John Nyman and the Economics of Health Care Moral Hazard

Abstract

In 2003, John Nyman published
The Theory of Demand for Health Insurance
. His principal contributions are (1) to replace the previously unexamined axiom of risk avoidance with the axiom of welfare maximization; (2) to uncover a misinterpretation in the literature on moral hazard, namely, the insurance payoff as a price reduction, rather than as an income transfer. The immediate consequence of these reformulations is to recognize insurance-induced health care utilization as resulting in an increase in social welfare. Despite its evident validity and enormous implications, Nyman’s work has received very little attention or recognition in the health economics literature.

Full text

Hindawi Publishing Corporation
ISRN Economics
Volume 2013, Article ID 603973, 8pages
http://dx.doi.org/10.1155/2013/603973
Review Article
John Nyman and the Economics of Health Care Moral Hazard
Sander Kelman1and Albert Woodward2
11500 Sawyer Avenue, Manasquan, NJ 08736, USA
2CBHSQ, SAMHSA, US Department of Health and Human Services, 1 Choke Cherry Road, Rockville, MD 20050, USA
Correspondence should be addressed to Sander Kelman; sanderkelman@gmail.com
Received 30 September 2012; Accepted 5 December 2012
AcademicEditors:M.J.Larson,I.Shoji,andJ.Zarnikau
Copyright © 2013 S. Kelman and A. Woodward. is is an open access article distributed under the Creative Commons Attribution
License, which permits unrestricted use, distribution, and reproduction in any medium,provided the original work is properly cited.
In 2003, John Nyman published e eory of Demand for Health Insurance. His principal contributions are (1) to replace the
previously unexamined axiom of risk avoidance with the axiom of welfare maximization; (2) to uncover a misinterpretation in the
literature on moral hazard, namely, the insurance payo as a price reduction, rather than as an income transfer. e immediate
consequence of these reformulations is to recognize insurance-induced health care utilization as resulting in an increase in social
welfare. Despite its evident validity and enormous implications, Nyman’s work has received very little attention or recognition in
the health economics literature.
1. Introduction
Although it remains to be seen whether the US can bring
its per capita health care costs into line with other industrial
nations [1], the US, aer nearly 100 years of eort, passed
national health care legislation in 2010. e Aordable Care
Act, as it is widely known, passed with expectations of even-
tually bringing the nation close to a state of universal health
care coverage. e legislative and other debates leading up to
passagecoveredawiderangeoftopics,butoneimportant
concept—health care moral hazard—was never explicitly
encountered in the debate.
e absence of moral hazard in the debate appears to
be an aberration. For more than 40 years one of the central
tenets of health care economics has been the presumption
that universal coverage would induce a rather substantial
degree of moral hazard and therefore would reduce national
economic welfare correspondingly.
Among economists, these tenets are rooted analytically
in a framework known as welfare economics,theobjective
of which seeks the circumstances leading to improved or
maximized human welfare.enatureoftheframeworkand,
more pointedly, the manner in which that framework has
been mobilized to characterize the health insurance policy
payo results in a habitual conclusion that more insurance-
inducedhealthcareutilizationresultsinadeclineinhuman
welfare. Consistent with that result had been the omnipresent
policy caution that extensions of health insurance coverage to
the general population were to be avoided.
In 2003, John Nyman published e eory of Demand
for Health Insurance [2]thatuncoveredanumberofwhat
he argued to be critical errors in the way in which the
insurancepayohasbeenunderstoodthroughthelensof
welfare economics, and that the cumulative eect of these
errors has been to introduce a decided bias in the formulation
of health coverage policy. e book is slim by page count, but
momentous in its ndings and implications. His analysis is
stunning, with potentially revolutionary implications for the
scientic-economic basis of health care nance; yet, ten years
on,thereappearstobelittlenotice,proorcon,intheusual
professional locations. is paper attempts to elaborate and
inform that state of aairs.
