Definition
Moral hazard arises when one party in an arrangement is shielded from the consequences of its actions, and therefore behaves more carelessly or takes more risk than it otherwise would. The classic setting is insurance: a fully insured driver may drive less cautiously because the insurer, not the driver, pays for an accident.
The hazard exists whenever the party bearing the cost cannot fully observe or control the behavior of the party taking the risk. It is a problem of hidden action rather than hidden information about a fixed trait.
Why it matters
How it works
Once an actor is insulated from downside risk, the private cost of careless behavior drops below its true social cost, so more risk is taken. A bank that expects a government rescue may make riskier loans; an employee paid a flat salary may exert less effort if effort is unobserved.
Remedies realign incentives. Deductibles make the insured share losses, performance pay ties reward to outcomes, and credible no-bailout commitments restore downside exposure. Monitoring reduces the hidden-action gap that makes the hazard possible.