Moral Hazard
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Moral Hazard
A Moral Hazard is a situation where the economic incentive does not match the risk. It’s a type of information asymmetry that results in one party taking a greater risk to the detriment of the other party.
An example is if there’s a 100% money-back lifetime guarantee, no questions asked, for a car. A user has little incentive to maintain it and can choose to never change the engine oil. When it is inevitably damaged, the user will use the guarantee, which unnecessarily costs the company.
Principal-Agent Problem
An example of a moral hazard is the Principal-Agent problem. This is where an agent is assigned to make decisions on behalf of the principal. The agent will take whichever action is best in self-interest.
A clear example is with realtors: they want to close the sale as quickly as possible and encourage the owner to lower the sale price of the home. Ideally, they would want to extract more out of the home sale, which benefits both the seller and the realtor. However, the incremental gain in commission is not worth their time, despite it being a proportionately larger value in sale price.