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.

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 bail out large corporations.
  • 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.
  • In general, those who pay the costs have limited information about the other party they are transacting with: the risky party.

Understanding Moral Hazard

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 bail out large corporations. Moral hazard is also more likely to occur when there are certain methods of salesperson compensation.

Moral Hazard and 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 bail out 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.

Moral Hazard in 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.

Moral Hazard in Insurance

Moral hazard is often associated with the insurance industry. Insurance companies fear that individuals may engage in more risky behavior because they are not concerned with the costs associated with damages that may arise from that risky behavior as the costs are covered by the insurance company.

For example, a car driver may drive faster knowing that the damage on their car will be covered by the insurance company if they get in an accident. Similarly, a homeowner that smokes in bed may be less concerned if a fire breaks out causing damages because they have homeowners insurance that includes fire coverage that would cover the costs.

Moral hazard only applies once an individual has insurance coverage, not before. Adverse selection is the term used when individuals are deciding on how much and the type of insurance to purchase based on their own risky behavior.

Moral hazard is an issue for insurance companies because the relaxed attitude of the insured customers usually results in insurance companies having to pay out more insurance claims.

Moral Hazard Examples FAQs

Why Is Moral Hazard an Economic Problem?

Moral hazard is an economic problem because it leads to an inefficient allocation of resources. It does so because one party is creating a larger cost on another party, which would result in significantly high costs to an economy if done on a macro scale.

What Is the Moral Hazard Problem?

The moral hazard problem is when one party in a deal or transaction is more comfortable taking risks, whether physical or financial, because they know that they will not be responsible for any negative consequences but rather the party not taking the risks.

Why Is It Called Moral Hazard?

It is called "moral hazard" because morality comes into play in determining parties' right and wrong behavior in a transaction that could lead to or prevent a hazard whereby the party not engaging in the behavior will possibly suffer the consequences.

Why Is It Important for a Business to Anticipate Moral Hazard?

Moral hazard is an economic cost so it is important for businesses to anticipate these costs. It is best seen through the insurance industry whereby insurance companies need to be aware that the behavior of individuals is likely to be riskier if they are insured so the likelihood of accidents and paying out claims increases. They will need to factor moral hazard into their overall financial plan, anticipating revenues, costs, and profits.