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lunes, 15 de septiembre de 2014

What is moral hazard?

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The term "moral hazard" originated in England in the 17th century, and was often used by insurance companies to involve fraudulent activity by one of its policyholders. Today, moral hazard is used in different situations, including insurance, finance and management. A moral hazard is a situation in which the behavior of one of the parties may change to the detriment of the other part after a transaction. For example, a person with a home theft insurance may be less cautious about their house, because the negative consequences of theft are now the responsibility of the insurance company. One part makes a decision about how much risk to take, while the other part absorb the costs if things go wrong. The isolated part of the risk behaves differently than it would if it were fully exposed to the risk.

Moral hazard occurs because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it should, leaving the other part to hold the responsibility for the consequences of those actions. Moral hazard can occur if a party that is insulated from risk has more information about its actions and intentions than the party ordered to pay the negative consequences of risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises as a principal-agent problem where the agent acts on behalf of the principal. The agent usually has more information about its actions or intentions than the principal does, because the principal can not completely control the agent. The agent may have an incentive to act inappropriately if the interests of the agent and the principal are not aligned.

In essence, a moral hazard is when a party decides how much risk to take when a third party bears the risk if things go wrong. For example, the bailouts of banks by governments may result in risky loans in the future if the banks know that they will not have to carry all the weight of the potential losses. Because they are not responsible for the consequences, they asume more risk.

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