Nyman’s book concerns itself with the formulation of
a coherent “theory of the demand1for health insurance.”
To the casual observer, this may appear to belabor the
obvious; in fact, what Nyman presents overturns decades
of questionable orthodoxy and brings economic theory into
coincidence with widespread lay American and professional
international thinking about health care nance and many
of the practices in all other developed countries. Moreover,
he does it without stepping outside the analytical norms of
traditional economics.

2ISRN Economics
Nyman’s book is not for everyone. Much of his argu-
ment proceeds in the language, geometry, and mathematics
of welfare economics, a particularly raried, but respected
subdiscipline within the canon of contemporary economics2.
Nyman’s conclusions, however, and particularly the implica-
tions of those conclusions are for everyone.
2. Background
Many in the US health care eld, including health economists,
have supported the idea of universal coverage. e tenets of
the professional discipline of health economics, however,
have not supported the notion of such coverage [3,4].
e modern professional economic argument on the
subject began with Arrow in 1963 [5]. Arrow’s argument
isbasedonthewidespreadandstrong3assumption that
consumers are averse to the risk of uncertain events4such
as unpredictable medical expenses. While this assumption
may appear to be self-evident, it means more in economic
parlance than the vernacular words connote. To economists,
risk aversion refers to the presumed tendency of people
to prefer the certainty of a fair insurance premium5to the
uncertainty of actuarially equivalent self-insurance (“going
naked”). Believing health insurance premiums at the time to
be largely fair, but observing a widespread lack of insurance
coverage, Arrow concluded that this was a notable instance of
market failure, a technical expression denoting the failure of
themarketplace,throughprivateincentives,tomakeavailable
goods and services which are demonstrably part of the
optimal,orwelfare maximizing, output of the economy or
otherwise revealed or understood to be highly meritorious
[6].
An important analytical challenge to Arrow’s argument
was introduced shortly thereaer by Pauly [7]. In it Pauly
argues that the lack of widely available insurance against most
health care costs may be for good and rational economic
reasons, not market failure. In particular, he points to moral
hazard, the curious coinage of insurance underwriters to
characterize the greater demand for services when covered
by insurance than when not covered. Pauly’s argument is
straightforward: (1) people covered by health insurance—
once the premium is paid—face much less expensive health
care services than do those in similar clinical circumstances,
but without insurance; (2) since it is less expensive, they
purchase more of it (“sliding down their demand curve”
for medical care services); (3) increased utilization leads, in
successive periods, to higher premiums, taxes, and foregone
wage increases to pay for it; and (4) the resulting increased
(premium) costs of coverage make insurance less attractive,
and, so goes Pauly’s argument, many people refrain from its
purchase6,7.
Whiletheforegoingargumentisadvancedtotakeexcep-
tion to Arrow’s nding of a market failure for health insurance
coverage, Pauly further argues that, given the presence of
moral hazard, any eort to extend health insurance coverage,
private or public, is likely to have the eect of reducing the
level of economic welfare across the population [7,page534].
More than anything, this questionable implication of Pauly’s
argument has resulted in the aversion of economists, and
especially health economists, to any signicant expansion of
health care coverage, referenced above.
Pauly views the insurance payo as an articial reduction
in price, resulting in an increase in purchase of medical care
services (and a reduction in the purchase of all other things),
and, from fairly settled welfare economic theory, this results in
an unambiguous decline in welfare8.
While somewhat obliquely stated in the original, it should
have been clear from Pauly’s original comment that this
argument was intended to apply only or primarily to the
relatively inexpensive and predictable elements of medical
care, “visits to a physician’s oce...dental care, eyeglasses or
drugs” [7,page535].In1983,herestatedthisqualicationand
persisted that, “the relevant theory, empirical evidence, and
policy analysis for moral hazard in the case of serious illness
have not been developed. is is one of the most serious
omissions in the current literature” [8]. Given the extent to
which moral hazard has dominated economist thinking on
health care nance—expensive as well as inexpensive—for
several decades, the neglect of this qualication is remarkable.
