Overview

If you have comprehensive car insurance, you might drive a little faster. Why? Because if you crash, the insurance company pays. That is Moral Hazard. It is the tendency to take risks when someone else is footing the bill. It is the reason banks crash the economy.

Core Idea

The core idea is Insulation from Consequence. When you separate the decision maker from the risk, bad things happen.

Formal Definition

A situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.

Intuition

  • The Rental Car: “Don’t be gentle, it’s a rental.” You drive a rental car harder than your own car because you don’t care about the long-term wear and tear.
  • The Bailout: “Too Big to Fail.” Big banks make risky bets. If they win, they keep the billions. If they lose, the government bails them out. It’s “Heads I win, Tails you lose.”

Examples

  • 2008 Crisis: Banks gave mortgages to people who couldn’t pay them back, then sold the mortgages to others. They didn’t care if the loan went bad because they had already sold it.
  • Health Insurance: If insurance pays for everything, you might go to the doctor for a common cold. This drives up costs for everyone. (Solution: Co-pays).
  • Safety Gear: American Football players hit harder than Rugby players because they wear helmets. The protection makes them more dangerous (Peltzman Effect).

Common Misconceptions

  • It’s about morality: It’s not about being “immoral.” It’s about rational response to incentives. If you pay people to be risky, they will be risky.
  • Principal-Agent Problem: The banker (Agent) takes risks with the depositor’s (Principal) money.
  • Skin in the Game: The solution. Making sure the decision maker shares the risk. (e.g., The banker loses his bonus if the bank fails).

Applications

  • Deposit Insurance (FDIC): Prevents bank runs, but creates moral hazard because depositors don’t check if their bank is safe.

Criticism / Limitations

  • Necessary Evil: We need insurance. We can’t abolish fire insurance just because it might encourage arson. We just have to manage the moral hazard (with investigations and deductibles).

Further Reading

  • Taleb, Nassim Nicholas. Skin in the Game.