Economic Research Initiative on the Uninsured
Working Paper Series
BENEFICIAL MORAL HAZARD AND THE THEORY OF THE SECOND BEST
Kevin D. Frick
Johns Hopkins Bloomberg School of Public Health
Michael E. Chernew
Harvard Medical School
ERIU Working Paper 57
Economic Research Initiative on the Uninsured
University of Michigan
109 S. Observatory, M3242, SPH-II
Ann Arbor, MI 48109-2029
Not to be distributed or copied without permission of the authors
Economic analysis of health insurance markets has long noted that insurance increases
consumption of heath care services because it shields individuals from the true price of care.
The additional consumption attributed to insurance is often labeled as “moral hazard” and, in
standard economic models, is considered to result in welfare loss. The cost associated with
additional consumption provides one argument against expanding coverage. This article
examines the welfare consequences of moral hazard and brings together several arguments
suggesting that in many cases the additional consumption could be welfare enhancing.
Since conditions for maximum economic efficiency fail to hold in the market for medical care,
the concept of the theory of the second best is important; in this case, the market distortions
caused by insurance may increase welfare by mitigating the averse consequences of other
distortions. We focus on three efficiency-related reasons why insurance-
induced consumption may improve welfare: (1) insurance can offset market power; (2)
insurance can remedy some externalities; and (3) insurance can mitigate problems
associated with mis-information that results in many types of care being underutilized. We
also focus on one distributional reason, the idea that insurance can facilitate desired income
transfers between healthy and sick states of the world. These arguments strengthen the case
for expanding coverage. Yet, the cost of additional consumption associated with expanding
coverage must be addressed, even if it enhances aggregate economic welfare. More
sophisticated benefit packages may be able to minimize the cost of additional consumption
associated with coverage by limiting detrimental moral hazard, while maximizing access to
the health care services that provide substantial value.
Analyses of health insurance markets over the past several decades have recognized that
insurance encourages beneficiaries to consume more health care than they would if they
were uninsured. Although advocates for universal coverage and improved access to care
may view this increase in utilization as positive, standard economic analysis suggests that
this extra consumption will diminish economic welfare and the label for this extra use, moral
hazard, reflects this negative connotation. In the context of exploring whether government
provision or encouragement of health insurance was welfare enhancing, Mark Pauly
presented the seminal analysis of this phenomenon in 1968.1 Today the phenomenon of
moral hazard has become one of the fundamental empirical findings in health insurance
markets and the debate associated with any change in the United States. Influential studies
of demand elasticity, such as the RAND health insurance experiment, devote considerable
attention to quantifying the changes in utilization and expenditures associated with greater
coverage,2 and the results have been used to estimate changes in welfare.3
In contrast, there is a growing body of research that argues that the extra consumption and
expenditures associated with insurance may not diminish welfare. Since conditions for
maximum economic efficiency fail to hold in the market for medical care, the idea that
insurance induced demand for care will increase welfare is an application of the second best
theory. This paper reviews those arguments, focusing specifically on three efficiency-related
reasons why insurance-induced consumption may improve welfare: (1) insurance can offset
market power; (2) insurance can remedy some externalities; and (3) insurance can mitigate
problems associated with mis-information that results in many types of care being
underutilized. We also focus on one distributional reason, the idea that insurance can
facilitate desired income transfers between healthy and sick states of the world.
The effects of the extra consumption on economic welfare is important for policy debates.
Specifically, over 46 million Americans lack health insurance coverage.4 One argument that
is consistently raised against expanding coverage is that the coverage will induce wasteful
spending (e.g. moral hazard.) Similarly, many insured individuals remain exposed to
relatively high levels of cost sharing at the point of service, and some policy initiatives
propose to encourage enrollment in such ‘high deductible plans’ as a means to lower costs
and improve the efficiency of the health care system. Thus, a comprehensive discussion of
the many possible effects of changes in utilization and expenditures associated with
additional insurance coverage can add insight to the debate on expanding insurance to those
who are uninsured and on making insurance more generous for those who are in high
deductible or high coinsurance plans.
