Random Thoughts on… Moral Hazard

An argument for studying economics is that one will leave school with an extensive knowledge of concepts and theories that are applicable in the real world.  An argument against studying economics, however, is that these theories are typically limited to a world where we assume all participants make rational decisions.  Given that Kath and Kim is still on the air, universal rationality is doubtful.

One economic concept, however, has stuck with me after college.  Moral hazard occurs when “an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would,” thus “leaving another party to bear some responsibility for the consequences of those actions.”  For example, there is a moral hazard associated with life insurance.  After purchasing insurance, individuals may decide to take greater risks with their life.  twilightThey may be keener to go skydiving, try bungee jumping, or enter a crowd of teenage girls in line for Twilight.  After all, these individuals are now insured, so we can rationally understand (from the individual’s point of view) why they would be more likely to participate in dangerous activities.  However, from the point of view of the insurer, braving crowds of crazed middle schoolers pining after vampires is not recommended. 

We face moral hazards every day.  On an individual level, athletes anecdotally have had a drop-off in production following the signing of a guaranteed, long-term contract.  We act differently in a hotel room than when we’re in our own homes.  In my intro economics course, Larry Summers summed it up in a guest lecture: “You don’t wash a rented car.”   

In that same line of thinking, government bailouts may cause big companies to take more risks, with anticipation of being saved if they fail.  This can lead to even more trouble, as evidenced by the mortgage crisis (mortgage lenders that securitized their junky loans, backed by Fannie and Freddie, became more lax in lending).  Part of the Fed’s rationale for letting Lehman Brothers go under was because it feared creating a moral hazard if it had stepped in again, especially after its role in the Bear Stearns deal. 

impalaBut still, it’s hard to quantify the size of a moral hazard.  And there are times when the negative risks of the moral hazard outweigh the potential benefits of, say, a government bailout.  In the case of the auto industry, I’m not sure what would be best.  All I know is that I’ve been driving a rented car for the past ten months, and I’ve gotten it washed.  Twice.

 

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2 Comments

Filed under Economy, Random

2 responses to “Random Thoughts on… Moral Hazard

  1. M

    Ahem, I love Kath & Kim. While it is on the whole a little boring, every once in a while there is a gem of a moment that makes the whole 30 min. worthwhile.

  2. Pingback: Keeping America Ugly « FRESH is BACK

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