What is Moral Hazard? Examples and Implications

📚 Quick Study Guide

• 💰 Moral hazard occurs when one party takes on more risk because someone else bears the cost of that risk. Think of it as a hidden action problem.
• 🚗 Common examples include insurance, where people might be less careful with their possessions because they are insured, and banking, where institutions might take excessive risks knowing they'll be bailed out.
• 📈 Implications can range from increased reckless behavior to market instability, requiring regulatory interventions to mitigate risks.
• 🤝 Principal-agent problem is related: one party (agent) acts on behalf of another (principal) but doesn't necessarily act in the principal's best interest due to misaligned incentives.
• 📝 Key takeaways: Identify situations where costs and risks are separated, creating potential for irresponsible behavior.

🧪 Practice Quiz

1. Which of the following is the best definition of moral hazard?
   1. A) The risk that a borrower will default on a loan.
   2. B) The lack of information about the quality of goods or services.
   3. C) The tendency for people to take on more risk when they are insured.
   4. D) The practice of charging different prices to different customers.
2. Which of the following is an example of moral hazard in the insurance industry?
   1. A) An insurance company refusing to pay a claim.
   2. B) A person driving more recklessly after obtaining car insurance.
   3. C) An insurance company increasing premiums after a natural disaster.
   4. D) A person carefully comparing insurance policies before purchasing one.
3. How does moral hazard relate to the principal-agent problem?
   1. A) It is unrelated to the principal-agent problem.
   2. B) It is the solution to the principal-agent problem.
   3. C) It is a type of adverse selection.
   4. D) It can arise when the agent takes on more risk knowing the principal will bear the cost.
4. Which sector is most commonly associated with moral hazard due to potential bailout expectations?
   1. A) Agriculture
   2. B) Manufacturing
   3. C) Banking
   4. D) Retail
5. What is a potential consequence of moral hazard in financial markets?
   1. A) Increased market stability.
   2. B) Decreased lending activity.
   3. C) Excessive risk-taking and potential market instability.
   4. D) Reduced government regulation.
6. Which of the following strategies can help mitigate moral hazard?
   1. A) Providing full insurance coverage to everyone.
   2. B) Reducing transparency in financial transactions.
   3. C) Implementing stricter regulations and monitoring.
   4. D) Eliminating deductibles in insurance policies.
7. In the context of employment, how might moral hazard manifest itself?
   1. A) Employees always working at their maximum potential.
   2. B) Employees shirking responsibilities because monitoring is lax.
   3. C) Employers always paying fair wages.
   4. D) Perfect alignment of employer and employee goals.