3. Implications and Consequences of
the Original Moral Hazard Argument
Feldstein [9] set the tone for much of the empirical research to
follow Pauly’s comment. In this 1973 study, Feldstein inferred
that,onthesubjectofAmericanhealthinsuranceofthetime,
the welfare losses resulting from moral hazard exceeded the
gains from risk avoidance (insurance coverage). To attenuate
this disturbing perception, he recommended raising the coin-
surance rate on health insurance to 66 percent. Over the next
several decades, many others replicated these inferences [10].
One other study worthy of note in this regard is the RAND
Health Insurance Experiment, conducted mostly during the
1980s [11].
Instead of merely a footnote qualifying Arrow’s paean
to universal coverage in favor of some form of catastrophic
coverage, Pauly’s comment launched a generation of pro-
fessional work purporting to document the loss in welfare
suered by American health care consumers as a result of
the tax exemption of employer-based insurance, rst- or
near-rst-dollar coverage (where it existed), and copayments
beneath the substantial level determined by some economists
to be “optimal” [10].Bythelate1970s,thisreasoningled,
among other things, to a policy posture of avoiding the
extension of public nancing of health insurance in favor of a
panoply of punitive, behavior modifying and micromanaging
measures to restrict this tendency to moral hazard:higher
deductibles and coinsurance, care management, prepayment,
gatekeepers, utilization review, voluntary and mandatory
second opinions, chronic disease management, and so forth,
all of which underlies much of the contemporary physician
displeasure with the health insurance system. Initially (in the
1970s and 80s) this emphasis was said to be erected in order
to insert discipline into the markets for health care services,
so that when some version of universal coverage came along,
it would not be wasted in welfare-reducing moral hazard [12].
Eventually, with the exception of one year during the Carter
and one or two during the Clinton administrations, there

ISRN Economics 3
was no serious progress until the Obama administration. is
islargelywherethemaincontoursofthetheoreticaland
empirical discourse remained until the past few years with
the publication of Nyman’s book and articles [13].
4. The Argument from Nyman
Nyman’sargumentcanberecapitulatedasfollows.
e present theory and analysis of the economics of
the demand for health insurance is encumbered by serious
anomalies and other diculties. What is needed is a new
formulation starting from rst principles, but without the
necessityofdeviatingfromanyofthefundamentalsof
modern welfare economics.
In particular, risk avoidance, the long-standing behavioral
assumption underlying the study of the demand for health
insurance, is both theoretically untenable and empirically
rejected.
Risk avoidance, as specied above, has formed the basis of
all discussions of the economics of the demand for any type
of insurance for nearly the past 60 years [14].
is axiom presumes that people purchase insurance
because they prefer the certain loss of paying the premium
to taking their chances with actuarially equivalent risky
outcomes (self-insurance). e degree to which people are
presumed risk averse is measured by the extent to which
they are willing to pay a premium that exceeds the sum of
actuarially equivalent, self-insurance outlays9.Butthismakes
no sense in the case of health insurance, argues Nyman,
since much of the high-end health care services normally
covered by health insurance policies are out of the reach
of most people’s self-insurance capabilities. If you cannot
aord to pay out of pocket for it, you are not buying health
insurance against it for risk-avoidance purposes. In other
words, if you cannot aord to pay the costs associated with the
unforeseen and expensive covered health care interventions,
then the premium for the policy covering those interventions
is not the actuarial equivalent of the nancial circumstances
you face. Your purchase behavior, in this situation, there-
fore, is not driven by what economists refer to as risk
avoidance10.
Additionally, argues Nyman, “the demand for insurance
has nothing to do with the demand for certainty, because
uncertainty exists with or without insurance. Even if the
consumer has insurance, the uncertainty is whether the
consumer will remain healthy and incur the loss of the
premium or become ill and receive an (insurance payment)”
[2, page 54], and even with the payment, it remains uncertain
whether the consumer’s health status will improve, with
obvious and serious economic and other implications.
