Moral Hazard as a Cause of Pareto Inefficiency
Moral hazard, a problem of post-contractual hidden actions, leads to Pareto inefficient outcomes. This inefficiency arises because one party, after entering an agreement, can take unobservable actions that benefit themselves at the expense of the other party. For example, an insured person may take fewer precautions, or an employee may exert less effort. Because the principal cannot perfectly monitor the agent's actions, the agent's incentives are misaligned with maximizing joint welfare. This prevents the achievement of a first-best, Pareto-efficient outcome that would be possible with perfect information.
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