Markets, Intervention, and Moral Hazard

If you leave, don't leave now
Please don't take my heart away
Promise me just one more night
Then we'll go our separate ways
--OMD

Nice points made here regarding the late Nobel laureate Kenneth Arrow's work on moral hazard. In a 1963 AER paper involving healthcare economics, Arrow theorized that doctors act as agents of insurance companies. Because agent behavior cannot be perfectly monitored, an agency problem is created where doctors will offer more treatments to patients. Because their behavior has been insured, patients will be likely to demand these additional services either by taking more risks or over consumption of treatments.

Insurers bear the cost of this moral hazard. Because they operate with incomplete information that prohibits them from pricing their services accurately, Arrow argued that insurers will be prone to reduce insurance coverage to 'suboptimal' levels. To rectify the situation, Arrow suggests that governments intervene using taxes or subsidies to stimulate desired forms of production. Or, of course, government itself could step in as an insurer.

However, Arrow's logic ignores the moral hazard problem from the standpoint of the entrepreneur. Previous scholars such as Frank Knight posited that it was the entrepreneur's job to deal with situations of incomplete information, particularly with respect to customer and employee (agent) behavior, in order to work out the best uses of society's scarce resources.

In the context of the health insurance problem, there is no predetermined 'optimal' level of coverage as Arrow suggests. Instead, there is a moment-to-moment best guess that constantly changes as entrepreneurs seek to satisfy customer needs under conditions of uncertainty and resource scarcity.

If government intervenes in this entrepreneurial pursuit then it is the one that creates moral hazard by socializing the costs of risky behavior. Entrepreneurial actions seek to reduce moral hazard thru innovation and thru focusing the consequences (positive or negative) of risky behavior on the people who take the risk.

Rather than being impartial referees that reduce moral hazard, governments encourage it. Markets work to reduce situations of moral hazard while intervention institutionalizes them.