Transactions for future performance create moral hazards that can frustrate expectations about costs and benefits. Inability to perfectly forecast and control future behavior is the key problem. For example, if you paid for knee surgery in advance, might a surgeon do sloppier work than if you will pay only if the knee responds satisfactorily? On the other hand, after your knee is repaired, might you delay payment and haggle over the surgeon’s charges?
A moral hazard occurs when one party to a contract can unexpectedly raise the costs or lower the benefits of the other party, who cannot perfectly monitor or control the first party’s actions.
Moral hazards arise because choices tend to reflect personal costs and benefits; the effects on others are, at most, secondary considerations. No contract for future performance can cover every possibility, so most transactions rely heavily on good faith efforts. But time tends to blur promises to diligently consider the interests of the other party to a bargain.
Suppose your instructor agreed to enter As in the grade book right now for every student who promises to work hard this semester. Would most students follow through and study diligently? Could ignoring the effects on other people cause athletes with guaranteed contracts to engage in riskier outside activities (e.g., skiing or hang-gliding)? Is moral hazard present when parents provide credit cards for emergencies to college students? Might drivers who always removed ignition keys after parking their uninsured cars tend to forget to lock them up if insurance covers losses from theft or vandalism? This is why insurance companies offer huge discounts for policies with high deductibles!
Opportunistic behavior after an arrangement is made is most severe if parties to a contract do not anticipate its renewal. Moral hazard is less important if both parties expect future agreements. Unexpectedly imposing costs or reducing the benefits of the other party causes it to rely less on good faith when a subsequent contract is negotiated. This reluctance will increase the bargaining costs of both parties. (We return to this point in a moment while discussing problems in used car markets.) If either party does not expect repeat business, a related problem known as adverse selection can be severe.