Moral Hazard, explained.
Moral hazard concerns changes in behaviour when a person's actions affect risk but some consequences are borne by another party.
Why it happens
Maintenance costs 3 and reduces a 20-unit loss probability from 0.4 to 0.1. Warranty coverage reimburses a fraction c. Compare expected private costs 3+2(1−c) and 8(1−c), choose an action, then reveal a seeded loss. Total maintenance-plus-loss expectations are 5 and 8.
Moral hazard concerns changes in behaviour when a person's actions affect risk but some consequences are borne by another party.
Read the result
Read expected private costs before revealing a realised loss. A lucky result does not change the incentive comparison that existed before the outcome.
A worked example
A warranty and the maintenance decision
At zero coverage, maintenance has expected private cost five while skipping has cost eight, matching total maintenance-plus-loss costs.
Increase coverage to seventy-five percent. Expected private costs become three and a half for maintenance and two for skipping.
Choose an action and reveal the seeded outcome, keeping the expectation separate from this single realisation and from the warranty transfer.
OPTIONAL DEEPER DETAILGo deeper: inside the model
Inside this model
Maintenance costs 3 and reduces a 20-unit loss probability from 0.4 to 0.1. Warranty coverage reimburses a fraction c. Compare expected private costs 3+2(1−c) and 8(1−c), choose an action, then reveal a seeded loss. Total maintenance-plus-loss expectations are 5 and 8.
Where this idea is useful
A practical use
A maintenance contract can change both who bears losses and the incentive to prevent them.
A common misconception
“Moral hazard means the insured person must be dishonest.”
The concept concerns incentives when consequences are shared. It does not require deception, and a simple expected-cost model does not explain every person's behaviour.
What this explanation leaves out
- Premiums, exclusions, information, monitoring and heterogeneous risk are omitted. These are teaching units, not an insurance quotation. Changed incentives do not imply dishonesty or explain every response to real coverage.
Why are premiums absent?
The board isolates prevention incentives after coverage is given. Pricing, screening, monitoring and exclusions would change the broader contract problem and require a richer model.
Which preventive action changes when someone else bears part of its possible downside?
Associated thinkers
Associations marked provisional are awaiting source review.
Further reading
Explore the original research or the teaching reference behind this experiment.