Moral hazard is a situation in which one party engages in risky behavior or fails to act in good faith because it knows the other party bears the economic consequences of their behavior. Any time two parties come into an agreement with one another, moral hazard can occur.

A driver in possession of a car insurance policy may exercise less care while operating their vehicle than an individual with no car insurance. The driver with a car insurance policy knows that the insurance company will pay the majority of the resulting economic costs if they have an accident. Any time an individual does not have to suffer the full economic consequences of a risk, moral hazard can occur. In the business world, moral hazard can occur when governments make the decision to bailout large corporations. Moral hazard is also more likely to occur when there are certain methods of salesperson compensation.

Key Takeaways

  • Moral hazard is a situation in which one party engages in risky behavior or fails to act in good faith because it knows the other party bears the economic consequences of their behavior.
  • Moral hazard can occur when governments make the decision to bailout large corporations because.
  • Bailouts send a message to executives at large corporations that any economic costs from engaging in excessively risky business activities (in order to increase their profits) will be shouldered by someone other than themselves.
  • When a business owner pays a salesperson a set salary, that salesperson may have an incentive to put forth less effort, take longer breaks, and generally have less motivation to increase their sales numbers than if their compensation was tied to their sales numbers.

The Great Recession

In the late 2000s, many giant U.S. corporations were on the verge of collapse as a result of years of risky investing, accounting blunders, and inefficient operations. These corporations–such as Bear Stearns, American International Group (AIG), General Motors, and Chrysler– employed thousands of workers and contributed billions of dollars to the country's economy. This time period is now known as The Great Recession, and the U.S. was in the throes of a deep global recession.

While many executives of these companies blamed the poor state of the economy for the financial troubles their businesses were experiencing, in actuality, the greater economic recession simply exposed the risky behaviors that they had been engaging in for many, many years before the start of the recession.

Ultimately, the U.S. government deemed these companies too big to fail and came to their rescue in the form of a bailout. This bailout cost taxpayers hundreds of billions of dollars; the U.S. government's reasoning was that allowing businesses to fail that were so crucial to the status quo of the country's economy could threaten to push the U.S. into a deeper economic depression from which it ultimately might not recover.

These bailouts– executed at the expense of taxpayers–presented a huge moral hazard situation; the willingness of the government to bailout their companies sent a message to executives at large corporations that any economic costs from engaging in excessively risky business activities (in order to increase their profits) would be shouldered by someone other than themselves. The Dodd-Frank Act of 2010 attempted to mitigate the likelihood of another moral hazard situation involving these "too-big-to-fail" corporations. The Act forced these corporations to create specific plans in advance for how to proceed if they got into financial trouble again. The Act also stipulated these companies would not be bailed out at the expense of taxpayers again in the future. When a moral hazard situation

Salesperson Compensation

The compensation method for how some salespeople are paid represents another situation where moral hazard is more likely to occur. When a business owner pays a salesperson a set salary–not based on their performance or sales numbers–that salesperson may have an incentive to put forth less effort, take longer breaks, and generally have less motivation to increase their sales numbers than if their compensation was tied to their sales numbers.

In this scenario, it can be said that the salesperson is acting in bad faith if they are not doing the job they were hired to do to the best of their ability. However, the salesperson knows the consequences of this decision (potentially lower revenues) will be shouldered by the management of the company or the business owner, while their individual compensation will not be impacted. For this reason, most companies choose to pay only a smaller, base pay salary to their salesforce, with the majority of their compensation coming from commissions and bonuses that are directly tied to their sales numbers. This compensation style may provide salespeople with a greater incentive to work harder because they will bear the cost of any missed sales opportunities in the form of lower paychecks.