Moral Hazard Explained

Quick Definition: Moral hazard is a situation when an individual in an economic transaction is willing to take more risks because the costs that could occur from their actions will not be felt by them.

What is moral hazard?

Moral hazard is a term that describes a situation when an individual is willing to take more risks than usual because the costs that could occur from these risks will not be felt by them.

Let’s now apply this concept to economics. Moral hazard occurs in an economic transaction when the buyer or seller is willing to take extra risks because the negatives impacts will fall on the other party.

For example, moral hazard is present in the insurance industry. Many car owners take out insurance on their vehicles in case they get damaged or stolen. However, this means that the owners are more likely to take risks when driving because it’s the insurance company who will pay for any damage to the car.

Moral hazard has been widely talked about since the financial crisis of 2007/08. This is because many people believe the crisis was caused by people who took unnecessary risks by selling complicated financial products, knowing that if they failed, they would not be the ones who would be responsible.

Key terms
  • Market failure – This is a situation when the free market system leads to an inefficient allocation of resources. An example of a market failure is an externality.
  • Asymmetric information – A situation when the buyer or the seller knows more than the other about the quality of the product. Asymmetric information is one cause of a market failure.
  • Adverse selection – This is a situation in a market when buyers and sellers have access to different information about each other and as a result, the market doesn’t function properly.