8 THE JOURNAL OF LAW AND ECONOMICS
premium levels that cover the cost imposed on sellers of insurance by these
moral hazards.14
Clearly, efficiency requires that moral hazards be economized. Otherwise,
we implicitly assert that the loss of assets that accompanies the realization of
a moral hazard imposes no cost on society. One way of economizing on moral
hazards is to allow self-insurance. If the size of the premium that is required
to get others to accept moral hazard cost is higher than people wish to pay,
it is appropriate to reduce the loss of assets that would accompany moral
hazard by allowing prospective buyers of such insurance to self-insure.
Do we shift risk or reduce moral hazards efficiently through the market
place? This question cannot be answered solely by observing that insurance
is incomplete in coverage. Is there an alternative institutional arrangement
that seems to offer superior economizing? There may well be such an arrange-
ment, but Arrow has not demonstrated it and, therefore, his allegation of
inefficiency may well be wrong and certainly is premature.
Turning now to the possibility of reducing risk through the device of pool-
ing, we find that Arrow takes the following position.
The central economic fact about the processes of invention and research is that
they are devoted to the production of information. By the very definition of
information, invention must be a risky process.... Since it is a risky process, there
is bound to be some discrimination against investment in inventive and research
activities.... The only way, within the private enterprise system, to minimize this
[moral factor] problem is the conduct of research by large corporations with many
projects going on, each small in scale compared with the net revenue of the corpora-
tion. Then the corporation acts as its own insurance company. But clearly this is
only an imperfect solution.15
14 Arrow employs the moral hazard argument in his paper, Uncertainty and the Wel-
fare Economics of Medical Care, 53 Am. Econ. Rev. 941-73 (1963). Mark V. Pauly
criticized this use of the moral hazard argument and Arrow replied to the criticism 58
Am. Econ. Rev. 531-38 (1968). My criticism of Arrow's argument is much the same as
Pauly's. Two parts of Arrow's reply to Pauly should be noted. First, Arrow concedes
"that the optimality of complete insurance is no longer valid when the method of insur-
ance influences the demand for the services provided by the insurance policy." So far so
good. However, secondly, Arrow states that "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
optimality will not be achieved either by the competitive system or by an attempt by the
government to simulate a perfectly competitive system." The supporting argument given
by Arrow in defense of this second statement leaves much to be desired since it assumes
that contracts between the insurer and insured that ration the insurance service are
somehow outside the competitive system, that the decision to consume more of the
service is somehow a "bad" even though the price of the insurance covers the full cost
of the service, and, implicitly, that adherence to contractual agreements is not an impor-
tant feature of the competitive system.
15 Kenneth J. Arrow, supra note 1 at 616.
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