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It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard. Example: You have not insured your house from any future damages.
Moral hazard occurs when there is asymmetric information between two parties and a change in the behavior of one party occurs after an agreement between the two parties is reached. Asymmetric information refers to any situation where one party to a transaction has greater material knowledge than the other party.
Moral hazard occurs when the agent's actions are not observed by the principal. More specifically, moral hazard is present when the subject's actions are: (1) influenced by the terms of the contract, and (2) in a way that is not fully specified in the contract.
1. In a hidden action or moral hazard model, the agent's choice of action affects the principal, but the principal does not observe the actions directly. 2. In a hidden type or adverse selection model, the agent's ?type? remains as private information until after the contract has been signed.