This paper will discuss (1) the standard economic evaluation of insurance, (2) efficiency
arguments for greater coverage in a section on the theory of the second best, (3)
distributional implications, and (4) balancing beneficial and detrimental moral hazard. Finally,
the paper will conclude
Standard economic analysis
Textbook analyses of moral hazard are typically based on a comparison of consumption
when insured to consumption when not insured (Figure 1). The optimal level of consumption
is at point A, where the demand curve intersects the price. Insurance that lowers the price
faced by consumers increases consumption to the quantity represented by point B. The cost
of the extra consumption is the added quantity multiplied by the price of care (represented by
the area AECD). The loss of economic welfare is generally computed as the cost of this care
minus an estimate of the value of the care. The value of care is measured by the area under
the demand curve. Thus, the incremental value is represented by the area ABCD. This
value is smaller than the cost, suggesting a welfare loss represented by the triangle AEB.
The welfare loss is felt by consumers when they pay the premium, which finances a large
part of the care. When they are ill, they treat the costs of the care (paid largely through the
premium) as sunk costs, and only perceive the costs and value associated with the extra
care. Moreover, if the premium is subsidized by employers or taxpayers, or otherwise not
transparent to the consumer, they may not perceive the welfare loss. However, the costs of
coverage (and, ultimately, care) are borne somewhere in the system. As a result, at the
aggregate level the welfare loss would still exist.
The key to this analysis is the comparison of the efficient and actual levels of medical care
consumption. If actual consumption is above efficient consumption (which, critically, is not
observed empirically),5 welfare loss will be present and equal to the cost of that care minus
its value as was shown in Figure 1. Similarly, if, for whatever reason, actual consumption is
below the efficient level, loss of welfare will occur as a result of the missed opportunity to
consume care that is valued at a level that is greater than what it costs to produce; the
welfare loss would equal the value of care not consumed, minus its cost.
In standard economic models of insurance, this welfare loss is offset by the fact insurance
coverage provides a benefit in the form of risk mitigation. Risk averse individuals wish to
avoid the potential for significant financial loss and are able to protect against that risk
through insurance. Institutional details, such as the tax treatment of coverage, provide
additional incentives to purchase insurance despite the societal welfare loss.
The standard economic analysis of the economically efficient level of insurance focuses on
the tradeoffs between welfare loss and risk mitigation. At the margin, in efficient equilibrium,
better coverage is purchased until the marginal disutility of the welfare loss associated with
better coverage equals the marginal utility of improved risk protection.
The point at which equilibrium is reached is an open empirical question that has received
considerable attention. For example, as early as 1973, Martin Feldstein performed a societal
welfare analysis of the raising the coinsurance rate for hospital services.6 In the analysis, the
demand for insurance in each state was modeled as a function of the price of insurance, the
group nature of the purchases, hospital prices and other variables. The estimation captured
the interactive nature of hospital coverage and hospital prices. Comparing the welfare loss
to risk mitigation, Feldstein suggested that having individuals face a higher out-of-pocket cost
(particularly for expenses of a moderate magnitude) would be welfare increasing.
Expanding the economic analysis to the theory of the second best
The core of these arguments is largely driven by standard economic theory assuming well-
informed consumers making purchases in markets of competitive health care providers; in
other words, the conditions for the optimality of a free market for health care are assumed.
