An Entrepreneurial Theory of Moral Hazard

0:00So, once again, I'm very grateful to be here now to present some of the work from my PhD dissertation, which is titled The Theory of Moral Hazard, Foundations and Extensions. The ideas that I'm talking about today are excerpted from the second chapter of that dissertation, in which I attempt to show that there are some distinctly Austrian ways in which to think about problems of perverse incentives and moral hazard problems in particular. So relatively quickly, I'll just go over what moral hazard is in general, what the mainstream economists make of it, and then what the limitations of the mainstream approach are, and then lastly, how the theory can be understood in light of the Austrian theory of the entrepreneur. So I think it's best to begin just by explaining broadly what moral hazard is. I think moral hazard is one of those terms that was mostly unknown outside of economic circles until recently.

0:56But with the events of the financial crisis and the bailouts, you begin to see it used more commonly in everyday language. Moral hazard is a variety of welfare problem. And you can't really define it in terms of just one individual. You really need more than one person to make the idea make sense, because it's only when you have more than one person that welfare conflicts can emerge. Now the topic of social interaction broadly begins with the possibility for peaceful and productive association and that possibility of course leads to the division of labor but the extension of the division of labor requires basically that at some point delegation will be necessary some sort of duties will have to be assigned to one individual by another and once you have delegation a type of agreement exists say between a principal and an agent Although it may not be a formal agreement, and simultaneously it also becomes possible with the agreement for either party to this contract to behave in ways that are undesirable to the other.

2:06And this can happen either within a firm, say between a manager and a laborer, or even just in simple exchange between buyers and sellers. So, there are many different ways to define moral hazard, but the definitions that summarize best revolve around the idea that when an individual does not bear the cost of his actions, especially when he can push the cost of his actions onto unwilling third parties, he has less incentive to take care to avoid negative outcomes. In the simplest sense, reducing the cost of something encourages you to do more of it, and what the Theory of Moral Hazards is concerned with are a series of ways in which this very basic cost principle results in negative outcomes.

2:54The standard example is from insurance. When your house is uninsured against fire, you have a very strong incentive to take care of it. Because if anything happens to it, the cost falls on you. But for instance, if you are fully insured against fire, you don't bear the entire cost if the house goes up in flames. And therefore, you have less incentive to take care, for example, not to have flammable materials in your house, not to have oily rags piled up in the garage, that kind of thing. And in fact, depending on the particular circumstances, the lack of an incentive to avoid an event may actually be an incentive to bring it about, as in the case where a man burns his own house down to collect the insurance money.

3:41But whether we speak in terms of simply taking less care or actually actively pursuing some kind of undesired outcome, the principle remains the same. Moral hazard as a specific concept appeared in the 19th century in the insurance industry where the term was first coined. and, in fact, insurance remains the most well-known and studied example of moral hazard, although, as I will mention, the principle is actually much broader than simple insurance contracts. As far as economics specifically is concerned, moral hazard entered the literature through the work of Frank Knight in his 1921 book, Risk Uncertainty and Profit, which, of course, includes discussions of the insurance industry and the economic rules that govern it.

4:33Knight was obviously also one of the great theorists of entrepreneurship and exercised a very important influence on Mises and the Austrian theory of the entrepreneur. So in a sense, it should not come as a surprise that there is going to be a way of looking at moral hazard problems that is both distinctly entrepreneurial and familiar to Austrians because of this influence of Knight. And although Knight does not really dwell on the problem of Moral Hazard, he does indicate that it falls within the scope of entrepreneurship, which is what essentially I will argue in a moment. Knight's role in bringing the idea of moral hazard into economics is also important because it highlights the fact that the idea of moral hazard, along with many of its attendant problems, such as delegation, asymmetric information, adverse selection, and so on, these concepts were not invented by the economic mainstream of the 60s and 70s, but had roots in much more Austrian-friendly and entrepreneurial ideas.

