Moral hazard

Moral hazard occurs when protection from the consequences of risk-taking encourages someone to take greater risks. It arises when one party’s actions are difficult for another party to observe or control.

Information asymmetry: A condition in which parties to an exchange have unequal information. The protected party often knows more about its own risk-taking than the party bearing the cost.
Insurance: A contract that transfers specified financial risks to an insurer in exchange for payment. Insurance is the classic setting where coverage may alter behavior after protection begins.
Adverse selection: A market problem in which people with hidden characteristics are more likely to enter a transaction. Adverse selection concerns hidden traits before agreement; moral hazard concerns behavior afterward.
Systemic risk: The risk that disruption in one part of a financial system will impair the system as a whole. Risk-taking encouraged across interconnected institutions can amplify threats to the wider financial system.
Kenneth Arrow: An American economist whose work shaped modern welfare economics, information economics, and health economics. Arrow analyzed how insurance coverage can alter incentives for care and risk prevention.
Principal–agent problem: A conflict arising when an agent acts for a principal but their interests or information differ. Insurers and lenders cannot always observe how policyholders or borrowers behave after an agreement.
Health insurance: Coverage that pays for some or all costs of medical care. Coverage can affect both demand for care and choices that influence health risks.
Fraud: Intentional deception used to obtain an unlawful or unfair advantage. Moral hazard can arise from ordinary incentives without deception or illegal conduct.
Too big to fail: The expectation that authorities will rescue a large or interconnected institution rather than allow its failure. Expected rescue can protect decision-makers from losses and weaken market discipline.
Arrow–Lind theorem: A result showing that under specific assumptions, public projects can be evaluated using expected costs despite aggregate risk. It clarifies that public risk-bearing does not automatically create moral hazard; incentives and assumptions matter.

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