Moral hazard
Shielded from the downside, people take risks they otherwise wouldn't.
What it means
A problem of hidden action arising after a contract is struck, when one party can take risks or shirk effort whose costs fall partly on someone else, weakening their incentive to be careful. Because the action is unobservable, the protected party behaves less prudently than if fully exposed — the classic case being insured agents who take greater risks. Remedies align incentives through deductibles, co-payments, monitoring, performance pay, and giving the agent skin in the game. It matters across insurance, banking, employment, and bailouts, where insulating actors from consequences predictably changes their behavior for the worse.
Examples
A driver with comprehensive, no-deductible insurance parks more carelessly than one who would bear the repair cost.
Traders whose bonuses ride on the upside while the losses land on the bank take positions they would never open with their own savings.
Handed an expense account nobody scrutinises, staff book the flexible fare and the better hotel. The same people spend an hour hunting deals when the money is their own.
First described in Insurance economics; Arrow (1963); Holmström (1979).
Where this comes up
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