In light of the many limitations to neoclassical economic reasoning, reconsideration of the
core of the moral hazard arguments is reasonable, and economic analyses motivated by the
theory of the second best (i.e. that moving away from some conditions of optimality may not
be inefficient when there are constraints to other optimality conditions already in place)
Insurance does increase utilization of health care services and the increased consumption
and expenditures have the potential to reduce welfare if the costs of the additional services
exceeds the value of the services rendered. Yet, if we expand the framework of analysis,
there are many situations in which the costs do not exceed the value, and, the extra
consumption would be beneficial and improve welfare. The common thread across these
reasons is that the efficient level of care is greater than the quantity consumed when a
person is uninsured. Constraints in the market may prevent efficient levels of consumption
from being attained by uninsured individuals; in this case, distortions caused by insurance
may actually improve welfare and removal of coverage, so patients must pay the full price of
care, are not guaranteed to increase economic welfare. In the case of health insurance, if
the efficient quantity is greater than the uninsured quantity, the welfare loss associated with
coverage diminishes. As a result, moral hazard may be beneficial or ‘welfare enhancing’.
Issue 1: Market power and excessive prices
The standard economic argument relies on the market price to define the efficient level of
consumption. This assumes a well-functioning competitive market so that the prices in the
market represent the true marginal social costs of providing medical care.
A range of reasons may result in firms in the health care industry charging prices above
marginal cost. In some markets there may be an insufficient number of providers to generate
competition. For example, there may be only one hospital or a few physicians of specific
specialties. In such markets, to the degree that the provider can set prices, the resulting
prices are an overestimate of the efficient amount of resources that society must use to
obtain effective care. Using price as the measure of social cost will lead to an overestimate
of the cost of care in a calculation of welfare loss. Also, in such a market, the quantity of
care consumed when uninsured would be less than a socially efficient quantity. This type of
market power is most likely in rural areas, although it may also reflect barriers to entry such
as licensing requirements or certificate of need laws.
Market power may even exist in markets with substantial numbers of providers due to
imperfections in the ability or willingness of patients to search for care based on price.
Pauly and Satterthwaite present a model in which more providers in a market leads to a price
increase, as opposed to a price decrease, because of the increase in the number of
providers increases search costs.7 Furthermore, the inability to observe quality limits
consumers’ willingness to seek care from the least expensive provider. Provider
differentiation along a number of dimensions, including location, reputation, and amenities
further limits the extent to which competition can drive prices down to marginal costs.
Finally, insurance itself exacerbates the problem of insufficient price shopping. Consumers
only retain a small portion of the savings, if any, if they seek care from less expensive
Patent protection is another source of monopoly power, most relevant in the market for
prescription drugs. Monopoly power allows the pharmaceutical manufacturer to obtain
economic profits and sell the product at a price that is higher than the marginal cost of
production. Uninsured prices in the market for pharmaceuticals will not necessarily maximize
welfare, although there are many arguments for why patents and the accompanying
economic profits may be a reasonable policy option for encouraging innovation. Regardless
of the positive and negative aspects of patent protection, the prices that are charged while
the patent applies are an overestimate of the costs to society when considering changes in
welfare that may occur when more individuals have insurance.
If market prices exceed marginal cost, as it likely in many cases, the efficient amount of care
depicted in Figure 1 is too low. If one were to instead calculate the efficient level of care
using a low price, efficient consumption would be higher and closer to the consumption with
insurance (Figure 2). In Figure 2, the efficient consumption is at point F. If patients were
uninsured, and consuming at point A, there would be a welfare loss associated with
underconsumption because the value of care going from A to F (the area under the demand
curve between A and F) exceeds the cost (the area under social marginal cost associated
with quantities C and D). The triangle AFG represents beneficial moral hazard. The only
welfare loss that is caused by insurance is the over consumption as patient moves to
consume the quantity at point B. This is represented by triangle FHB and is smaller than
under the standard analysis. When the social marginal cost is very low, as in the case of
many prescription drugs, the insured price may not be below social marginal cost and moral
hazard may not decrease welfare at all; there may be only beneficial moral hazard.8
The market has generated alternatives to providing less coverage to control the increase in
utilization and expenditures associated with greater insurance. Managed care plans can
mitigate this problem and reduce the mark-up of prices above marginal cost. They can do
this by limiting their networks and using their negotiating power. In essence, this is searching
on behalf of their beneficiaries. The beneficiaries can obtain a less expensive premium, but
in exchange they may have to accept a limited provider network. Moreover, in equilibrium it
is theoretically possible for greater search by managed care plans to lower prices without
requiring substantial reductions in network breadth. The threat of limiting access to the
network may be sufficient.
