Moral Hazard: In contrast to adverse selection, which is caused by a hidden characteristic, this section moves on to consider moral hazard, which occurs due to a hidden action.  In addition, it is worth noting that moral hazard is a problem that occurs after a transaction.

 

As with adverse selection, the market for insurance provides numerous examples of moral hazard that students should find compelling.  Providing one or two of these examples and then opening things up for class discussion usually is quite fruitful.

 

It is also a good idea to carefully walk students through the textbook example of Paul and Amy.  The details of the moral hazard problem that exists in their principal/agent relationship is illuminating and it continues to be used into the next section on using contracts to mitigate the problem of moral hazard.