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MORAL HAZARD

I am the one taking the risk, but someone else is responsible for it, and they’ll pay if I fail…

When an insurer sells vehicle insurance, he doesn’t know the manner in which the vehicle is going to be driven, but he still has to set a price. The driver knows that the insurer lacks this information, so he’s not worried about his premium rising if he drives dangerously, as long as he doesn’t crash. On top of this, if he does crash, the damage will be paid by the insurer. This situation, when the owner has more information about how the vehicle is driven, and has less of an incentive to drive safely, is called ‘moral hazard’. The owner’s driving behaviour changes as a result of him having insurance, and this increases risk for the insurer. Even though the vehicle is owned by the driver, and he doesn’t want it to be damaged, it is the insurer’s responsibility if something goes wrong. Similarly, big companies or banks can be incentivised to take risks if they know they won’t have to pay for any negative consequences of their actions. For example, if a company is treated as if it’s ‘too big to fail’, and it believes the government will bail it out, it can make risky investments without worrying about the consequences.

The term ‘moral hazard’ is often taken to refer to fraudulent or immoral behaviour, but that doesn’t have to be the case; moral hazard simply shows the challenges that markets may face in providing the best results for everyone. When information is not perfectly distributed, one party might be able to pursue its interest at the expense of the other. Of course, the other party has an incentive to design contracts that control this risk, and sometimes the intervention of the government may be necessary.

MARGINALISM

It’s not the ‘importance’ of a product, but the combination of its abundance and desirability that determines its price…

One of the oldest debates in economics is the value controversy. Early political economists, such as Adam Smith, held that it is the average amount of labour time necessary to make a product that determines its value. Against this ‘labour theory of value’, late 19th-century economists, such as William Stanley Jevons and Alfred Marshall, argued that it is the marginal utility of a product that determines its value. This ‘exchange theory of value’ is based on the idea that people will derive less enjoyment from the consumption of every extra unit of a product that they consume. You might like apples, but you won’t keep eating them until they run out. At some point you’ll be fed up with them and start eating something else instead. But how does this relate to the price of things? Take, for example, the paradox of water and diamonds. Water is essential to people for their survival, whereas diamonds aren’t. But water, although essential to life, is far cheaper than diamonds. This is because globally water is abundant in a way that makes little difference whether you have an extra gallon of it or not. Its price is, therefore, low. Diamonds, on the other hand, are rare – and having a diamond or not makes a huge difference in financial terms. Therefore, its price is high.

The theory sounds on target. But can it really explain everything that happens? It assumes an equilibrium where supply and demand meet, but in reality this equilibrium is very rarely reached and maintained. Nor does the theory say what happens to demand and supply over time – it doesn’t explain change. It is a static theory, whereas capitalism is the most dynamic economic system in human history.

PROPERTY RIGHTS

Missing property rights? Inefficient markets…

Property rights give the owner exclusive authority on a good, a company, a piece of land, or even an intellectual creation. The owner, whether an individual or a government, acquires the exclusive right to use the good, earn income from it, sell it, or transfer it. Well-defined property rights are a fundamental part of the capitalist economic system. In some cases, however, property rights are difficult to define for practical or historical reasons, and can lead markets astray. Too much pollution? That’s because there aren’t well-defined property rights to the air. Fisheries over-harvested? That’s because fishermen are competing for the same shared resource. Because commodities, such as air and fish, are not owned by anyone, no one can restrict their usage. Solution? Create property rights. From tradeable permits that cover air pollution, to tradeable fishing quotas, economists have long advised governments on how to create property rights. The use of the commodities becomes restricted to the person in possession of the permit, so that the overall use of the resource can be capped. As these permits then become tradable, a market is created, which determines a price for the use of the resource.

Even if private property is central to the functioning of the capitalist system, not everything can be privately owned. Certain essential public goods and services, such as roads or national defence, need to be provided by the government because private companies would be unable to make a profit from them. Some economists believe certain public services, such as public transport or electricity, can be provided more efficiently through private companies, others argue this is not the case.

