Moral Hazard and Competitive Insurance Markets

Abstract

Most work on the theory of moral hazard in the context of insurance investigates the properties of the schedule relating the net insurance payout to the accident damage in a partial equilibrium context. This paper reviews some results from a long-term research project undertaken by Joseph Stiglitz and the author, which in contrast focuses on moral hazard in general equilibrium. Topics addressed include the properties of indifference curves, the form of competitive insurance contracts, the existence of competitive equilibrium, and the descriptive and welfare properties of equilibrium.The central finding is that the presence of moral hazard radically alters the nature of competitive equilibrium: a) At one extreme, equilibrium may not exist; at the other, there may be an infinity of equilibria. b) When equilibrium exists, some insurance markets may be inactive even though there is demand for insurance. c) In active insurance markets, equilibrium may be characterized by positive profits, rationing of insurance, and/or random premia and payouts. d) Neither the first nor the second welfare theorem holds. e) Market prices do not reflect social opportunity costs. As a result, the potential scope for efficiency-improving government intervention is considerable. Key wordsMoral hazardinsurancecompetitionequilibriumexistenceuniquenesswelfare economicsprincipal-agentfirst-order approachadverse selection