Moral hazard problems

Moral hazard is a risk that arises when one party has more information than another, or has less incentive to act in a responsible manner due to the presence of protective measures. It is a situation in which one party is more likely to take risks because the consequences of their actions are not fully felt by them. For example, a company may provide an employee with health insurance, which could incentivize them to take risks that may result in costly medical bills. From a management perspective, moral hazard can lead to higher costs, reduced efficiency, and a lack of accountability. To prevent moral hazard, organizations should ensure that incentives are aligned between parties and that responsibilities and risks are clearly defined and communicated.

Example of moral hazard problems

• Insurance companies: Insurance companies face moral hazard when customers purchase a policy and then become less careful in protecting their property due to the assurance of coverage.
• Banks: Banks face moral hazard when customers take out loans knowing that the bank will not be able to recoup their losses if the customer defaults on the loan.
• Government subsidies: Government subsidies can create moral hazard when businesses become dependent on the subsidies and do not take the necessary steps to reduce costs or increase efficiency.
• Employee compensation: Moral hazard can arise when employees are given compensation packages that do not align with organizational goals. For example, when employees are paid based on the number of sales they make, they may be incentivized to make sales at any cost, even if it is not in the best interest of the company.
• Corporate governance: Moral hazard may arise when corporate executives are rewarded with large bonuses regardless of the company’s performance. In this case, executives may take risks that are not in the best interest of the company in order to increase their own personal gain.

Types of moral hazard problems

Moral hazard is a risk that arises when one party has more information than another, or has less incentive to act in a responsible manner due to the presence of protective measures. It can manifest itself in a variety of ways, including the following:

• Adverse selection - This occurs when a party is able to select an option that reduces the risk of a loss, such as an insurance policy. This can lead to increased costs for others.
• Risk shifting - This occurs when a party is able to transfer the risk of a potential loss to another, such as through a contract or agreement. This can create an environment of unfairness or inequality.
• Principal-agent problems - This occurs when an agent or employee is not held to the same standards as the principal or employer. This can lead to unproductive behavior or a lack of accountability.
• Externalities - This occurs when the actions of one party have an effect on another, such as when pollution affects the environment. This can lead to economic losses and social harms.

Steps of moral hazard prevention

A moral hazard problem typically involves four steps:

• Identification: The first step is to identify the moral hazard, which is the risk that arises when one party has more information than another, or has less incentive to act responsibly due to the presence of protective measures.
• Risk Assessment: Once the moral hazard is identified, it is important to assess the risk associated with it. This involves determining the potential costs, liabilities, and consequences of the moral hazard.
• Mitigation: The third step is to mitigate the risk associated with the moral hazard. This can involve implementing policies, procedures, and systems to reduce the risk and ensure that everyone involved is held accountable.
• Evaluation: The fourth step is to evaluate the effectiveness of the mitigation measures. This can involve conducting periodic audits and reviews to ensure that the measures are working as intended.

Limitations of moral hazard problems

Moral hazard presents a number of limitations in terms of its effects on an organization. These include:

• Reduced Efficiency: Moral hazard can lead to inefficiencies in an organization as employees may take unnecessary risks due to a lack of accountability.
• Increased Cost: Moral hazard can lead to an increase in costs as one party may not consider the financial consequences of their actions.
• Lack of Accountability: Moral hazard can lead to a lack of accountability among parties as the consequences of their actions are not felt by them.
• Increased Risk: Moral hazard can lead to an increase in risk-taking behavior as there is a lack of incentive to act responsibly.
• Difficult to Monitor: Moral hazard can be difficult to monitor and detect, as it is often based on incentives and expectations that are not openly discussed.

Moral hazard problems — recommended articles

Conflict of interest — Specific risk — Transfer risk — Reduction of risk — Financial loss — Retention of risk — Risk appetite statement — Risk treatment plan — Acts of corruption

References

• Holmstrom, B. (1982). Moral hazard in teams. The Bell journal of economics, 324-340.
• Demski, J. S., & Sappington, D. E. (1991). Resolving double moral hazard problems with buyout agreements. The RAND Journal of Economics, 232-240.