Moral Hazard and Search Activity

Abstract

An interpretation of moral hazard in relation to consumer search activity is proposed. Moral hazard is defined as a drop in search activity under insurance since the insurer cannot observe, ex-ante, this activity. Insurance strategies are studied with a view to correcting this problem. The main result of the paper concerns the involvement of the insurer in search activity in order to eliminate this kind of moral hazard. The object of this paper is to present an interpretation of moral hazard in relation to consumer search activity. There exist two types of moral hazard in the economic literature on insurance. The first type is defined as the reduction of self-protection by the insured due to the difficulty on the part of the insurer in observing this type of activity and in using this information to set the premium. Since the insurance premium does not vary with the effort to prevent loss, the insured has less incentive to do such activity. Therefore, the probabilities of loss increase under insurance. Partial insurance coverage reduces the misallocation of resources related to this problem of information since it exposes the insured to some financial risks. This interpretation of moral hazard stems from the studies of Ehrlich and Becker [7], Pauly [16], Helpman and Laffont [110], Marshall [12], Laffont [111] and Shavell [21]. The second type of moral hazard is defined as the increase in consumption of insured services due to a decrease in the price paid by the insured for these services. The insured is subsidized by the insurance coverage and continues to spend for the services after marginal benefit falls below marginal cost. In that case, the insurer can observe the amount of loss but cannot verify, in a costless fashion, the state of the world that has created this expense. This interpretation of moral hazard was first proposed by Pauly [ 15] in a comment on a paper