Concepts / Institutions
Moral hazard.
When people are shielded from the consequences of their decisions, they may take risks they would otherwise avoid. The gains stay with them, while part of the losses falls on others. Economists call this moral hazard.
The term was used in insurance in the nineteenth century. Kenneth Arrow's 1963 study of medical care helped bring it into modern economics, and later work, notably by Bengt Holmström, showed how it depends on what others can observe.
How it works
Protection changes behaviour.
Moral hazard arises when two things combine: someone else carries part of the cost, and they cannot fully see how carefully the decision is made.
- 01
A shield
Insurance, a guarantee or an expected rescue covers part of any loss.
- 02
Hidden action
Those providing the shield cannot fully observe how much care is taken.
- 03
More risk
Because the downside is shared, taking risk becomes more attractive to the decision-maker.
- 04
Costs shift
When things go wrong, much of the loss falls on those who provided the protection.
Why it matters
Incentives, not bad character.
Despite its name, moral hazard is not a claim that people are dishonest. It describes how sensible people respond when they do not bear the full cost of their choices. Many valuable arrangements, from insurance to deposit protection, create some moral hazard. The question is how to design them so that protection does not invite excessive risk. Try it in the graphic: raise the safety net, then add monitoring.
Where it can show up
Wherever risk and its costs are separated.
These are general patterns, not findings about any particular party, institution, government or election.
Insurance and guarantees
People who are insured may take less care, which is why insurers use excesses and co-payments.
Organisations and finance
Institutions that expect to be rescued if things go wrong can take on more risk than they otherwise would.
Public decisions
Decision-makers who will not bear a project's costs, or who will have moved on before results arrive, can favour riskier choices.
Delegation
When an agent's effort cannot be observed, they may take less care than those relying on them would want. See the principal–agent problem.
Designing protection well
Ways to limit moral hazard.
The aim is to keep the benefits of protection while keeping decision-makers connected to the consequences.
- Keep some of the cost with the decision-maker, through excesses, co-payments, deposits or a stake in the outcome.
- Improve monitoring and reporting, so that risk-taking can be seen and responded to.
- Reward long-term results, not only short-term gains.
- Set clear limits in advance on what will and will not be covered.
- Keep accountability in place when people change roles or move on.
Origins and further reading
Where the idea comes from.
A related idea is adverse selection. It concerns hidden information before an agreement is made, while moral hazard concerns hidden action after it.
- Arrow, K. J. (1963). Uncertainty and the welfare economics of medical care. American Economic Review, 53(5), 941–973.
- Pauly, M. V. (1968). The economics of moral hazard: comment. American Economic Review, 58(3), 531–537.
- Holmström, B. (1979). Moral hazard and observability. Bell Journal of Economics, 10(1), 74–91.
About this concept
A general idea, not a verdict.
This page explains a general concept from economics and political science. It does not describe or assess any particular party, institution, government or election. Related: The principal–agent problem and Selectorate theory.