Question

When Nick didn't have renter's insurance, he was very careful not to leave candles lit in his apartment, and he always locked the door when he left. Now that he has renter's insurance, he frequently leaves candles burning and forgets to lock the door because he knows that, even if his apartment catches on fire or gets broken into, his insurance will cover it. Which of the following economic problems is characterized in the story?

a) The free-rider problem
b) Moral hazard
c) Government failure
d) Adverse selection

Answer 1

Answer:

b) Moral hazard

Explanation:

This is an example of a moral hazard. Moral hazard occurs when a party that has entered into a contract changes its behaviour after the contract is signed, leaving the other party worse off. It can also occur when a party does not enter into a contract in good faith from the beginning.  In this case, Nick changed his behaviour after purchasing the insurance, which leaves the insurance company in a worse position as Nick's risk has increased.