A:

An economist identifies moral hazard as any situation where one party has an incentive to use more resources than he otherwise would have used because another party incurs the costs. This produces inefficient microeconomic outcomes. The term "moral hazard" is somewhat of a misnomer; no normative statements about morality or value judgments are intended.

Perhaps the most well-known instance of moral hazard is the Tragedy of the Commons. In a scenario where resources are publicly owned, each individual actor has an incentive to consume as many as possible because he does not bear costs equal to his resource usage. Other examples of moral hazard include banks that make risky loans because they believe the government will not allow them to go out of business or salaried employees taking longer breaks because they do not get paid any less.

Economic Explanation of Moral Hazard

The most common explanation for moral hazard is called "informational asymmetry." This occurs when separate parties in a contract have unequal information. Consider a subprime mortgage lender that knows its borrowers have a relatively high default rate. If the lender sells a pool of mortgages as a financial derivative, however, the purchasing party may not understand the borrower profiles.

Another explanation for moral hazard is that two or more economically connected parties face different incentives. This can commonly be seen with insurance contracts, where the insurer has an incentive to reduce total costs but the insured no longer bears the full costs of his risky behavior. This is known as the "principal-agent problem."

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