Insurance protects people from losses, but it can also change what they do. When one side's actions after a deal are hidden, the other side bears costs it can't control.
Key idea
Moral hazard: a person changes her hidden behavior after a deal because someone else now bears part of the cost. Contracts restore incentives by leaving some of the cost with her: deductibles, copays and coinsurance for insurance, and pay tied to results (bonuses, commissions) for work. The price is that she bears some risk again.
Why it works
With full insurance, a careful driver pays the cost of care but the insurer gets all the savings from fewer accidents, so care doesn't pay. If the driver keeps a deductible $D$ per accident, care cuts her expected losses by $(\pi_H - \pi_L)D$, where $\pi_H$ and $\pi_L$ are the accident chances without and with care. Care is worth it when that saving covers its cost $c$: $$D \ge \frac{c}{\pi_H - \pi_L}.$$ The same incentive condition sets the smallest bonus that makes hidden effort worthwhile at work.
Worked example: The smallest deductible
Care costs the equivalent of \$60 a year and lowers the yearly accident chance from 0.2 to 0.1.
- Saving from care: $(0.2 - 0.1)D = 0.1D$.
- Care pays when $0.1D \ge 60$: $D \ge 600$.
Answer: \$600.
Worked example: A bonus for hidden effort
Extra effort costs a salesperson the equivalent of \$200 and raises her chance of landing a client from 0.4 to 0.8. What bonus for landing the client makes effort worth it?
- Effort raises the expected bonus by $(0.8 - 0.4)B = 0.4B$.
- $0.4B \ge 200$ gives $B \ge 500$.
Answer: \$500.
Common mistake
Calling any risky behavior moral hazard. A skydiver who loves risk and pays her own costs is not an example: no one else bears the consequences of her choice. Moral hazard needs a deal that shifts costs to someone else and an action that party can't see. Check: who pays for the bad outcome, and could they observe the behavior?
The trade-off is real: deductibles and performance pay improve incentives but make people bear risk they would rather insure, so the best contract balances the two. How large moral hazard effects are in health care and other markets is measured in many studies, with results that vary by setting.