Moral hazard is a situation in which one party to an agreement engages in risky behavior or fails to act in good faith because it knows the other party bears the consequences of that behavior. For example, a driver with an auto insurance policy that provides full coverage, accident forgiveness, and no deductible may exercise less care while driving than someone with no insurance or a less generous policy because the first driver knows the insurance company, not him, pays 100% of the costs if he has an accident. In the business world, common examples of moral hazard include government bailouts and salesperson compensation.
The Great Recession
In the late 2000s, during the throes of a deep global recession, years of risky investing, accounting blunders, and inefficient operations left many giant U.S. corporations, all of which employed thousands of workers and contributed billions of dollars to the country's economy, on the verge of collapse. Bear Stearns, American International Group (AIG), General Motors, and Chrysler topped this list of struggling corporations. While many executives blamed the economic malaise for the woes of their businesses, the truth was that the recession only brought to light the risky behaviors in which they had already been engaging. Ultimately, the U.S. government deemed these companies too big to fail and came to their rescue in the form of a bailout costing taxpayers hundreds of billions of dollars; its reasoning was that allowing businesses so important to the country's economy to fail would push the U.S. into a depression from which it might not recover.
The bailouts of AIG, General Motors, and others at taxpayers' expense presented a huge moral hazard, as it sent a message to executives at large corporations that any fallout from engaging in excessive risk to increase profits would be shouldered by someone other than themselves. The Dodd-Frank Act of 2010 attempted to mitigate some of the moral hazard inherent in too-big-to-fail corporations by forcing them to draw up concrete plans in advance for how to proceed if they got into financial trouble and stipulating that, going forward, companies would not be bailed out at the expense of taxpayers.
Salesperson compensation represents another area often rife with moral hazard. When a business owner pays a salesperson a set salary not based on performance or sales numbers, the salesperson has an incentive to put forth less effort, take longer breaks, and generally have less motivation to be a sales superstar than if the compensation is tied to performance. In this scenario, the salesperson is acting in bad faith by not doing the job they were hired to do to the best of their ability. However, the salesperson knows the consequences of this decision, lower revenues, are shouldered by the boss, the business owner, while the salesperson's compensation remains the same. For this reason, most companies prefer to pay only a small base salary to salespeople, with the majority of their compensation coming from commissions and bonuses tied to sales performance. This compensation style provides salespeople with incentives to work hard because they bear the burden of slacking in the form of lower paychecks. (For related reading, see "What Is Moral Hazard?")