What is moral hazard, and how can it create market failures?

• A. Moral hazard arises when both parties share risk evenly, reducing incentives to avoid loss.
• B. Moral hazard arises from information symmetry.
• C. Moral hazard arises when one party takes risks because another bears the cost.
• D. Moral hazard is when taxes create distortions.

Answer: (C)

Moral hazard happens when one party takes more risks because someone else bears the costs of those risks. When you’re protected from negative outcomes—like by insurance, a government guarantee, or a bailout—the incentive to avoid losses or to monitor risky behavior is reduced. That change in behavior can raise the likelihood or size of losses, which shifts costs onto others or onto society at large. In markets, this misalignment of incentives means resources aren’t allocated to their most social beneficial use, since people or firms don’t bear the full consequences of their choices. For example, insured individuals may overuse medical care or take riskier actions because the insurer covers the cost, pushing up premiums for everyone and leading to less efficient outcomes. That’s why moral hazard can be a source of market failure, prompting interventions like deductibles, copayments, monitoring, or regulation to realign incentives.