5:41But unfortunately, after Knight's promising start, the idea of moral hazard dropped out of the literature for some time, and Knight's uncertainty-based sort of entrepreneurial view was basically forgotten. Moral hazard doesn't appear much in the non-insurance literature until the early 60s. One economist began to talk about economic behavior explicitly and sometimes exclusively in terms of incentives. And over the course of the decade from about 1963 to the early 70s, the idea of moral hazard was gradually formalized and included in a series of developing literatures and economics on incentives, contracts, and especially the economics of information. Kenneth Arrow published a famous paper on the market for medical care in 1963 that inspired like decades of research into moral hazard and there were other very closely related studies as well like Akerlof's 1970 paper on the market for lemons which was the paper that formalized the concept of asymmetric information.

6:44So what was really only through this sort of literature that moral hazard has come to be known in economics and the predictable result is that economists thinking on moral The behavioral hazard is usually based on a few conventional assumptions about behavior that are common, that are actually matters, of course, for the mainstream, but are not really compatible with the Mungarian tradition. For instance, the idea that behavior should be modeled as deterministic as opposed to involving some kind of real choice. Second, that behavior involves consistent maximization of clearly defined objectives. Third, that the results of choice can be analyzed and welfare implications drawn in terms of the properties of some relevant equilibrium.

7:32Specifically, the outcome of decision-making under moral hazard can be defined and analyzed in terms of a comparison between different market models. Specifically, some well-defined market model where moral hazard exists compared to some equally well-defined model where there are no perverse incentives or where there is no moral hazard at all. Typically, some variety of perfectly competitive model. In practice, this means constructing models of moral hazard that start with a description of some kind of agency relationship. Typically, both principal and agent are fully rational utility maximizers, each with their own specific decision functions.

8:20The relevant incentives that push people in one direction or another are implied in their respective functions and in their faculty of rationality. As is conventional with this type of decision making, individuals are essentially at the mercy of the incentives they face. As Kirzner puts it more generally, a chosen course of action, because it was pronounced mathematically to have been the optimal course of action within the given decision framework, cannot fail to be chosen again and again so long as that given framework prevails. And from these decisions that people make, we can derive various properties relating to equilibrium from this given set of starting assumptions. And then once we have different outcomes to compare, we can then talk about welfare, and that in turn is supposed to tell us if moral hazard results in some kind of like welfare loss that we should be concerned with.

9:17The result of this reasoning, this mainstream approach, the reason why we're supposed to care about it, is that moral hazard is sometimes used to demonstrate the existence of market failure and provide a rationale for some type of intervention. The idea is that markets sometimes provide these sort of perverse incentives for people to behave in undesirable ways that lead to non-optimal welfare outcomes. So for example, if health insurance companies provide full coverage, they end up encouraging people to engage in all types of risky behavior. So essentially by trying to help people avoid a negative outcome, you end up subsidizing that outcome. So, you know, on the sort of negative results this is supposed to bring about, they come in a few different varieties.

10:08On the one hand, people can simply sort of abuse the system and consume more of a service than is deemed optimal. In the case of like a health insurance, they would be consuming more medical services than is deemed optimal by the insurance firm. But then on the other hand, perhaps more importantly, there's a broader sort of market implication, which is that, again, to take the insurance case, insurance companies will presumably know that this is how people behave when facing certain incentives within a certain type of contract, so insurance companies can simply respond to this expected behavior by not offering certain types of contracts that they believe will involved these incentives and so the end result in terms of the market for something like insurance will be that there are fewer, there's a smaller menu of contracts and simply fewer insurance services available for purchase. So the market for insurance will be smaller than it might conceivably be and presumably there will be people out there who are sort

11:20And again, this applies to many different types of markets, not just insurance, any time we would have these sorts of conflicting incentives at play, those could also be cases of moral hazard, so it should not come as a surprise that this is a rather mechanistic way of looking at things, especially in that there's really no room in these models for real choice or true There's really no room in these models for real choice or true uncertainty, and especially not for entrepreneurs. The outcome of this process is already implied in the conditions of the problem, in the decision functions of the principles of the agents or what have you.

