Government Management and Moral Hazard
Toshihiro Ihoria and Martin McGuireb
Abstract
This paper extends existing analyses of self-insurance and self-protection that countries may implement at a national level in pursuit of their security. The distinctions of self-insurance, self-protection, and market insurance were first made by Ehrlich and Becker (1972). But application of their models to international security where market insurance for entire countries is usually unavailable remains surprisingly sparse.
We show that, when no market insurance is available, self-insurance alone raises important new issues as to the definition of “fair pricing” and as to the relations between pricing, optimization, risk aversion, and inferiority that are significantly different from standard, conventional market analysis. For instance, when only self- insurance is available supplied with diminishing returns and there is no market insurance, then fair insurance pricing does not induce income equivalence across contingencies and thus risk neutrality at an optimum --- a result precisely the opposite of optimization when fairly priced market insurance can be purchased.
We also discover a hitherto unrecognized tendency for misallocation between self-protection and self-insurance when both are available and considered together. Because of external effects running from self- protection to self-insurance, governments ruled by myopic bureaucracies and trying to find the right balance face incentives that encourage extreme, self-inflicted moral hazard, to the detriment of self-protection.
The paper is macro-economic in theme, micro-economic in methodology.
JEL Codes: H4, F1, D7, D8
Keywords: self-insurance, self-protection, actuarially fair condition, inferior goods, alliances, public goods.
A : Professor, Department of Economics, of, Hongo, 113-0033,. phone: 03-5841-5502, fax: 03-5841-5521. Email: ihori@e.u-tokyo.ac.jp
B : Professor, Department of Economics, of,, . tel: 949-824-6190, fax: 949-824-3401, Email: mcmcguir@uci.edu