Question

1. Pretend you are working for a policy maker and your task is to explain the concept of moral hazard. Use the space below to formulate your explanation.

2. Economist disagree about the likely extent of moral hazard in the health care system. What are 2 arguments/evidence to suggest that moral hazard does exist? What are 2 arguments/evidence to suggest that moral hazard does not exist?

Answer 1

1.) Moral hazard problem refers to the problem when one party takes a risky option/decision knowing that he/she is protected against the risk and other party will bear the cost of his/her actions. Moral hazard problem arises when there is asymmetric information.

When the policy makers formulate a policy they do not have symmetric information regarding the actions of the public. For example, say the government makes a law that says farmers who are unable to pay their loans due to bad crop yield would be waived against loans. A loan waiver. Thus, there would be a moral hazard problem. The farmers would be prone to make risky decisions like, doing less irrigation, choosing cash crops that tend to fail often, buying equipments that could have been rented (i.e, irrational decision) knowing that the government would waive their loans if the crops fail. This increases the problem of moral hazard in policy making because the government doesn't know how to identify genuine farmer/rational decision makers.