Some research suggests that this is how managed care plans achieved savings in the
1990s.9 Other evidence suggests that at least for some services in some markets health
maintenance organizations (HMOs) may pay close to marginal cost.10 This is most likely to
be the case in markets with many providers.10,11 The same work suggests that even in
competitive markets, less managed plans likely pay above marginal cost.
Alternative methods to mitigate the problems associated with market power have been
developed such as price regulation and policy initiatives. Initiatives include information
provision and product standardization; these options may improve the search process for
consumers. In fact some evidence suggests that demand elasticities are greater when
quality information is provided.12,13 However when pursuing these policies it is important to
distinguish between high prices due purely to a lack of competition or search and high prices
that reflect patents and an associated incentive for innovation.
Issue 2: Externalities
The demand curve posited in the standard economic analysis of moral hazard typically does
not reflect externalities that suggest optimal coverage should exceed the level that would be
consumed in the absence of insurance. A classic case of externality is infectious diseases; in
this case the use of health care services can improve health for other members of society.
This is the case for situations such as vaccinations. This would decrease the long-term risk
exposure for the individual that comes in the form of the risk of becoming ill and the risk of
having one’s risk change and decrease the risk to society of having more high risk
Issue 3: Flaws in decision making
The demand curve depicted in Figure 1, and relevant for welfare analysis, assume rational,
fully informed, decision makers. Yet a growing body of research identifies many reasons
why individuals may not make choices in their best interest. In some cases the explanations
are simple, such as a lack of information or understanding of the consequences of different
treatment decisions. This includes distortions in consumption due to imperfect agency. It
also includes a range of cognitive explanations related to the inability of individuals to
process complex information or manages their medical care in an environment with many
In other cases the explanations are more complex, such as hyperbolic discounting, in which
patients do not internalize future events in an optimal manner. Similarly, individuals may
have difficulty appropriately responding to uncertainty in settings where the consequences of
their actions, or inaction, maybe to some extent random. For example, failure to take
cholesterol medication does not guarantee a heart attack, but in increases the likelihood of a
Whatever the reasons, considerable evidence suggests that individuals often fail to utilize
medical services that are proven to be effective and to offer large benefits relative to the
costs.5,14-1516171819 This underutilization can occur at any number of points in the process of
providing appropriate medical care. Underutilization can occur in the management of an
ongoing condition like hypertension, diabetes, or heart disease. For example, patients with
diabetes and high blood pressure should take their glucose control medications and blood
pressure medications. Patients that have had a heart attack and have high cholesterol
should take their cholesterol medication. Patients that have had a heart attack should take a
beta-blocker. While it is true that in some cases these conditions can be managed with
lifestyle changes, evidence suggests that a substantial number of patients are not effectively
managing their disease. Similarly, many screening and prevention services are considered to
provide exceptional value. These could be simple screening for cancer, like mammography,
or the utilization of vaccinations (like influenza vacation for older adults or any portion of the
Some of this underutilization can be attributed to the physician behavior as the physicians
clearly have control over what type of care is used in some situations (e.g. prescriptions).
However, in many cases the cause of underutilization may be more a problem with the
Over the past decade, initiatives designed to improve the quality of care received have
identified these high value services. Often they are incorporated into quality measures used
to evaluate physician or health plan performance. In other cases they are used as the basis
for reimbursement schemes such as ‘pay-for-performance’. In still other cases these
services are targeted by the growing array of disease management programs designed to
encourage use of these services. The disease management interventions use a range of
information interventions to increase use of these highly effective services. When an
individual does not manage their disease or utilize appropriate screening or prevention
services it is assumed that they have made a poor decision that needs remedy. Often
considerable resources are devoted to improving the decisions.
