What is Moral hazard?
- Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.
- Moral hazard is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims. Insurers fear that a “don’t worry, it’s insured” attitude leads to policyholders with collision insurance driving recklessly or fire-insured homeowners smoking in bed.
Moral Hazard in Business
- The idea of a corporation being too big to fail also represents a moral hazard. If the public and the management of a corporation believe the company will receive a financial bailout to keep it going, management may take more risks in pursuit of profit. Government safety nets create moral hazards that lead to more risk-taking, and the fallout from markets with unreasonable risks—meltdowns, crashes, and panics—reinforces the need for more government controls. Consequently, governments sometimes impose laws that increase the moral hazard in the future.
- The alternative to creating a it is to simply let corporations fail when they risk too much and let the stronger corporations buy up the wreckage. This theoretical free-market approach should remove any moral hazard. In a true free market, companies would still fail, just as houses burn down whether they’re insured or not, but the impact would be minimized. There would be no industry-wide meltdowns because most companies would be more cautious, just as most people choose not to smoke in bed whether they are insured or not. In both cases, the risk of getting burned is enough to prompt serious second thoughts.
Ways to Reduce Moral Hazard
- There are several ways to reduce moral hazard, including incentives, policies to prevent immoral behavior and regular monitoring.
- At the root of moral hazard is unbalanced or asymmetric information.
- The party taking risks in a transaction has more information about the situation or intentions than does the party that suffers any consequences.
- Generally, the party with extra information has more motivation or is more likely to behave inappropriately to benefit from a transaction.
- The benefit of the asymmetric information often occurs after the transaction has concluded.
- Moral hazard occurs in different types of situations and different arenas. In the financial sector, one motivator can be bailouts. Lending institutions tend to make their highest returns on loans that are considered risky. They are more inclined to make such loans when they have the assurance or expectation of some sort of government aid in the event of loan defaults.
- In the health insurance market, when the insured party or individual behaves in such a way that costs are raised for the insurer, moral hazard has occurred. Individuals who don’t have to pay for medical services have an incentive to seek more expensive and even riskier services that they would otherwise not require. For these reasons, health insurance providers generally institute a co-pay and deductibles, which requires individuals to pay for at least part of the services they receive.
Moral hazard in one of its most basic form occurs when employees shirk responsibility at their places of employment. An employee has a basic incentive to do the least amount of work for the same amount of pay. It benefits the employer to cut down on this moral hazard. The employer may establish incentives that encourage employees to accomplish an above-average workload. For example, the offering of bonuses (which may be cash or company stock) for completing a certain number of tasks or for generating more business can serve to steer employees in the direction of desirable behavior and away from undesirable behavior. It also behooves employers to offer long-term benefits designed to motivate employees to be productive and loyal.
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