From insurance practice, formalized by Kenneth Arrow (Uncertainty and the Welfare Economics of Medical Care, 1963), Mark V. Pauly (The Economics of Moral Hazard, 1968), and Bengt Holmström (Moral Hazard and Observability, 1979).
Identifies where one party is shielded from the cost of its own risky choices, predicts the extra risk it will take, and designs terms that restore the cost.
When to reach for it
Contracts, bonus plans, guarantees, or bailouts protect someone from downside, and the question is how their behavior will change once protected.
How it runs
- Name who is protected and who absorbs the loss.
- List the costs the protected party no longer bears.
- Predict which behaviors become more attractive as a result.
- Check whether the protector can see those behaviors.
- Choose a fix: shared loss, monitoring, outcome terms, or caps.
- Watch for side effects and adjust.
Where it sits in SOLVE eX
Go to the source
- Uncertainty and the Welfare Economics of Medical Care, American Economic Review, 1963
- The Economics of Moral Hazard: Comment, American Economic Review, 1968
- Moral Hazard and Observability, Bell Journal of Economics, 1979