Moreover, continues Nyman, empirically, all of the sci-
entic research to date on Prospect eory11 [15,16], which
extends to all aspects of economic chance taking, suggests
that people generally prefer uncertain losses to certain losses
of the same expected magnitude. ese consistent empirical
ndings cannot be consistent with an axiom that posits
a predictable preference for a certain loss over actuarially
equivalent uncertain losses, and where empirical ndings
regularly contradict prevailing theory, the theory ought to be
in question.
In place of the traditional risk avoidance formulation
of consumer motivation, Nyman substitutes the historically
prior and more general and familiar, “weaker,”premise,
namely, that consumers base their purchase decisions regard-
ing health insurance on their eort to maximize expected
utility12. is formulation has the added benet of rendering
the theory of the demand for health insurance consistent with
the theory of demand for everything else.
e second anomaly in the contemporary economics of
health insurance is the treatment of the insurance payo as a
reduction in price, leading to an increase in utilization.
Beginning with Pauly [7]alldiscussionsofhealthcare
moral hazard have adopted the surprisingly arbitrary con-
vention, as described above, that treats the insurance payo
as making the purchase of covered health care services by
insured persons as if those services are available to those
insured persons at substantially reduced prices (deductibles
and coinsurance). e problem with this is neither logical
inconsistency nor empirical contradiction as was the case
with risk avoidance.Inthiscasetheproblemisanerrorin
adducing the welfare implications of the insurance-induced
increase in utilization. e argument is as follows.
Fundamentally, argues Nyman, consumers demand
health insurance in order to obtain income transfers from
the insurance pool in the event of sickness.
Having discarded risk avoidance and using the weaker13
Bernoulli [17]welfare maximization premise, Nyman pos-
tulates that consumers attempt to maximize their utility
by purchasing health insurance, in order to have access to
income transfers, which are the payos from the insurance
pool in the event that they are sick. is enables them to
purchase needed, oen expensive, health care services that
they would never have been able to aord without insurance.
Normally in economic discourse, “aordability” refers to
discussions of purchases of which people with low incomes
cannot avail themselves; in this case the subject is health care
services which form the standard of care in treating many
serious conditions, services which are not aordable out of
pocket even by a signicant majority of the population.
ese services are the oen life-saving diagnostic and
therapeutic interventions: non-X-ray diagnostic radiology,
heart surger y, organ and bone-marrow transplants, therapeu-
tic radiology, chemotherapy, and many, many others. ese
interventions cost tens and even hundreds of thousands
of dollars for a single application and in most instances
would not be purchased were it not for widespread insurance
coverage14. ese are presumably the services about which
Pauly argued that the relevant theory, empirical evidence,
and policy analysis for moral hazard inthecaseofserious
illness had not been developed [8]. Arguably, Nyman’s new
formulation of the demand for health insurance oers a
plausible answer to Pauly’s honorably modest qualication of
his own work.
Given this new formulation of the demand for health
insurance, economic theory suggests that much of the
resulting increase in health care utilization represents an

4ISRN Economics
improvement in economic welfare, not the worsening that has
been argued for the past 40 years.
e immediate consequence of this shi in motivational
specication of the demand for health insurance brings with it
a major change in the economic implications of the insurance
payo. Nyman’s characterization of the insurance payo is
as the payment of a transitory income transfer to the insured
from the insurance pool. is results in the insured consumer
demanding more health care at every price than he/she had
previously (to the income transfer, not to the holding of
insurance). By the same long-standing welfare economics
invoked above, this increased demand from increased income
results in an unambiguous increase in utility or welfare.
By retaining the stronger risk-avoidance assumption and
thereby overlooking the likely unaordability of the sick-
ness outcome in the Friedman and Savage scenario [18],
economists from Pauly forward have been blinded to the
income transfers inherent in the insurance payo and have,
instead, viewed the insurance payo as merely reducing the
price at which health care services are available to members
of the insurance pool.
ey do not account in the theory for how the price
declines. But the insurance payo is as much a component
of transitory income [19] as are winnings at the gaming table.
