7.4.6—Asymmetric information and moral hazard

Asymmetric information exists when one party knows more relevant information than another. Moral hazard occurs when someone takes more risk because another party bears part of the consequences after an agreement.

Before a transaction, hidden information can cause adverse selection; after it, hidden action can create moral hazard. Monitoring, contracts, deductibles and disclosure can reduce—but not always remove—the problem.

An insured driver may take less care because the insurer covers much of the loss. A larger excess or monitoring device makes the driver face more of the marginal cost.

Moral hazard is not simply dishonesty and does not require a hidden type; it is a changed action caused by the incentive structure after protection is provided.