Define: Moral Hazard

Moral hazard refers to the situation where individuals or entities are inclined to take greater risks or engage in reckless behavior because they are insulated from the potential consequences of their actions. This phenomenon commonly occurs in situations where one party has asymmetric information or lacks sufficient incentives to act prudently due to the presence of insurance, guarantees, or bailouts. For example, individuals might engage in risky behavior if they know they are protected by insurance coverage. In the context of financial markets, moral hazard can arise when institutions take on excessive risks, assuming that they will be bailed out by governments or central banks in the event of failure. Addressing moral hazard is crucial for maintaining stability and efficiency in various sectors, often requiring measures such as risk management protocols, regulatory oversight, and incentives alignment.

Moral hazard can be referred to as a social offence in economics. The situation of moral hazard arises when any business party or economic agent provides wrong information about its assets, liabilities or credit capacity in order to mislead associated organization. Moral hazard can arise when there is a breach of contract or any party takes unusual risks in order to desperately earn a profit before the settlement of any contract.

Moral hazard is a common phenomenon when there is a contract agreement between any two parties. In any type of contract there remains ample scope for each party to gain by acting contradictory to the agreement. A simple example can be noted in order to understand the situation of moral hazard. If in any case a salesperson is given only a salary without commission against his sales, then there remains a possibility of that salesperson not having to show much dedication to his or her work. That salesperson would not mind if the business incurs loss or less profit. This situation is termed as a moral hazard in economics where social welfare diminishes due to an irresponsible or false act of any individuals or group of individuals.

Moral hazard can be referred to as a type of market failure. Such type of hazard is visible in the insurance market. People involved in the insurance sector take more risks and when there is more risk there are more chances of arousal of moral hazard. Maximizing behaviour of individuals is responsible for moral hazard. When benefits exceed costs, actions taken by an individual lead to moral hazard for an economy. Moral hazard is not always intentional, it can occur due to misfortune or lack of proper speculation.

Only a few steps can be put in the right way in order to minimize moral hazard. Moral hazard can be minimized if both parties sit together and decide over gains and benefits and cost to be borne. If an insured person gets what he or she claims at the right point of time, then also moral hazard can be diminished.

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This glossary post was last updated: 29th March, 2024.