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What is moral hazard?

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What is moral hazard? Powered By Docstoc
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Moral hazard refers to risky situations between two agents or contracting parties, it first
appeared in the field of insurance. In principle, it is the possibility for a person to act immorally in
a situation not anticipated by the designers of a system.

Moral hazard could occur if a higher authority, such as a government, or a collective body wants
to enforce a collective rationality, but this is exploited by individuals for their own interests and
thus possibly evaded.

More generally, and by extension moral hazard can entail any change in the behavior of a
contractor against the interests of other parties to the contract, compared to the situation
prevailing before the conclusion of the contract (eg degradation of an employee after the end of
the trial period).

Moral hazard is fully linked to the phenomenon of informational asymmetry. However, it should
not be confused with anti-selection, which describes the fact that insurance is more
advantageous for those whose risk is greater, but the two phenomena can be analyzed similarly
(asymmetric information, principal-agent problem), and are not distinguishable by an insurer.

From the perspective of principal-agent relationship, the idea of moral hazard is to assume that
the principal does not know the effort level of the agent. The main goal is to propose a contract
in which salary levels are set and the proposed level of effort required such that the agent
accepts the contract.

The relationship of moral hazard with morality is very small: it amounts to the fact that it can
induce the agent not to increase too much the level of risk he takes. Moral hazard can also
mean a pernicious effect of a regulatory system or contract with a major legal loophole that
opens up huge potential for abuse or fraud. Or in common parlance, a free ride to those who
want to take advantage of a settlement or contract by diverting an initial standpoint.

When there is an economic crisis involving individual countries or large companies, international
institutions and major industrial states are usually forced to help out with funds. This can lead to
risky behavior by individual governments and large companies who trust that they will be helped
if need be.

Banks in particular may feel protected against their own imprudence and take more risks when
granting credit or in the execution of market operations. This is summarized by some form of
privatization profits and nationalization of losses.

				
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posted:11/21/2012
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