12:06And in my opinion, trying to set the theory of moral hazard on firmer ground involves applying a series of just very simple Austrian insights to this sort of conventional view, particularly for allowing for true choice and especially for uncertainty. So just to see how Austrians might approach moral hazard problems, we can just think in terms of a conventional agency problem, where a principal is delegating some sort of responsibilities to his agent. Moral hazard is most commonly modeled as a principal agent problem, where the principal is an employer and the agent is a laborer or a subordinate of some sort. Now, the problem arises mostly with regard to information asymmetries.

12:56The problem is essentially that if the principal could monitor the agent at all times, there would be no problem. Because there would be no opportunity for hidden behavior, which is another expression for moral hazard. But because monitoring is imperfect, it becomes possible for the agent to get away with not doing his job all the time or putting in less effort than he agreed to. And by doing this, he imposes some kind of additional cost on the principle. In the conventional view, that would be basically it, end of story, because the agent must pursue to the incentives that define his decision function. But in the real world, of course, the problem is that just because the possibility for shirking exists doesn't mean that it will occur.

13:48People are not utility maximizers in this very restrictive sense, and they face an enormous range of incentives all the time, only one of which is going to be the incentive to, to say, slack off. No one is obliged to follow any particular incentive. You might, you might not. And this is just a very, this is an extremely simple idea, but I think it throws a lot of the idea of moral hazard into confusion, because by introducing the concept of real choice and action into an agent's decision, you can also introduce uncertainty about what that decision will be. And naturally, once we start talking about uncertainty, this is where the entrepreneur is going to come in.

14:34Because it ends up being one of the entrepreneurs' fundamental duties and tasks to judge and arrange the incentives that are present, say, within a firm. And more importantly, it's a task of the entrepreneur to judge how laborers or agents will react to prevailing incentives. Are workers likely to shirk? If so, how different will their performance be from the duties outlined in the labor contract? What sort of effect will that behavior have on overall productivity? These questions have to be addressed by the entrepreneur who speculates about the hidden behavior of his agents according to his own judgments.

15:19The entrepreneur as the residual controlling force in the production process plays the fundamental role in arranging incentives so as to promote the success of his own enterprise. And in practice, that will mean that the entrepreneur will basically make judgments about how the arrangement of incentives will affect the productivity of labor. And then further, he will also make judgments about how expected labor productivity will compare to expected productivity of capital and so on. And so the entrepreneur has to constantly account for the presence of hidden action, in information, in the incentives that, within his firm or within his market, and this is really just another component, in my opinion, of the notion of entrepreneurial calculation that Mises suggested.

16:10And I think that looking at things this way lets us contrast the conventional from the Austrian view, because when we acknowledge that arranging incentives is an entrepreneurial and Entrepreneurial Activity, we can see that the arrangement process is open-ended just like other entrepreneurial ventures. Entrepreneurs can be successful in figuring out how to properly motivate people and inspiring them not to shirk, but entrepreneurs can also fail and provide disastrous ways of remunerating agents such that they ruin the entrepreneur's own business. But the overall point is that there are always very broad arrays of incentives that are available and the interaction between principle and agent, especially between entrepreneurs and their subordinates is likewise a constantly shifting problem of anticipation and speculation.

17:04This entrepreneurial behavior is just a necessary part of the market process. It's not an aberration as it's often treated in the mainstream literature. So pointing out that incentives are a problem for entrepreneurs is one way in which moral hazard can be thought of from an Austrian perspective. Another very important way that I'm going to have to skip over, although actually it's fortunate because in a sense it's already been covered today, another very important aspect of these moral hazard problems isn't just defining what negative welfare outcomes are to begin with. This morning in the author's forum a couple of different people brought up this idea of the nirvana fallacy that you can't compare the real world to some sort of abstract equilibrium where all the relevant problems have been assumed away.

17:54This gets right at the core of the idea of moral hazard because in the mainstream literature it's constantly defined in terms of one of these equilibrium points. Unfortunately, I'm out of time so I won't have time to talk about any more explicitly Austrian takes on this, but essentially, I mean, I think you can anticipate the punchline of this. And that will be that true moral hazard problems are going to be emerging in situations in which this entrepreneurial market process is disturbed, particularly when it's disturbed through some type of coercion, be it private or public. As I said, there are many more details in this, but unfortunately, I'm out of time. So thank you for your attention.

18:41Thank you very much.