THE TRAGEDY OF THE COMMONS

When resources are shared but limited, no one acts to preserve them – which means rational actions can prove irrational in the long run…

Several herders graze their cows on common pasture. From each herder’s point of view, it’s rational to add more cows to his herd, because his profits will increase. However, every additional cow depletes the pasture’s resources. If every farmer acts ‘rationally’ by adding more cows to his herd, the common land will eventually be overgrazed, grass will stop growing, and all the herders will suffer. In essence, actions that are rational for the individual may be irrational for the group. Yet from each farmer’s point of view, buying more cows is rational, because he as an individual reaps all the benefits they bring, while the negative impact is split equally among all the farmers. Garrett Hardin used this example to illustrate ‘the tragedy of the commons’ in an influential article published in 1968. The term can be applied to the consequences of any situation in which a limited resource is treated as common property and, as a result, may become overused. The tragedy is commonly found in environmental issues, such as over-fishing and pollution. This depletion of common resources is an example of an economic externality, or side effect – for example, pollution from a factory can impose clean-up costs on people who live nearby.

Capitalism’s critics offer the tragedy of the commons as proof that the invisible hand doesn’t always work. But how to regulate it? Hardin believed altruism and common sense wouldn’t work, and that private property rights are the best way to manage common resources; governments should limit resource use – such as limiting fishing permits – or common goods, such as water, should be privatised. However, economist Elinor Ostrom challenged this view by showing how many communities do manage resources sustainably over the long term – a contribution that earned her a 2009 Nobel Prize.

THE INVISIBLE HAND

To create more wealth, just help yourself…

A butcher doesn’t sell meat because he’s altruistic; he slices and dices to turn a profit. But to sell the meat, he needs to pay attention to what his customers want. Thus to pursue his own wealth, the butcher serves the needs of society – and in a market economy, according to Adam Smith, most people behave the same way. That is, when people can choose freely what to produce and what to buy, the ‘invisible hand’ of competition guides the exchange of goods and services so that personal greed leads to collective gain. For example, when entrepreneurs want to attract more business, they offer lower prices. It’s a win-win game and a dynamic, self-regulating process that occurs and adjusts automatically. Smith used this theory to argue against government regulation and protectionism in a market economy – although for the invisible hand to work properly, society must have strong property rights, established legal and moral codes, and the exchange of information. Smith is often considered the ‘father of economics’, and for good reason. His theory of the invisible hand, coined in his 1776 book The Wealth of Nations, guided the era of classical economics for more than 150 years and still shapes the economic debate today.

Seems simple enough – but does it work? Not always. Even Adam Smith recognised that self-interest for wealth creation had its limits, and believed government had to step in when it came to protecting private property and providing public goods, such as roads. Take environmental goods as an example: Hardin’s ‘Tragedy of the Commons’ theory shows that when multiple actors using a shared resource pursue individual gain, the resource will be depleted unless strong property rights are in place.

EFFICIENT MARKET HYPOTHESIS

Think you can outguess the stock market? That’s fool’s gold, unless you know something the market doesn’t…

These days finance seems to be the central issue in economics. But traditionally it was given attention once economists had developed theories to explain how the ’real’ economy works. For a broad array of believers in the free market, financial markets function on the basis of the efficient market hypothesis. This is more or less an adaptation of general equilibrium theory. It assumes that in a financial market, such as Wall St, the prices of traded assets – in this case, stocks and bonds – already reflect all existing knowledge about them. Because of that, it is virtually impossible for any investor to consistently make gains by speculating on the prices of these assets. This is because until new information alters the value of an asset, no one can really know how its price will evolve. That means that only luck can help you when speculating, or indeed possession of insider information, which is forbidden by law. The efficient market hypothesis had circulated among economists for many decades before Eugene Fama at Chicago gave a standard version of it. It was the main theory for analysing financial markets until the 1990s, when financial volatility and ‘irrational exuberance’ became the norm in finance.

The last 20 years, and especially the great financial crisis of 2007-2009, have created many problems for the efficient market hypothesis. Many prominent experts of financial markets, such as Martin Wolf of the Financial Times, now dismiss it as useless. The main attack against it is that it doesn’t take account of psychological aspects of how finance works – what some dissident economists have called the ‘herd instinct’.

The book: For more Economics 101, pick up a copy of 30-Second Economics: the 50 most thought-provoking economic theories, each explained in half a minute, edited by Donald Marron, out now (Icon Books; £12.99)