Moral Hazard

Moral hazard is the risk one party has when dependent on the virtuous, or moral, behavior of others. These risks increase when there is no effective way to control that behavior. To distinguish moral hazard from all cases in which people misbehave, moral hazard problems arise in situations in which two or more parties form an agreement or contractual relationship, and the arrangement itself creates the incentives for misbehavior. For example, for a person to have an incentive to exceed the posted speed limit so that he or she can be home in time to watch a favorite television show would not be an example of moral hazard. However, if one's employer agrees to pay all misdemeanor moving violations that he or she would incur when using a company car, then that would create a moral hazard problem by giving one an incentive to take an action (speeding) that harms the employer (paying for speeding violations). Because moral hazard problems arise within the context of agreements or contractual relationships, they are also a type of postcontractual information problem.

Suppose there is an arrangement between an individual and another person or entity, such as an organization, in which the individual agrees to behave in a certain way, perform a specified task, or provide a specific product. The potential for a moral hazard problem arises when the following conditions exist. First, there is uncertainty regarding the moral character of contracting parties. Second, the interests or objectives of the individual are not aligned with the interests or objectives of the person or organization with whom he or she made the agreement. Third, the agreement creates incentives for the individual to act in such a way so as to benefit himself at the expense of the person or organization he or she has agreed to help. Finally, it is costly, difficult, or impossible for the person or organization to fully monitor the activities of the individual. The problem of monitoring is critical. If contracting parties could effectively observe or monitor the activities of their partners, then moral hazard problems would be almost entirely eliminated.