Moral hazard and protection from losses
| English | 中文 | Pinyin |
|---|---|---|
| moral hazard/ˈmɒrəl ˈhæzəd/ | 道德风险 | dào dé fēng xiǎn |
| deductible/dɪˈdʌktɪbl/ | 免赔额 | miǎn péi é |
A decision you can investigate
- After buying cover, a person may take fewer precautions if someone else now pays part of an accident’s cost. A bank may take greater risks if its decision-makers expect rescue.
- The relevant mechanism is the incentive change, not an accusation that every insured person behaves badly.
Build the explanation
- Moral hazard 道德风险 arises when protection from consequences changes incentives to take care or take risks. Hidden or costly-to-monitor actions can reinforce the problem. Consumers may reduce prevention; producers may take riskier decisions; workers’ effort or safety incentives can weaken under poorly designed protection; government may face larger expected claims or rescue costs.
- Insurance and banking also provide useful risk sharing and finance. Deposit protection can help confidence while expected rescue may weaken monitoring or encourage risky lending. Distinguish shareholders, managers, depositors, borrowers and taxpayers: they do not necessarily receive the same protection.
Work through the evidence
- A fictional precaution costs 30 and reduces accident probability from 10% to 2%; damage is 1000. Without cover, expected avoided loss=(0.10−0.02) × 1000=80, exceeding cost 30. With full cover and no premium response, the person avoids no out-of-pocket damage by taking the precaution.
- With a deductible 免赔额 of 200 per accident, expected avoided private loss=(0.10−0.02) × 200=16, still below cost 30 in this simplified risk-neutral case. A deductible therefore restores some incentive but does not necessarily restore enough. In banking, a decision that pays managers a bonus on an upside while losses fall on creditors or an expected public rescue can similarly separate private rewards from social risk.
What is expected avoided loss without cover?
The probability reduction is 0.08; multiply by damage 1000.
Test the limits
- Real choices include risk aversion, inconvenience, injury not covered by money, premium changes, exclusions and legal duties. The numerical example is an incentive model, not advice about buying insurance.
- Monitoring, deductibles, co-payments, capital requirements and credible loss-sharing can help but create costs and may reduce access or valuable risk taking. A worker’s safety can depend on an employer’s equipment, not simply individual effort. Adverse selection concerns hidden types entering a contract; moral hazard concerns changed incentives under protection.
What private expected loss is avoided with the stated deductible?
0.08 × 200 =16.
Introducing any deductible necessarily eliminates moral hazard.
Its size and behavioural response matter; restored incentives may remain too weak.
Apply and explain your answer
- Why does the deductible fail to induce the precaution in the stated model?
- It raises avoided private loss to 16, but the precaution still costs 30; compare the person’s marginal private gain with cost.
Which banking arrangement can create moral-hazard incentives?
Protection can separate the chooser’s private risk from wider consequences.
Use the terms precisely
- moral hazard: Protection from consequences changes incentives to take care or take risks.
- deductible: The amount of an insured loss borne by the policyholder before cover pays the remainder.
Match the terms to their meanings.
Use each term for its stated economic relationship.
A fictional precaution costs 30 and reduces accident probability from 10% to 2%; damage is 1000. Without cover, expected avoided loss=(0.10−0.02) × 1000=80, exceeding cost 30. With full cover and no premium response, the person avoids no out-of-pocket damage by taking the precaution. With a deductible of 200 per accident, expected avoided private loss=(0.10−0.02) × 200=16, still below cost 30 in this simplified risk-neutral case. A deductible therefore restores some incentive but does not necessarily restore enough. In banking, a decision that pays managers a bonus on an upside while losses fall on creditors or an expected public rescue can similarly separate private rewards from social risk.
Real choices include risk aversion, inconvenience, injury not covered by money, premium changes, exclusions and legal duties. The numerical example is an incentive model, not advice about buying insurance. Monitoring, deductibles, co-payments, capital requirements and credible loss-sharing can help but create costs and may reduce access or valuable risk taking. A worker’s safety can depend on an employer’s equipment, not simply individual effort. Adverse selection concerns hidden types entering a contract; moral hazard concerns changed incentives under protection.
Moral hazard arises when protection from consequences changes incentives to take care or take risks. Hidden or costly-to-monitor actions can reinforce the problem. Consumers may reduce prevention; producers may take riskier decisions; workers’ effort or safety incentives can weaken under poorly designed protection; government may face larger expected claims or rescue costs.