The economics of moral hazard: further comment

Abstract

Mr. Pauly's paper has enriched our understanding of the phenomenon of so-called moral hazard and has convincingly shown that the optimality of complete insurance is no longer valid when the method of insurance influences the demand for the services provided by the insurance policy. This point is worth making strongly. In the theory of optimal allocation of resources under risk bearing it can be shown that competitive insurance markets will yield optimal allocation when the events insured are not controllable by individual behavior. If the amount of insurance payment is in any way dependent on a decision of the insured as well as on a state of nature, then the effect is very much the same as that of any excise tax, and optimality will not be achieved either by the competitive system or by an attempt by the government to simulate a perfectly competitive system. … In this note I would like to stress a point which Mr. Pauly overlooks in his exclusive emphasis on market incentives. Mr. Pauly has a very interesting sentence: “The above analysis shows, however, that the response of seeking more medical care with insurance than in its absence is a result not of moral perfidy, but of rational economic behavior.” We may agree certainly that the seeking of more medical care with insurance is a rational action on the part of the individuals if no further constraints are imposed. It does not follow that no constraints ought to be imposed or indeed that in certain contexts individuals should not impose constraints on themselves.

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