Decision making
Kenneth Arrow (1921–)
From 1600 “Moral hazard” is used to describe situations where individuals may not be honest.
1920s–30s US economist Frank Knight and British economist John Maynard Keynes grapple with the problem of uncertainty in economics.
1970 US economist George Akerlof publishes The Market for Lemons, looking at the problem of limited information about a good’s quality.
2009 Mervyn King, governor of the Bank of England, describes government bailouts of the banking system as “the biggest moral hazard in history.”
The standard model of economic behavior, first set out by Adam Smith in the 18th century, assumes that all the participants in markets are rational and well-informed. However, this is not always the case.
US economist Kenneth Arrow was among the first to analyze the problem of less-than-complete information in markets. He pointed out that, while two sides can agree to write a contract, there is no guarantee that either will fulfill it. Where one party cannot observe the behavior of the other, there may be an incentive for the less-observed party not to deliver on all clauses of the contract, unknown to the other. There is an imbalance of information because actions are hidden.
This situation is known as “moral hazard.” In the insurance market, for instance, an insurance policy may act as an incentive for the person insured to take more risks because he or she knows that the insurer will cover the cost of any damages. The result is that insurers offer less insurance coverage, since they are fearful of encouraging excessive risk-taking and ultimately bearing excessive costs. This means there will be a market failure: those obtaining insurance will pay too much, and many people could find themselves excluded from the insurance market altogether. Arrow suggested that, in these circumstances, there is a case for government intervention to correct the market failure.
Moral hazard can emerge in any situation where one person (the “principal”) is trying to get another (the “agent”) to behave in a certain way. If the behavior desired by the principal takes effort by the agent, and if the principal cannot observe the agent’s actions, the agent has motive and opportunity to avoid work. Insurance contracts are between firms and their customers, but the problem can emerge even within one firm: employees may shirk their duties when an employer isn’t watching over them. These principal–agent problems often come about with long-term contracts for complex tasks. In such circumstances every requirement cannot be stipulated in advance, and moral hazard can emerge in unforeseen ways. Principal–agent problems have led to the development of a large literature on the management of complex tasks, dealing with the best way to word the contracts.
Travel insurance may encourage vacationers to try out more hazardous activities. As a result insurance firms raise the price of coverage.
Moral hazard has more recently become a critical issue in political arguments following the 2008 financial crisis. When banks are described as “too big to fail,” a version of moral hazard may be at work. Major banks know their failure could cause a recession, so they may believe that they will be supported by governments no matter what. Economists have suggested that this leads banks to take on excessively risky investments. The euro crisis of 2012 is also thought to be an example of moral hazard at play: countries such as Greece were suspected of having run economies on the grounds that the country was “too big to fail.”
A native New Yorker, American Kenneth Arrow was born in 1921. He was educated entirely in New York, graduating in social science from City College before going on to receive an MA in mathematics from Columbia University. He switched to economics, but after the outbreak of World War II he was sent to join the US Army Air Corps as a weather officer, researching the use of wind.
After the war Arrow married Selma Schweitzer, with whom he had two sons. He began lecturing at Columbia in 1948, then had professorships in economics at Stanford and Harvard. In 1979 he returned to Stanford, until his retirement in 1991. He is best known for his work on general equilibrium and social choice, and won the Nobel Prize in 1972 for his pioneering contributions to economics.
1951 Social Choice and Individual Values
1971 Essays in the Theory of Risk-bearing
1971 General Competitive Analysis (with Frank Hahn)