Risk, Uncertainty and Moral Hazard

Abstract

This paper gives precision to the meaning of the term hazard. It then analyses the implications which the phenomenon of moral hazard has on the welfare effects of public insurance schemes and the present shortage of medical doctors and hospitals in the United States. It concludes that the existence of moral hazard does not necessarily invalidate the case for welfare increasing public provision of insurance as Pauly has claimed in his criticism of Arrow. Finally, the analysis explores the implications the phenomenon of moral hazard has for Knight's famous distinction between risk and uncertainty. analysis of the conditions under which compulsory government insurance schemes raise public welfare is of considerable theoretical and practical significance. One aspect of Arrow's important contributions to this issuel has recently been challenged by Pauly,2 who argued that Arrow's formal demonstration of the welfare raising effects of compulsory insurance is invalidated by the proper consideration of an empirical phenomenon Grateful acknowledgment is made for the helpful comments Herbert S. Denenberg and Mark V. Pauly made on an earlier draft of this paper. However, since all of their advice was not followed, remaining errors and ambiguities are solely the responsibility of the author. Herbert G. Grubel, Ph.D., is Associate Professor of Finance in the University of Pennsylvania. In 1969, Dr. Grubel was Visiting Fellow, Australian National University, Institute of Advanced Studies. His previous teaching includes service at Yale, Stanford, and the University of Chicago. This paper was submitted in April, 1970. 1 K. J. Arrow, Aspects of the Theory of RiskBearing, Helsinki, 1965; Uncertainty and the Welfare Economics of Medical Care, American Economic Review, December 1963, 53, 941-73; The Economics of Moral Hazard: Further Comments, American Economic Review, June 1968, 58, 537-39. 2 M. V. Pauly, The Economics of Moral Hazard: Comment, American Economic Review, June 1968, 58, 531-37. known in the literature of insurance economics as hazard. paper is designed to give greater precision to the concept of moral hazard than has hitherto been available and to analyze its cause in some detail, in the process shedding light on the Arrow-Pauly controversy. concept is shown to have very important implications for current and future decision-making about public insurance schemes and the alleged present shortage of medical doctors and hospital space in the United States. second part of the paper develops a criterion allowing the judgment to be made whether or not a given compulsory public insurance scheme improves welfare even when moral hazard exists. In the last part, it is shown that the concept of moral hazard and the previously developed decision-making criteria add to an understanding of Frank H. Knight's famous distinction between risk and un-