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moral hazarda situation in which one of the parties to a CONTRACT has an incentive, after the contract is agreed, to act in a manner that brings benefits to themselves at the expense of the other. For example, employees may work less conscientiously than expected by the terms of their CONTRACT OF EMPLOYMENT (i.e. they indulge in ‘shirking’ and time wasting). See PRINCIPAL-AGENT THEORY, AGENCY COST.
moral hazarda situation in which one of the parties to a CONTRACT has an incentive, after the contract is agreed, to act in a manner that brings benefits to himself at the expense of the other party to the contract. Moral hazard is a consequence of hidden actions in TRANSACTIONS, that is, actions that parties to a transaction may take after they have agreed to execute a transaction. If these actions are unobservable to the other parties to the transaction and if they may harm the interests of these other parties, then these hidden actions may prevent the successful completion of the transaction.
Even the anticipation that such hidden action is possible may prevent the transaction from taking place. For example, if insurance companies offer fire insurance at premiums that reflect a normal likelihood of fire damage, there is a danger that people who are insured against fire accidents will tend to behave less cautiously or even with malicious intent so that fire claims upon insurance companies are excessive.
Moral hazard can also apply to EMPLOYMENT CONTRACTS where employees may work less conscientiously than was expected in their employment contracts (i.e. they engage in ‘shirking’) if work supervision is not extensive (see TEAM PRODUCTION). Moral hazard can apply particularly to employment contracts of senior managers who might not act strictly as agents of the shareholders but pursue their own goals in the absence of sufficient shareholder scrutiny (see PRINCIPAL-AGENT THEORY). See ASYMMETRICAL INFORMATION.