Moral Hazard
Hidden actions after the contract is signed, insurance, effort, and incentive design.
Definition
Behavior changing once risk is shifted to someone else, hidden actions after a contract, like insured drivers taking less care.
Key equation
Trade-off: full insurance ⇒ zero care incentive; optimal contracts leave some risk (deductibles, equity stakes)
The intuition
The principal can't watch the agent's effort, only noisy outcomes, so pay must ride on outcomes, which loads risk onto the agent and costs a premium. Every deductible, bonus scheme, and bank-capital rule is a patch for this problem.
Exam tip
Identify the unobservable action explicitly; if the hidden thing is a TYPE not an action, you're in adverse selectionadverse selectionBad types crowding out good ones when quality is hidden before a deal, the lemons problem..
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