Moral hazard occurs when an economic actor takes on more risk because it won't bear the full costs
Image: Philippe Giabbanelli, CC BY 3.0, via Wikimedia Commons
Moral hazard
Moral hazard occurs when an economic actor takes on more risk because it won't bear the full costs
Moral hazard arises when an economic actor, such as a corporation with insurance, engages in riskier behavior because it doesn't fully absorb the consequences. This situation often occurs due to information asymmetry, where the risk-taker knows more about its intentions than the party bearing the risk. The principal-agent theory illustrates this, where an agent may act too riskily if they have more information than the principal.
Example
A corporation with insurance may invest in high-risk ventures, knowing that any losses will be covered by its insurance policy.
Understanding moral hazard is crucial for designing effective risk management strategies and insurance policies.
Related concepts
Endowment effect
People value owned items more than unowned ones
Adverse selection
Adverse selection occurs when one party has more information than the other
Deflation
Deflation increases the real value of money
Risk parity
Risk parity allocates based on risk contribution, not capital allocation
Recency bias
Recency bias overvalues recent events in decision-making
Paradox of thrift
Paradox of thrift: individual saving decreases aggregate demand and gross output
Educational content, not financial advice.
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