Moral hazard
Moral hazard is the incentive of a person to use more resources than he otherwise would have used, because someone else will provide these resources, against his will, and is unable to immediately sanction this expropriation.[1]
Examples
For example, automobile insurance, creates a moral hazard for drivers; it creates an additional incentive for risky driving because other insurance clients will pay a part of the costs of the driver's accidents. Similarly, in the presence of unemployment insurance, an unemployed person has an additional incentive to stay unemployed because other people will pay at least a part of his living expenses. Or, in the presence of health insurance, insured people will have an additional incentive to engage in risky activities or lifestyles because others will pay at least a part of the treatment in case of illness or accidents.
Employees can be subject to moral hazard to the extent that they can reduce their efforts without fearing reduced pay. Debtors may be subject to moral hazard if they believe they can squander the money without negative consequences when they turn out to be incapable of paying back. Certain auditing firms have been subject to moral hazard when they sold consulting services to the very companies they were supposed to audit (for example, in the Enron case). A central bank can produce moral hazard in the banking community if the commercial bankers perceive the central bank as a lender of last resort. The IMF can produce moral hazard among debtor governments. Taxpayers are said to be subject to moral hazard if they can evade high-tax regions, and so on. Similarly, in the literature on public choice and constitutional political economy, governments and parliaments are often portrayed as agents prone to moral hazard, whereas the voters are the less informed principals.[1]
Conventional theory
Conventional economic theory explains moral hazard as a consequence of the fact that market participants are unequally well informed about economic reality. In other words, it results from "asymmetries of information" and the theory of moral hazard is therefore considered to be a part of the economics of information. The other condition is the separation of ownership and control.
In a co-ownership, if one co-owner of a swimming pool cannot effectively monitor the activities of his fellow-owners, the latter have an incentive to swim without cleaning up, repairing the fences and so on, thus increasing their own (monetary and psychic) income at his expense. In the Principal-agent problem, when the principal cannot effectively monitor the activities of his agent, the latter has an incentive to increase his own (monetary and psychic) income at the expense of the former.[1]
Moral hazard in the free market
In a free market, a property owner can use his property as he sees fit, including the (voluntary) separation of ownership and control. Moral hazard, even with asymmetric information, leads to a systematic expropriation only when the ownership and control of a resource are separated without the consent of the owner.
Information asymmetries are a universal aspect of human life, so moral hazard is not a market failure, but an unavoidable risk. The real key is the role of expectations and good judgment. To the extent that the expectations of the principal are correct, moral hazard on the part of the agent cannot lead to a situation where he could enrich himself at the other party's expense.
There are various ways moral hazard can be dealt with:
- Payment to new employees is lowered by a factor that represents the risk of bad work due to lack of supervision.
- Design contractual relationships to minimize (a) the danger of moral hazard arising in the first place and (b) the danger of moral hazard, once there, affecting them negatively. In health insurance, for example, exclusions, deductibles, and copayments are tools intended to reduce moral hazard. Similarly, moral hazard in road traffic has been effectively reduced with the help of radar controls and black boxes in vehicles.
- On a free market, principals can sever contractual relations with agents at any time. The threat of being fired is probably the most powerful incentive to deliver diligent work rather than succumb to moral hazard.
- Reputation effects and blacklists work in a similar way.
- In co-ownerships, the co-owners have an incentive to set up and accept rules for its use. If the number of co-owners is high, individual capitalist-entrepreneurs might step in and provide the co-property and the rules, as for example in urban development.[1]
Unclear property rights
For a great number of economic goods there are no clearly defined property rights. The air and oceans and their inhabitants, birds and fish, are often considered to be the commonwealth of humanity. Human beings appropriate these resources with weak attempts at creating something like property rights, a system of co-ownership without rules. Not surprisingly, the result is universal moral hazard; everybody has an incentive to use the resource in question as much as possible. This is a sure recipe for quick depletion, as has been known at least from the times of Aristotle. The phenomenon is known as "tragedy of the commons."
Note, in this highly important case, information asymmetries play no role. Moral hazard would be at work even if each co-owner were perfectly aware of the activities of his fellow owners. It can be argued, that moral hazard could have an even larger effect.[1]
References
External links
- Moral hazard on Wikipedia
- Economics 101: Moral Hazard (video), a short lesson on the concept from the Center for Freedom and Prosperity