What is moral hazard?

By Andrew Beattie AAA
A:

An idea that a party that is protected in some way from risk will act differently than if they didn't have that protection. We encounter moral hazard every day - tenured professors becoming indifferent lecturers, people with theft insurance being less vigilant about where they park, salaried salespeople taking long breaks, and so on.

Moral hazard is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims. Insurers fear that a "don't worry, it's insured" attitude leads to policyholders with collision insurance driving recklessly or fire insured homeowners smoking in bed.

The idea of a corporation being too big or too important to fail also represents a moral hazard. If the public and the management of a corporation believe that the company will receive a financial bailout to keep it going, then the management may take more risks in pursuit of profits. Government safety nets create moral hazards that lead to more risk taking, and the fallout from markets with unreasonable risks - meltdowns, crashes, and panics - reinforces the need for more government controls. Consequently, the government feels the need to strengthen these nets through regulations and controls that increase the moral hazard in the future.

The alternative to creating a moral hazard is to simply let corporations fail when they risk too much and let the stronger corporations buy up the wreckage. This theoretical free-market approach should remove any moral hazard. In a true free market, companies would still fail, just as houses burn down whether they're insured or not, but the impact would be minimized. There would be no industry-wide meltdowns because most companies would be more cautious just as most people choose not to smoke in bed whether or not they are insured. In both cases, the risk of burning up is enough to prompt serious second thought on any risk taking behavior.

True free market capitalism doesn't exist, so the taxpayers of many countries are the unwilling insurers for markets. The problem is that insurers profit by selling policies, whereas taxpayers gain little or nothing for footing the bill on the policies and bailouts that create moral hazards.

To learn more about moral hazard, read our article Moral Hazards: A Bump In The Contract Road.

This question was answered by Andrew Beattie.

RELATED FAQS

  1. How might having insurance increase moral hazard?

    Would you drive safely if your insurance company knew nothing about your driving habits? Learn how insurance increases moral ...
  2. What math skills do I need to study microeconomics?

    Find out how and why mathematics are used in microeconomics, what its limitations are and the kinds of math skills that economics ...
  3. What kinds of topics does microeconomics cover?

    Read about the purpose, derivations and uses of microeconomics, and see how the interaction of scarcity and choice drives ...
  4. How does the "Buffett Premium" increase Berkshire Hathaway's stock price?

    Explore the theory that Berkshire Hathaway stock carries a Warren "Buffet Premium" that would disappear upon his death and ...
RELATED TERMS
  1. Endowment Effect

    The endowment effect describes a circumstance in which an individual ...
  2. Self-enhancement

    The self-enhancing bias is the tendency for individuals take ...
  3. Gamification

    Gamification describes the incentivization of people's engagement ...
  4. Anchoring and Adjustment

    Anchoring and adjustment is a cognitive error described by behavioral ...
  5. Sample Size Neglect

    Sample size neglect occurs when an individual infers too much ...
  6. Commercial Package Policy (CPP)

    An insurance policy that combines coverage for multiple perils, ...

You May Also Like

Related Articles
  1. Credit & Loans

    Which Is One Of The Nation’s Safest ...

  2. Active Trading Fundamentals

    How does the "Buffett Premium" increase ...

  3. Economics

    The New Global Banking Regulations To ...

  4. Stock Analysis

    How Warren Buffett made Berkshire Hathaway ...

  5. Entrepreneurship

    Want To Sell Life Insurance? Read This ...

Trading Center