Moral Hazard

02What People Think

“If a person is protected from a loss, nothing changes except who pays when bad luck strikes.”

03What’s Underneath

Imagine an adult borrowing a relative’s car. They drive carefully until the relative promises to cover every repair, then start taking rough shortcuts. The protection has changed the borrower’s behavior, while part of the possible cost remains with someone else.

Moral hazard concerns that shift in incentives. Insurance, guarantees or expected rescue can reduce the personal consequence of risk or carelessness. The technical term does not mean a person is morally defective. It identifies an arrangement in which actions can become less cautious because the actor bears less of their cost.

Protection can be valuable even when it creates this tension. Coverage does not inevitably make people reckless, and an accident by itself proves nothing about incentives. The distinction from adverse selection is important: moral hazard concerns behavior affected by the arrangement, whereas adverse selection concerns hidden differences among the people or goods entering it.

04The Game

After protection is provided, what changes about the incentive to take care? Who makes the risky choice, who can observe it, and who pays if it goes badly?