Moral hazard refers to a situation where one party to a contract alters their behavior after the contract has been established. This concept is often discussed in the context of a principal-agent relationship, where the principal entrusts the agent with a task, typically involving some form of compensation. The principal is the individual or entity that delegates responsibility, while the agent is the one who carries out the task on behalf of the principal.

To understand moral hazard, it is essential to differentiate it from adverse selection, which occurs before a transaction. In contrast, moral hazard arises after the agreement is made, leading to potential changes in behavior that can affect the outcome of the contract.

For example, consider the employer-employee relationship. Here, the employer acts as the principal, and the employee is the agent. Once hired, the employee may not be under constant supervision, which creates an opportunity for the employee to slack off or not perform to the best of their ability when the employer is not watching. This change in behavior after the contract is signed exemplifies moral hazard.

Another example can be found in the insurance industry. In this scenario, the insurance company serves as the principal, while the insured individual is the agent. The insurer expects the insured to maintain the same level of caution while driving, regardless of their insurance status. However, once insured, the individual may take more risks, believing that they are protected from financial loss. This shift in behavior, where the insured drives less cautiously due to the safety net provided by insurance, illustrates moral hazard as well.

In both examples, the core issue of moral hazard is the change in behavior that occurs after the contract is established, highlighting the challenges in monitoring and ensuring compliance with the original terms of the agreement.