Why does moral hazard relate to asymmetric information?

Moral hazard relates to asymmetric information as it arises when one party has more or better information than the other party.

Moral hazard is a situation in which one party is involved in an agreement where they have the opportunity to take risks because the cost that could result will not be felt by the party taking the risk. This is often seen in situations where the behaviour of one party changes in a way that is hidden from or unobservable by the other party. This is where the concept of asymmetric information comes in. Asymmetric information, in the context of economics, refers to any situation where one party to a transaction has greater material knowledge than the other party.

The link between moral hazard and asymmetric information is that the former is a consequence of the latter. When one party has more or better information than the other, they have the ability to make decisions that benefit them, potentially at the expense of the other party. This can lead to a moral hazard situation. For example, in the insurance industry, if the insured party has more information about their behaviour and risk level than the insurer, they may take more risks knowing that the insurer will bear the cost. This is a classic example of moral hazard caused by asymmetric information.

In essence, moral hazard is a problem of incentive misalignment under asymmetric information. The party with more information has an incentive to behave in ways that may not be in the best interest of the other party, because they know they can get away with it due to the information imbalance. This can lead to inefficiencies and potential losses for the less informed party, and is a major concern in many economic transactions, particularly in the financial and insurance sectors.

Therefore, understanding the relationship between moral hazard and asymmetric information is crucial in designing contracts and policies that align incentives and mitigate the potential negative impacts of these phenomena.