Hidden Actions, Moral Hazard and Contract Theory

Abstract

‘Moral hazard’ in the literal sense refers to the adverse effects, from the insurance company’s point of view, that insurance may have on the insuree’s behaviour. As an extreme but standard example, a fire insurance holder may burn the property in order to obtain the insured sums. Although the expression can be found in earlier literature, its extensive use in economics can be dated from Arrow’s Essays in the Theory of Risk-bearing (1971), which had a decisive influence in popularizing the term as well as in stimulating a systematic study both of the subject itself and of related phenomena. Arrow stresses that the complete set of markets required for first best efficiency often cannot be organized. The (so-called) Arrow-Debreu contracts which are needed would have to be contingent on states of nature. This term, ‘states of nature’, has to be taken in its meaning in decision theory where it refers to random events whose realization reflects an exogenous choice by ‘Nature’, and not an endogenous choice by agents. However, states of nature may not be observable either directly or indirectly, so that real contracts have to rely upon imperfect proxies. Take the overly simple fire insurance example. Arrow-Debreu contingent contracts would make indemnification conditional only on the occurrence of those natural events that can cause fire, such as thunderstorms, whereas actual real-world contracts make it dependent upon the occurrence of fire itself, whether due to an unusual exogenous event, or to a more normal exogenous event coupled with insufficient care.