Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured.
Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured.