Effects of Insurance and Moral Hazard on the Division of Labor and Productivity

Monchi Lio
Department of Political Economy
National Sun Yat-sen University, Taiwan

Abstract
This paper investigates the effects of insurance and related endogenous transaction costs caused by moral hazard on the division of labor and aggregate productivity. Using a model with endogenous specialization, we prove that insurance can enlarge the network size of division of labor and improve aggregate productivity. But the emergence of insurance may incur opportunistic behaviors and related moral hazard. Three types of related endogenous transaction costs are identified, which may result in Pareto inefficient levels of division of labor in addition to Pareto inefficient resource allocation. Endogenous transaction costs and the level of division of labor may increase concurrently as a result of improvement in exogenous transaction efficiency.

Keywords: the division of labor, insurance, moral hazard, endogenous transaction costs
JEL classification: D23, G22

1. Introduction
Transaction costs are now widely recognized as one of the most important factors in determining the performance of economic development. Higher transaction efficiency allows a larger network size of division of labor, which enables individuals to be more specialized and to further exploit increasing returns from learning investments. In fact, one of the most important features in economic development is that people would develop a variety of institutions to improve transaction efficiency and extend the network of trade while aggregate productivity is enhanced from economies of division of labor.

Insurance is one of the most important institutions ever developed to mitigate the negative effects of transaction risk, an important element of transaction costs, on the network size of division of labor. Consider the case of ocean shipping. As economic historians have pointed out, the development of insurance for ocean shipping significantly contributes to the extension of world trade (John 1958, North 1968, Price and Clemens 1987). Even in our days, the arrival of a cargo ship could be delayed or even cancelled unexpectedly by risky factors such as bad weather, a storm, a mechanic problem, a strike of harbor workers, a war or an epidemic breaking out in the route, or an attempt of robbery by pirates. If the probability of suffering heavy losses in transactions is too huge, risk-averse people would choose to self-provide a lot of goods and services they consume rather than depend on the market. Thus, the existence of insurance against transaction risk could have significant positive effects on the network size of division of labor.

The adverse effects of transaction risk on the extent of the market and the network size of division of labor are usually overlooked by economists. Since most of economic theories about uncertainty neglect the network effect of division of labor on aggregate productivity, as Laffont (1989, p.12) has observed, in these theories risks "have no effect on society's aggregate resources but can seriously affect the welfare of the unfortunate individuals." To incorporate the network effect of division of labor into the theory of uncertainty, following Yang and Ng (1993), Lio (1998) develops a model with transaction risk, endogenous specialization, and endogenous level of division of labor, which demonstrates that a higher probability of suffering huge transaction losses will result in a lower level of division of labor and thus reduce aggregate productivity. Lio has proved that the emergence of insurance against transaction risk raises the level of division of labor, the extent of the market, the level of specialization, aggregate productivity, and per capita income.

However, Lio (1998) did not consider the possibility of post-contractual opportunistic behavior due to asymmetric information in the insurance market. An insurance market where the insurance company can monitor and enforce the behavior of the insured seems to be an infeasible utopia. Opportunistic behaviors which generate moral hazard may lead to incomplete insurance contracts or even make insurance contracts nonviable, and therefore generate adverse effects on the network size of division of labor and related aggregate productivity. Several models, e.g. Holmstrom and Milgrom (1995), have investigated the endogenous transaction costs, i.e. distortions caused by conflicts between self-interested decisions or by the incentive incompatibility problem, incurred by moral hazard. But most of these models are decision or partial equilibrium models that cannot formalize the mechanisms that simultaneously determine the network size of division of labor, the level of specialization, total exogenous and endogenous transaction costs, and productivity. Therefore, in these models the effect of moral hazard on distorting the efficient level of division of labor is not fully explored.
In this paper we will introduce moral hazard into the Lio model. A model with economies of specialization, transaction risk, and insurance is developed to show that moral hazard would generate endogenous transaction costs that cause Pareto inefficient levels of division of labor in addition to inefficient resource allocation. An important implication of this model is that opportunistic behavior would have negative effects on aggregate productivity and per capita income by generating endogenous transaction costs that restrict the institution of insurance from fully playing its role in improving transaction efficiency and extending the network of division of labor. Nevertheless, incomplete insurance contract can reduce exogenous transaction costs and thereby promote the division of labor and enhance aggregate productivity. Increases in endogenous transaction costs and in the level of division of labor may take place concurrently as a result of decreases in exogenous transaction cost coefficients.

This paper is organized as follows. Section 2 specifies a general equilibrium model with endogenous specialization, exogenous risky transportation costs and endogenous transaction costs caused by moral hazard. All possible configurations and structures are identified and the corner equilibrium in each structure is solved in section 3. The general equilibrium, the comparative statics and the findings are reported in section 4. Section 5 concludes this paper.

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