Question

Think critically about this question: Have you ever engaged in moral hazard - taking a bigger risk than you normally would - with a financial decision? Were there any negative consequences to this moral hazard for you or someone else?

Response must be at least 250 words.

Answer 1

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

Description: In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan.
It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.

Example: You have not insured your house from any future damages. It implies that a loss will be completely borne by you at the time of a mishappening like fire or burglary. Hence you will show extra care and attentiveness. You will install high tech burglar alarms and hire watchmen to avoid any unforeseen event.
But if your house is insured for its full value, then if anything happens you do not really lose anything. Therefore, you have less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

Moral hazard can be present any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement. For example, when a salesperson is paid a flat salary with no commissions for his or her sales, there is a danger that the salesperson may not try very hard to sell the business owner's goods because the wage stays the same regardless of how much or how little the owner benefits from the salesperson's work.

Moral hazard can be somewhat reduced by the placing of responsibilities on both parties of a contract. In the example of the salesperson, the manager may decide to pay a wage comprised of both salary and commissions. With such a wage, the salesperson would have more incentive not only to produce more profits but also to prevent losses for the company.