Wednesday, May 25, 2016

Moral Hazard, expanded

Those who know me, know that moral hazard is, to me, the most important concept in economics, particularly because of its spillover into ethics and morality. My problem with the economics profession as a whole, is that its members tend to use an extremely narrow definition of the term, hobbling its significance and importance. I'd like to change that.

How do most people define the term? Let's look to Wikipedia first:


In economics, moral hazard occurs when one person takes more risks because someone else bears the cost of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

Moral hazard occurs under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.



It might also help to know what "information asymmetry" is:


In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.


The definition is thus limited to cases of "taking risks" you wouldn't otherwise take, because someone else is "bearing the costs." Somehow this seems incomplete to me. Why just this one behavior, and not any other actions you might have taken when you realize (or believe) you yourself are not fully bearing (or not bearing at all) the burdens involved, because of the particular structure of incentives? It turns out, every action you take entails unique risks. There is no distinction between incentives to take alternate actions and incentives to take alternate risks. Every incentive does both.

In the Milgram Experiment, everyday people were subjected to perverse incentives, and actively victimized others (or in this case, carried this illusion -- nobody was actually hurt; it was acted) as a result. An authority figure absolved them from any responsibility for their actions, so most of the test subjects complied, to one degree or another (Link to: Milgram experiment on Wikipedia). Is directly imposing burdens (pain, injury, impeding others, etc.) upon others a form of moral hazard (especially if someone is explicitly absolved from responsibility for the effects of these violent actions)? This seems to follow the form and spirit of the term, so I would say "yes."

Moving to "information asymmetry," we are talking about a situation where one person knows more than another person regarding the particulars of a mutual arrangement. What is it called when you don't know something, or don't fully understand something? Ah yes, ignorance! If your ignorance causes you to believe in a different set of incentives (and apparent burdens) than actually exist, this would encourage you to act differently than you might otherwise act, wouldn't it? If you are aware of someone else's ignorance, isn't that also an incentive to act in ways you might not otherwise act, in regards to that person? Doesn't this also fit the form of the term "moral hazard"? I think "yes" to this as well.

Getting to the conclusion, moral hazard describes any situation whereby the burdens of an action are either not fully borne by the person acting, or the person ignorantly believes this to be the case. Now, this has far-reaching implications in other fields of study, which I intend to touch upon in future blogs. Stay tuned, and in the meantime, think about it.

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