Managerial Economics and Strategy, 2/e

15.3 Moral Hazard

We now turn from adverse selection problems caused by hidden characteristics to moral hazard problems that result from hidden actions. Examples include individuals driving rental cars off-road, workers loafing when the boss is not watching, and lawyers acting in their own interests instead of those of their clients.

We start by examining moral hazard problems that occur in insurance markets and in principal-agent relationships. Later, we discuss means of reducing or eliminating these moral hazard problems.

Moral Hazard in Insurance Markets

The insurance industry introduced the term moral hazard into common usage. Many types of insurance are highly vulnerable to hidden actions by insured parties that result in moral hazard problems. ...