Moral Hazard and Risk Spreading in Partnerships

by Paul Gertler, Martin Gaynor

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Partnerships provide a classic example of the tradeoff between risk spreading and moral hazard. The degree to which firms choose to spread risk and sacrifice efficiency incentives depends upon risk preferences, for which data are typically unavailable. The authors use a unique dataset on medical group practice to investigate this tradeoff. Risk aversion leads to compensation arrangements, which spread more risk through greater sharing of revenues. The authors find that compensation arrangements with greater degrees of revenue sharing significantly reduce physician effort. The results imply that changing the method of physician payment from fee-for-service to capitation will dramatically reduce physician effort.

Originally published in: RAND Journal of Economics, v. 26, no. 4, Winter 1995, pp. 591-613.

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