Moral Hazard

Conceptual Overview

Although early economists like Adam Smith were aware of the existence of moral hazard, the possibility [Page 918]of moral hazard, and opportunistic behavior in general, was ruled out in neoclassical economics, which assumed perfect competition, rational actors, and that parties to a transaction could verify whether the terms of the transaction had been met without incurring costs. With the development of new institutional economics, it was increasingly recognized that these assumptions are not realistic, because gathering information is costly and economic agents often engage not merely in the pursuit of self-interest but do so with guile.

The term moral hazard originates in the insurance industry, where it refers to the tendency of individuals with insurance to change their behavior in a way that leads to larger claims against the insurance company. For example, being insured may make individuals lax about taking precautions to avoid or minimize loses. The incentive to engage in moral hazard would not be a problem if it were easy to determine when the behavior was appropriate. However, this sort of monitoring is often not possible, or it is very costly. As a result, agents do not bear the full impact of their actions. Consequently, contracting is incomplete, because it is not possible to specify in a contract particular behavior when it cannot be observed.

Because moral hazard is quite common and can arise in any situation when an individual is tempted to take an inefficient action or to provide distorted information in order to increase the individual's outcome of the transaction, it has been generally referred to as hidden action. Examples include employees shirking, free-riding behavior in groups, managerial misbehavior, and professional-client relationships. Such situations are also called agency relationships and are the main focus of principal agent theory. One individual (the agent) acts on behalf of another (the principal) and is supposed to advance the principal's goals. The moral hazard problem arises when agent and principal have different individual objectives and the principal cannot control the agent's actions. These difficulties often arise because monitoring actions or verifying reported information is costly or impossible. Those costs are described as monitoring costs. Thus, moral hazard occurs if three conditions are met. First, there must be a potential divergence of interests between individuals. Second, there must be some transaction between these individuals that activates their divergent interests. Third, and critically important, it must be difficult for the involved individuals to determine whether the terms of the agreement have been followed.

The doctor-patient relation is often cited as a notorious case of hidden action. The doctor is the agent who chooses actions affecting the welfare of the principal (the patient). Because the doctor has a superior knowledge, the patient cannot check if the actions of the doctor are as diligent as they could be. This is complicated by the fact that not only the actions of the doctor, but also other aspects influence the well-being of the patient, so that the patient cannot conclude to what extent the actions of the doctor have been appropriate. Therefore, moral hazard is the result of information asymmetry in uncertain situations. The opportunistic scope of action in such cases causes so-called agency costs, which reduce the efficiency of economic transactions. Agency costs are shared by agent and principal and consist of the agent's guarantee costs, the principal's monitoring costs, and a remaining welfare loss. It has been suggested that the nature of the firm can be explained by referring to moral hazard problems and the ability of firms to reduce the agency costs associated with team production.

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