Adverse Network Effects, Moral Hazard, and the Case of Sport-Utility Vehicles

Abstract

The paper examines a class of phenomena that combine adverse network effects with moral hazard, using the motor vehicle market as an example to develop and illustrate the key concepts. It is hypothesized that consumers behave as if there is a network externality with respect to vehicle size: the more large vehicles there are on the roads, the greater a consumer’s propensity to seek protection from them by driving a large vehicle herself. One consequence of this is that motor vehicle manufacturers are discouraged from making large vehicles less hazardous to other motorists. The paper measures the network effect and consequent moral hazard using disaggregate data on choice of vehicle type and related household characteristics, combined with a state-level measure of the incidence of traffic fatalities. The results show that for each 1 million light trucks that replace cars, between 961 and 1,812 would-be car buyers decide to buy a light truck instead, in reaction to the increased risk of death posed by the incremental light trucks. This network effect, when run in reverse, creates egregious incentives for vehicle manufacturers: for every life saved due to safety innovations that make light trucks less deadly to other motorists, manufacturers can expect to sell about 31 fewer light trucks.