Principal-Agent problem

Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

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Conflicts of Interest in Finance

Angered by a foreign downing of a U.S. airliner, and frustrated by the ineffectiveness of customary retaliation, fictional West Wing President Bartlet challenged his military advisors to devise a “disproportional response” that would go beyond “the cost of doing business” to deter future attacks and make Americans safe.

Financial corruption does not put our lives directly at stake. Yet, it is easy to imagine how widespread and recurring corruption could lead a future U.S. President – frustrated by the failure of markets, regulators, and the courts to change financial intermediaries for the better – to ask her financial and legal advisors for a similar disproportional response to make Americans safe...

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