Moral hazard is a case of asymmetric information. It occurs when both parties (usually an agent and a principal) assign or are subject to a different probability of a same (normally adverse) event occurring. The behaviour of the agent changes ex-post, after a contract is signed and as a consequence of their new, advantageous position. As economist Paul Krugman puts it, moral hazard refers to “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly”.
In order to clarify this concept, let’s take a quick look at an example: insurance premiums. The person taking out an insurance policy is at an advantage versus the insurer, who therefore charges a premium for the risk derived from their imperfect information, aside from any mark-up designed purely in order to generate benefits.
Lucy has never smoked in her life, because she has always been concerned about expensive hospital stays taking away disposable income that could be better spent on her butterfly-collecting hobby. However, her cautious friend who works for a large insurance company talks her into subscribing to a healthcare policy. After this, Lucy decides that as her health is now a fixed cost (she pays the same premium whether she becomes ill or not), she might as well start smoking, drinking, and driving like a lunatic. In fact, she swaps her butterfly collecting hobby for cliff jumping. Lucy’s advantage is ex-post.
Moral hazard also appears in other markets, such as in the credit market. In their article about credit rationing, economists Joseph E. Stiglitz and Andrew Weiss explain how raising interest rates will make indebted people take higher risks.