The common thread underlying all of these quality initiatives is that the demand for these
services ‘should’ be highly inelastic. If we accept these clinical perspectives, then in these
situations there cannot be welfare diminishing moral hazard. Over-consumption is not
possible. To the extent that financial barriers contribute to the underconsumption of these
services, moral hazard can be beneficial.
In fact, although there are many reasons for underconsumption of highly valuable services,
as noted above, considerable evidence suggests that financial barriers are a part of the
explanation. Evidence suggests that when faced with higher cost sharing requirements
individuals reduce utilization of high value and low value services in similar proportions.20,21
Individuals with chronic disease are less likely to take there medications if they face a higher
price. 22-2324 Conversely, individuals are more likely to take their medications when copays
are lowered, even if they already are subject to disease management programs. Similarly
patients are less likely to receive cancer screening services.25 Higher copayments reduce
the likelihood individuals will comply with commonly accepted quality metrics.26 The impact
is greater for low income individuals.27 Evidence suggests that these decisions may lead to
adverse clinical outcomes.28 Because of the potential to reduce adverse events, in some
cases reduced cost sharing requirement may actually save money.29
The beneficial moral hazard in these cases is depicted in Figure 3. Specifically, we have
now drawn a perfectly inelastic demand curve to represent the prefect information demand
curve. Consumption should be at quantity F. The misinformed demand curve generates
actual consumption at point A if the individual is uninsured. The welfare loss in this case is
captured by ADF. Insurance increases consumption to point B, which yields less welfare
loss (BCF) because it reduces underconsumption. Moral hazard is beneficial because it
helps move people to the efficient level of consumption.
Distributional issues with increasing moral hazard
Before addressing the one issue that is specific to distributional considerations, it is worth
noting that two of the efficiency issues also have distributional implications. First, although
beneficial moral hazard may improve the aggregate economic efficiency of the system and
counter market power, financing the additional spending may be a cause for concern.
Specifically, even if insurance charged consumers the social marginal cost, so that
consumption with insurance was socially efficient, the increased consumption would entail a
potentially large transfer to providers who were charging prices above marginal cost. That
transfer does not represent a loss of aggregate welfare, but creates distributional issues
because consumers (or taxpayers) are transferring money to providers. With public financed
insurance there may also be associated inefficiencies associated with taxation necessary to
fund the transfer.
Second, related to externalities, as a society we care about the health of others. Disutility
associated with poor health outcomes extends beyond the individual. Public health
programs and the existence of safety net providers reflect these values. Since others in
society care about individuals but individuals’ decisions are based only on their own benefit,
individuals without coverage may underconsume care. In these cases, the additional care
associated moral hazard may move consumption closer to the efficient level and thereby be
An issue specific to distributional concerns is income transfers, although in the case of health
insurance it has been described as a matter of transferring income to oneself from a healthy
state to a sick state. The welfare analysis of the standard economic model is often
presented using the observed demand curve. This demand curve represents the change in
consumption due to a change in price. Economic theory identifies two reasons why
consumption rises when price falls. The first reason is that consumers substitute towards the
commodity whose relative price has fallen, in this case the relevant commodity is health care.
This is labeled the substitution effect. The second reason is that, with lower prices,
consumers are effectively wealthier. They can consume more of everything. This latter
effect is labeled the income effect.
Welfare analysis considers only the substitution effect a distortion because only the
substitution effect captures the impact of distorted relative prices. If insurance simply gave
beneficiaries a fixed payment when they became ill, but did not distort relative prices, there
would be an income effect, but no substitution effect. Hence there would be no welfare loss
associated with additional consumption.
