster and more recklessly to get to your destinations. Since you will be covered for accidents, why not get to your destination a little faster? You are effectively altering your behavior to benefit yourself when you are insured. In contrast, you will be less likely to drive recklessly if you are not insured since you will have to pay for any damages to your car and anyone else's car you are responsible for. In this example, you are the agent, and your insurer is the principal; you have information about your actions that your insurer does not.
Moral Hazard Problem
What is the problem with moral hazard? The problem with moral hazard is that it is not a self-contained issue. To expand, let's look at a moral hazard problem for unemployment insurance.
Unemployment insurance may alter the way employees work in their jobs. For example, if employees know that they will be insured if they are fired from their employer, they may slack off at their job since they know there's a safety net. If the moral hazard problem was contained to one employee, then the simple solution would be to not hire them to avoid this issue. However, this is not the case.
A moral hazard becomes a problem because it will not just apply to one person but to many people. People's self-interest causes them to alter their behavior to benefit them at the expense of another individual or entity. Since this problem doesn't pertain to one person, many people will work less in the workplace since they have the safety net of unemployment insurance. This can cause a problem for the workplace and for the insurance company, respectively. Too many people altering their behavior for their self-interest will result in market failure.
Want to learn more about market failure? Check out this article:
- Market Failure
Moral Hazard Market Failure
How does a moral hazard cause market failure? Recall that a moral hazard occurs when someone knows more information about their actions to benefit themselves at the expense of another person. A market failure occurs when the pursuit of one's self-interest makes society worse off. Therefore, the natural question arises: how does moral hazard lead to market failure?
Moral hazard leads to market failures when it goes from a micro-level problem to a macro-level one.
For example, people that do not look for work in order to take advantage of welfare benefits are an example of a moral hazard.
On the surface, a couple of people refusing to work to utilize their welfare benefits doesn't seem to be a big deal. However, what would happen if a few people turned into a majority of people? Suddenly, most people are refusing to work due to welfare benefits. This would lead to a low supply of labor, which leads to low production and goods and services. This will lead to a shortage in the market and leave society worse off, resulting in a market failure.
Fig. 1 - Labor Market Shortage
What does the graph above show us? The graph above shows a shortage in the labor market. A shortage can occur if there is a low supply of workforce in the market, and as we can see through our previous example, it can occur through a moral hazard. To ameliorate the problem, wages will need to increase to restore equilibrium in the market.
Fig. 2 - Effects of Moral Hazard
What does the graph above tell us? The graph depicts the marginal benefit of driving where insurance companies know how many miles people are driving. Initially, insurance companies will charge a higher premium based on the number of miles that people drive. Therefore, people will pay $1.50 for every mile they drive. However, if insurance companies cannot monitor how many miles people drive per week, then they cannot charge higher premiums. Therefore, people will perceive the cost per mile to be lower at $1.00.
Market failure resulting from moral hazard occurs when the pursuit of one's self-interest makes society worse off.
Check out our article on market equilibrium:
- Market Equilibrium
Moral Hazard Financial Crisis
What is the relationship between moral hazard and the 2008 financial crisis? To preface this discussion, the moral hazard we are looking at takes place after the financial crisis occurred. In order to understand this relationship, we need to understand who or what was the agent and who or what was the principal in the financial crisis. Recall that the agent is the entity that is performing the task, and the principal is the entity that the action is being done on behalf of.
Financial investors and financial services are the agents, and Congress is the principal. Congress passed the Troubled Assets Relief Program (TARP) in 2008, which gave "bailout" money to financial institutions.1 With this bailout money, financial institutions were helped and avoided bankruptcy. This relief underscored the notion that financial institutions are "too big to fail." Therefore, this relief may have given financial institutions an incentive to continue making risky investments. If financial institutions know that they were bailed out for risky lending in the 2008 crisis, then they will likely engage in risky lending in the future with the assumption that they will be bailed out again.
Want to learn more about the financial crisis? Check out our article:
- Global Financial Crisis
Moral Hazard - Key takeaways
- A moral hazard occurs when one individual knows more about their actions and is willing to alter their behavior at the expense of another individual.
- An agent is someone who performs a task for a principal;A principal is someone who receives a service from the agent.
- Moral hazard becomes a problem when too many people act in their own self-interest.
- Market failure resulting from moral hazard occurs when the pursuit of one's self-interest makes society worse off.
- The relief for financial institutions during the financial crisis arguably contributed to a rise in the moral hazard problem.
References
- U.S. Department of Treasury, Troubled Assets Relief Program, https://home.treasury.gov/data/troubled-assets-relief-program#:~:text=Treasury%20established%20several%20programs%20under,growth%2C%20and%20prevent%20avoidable%20foreclosures.
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