Question

Give an example where there is a possibility of moral hazard. Also discuss how can the possibility of moral hazard be addressed?

Answer 1

Moral hazard is the idea that people have opportunities to adjust their actions when others bear their danger of bad-decision. Examples of moral hazard include: Large insurance schemes minimize the motivation to take care of your assets Governments may induce banks to take greater risks by offering to bail out loss-making banks.

There is asymmetry to details. Where one group keeps more information than another. For example, a company that sells subprime loans may realize that the people who take out the loan are liable to default. But the bank that buys the mortgage package has less detail, and assumes the mortgage is going to be fine.
A contract is influencing two specific agents' behaviour. Two parties are in some cases faced with different opportunities. If you are insured so there will be less reason for you to take care of risks. For example, if a country knows that it will obtain an IMF bailout, it will have less of an urge to reduce debt.

The 2008/09 financial crisis resulted in many banks / large financial institutions running short of liquidity. Governments in the UK and the US have intervened to provide large-scale bailouts. The problem with bailing out banks is setting a new precedent for the future. It could promote potential risk-taking by the banks. Despite this moral hazard issue, however, the economic cost of letting banks fail will be even greater. The alternative is to seek to split banks into branches to invest and save. In other words, governments must guarantee ordinary savings, but if banks make a risky investment in subprime, governments do not need to bail out this branch of banking operation

In the course of the transaction, the disservice to the second party can occur to get the transaction to take place, and even after the transaction has taken place. There are many ways to reduce the moral hazard, including rewards, unethical conduct mitigation measures, and frequent monitoring. Unbalanced, or asymmetric knowledge is at the center of moral hazard. During a deal, the party taking risks has more knowledge about the circumstance or motives than the party which is experiencing any consequences. The group with extra details usually has more incentive or is more likely to behave improperly in order to benefit from a transaction.