Moral hazard

Moral hazard is a term originally used in the insurance industry to explain the fact that, when insured, individuals might act more recklessly than when not insured.

For example, being insured to drive a car might make drivers less cautious when driving given that they know that, in the event of an accident, the insurance company will pay for the damages. In the insurance industry, moral hazard is taken into account when underwriting many types of risk.

The concept is also widely used in economics to assess the effect of the state provision of services, benefits, and bail-outs, including healthcare, welfare payments, and bail-outs in the financial sector.

For example, the provision of healthcare free at the point of need (real or perceived) may affect the decisions by individuals regarding their own health. Knowing that treatments are available for alcoholism might encourage some individuals to drink excessively and beyond they level that they might do if no treatments were available through state healthcare provision.

Similarly, the provision of welfare benefits might lead individuals either not to look for work, or to leave a job without a suitable alternative job given that, at least at a basic level, the state will provide for them for a period of time.

Many have argued that the numerous bank failures associated with the ‘financial crash’ were, at least, partly the result of moral hazard in the banking sector.

Given that bank employees may have thought that banks were ‘too big to fail’ some may have carried on their high-risk lending and investment activities assuming the state would ‘come to the rescue’.

While the impact of moral hazard is difficult to quantity, and hence difficult to prove, it is used widely in economics in terms of evaluating of whole range of economic policies and behaviours.

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