In some types of contractual agreements, it is not always possible for one party to effectively monitor if the other party is abiding by the contract. When this is the case, agents may have reason to change behavior after the contract is entered. This tendency to change behavior after entering contractual arrangements, called moral hazard, can cause markets to work inefficiently.
In insurance markets, for example, it is impossible or highly costly for the insurance companies to follow up the activities of each and every customer. As a result people may exert less effort and may want to spend less on preventing damage on the insured assets. This increases the probability of occurrence of the loss and hence may result in unexpected frequency and magnitude of claims. As a result the insurance market may be forced to provide only partial coverage or may refuse to provide coverage at all.
Moral hazard problems are pervasive in credit markets as well. Since it is difficult (highly costly) for banks (lenders) to access all the detailed information on the nature of the borrowers and their projects, the borrowers may have incentive to use the money for unintended purposes. As a result the money may be mis-utilized leading to a higher rate of default and failure of the credit market.
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