One important aspect of health insurance is that it allows individuals to purchase care they
would otherwise not be able to afford (or finance through loans). This is essentially an
income transfer from individuals when they are healthy to themselves if and when they
become sick. Healthy individuals recognize that if they become ill they may need more
money. This additional purchasing power leads to welfare improvements as long as the care
that is purchased as a result would be purchased if the individuals were to face undistorted
Extensive analysis of this issue by John Nyman has demonstrated the welfare enhancing
aspect of the income transfer portion of moral hazard.30,31 In that analysis, the efficient level
of consumption is not the amount an uninsured person would consume if they became ill, but
instead the amount an insured person would consume if the insurance transferred the
optimal amount of income but did not distort prices. This level of consumption would be
greater than point A in Figure 1.
As in the discussion of beneficial moral hazard that mitigates market power, the portion of
moral hazard that moves consumption to the efficient level given optimal income transfer is
beneficial moral hazard. To the extent that insurance distorts prices, some traditional
detrimental moral hazard remains. Nyman estimates that accounting for this effect would
reduce estimates of detrimental moral hazard substantially and could be used to justify a
national health insurance policy.32
Balancing beneficial and detrimental moral hazard
As noted, a standard economic marginal comparison argues that the economically efficient
coinsurance rate is the rate that balances the marginal welfare loss associated with moral
hazard with the marginal social benefit of mitigating the financial risk associated with illness.
The preceding analysis suggests that in some cases moral hazard may be beneficial, or offer
a second best solution in light of the fact that there are distortions in the market that prevent
ever achieving maximum economic efficiency. The challenge for those designing benefits is
to design insurance packages that mitigate detrimental moral hazard but permit beneficial
moral hazard. At present, many individuals may have less coverage than is efficient,
particularly for high value services. This situation may worsen as cost containment efforts
include movement to high deductible plans that offer less coverage. While high deductible
plans are supposed to maintain undistorted relative prices when a consumer spends little on
medical care, evidence that consumers are often unable to make decisions consistent with
the utilization of appropriate, effective, high value care suggests that these supposedly
appropriate incentives may lead to significant decreases in health.
To date, the changes in coinsurance rates have been used as a fairly blunt tool, with few
distinctions made across services that offer different value. Coinsurance may be used more
effectively if it were used as a more finely tuned tool. For example, Fendrick and Chernew
argue for a system of value based insurance design (VBID), in which cost sharing is
designed to encourage use of high value services and discourage use of less valuable
With the availability of more sophisticated health information technology, it is increasingly
possible to design benefit packages that provide different levels of coverage for different
services and even for different subsets of the population. Accordingly, a number of
employers have adopted VBID programs, lowering copayments for services deemed to be
high value,34 although the adoption of such plans has been limited so far.35 In some cases,
such the University of Michigan’s Focus on Diabetes initiative, copayment reductions have
been targeted to patients with specific diseases.
The merits of such VBID benefit packages depend on the welfare gain associated with
exploiting beneficial moral hazard, relative to the costs of designing, implementing, and
maintaining such programs. The costs of other mechanisms that could be used to limit or
encourage utilization may be substantially higher as they require significant amounts of
labor—either to manage utilization or to encourage utilization through disease management
Economic analyses have traditionally considered moral hazard to be a cause for concern.
Consumer oriented cost containment strategies are commonly based on the premise that
higher cost sharing will reduce utilization, which will mitigate moral hazard and thereby
enhance welfare. Our analysis suggests that for several reasons moral hazard may be
beneficial. For example, moral hazard can mitigate underutilization due to market power. It
can facilitate efficient income transfer, encourage increased utilization to mitigate negative
externalities and increase in positive externalities, and offset the detrimental effects of poor
decision making that leads to underconsumption.
Both detrimental and beneficial moral hazard will result in higher expenditures, Yet, the
objective function is usually specified as improving net social welfare rather than simply
saving money. In this context, greater coverage and the associated moral hazard can be a
useful tool. More generous coverage, in targeted cases, may be warranted and may bring
about increases in utilization that are worth more to society than the additional expenditures
that are incurred.
