Moral Hazard

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It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome

In economic theory,moral hazard is a situation in which a party insulated from risk behaves differently from how it would behave if it were fully exposed to the risk.. Economist Paul Krugman described moral hazard as: "...any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company. Moral hazard also arises in a principal-agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned. 1.A. Mas-Colell, M. Whinston, and J. Green (1995), Microeconomic Theory. Chapter 14, 'The Principal-Agent Problem', p. 477. 2. Holmstrom, B. (1979), "Moral hazard and...
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