Gabbar Singh teaches us about Moral Hazard, Banking crisis and NPAs

Avinash Tripathi (@qfint)is quickly becoming one of the key guys to read/follow regarding economics (and movies).

His recent piece is on what Gabbar Singh teaches us about moral hazard, banking crisis and NPAs. He is hardly new to this genre and has written earlier pieces linking game theory to Sholay, RGV’s Company and now Sholay’s Gabbar to moral hazard.

Though, this time Avinash even quotes from Hebrew Bible:

Countless movie-goers have watched the entry scene of Amjad Khan (aka Gabbar Singh) in Sholay with rapt attention. Even today, going by the number of spoofs and parodies available on the internet, it remains incredibly popular. What if I tell you that this scene also teaches a lot about economic theory in general and financial crises in particular?

The invisible thread that connects the iconic scene with financial crises is Moral Hazard. Moral Hazard is a central idea in information economics; as Joseph Stiglitz once said, moral hazards are everywhere. Alas, the term is a bit of misnomer: It is neither about morality, nor about hazards.

Essentially, Moral Hazard is about the age-old problem of separating effort from luck. Ecclesiastes, part of the Hebrew bible, noted the problem some two thousand years ago in a beautiful expression:

I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favor to men of skill; but time and chance happeneth to them all.

If the race is not to the ‘swift’ and there is an element of ‘chance’ in every outcome, some economic transactions become extremely hard to execute. Sholay provides one such example. In the movie, Gabbar Singh is the principal and Kaliya (Viju Khote) is the agent. Gabbar is in the business of robbery and allied activities (one assumes) such as extortion and levy-collection. Like every savvy businessman, Gabbar cares deeply about his reputation. He beams with pride while declaring that government has announced a reward of fifty thousand rupees (purey pacchaas hazaar) on his head. He is pleased by the fact that in an area covering fifty kilometers, his name is sufficient to scare off little children.

Such a formidable reputation can not be built individually. It requires a team effort. That is where Moral Hazard rears its head. The first element of moral hazard is the asymmetry of cost and benefits. While much of the benefit of reputation-building goes to the principal (Gabbar Singh), the costs are borne by the foot-soldiers like Kaliya. He must pick up dangerous fights every time Gabbar’s writ is challenged.

The second element of moral hazard is the obfuscation of effort and chance. Not every fight of Kaliya can be personally observed by Gabbar. Only the outcome of his effort can be monitored. (For example, whether he has brought enough booty or not.) Outcomes are a product both of the agent’s effort and chance. As such, the best course of action for agent (Kaliya) is to make no effort, just run away and report that he lost the fight due to bad luck (or some other factor beyond his control). That is precisely the course of action followed by him in the movie.

So what does Gabbar do to ensure his reputation remains intact? Shoot Kaliya and leave a strong message..

The same message should be applied to banks who keep wasting public money and create NPAs every now and then…

Really interesting writing…

2 Responses to “Gabbar Singh teaches us about Moral Hazard, Banking crisis and NPAs”

  1. Anantha Nageswaran Says:

    I am not sure his understanding of ‘moral hazard’ is correct. If one could say it is about law of unintended consequences or about the road to hell being paved with good intentions, it might make sense.

    Think insurance and the unintended inducement to risk-taking. An incentive designed to eliminate some risk or bad behaviour or their consequences ending up encouraging bad behaviour and creating greater dangers is moral hazard.

  2. Avinash M. Tripathi Says:

    It’s a pleasure to respond to Dr. Nageswaran’s comment whose writings on Indian economy I keenly follow and admire.

    As regards the moral hazard, I think part of the confusion comes from the fact that it has been used by two communities in two (closely related) senses. Originally, Moral hazard has been used in insurance industry to refer to a kind of ‘insurance-incentive trade-off’. It is a situation where provision of insurance encourages undesirable behavior (or discourages desirable behavior). Third-party motor insurance leading to drunk driving may be one example of this usage.

    However, 1970s onwards, moral hazard has been formalized in economic theory by economists such as James Mirrlees, Joseph Stiglitz and Kenneth Arrow (among many others). They defined moral hazard as a ‘hidden action’ problem. In their formulation, it refers to the problem of providing right incentives where the action of an agent can not be perfectly monitored.

    Both notions are consistent with each other in a precise logical sense. ‘Hidden action’ is the assumption, the hypothesis, the premise; ‘insurance-incentive trade-off’ is the result, the consequence, the conclusion. As such, neither view is ‘wrong’. However, the notion of ‘hidden action’ is considerably more general than the ‘insurance encourages bad behaviour’ view (especially if insurance is narrowly defined as a contract offered by the insurance industry).

    ‘Sholay’ example makes it abundantly clear: The problem of ‘hidden action’ (where Gabbar can not monitor Kaliya’s actions personally) is present even in the ravines of Ramgarh, even though no insurance company is operating there!

    As usual, Kenneth Arrow provides the most careful and clear analysis:

    “There is one particular case of the effect of differetial information on the working of the market economy (or indeed any complex economy) which is so important as to deserve special comment: one agent can observe the joint effects of the unknown state of the world and of decisions by another economic agent, but not the state or the decision separately. This case is known in the insurance literature as “moral hazard”, but because the insurance examples are only a small fraction of all the illustrations of this case and because as Pauly (1968) has argued, the adjective ‘moral’ is not always appropriate, the case will be referred as the ‘confounding of risks and decisions.’ An insurance company may easily observe that a fire has occured but can not without investigation, know whether the fire was due to causes exogenous to the insured or to the decision of his (arson, or at least carelessness). In general, any system which, in effect, insures against adverse final outcomes automatically reduces the incentives to good decision making.” (Kenneth Arrow; ‘The organization of economic activity: Issues pertinent to the choice of market versus non-market allocation’.)

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