Moral hazard
Moral hazard is the tendency to take more risk when its costs fall on someone else.
People take more risks when someone else bears the cost. That simple, pervasive fact, moral hazard, shapes insurance, finance, and the design of every incentive.
Moral hazard is a problem of asymmetric information that arises after a transaction, when one party, shielded from the consequences of its actions, changes its behaviour in ways the other party cannot observe or control. Protection from risk alters the incentive to avoid it.
Hidden action after the deal
Where adverse selection concerns hidden information before a deal, moral hazard concerns hidden action after it. Once a party is insured against a risk, protected from a loss, or able to pass consequences to others, it has less reason to take care, and may take more risk than it otherwise would. The insured drive less carefully, the bailed-out bank lends more recklessly, the employee on a fixed salary works less hard. The behaviour changes precisely because the actor no longer fully bears the downside.
Where it appears
Moral hazard is everywhere that risk and responsibility are separated. Insurance is the classic case: cover against theft or illness can reduce the effort people make to prevent them. Finance is rife with it: lenders and firms expecting rescue take risks they would otherwise avoid, the too-big-to-fail problem. Employment involves it whenever effort is hard to observe. Any arrangement that shields someone from the results of their actions invites it.
Designing against it
Because moral hazard cannot be eliminated where actions are hidden, institutions are designed to blunt it by keeping the actor exposed to some of the consequences. Insurance uses deductibles and co-payments, so the insured still bear part of the loss. Employment uses performance-related pay, tying reward to results. Lenders require collateral and a stake in the outcome. The common principle is to align incentives by ensuring the party who takes the action still feels some of its consequences, so the temptation to take hidden risks is curbed.
Moral hazard is one of the central concepts in the economics of information and incentives, the recognition that protecting people from risk changes how they behave. It explains why insurance is never unlimited, why bailouts are so fraught, and why so much of contract and institutional design is the careful business of making sure those who act still bear enough of the consequences to act with care.