Moral hazard

How moral hazard arises

Moral hazard occurs when an individual or organisation takes more risks because they do not bear the full cost of those risks: someone else will pay if things go wrong. It arises after an agreement is made and depends on asymmetric information: the party bearing the cost cannot fully monitor the behaviour of the other.

Examples:

• after buying phone insurance, a person takes less care of their phone
• a driver with comprehensive insurance drives less carefully
• a bank makes riskier loans because it expects the government to rescue it if it fails ('too big to fail')

Insurance

• Consumers: insured people take fewer precautions, so more claims are made. Premiums rise for all customers, including careful ones.
• Producers (insurers): face higher claims and costs; they respond with excesses (the customer pays the first part of any claim), no-claims discounts, conditions and monitoring (black boxes in cars).
• Government: may need to regulate the market; if health insurance is state-funded, moral hazard raises public spending.

Banking

If banks believe the government or central bank will bail them out, they gain the profits from risky lending in good times but do not bear the full losses in bad times.

• Consumers: savers may stop checking how safe their bank is if deposits are guaranteed; they may lose out if a crisis cuts lending and incomes.
• Producers (banks and other firms): banks take excessive risks; firms that depend on bank lending suffer when credit is cut in a crisis.
• Workers: job losses across the economy when bank failures cause recession; bank employees paid bonuses for short-term profits may take risks with little personal downside.
• Government and taxpayers: may have to fund rescues, raising government borrowing and leaving less for other spending. Regulation (capital requirements, limits on bonuses) aims to reduce moral hazard.

Worked example

Explain how a government guarantee to rescue large banks can create moral hazard.

1. The guarantee means banks expect not to bear the full losses if risky loans go bad.
2. So the expected cost of risk-taking falls while the potential profits stay the same.
3. Banks therefore lend more riskily than they otherwise would.
4. If losses happen, taxpayers bear the cost: a market failure.

Answer: Protected from losses, banks take excessive risks whose costs fall on taxpayers.

Check yourself

1. Moral hazard occurs when
   • sellers know more than buyers before a sale
   • goods are non-excludable
   • the government sets a maximum price
   • people take more risks because they do not bear the full cost of those risks
   Show answer

   people take more risks because they do not bear the full cost of those risks. Protection from consequences changes behaviour.

2. After insuring her bicycle, a student no longer bothers to lock it. This is an example of
   • herding
   • moral hazard
   • the free-rider problem
   • a positive externality
   Show answer

   moral hazard. Insurance reduces the cost to her of theft, so she takes less care.

3. Why do insurers often require customers to pay an 'excess' on each claim?
   • To reduce the price of insurance to zero
   • To increase moral hazard
   • To make insurance a public good
   • To make customers bear part of the cost of losses so they take more care
   Show answer

   To make customers bear part of the cost of losses so they take more care. Sharing the cost restores some incentive to be careful.

4. Which group is most likely to bear the cost when a government rescues a failed bank?
   • Taxpayers
   • The bank's competitors only
   • Foreign governments
   • No one, because rescues are free
   Show answer

   Taxpayers. Rescues are funded by government borrowing or taxation.

5. How can moral hazard in banking affect workers outside the banking industry?
   • It always raises wages
   • It reduces income tax rates
   • A banking crisis can reduce lending and cause job losses across the economy
   • It has no effect outside banks
   Show answer

   A banking crisis can reduce lending and cause job losses across the economy. Firms that cannot borrow cut output and jobs.

6. Explain how moral hazard can cause market failure in the insurance market.
   Show answer

   Once insured, people take less care because the insurer bears the cost of losses. Claims and costs rise, so premiums rise for everyone and resources are misallocated, with more losses than if people bore the full cost of their actions.. Behaviour change, why, and the consequence.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.