Back by popular demand (well, at least from one person) for the new season is the continuation of our series on trying to explain Economic Theory by applying the principals to football. The first in series 2 is concerning the Moral Hazard Theory and how a player’s behaviour changes once he has a new contract.
In the 2014 film The Big Short, the real reasons behind the start of the Global Economic Crisis were explored. To many of us, the years between 2007 and 2010 saw unprecedented financial pressure, driven by trusted establishments as well as our own need to budget based on our circumstances. Few people really understood how our boom had suddenly been the biggest bust in history, so the film aimed to explain what really happened, using examples such as chefs making fish stew or actress Selena Gomez playing poker to explain some of the more complex terms such as synthetic derivatives and the concept of sub-prime lending. Whilst these were good examples that helped us understand, it would have been much better if they would have used an example relating to the beautiful game.
The basic premise of the film and the core compelling event behind the Global Economic Crisis was that of Moral Hazard. The theory of the Moral Hazard is originally attributed by some back to the 17th century, but economists Allard Dembe and Leslie Boden created the current theory when trying to explain the situation of Winston Bogarde wasting away in Chelsea’s reserves*, happy to do the bare contractual minimum to earn his substantial weekly wage. The Moral Hazard Theory related to a situation where the behaviour of one person or party may change to the detriment of another after a transaction or contract has been completed. Insurance policies are a more conventional example where the insured party may take more risks knowing that there’s a financial safety net should things go wrong. But how did Dembe and Boden apply the theory to Non-League football?
For example, let’s say a Non-League club sign a promising centre forward on a year’s contract. The day after the ink dries on the contract the player damages his knee in a non-football related incident (such as falling off a table whilst dancing in a Crawley nightclub, drunk at 2am) but hides the injury until the first pre-season training session where he goes down in real pain after an innocuous challenge in the first minute of the practice match. The injury keeps the player out for the rest of the season. The club would be liable to continue to pay his wages despite having no liability in terms of the injury because the player’s behaviour changed once the security of the contract had been completed. Would he have still claimed he was injured in pre-season training if he wasn’t under contract? Probably not.
The reason why is that the Moral Hazard Theory works under the premise of information asymmetry, in other words where one party in the transaction having more information and acts or behaves inappropriately than the other party, normally the one who has to pay the consequences of the risk, which in the above example is the player knowing about his injury but not revealing it to the club.
So that is the Moral Theory and how it influences our thinking today and in the future.