Lesson preview · Moral Hazard
Hidden Actions
~6 min · Free to read
Moral hazard occurs when one party changes their behavior after a contract is signed, because the other party cannot observe or verify their actions. The key word is “hidden” — the actions that matter are invisible to the party bearing the consequences. Unlike adverse selection (hidden information before the contract), moral hazard is about hidden actions after the contract.
Key Term
Moral Hazard
Moral hazard is the tendency for a party who is insulated from risk to behave differently than they would if fully exposed to the risk. It is a post-contractual problem driven by hidden actions: the insured person drives recklessly, the employee shirks, the bailed-out bank takes excessive risks.
Classic examples: (1) Insurance: a fully insured homeowner may not install a smoke detector because the insurer bears the fire loss. (2) Employment: a salaried worker may put in less effort since pay is not directly tied to output. (3) Finance: a bank that expects a government bailout may take excessive risks (“too big to fail”). In each case, the insulated party reduces care or effort because someone else bears the cost.
The agent chooses effort to maximize wage minus the cost of effort. If the wage doesn’t depend on effort (flat salary), the agent chooses minimum effort.
Worked Example
A delivery company pays drivers a flat salary of 200 dollars/day. Fuel-efficient driving saves the company 50 dollars/day but costs the driver 20 dollars in extra attention and slower routes. Will the driver drive efficiently?
Check yourself · no marks
How do insurance deductibles reduce moral hazard?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
Moral hazard differs from adverse selection because moral hazard involves:
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