A situation of Moral Hazard?

There are a number of very similar definitions available. Some suggested definitions are;

"The tendency whereby people expend less effort protecting those goods which are insured against theft or damage." (Frank (1991) p.193)

"Moral Hazard refers to situations where one side of the market can't observe the actions of the other. For this reason it is sometimes called a hidden action problem." (Varian (1990) p. 589)

"Another name given to situations of hidden action because, in such cases, the informed side may take the 'wrong' action." (Katz & Rosen (1994) p. 593)

"Moral hazard arises when individuals, in possession of private information, take actions which adversely affect the probability of bad outcomes." (McTaggart, Findlay & Parkin (1992) p. 440)

From these definitions we can see that the key features of moral hazard are;

1. The presence of hidden action. One party, e.g. an insurer, is unable to observe the action of the other party, e.g. the insured.
2. The party who's actions are hidden, either through acts or omissions, increases the probability of a 'bad' outcome.

Some simple examples would be;

• Householders taking less care in locking up their home once it is insured
• Motor vehicle owners driving more recklessly because their vehicle is insured.
• People taking less care of their health once they have health insurance.

As mentioned before moral hazard is a problem of hidden action. In simple terms there is a cost involved in taking care and precautions to avoid a particular loss. When a party has full insurance, they have no reason to incur these costs since their insurance will fully cover the loss.

Figure 1 - Moral Hazard and Insurance Contracts (Gravelle & Rees (1993) p.683)

Let us examine this situation more formally. Figure 1 represents the market for insurance.

• Assumes insurance supplied by competitive, risk neutral insurers, with no administration costs.
• The probability (p) of loss (L) is endogenous and depends on the level of expenditure on care a₁, a₀, where a₁ > a_{0 .}
• Set a₀ = 0, now probability of loss when a = 0 is p_{0 ;} and a = a₁ by p₁ .

For it to be worth spending a₁ care rather than a₀ care, it is necessary that;

(p₀ - p₁)L > a₁ or expressed another way; p₁L + a₁ < p₀L

Now;

• When the individual chooses a₀ = 0, the insurance companies break even budget line is the line B₀y⁰.
• The individuals budget line where they spend a₀ = 0 is B'y⁰. When they spend a₁ it is B₁a .
• Where there is perfect information (i.e. no hidden action ) and the insurer can observe that a₁ care has been taken it will offer full insurance anywhere along the new insurer break even budget line of B₁a.
• For the individual in Figure 1., it is clearly better to spend a₁ on care since this will place them on a higher indifference curve I' then if they choose a₀ (which places them on the lower indifference curve I⁰ ).

But this is the situation under perfect information. As was mentioned before moral hazard occurs because of asymmetric information. The actions of one party (the insured) are not observable by the other party (the insurer). Now what if the insurer is unable to observe the level of care being taken? Consider the situation where they assume that the insured party chooses a₁ level of care. In this situation;

• The insurer will offer an insurance contract based on the break-even budget line B₁a . The associated premium for full cover is given by p₁L.
• But, the insured can choose their level of care! They will choose a₀ level of care as this will place them at the point A'₁. This is on a higher indifference curve than the perfect information situation. The insured thus has an incentive to choose a₀ level of care.
• This situation is clearly unfavourable to the insurer since it makes a loss, the expected payments exceed the expected premiums : p₀L > p₁L .
• A situation of moral hazard thus exists.

Given these two private responses to the problem of moral hazard in insurance markets, is there anything that governments can do? The answer lies in the introduction of taxation on activities which increase risk, and subsidy of activities that improve the care an individual takes.

If we return to the situation described previously. Consider the situation where:

• The government offers a subsidy 's' on expenditure on care and activities which reduce risk.
• The cost to an individual of reducing their probability of loss to p₁ is now (1-s)a₁ .
• At the same time, the government introduces a lump sum tax of T = sa₁ .
• This level of tax is paid now no matter what level of care an insured person chooses.
• If the government sets s = 1 ; T = a₁ , then individuals will have an incentive to take care of a₁ since if they do not they will be worse off.

This sort of intervention might persuade insurance companies that on the break even contract line B₁a they can now offer better coverage - e.g. lower deductibles or lower co-payments.

However government intervention, like the private decision relating to deductibles and co-payments, requires that the government have information about the optimal sizes of the tax and subsidy it offers.

There are a number of implications for government policy of the existence of moral hazard.

1. If the government decides to introduce a system of universal health care, i.e. a situation where the government assumes the role of the health insurer through the introduction of compulsory payments (a medical care tax) used to fund a public health system open to all with no extra payments. Moral hazard could lead to citizens taking less care of their health than where they must privately bear the cost of their actions. This may lead to rising costs in the health budget.
2. In the presence of universal health insurance and a public health system the government may need to introduce a variety of taxes and subsidies in order to reduce the moral hazard problem and pay for the rising health costs associated with a particular risky practice. E.g. higher taxes on tobacco products to discourage that risk activity and to finance the health care associated with smoking.
3. The other option open to the government to discourage abuse of the public health sector is the introduction of deductibles and co-payments. However if consumers are able to purchase private health insurance to cover the co-payments then the moral hazard remains.
4. Eliminating moral hazard and its effects on the health component of the budget thus becomes quite difficult, especially where private insurance exists along side public health and universal cover.

What then are the main points to be gained from this seminar.

• Moral hazard is a problem of hidden action which leads to increased likelihood of undesirable outcomes.
• Moral hazard in insurance markets occur because consumers are able to obtain full loss coverage at a premium based on a level of care a₁ whilst in fact they may take no care in avoiding the loss.
• Private responses to moral hazard include the use of deductibles and co-payments, the choice depending on whether the moral hazard increases the risk or whether it increases the size of the loss.
• Government response is normally through taxes and subsidies.
• Moral hazard can be a particular problem if the government chooses to provide universal coverage and public health care alongside private insurance.

Frank, H (1991) Microeconomics and Behavior, McGraw Hill, New York.

Gravelle, H and Rees, R (1993) Microeconomics, Longman Group, Singapore.

Katz, M and Rosen, H (1994) Microeconomics,2nd ed, Irwin, Illinios.

McTaggart, D Findlay,C and Parkin, M (1992) Economics, Addison-Wesley, Sydney.

The Economist (1995) An Insurers Worst Nightmare, The Economist, 336, 66.

Varian, H R (1990) Intermediate Microeconomics: A Modern Approach, 2nd ed, W W Norton and Co., New York.