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Moral hazard

From Academic Kids

In law and economics, moral hazard is the name given to the risk that one party to a contract can change their behaviour to the detriment of the other party once the contract has been concluded.

The most well known examples of moral hazard come from insurance. Fire insurance, for instance, gives people an incentive to commit arson, especially if they are operating a failing business and decide that they'd rather have the cash from the insurance proceeds on the buildings than the buildings themselves. Many, perhaps most, police investigations of arson are the result of leads from suspicious insurance adjusters. More generally, insurance may encourage riskier behavior, such as sloppy fire prevention. For example, the expectation that federal government disaster aid will come seems to encourage the residents of Malibu, California to let bushes and trees grow near their houses, raising the risk of fire.

Moral hazard appears in other insurance-related areas as well: automobile insurance makes it safer for people to have accidents that cause injuries or property damage. Because of these hazards, actuaries are careful to avoid insuring any property for more than it is worth, or even for its replacement cost, and almost always require that there be a deductible, an initial up-front sum which the insured must pay out of his or her own pocket. They may also impose conditions, such as the ownership of fire extinguishers (in the case of fire insurance).

Moral hazard also appears in politics, for example, as it regards anti-poverty transfer programs and similar programs. The Central Bank's rescue of the creditors of a country suffering from a financial crisis (such as Mexican "Tequila Crisis" of 1994-95) encourages the creditors to make such risky loans again in the future. Arguments using moral hazards are used by both supporters and opponents of economic deregulation. A supporter of deregulation might argue that guaranteed high wages and strictures on employment conditions create worker inefficiency and reduce industrial productivity by entrenching worker benefits regardless of the quality of their work. Conversely, an opponent of deregulation might argue that the removal of price controls will result in a morally hazardous situation where producers of a good collude to raise their prices, thus harming consumers.

Conservatives argue that unemployment benefits discourage people from seeking work, and that subsidy for single mothers encourages the birth of children out of wedlock. Progressives argue along the same lines that military spending increases the risk of war.

Abraham Lincoln and an example of moral hazard

Abraham Lincoln was involved in a court case involving the moral hazard of a 19th-century Illinois law that exempted under-aged debtors from paying their debts. Two youngsters had hired a ploughing team, and advised by their lawyer, refused to pay. Lawyer Lincoln was engaged on behalf of the ploughing team to have the debt paid. Lincoln conceded that that was what the law allowed. But Lincoln changed tack and said the boys should not be allowed to enter adult life with their names tarnished by a reputation for not paying their debts. Pointing his arm at the opposing lawyer, Lincoln castigated lawyers who prostituted their profession with such advice.

The jury found for the man owed the debt by the boys, without even leaving their seats, and the boys were by this time overjoyed to be made to pay.

See also

External links

fr:Ala moral ja:モラル・ハザード fi:Moraalinen hasardi

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