In general, moral hazard exists when one party to a transaction has
both the incentive and the ability to behave in a way that shifts costs onto
the other party. Moral hazard problems often arise from insurance
contracts. For example, if you have not insured your home against fire
and theft, you have an incentive to protect yourself against those events
by installing fire extinguishers and burglar alarms. If, however, you are
fully insured against those events, in the event of mishap you do not
really lose anything since the costs will be borne by the insurance
company. With insurance, therefore, you have less incentive to install fire
extinguishers and burglar alarms and prevent those mishaps in the first
place. (This is why the premiums you pay for home insurance are reduced
if you have smoke detectors and fire extinguishers.)
With moral hazard, the market failure arises because the action by the
insured individual or firm raises total costs for society. In our example,
the decision not to take action to prevent fire and theft reduces costs for
the individual but, in the event of a mishap, increases by much more the
costs to the insurance company.
Insurance is not the only context in which moral hazard problems arise.
Another example is professional services. Suppose you ask a dentist
whether your teeth are healthy or a lawyer whether you need legal
assistance. The dentist and the lawyer both face moral hazard in that they
both have a financial interest in giving you answers that will encourage
you to buy their services, and it is difficult for you to find out if their
advice is good. In both cases, one party to the transaction has special
knowledge that he or she could use to change the nature of the