The discussion throughout this paper supports the notion that there is nothing inherently
immoral or amoral about the concept of moral hazard from health insurance, supporting an
argument first put forth by Mark Pauly in 1968. Instead, there are simply a combination of
effects that lead to higher medical care expenditures and effects that lead to improvements in
welfare that must be considered as tradeoffs when increasing the level of coverage for any
service and for any segment of the population. The idea that we have provided overly
generous levels of protection against potentially high and potentially unpredictable medical
care expenditures deserves reconsideration in general and specifically with respect to the
notion that providing coverage to those without insurance at present will decrease welfare in
the United States. The potential existence of a second best solution that involves greater
amounts of coverage requires careful scrutiny.
The discussion in this paper has been limited in several ways. It has focused on expanding
the economic arguments about increasing coverage and not on several elements of a more
general policy debate. The policy discussion must include attention to distributional issues of
who pays for care as well as the more narrow question of whether aggregate welfare
improves. In these discussions, perspective matters. Expanding public or private coverage,
including VBID programs, will typically cost more from the perspective of the payer than from
the societal perspective because the payer pays for both the increased use (which is the
societal cost) as well as a greater share of the use that is already occurring (which, from the
societal perspective, is only a transfer). The decision by Medicare to cover influenza
vaccinations presents a classic example. Even before Medicare began to cover the service
in the early 1990’s, nearly half of the older adult Medicare enrollees were already obtaining
influenza vaccinations each year. In the time since Medicare began coverage, the
vaccination rate has risen. Medicare has paid not only for the increased vaccinations, but
they also paid more for the vaccinations that would have occurred anyway.
Other issues that lead to inefficiencies in the provision and financing of health care also were
not discussed. These include the fragmentation of the health care system (i.e. a lack of
integration between providers creates inefficiencies in production of care, arising from
problems such as incomplete transmission of information and inability of any one provider to
capture all the rents from better care), the fragmentation of the health care financing system
(i.e. competitive insurance products so that no one insurer will necessarily enjoy the long-
term benefits of prevention and so that insurers use considerable resources to compete on
product differentiation), and the potential for deadweight loss from specific financing options
(particularly options that use taxes to collect resources to finance health care). The last of
these cannot be resolved with any changes to policy that are likely be considered. A
completely free market for health care and health insurance is never going to be allowed in
the United States. Deadweight loss will accompany any third party financing mechanism
that involves taxes or that involves a single source of health insurance. Other market
inefficiencies can be subject to policy changes—although some options may be more or less
likely. For example, a single payer system will allow the payer to obtain many of the benefits
of prevention and high quality care that occur over time and that are less likely to be captured
by any payer in a fragmented third party payer system.
While the safety net is not necessarily a market inefficiency, the fact that the United States
policy system chooses to provide a safety net allows individuals to make choices about
insurance that are not necessarily consistent with utility maximization in a setting that did not
involve a safety net. It also provides a level of economic well being against which any choice
to change policy must be compared. The safety net is neither necessarily high quality nor
particularly efficient but it must be acknowledged in the discussion of potential alternative
policies for insurance of individuals who are uninsured at present.
Of course more sophisticated cost sharing is not a panacea for what ails our health care
system. Supply side interventions such as provider payment reform and organizational
changes are likely necessary and demand side interventions unrelated to cost sharing (such
as information interventions) are likely valuable. What is clear is that traditional models, that
ignore the heterogeneity in the effect of moral hazard, are limited and do not provide a
complete picture that is necessary for welfare analysis.
The discussion in this paper can contribute to the debate about universal coverage by
encouraging a reexamination of the premise that greater coverage leads to welfare loss. In
some cases, not surprisingly in light of the theory of the second best, greater coverage can
improve efficiency. Thus a more nuanced view of cost sharing is needed. More
sophisticated benefit packages that recognize the heterogeneity in value and welfare loss
across services and populations may address the need for cost containment, while
encouraging access to the high value services that motivate many proponents of universal
Figure 1: Welfare Loss
Figure 2: Beneficial moral hazard with market power
Price faced by
Social Marginal cost
Figure 3: Beneficial moral hazard with misinformation
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