Itwouldbediculttooverstateeitherthecentralityorthe
wrong headedness of both the risk aversion assumption and
the insurance payo/price reduction convention for deter-
mining the welfare implications of holding health insurance.
Nyman is not denying the presence of moral hazard—
the tendency to purchase more as prices decline. He is
diering with the prior formulation of the consumer demand
for health insurance, the characterization of the insurance
payo to sick insured individuals, and, therefore, the welfare
implications of greater insurance coverage.
Following on this reformulation, Nyman distinguishes
between ecient and inecient moral hazard.Eachisa
component of the total welfare eect of the measurable
increase in utilization resulting from increased insurance
coverage. Ecient moral hazard is that component of the
utilization increases attributable solely to the increase in
income the transfer aords. From well-developed welfare
theory, this results in an unambiguous increase in welfare.
Inecient moral hazard is that component of the increase
attributable to the fact that the utilization is purchased at
deductible and coinsurance rates, not full price. As reviewed
in Section 2,thislattercomponentresultsinanunambiguous
reduction in welfare.
While the theory in question is considerably more com-
plicated even than this discussion, it is not a distortion to
say that the moral hazard argument of the past 40 years, as
it has been applied to health insurance policy, contains an
error (or at least an unrecognized assumption) that is oen
the barb of introductory microeconomic course pedagogy—
the error of confusing a movement along a demand curve with
ashi in the demand schedule. More specically until Nyman,
economists have erred in interpreting the insurance-induced
increase in health care expenditure as a movement downward
along a given individual’s demand curve in response to the
appearance of a reduction in price. Instead, what Nyman sees
is an outward shi in the individual’s demand curve,resulting
from the income transfer originating in policy-holder pre-
mium payments. e “pivot point” of the two interpretations
is in the analytical choice between risk avoidance and welfare
maximization (see Friedman and Savage [18] versus Bernoulli
[17]), and the welfare implications of the two perspectives are
starkly dierent. According to the orthodox theory, based on
risk avoidance,allmoral hazard is inecient.
Indeed there is another respect in which the old
moral hazard argument is in theoretical default. Within
the presently-accepted welfare economic or general equilib-
rium framework, one can imagine people purchasing health
insurance on the basis of either risk avoidance or welfare
maximization. In either case, premium payments are made
into an insurance pool. Of the people making the payments,
some remain healthy throughout the term of the contract.
Others do not and, if covered, submit claims for needed
services; if approved, payments are made to insureds, eec-
tively increasing their income and purchasing power. As a
result, according to Nyman, the correct formulation of the
insurance payo is using the pool to transfer income from
allpremiumpayerstothosewhoareorbecomesickand
are covered and authorized for needed services; this transfer
is a form of transitory income [19]enablingthepurchaseof
otherwise unaordable services15.Welfareisunquestionably
increased16.
From the point of view of the traditional theory, however,
insureds are viewed, not as receiving an income transfer
from the pool, but rather facing prices signicantly beneath
market prices for covered health care services. Within this
(traditional) theory, the insurance pool ceases to be a part
of the theory. It disappears once the insurance premium is
paid. Under Nyman’s theory premium payments are made
tothepool,andincometransfersaremadefromthepoolto
qualifying insureds, which use it (only) to purchase covered
and authorized services. Providers, in turn, use the money
to pay suppliers, purchase equipment, hire labor, and so
forth. As theory, the reduced price formulation is seriously
truncated.
is is the crux of Nyman’s contribution—to extend
the Pauly formulation in favor of the more tenable and
theoretically consistent view that health insurance results in
a system of income transfers from the healthy to the sick,
and that these transfers oen result in net welfare increases.
Boldly put, in the face of nearly 40 years of economists
trumpeting the welfare-reducing eects of health insurance
coverage, Nyman insists, with arguably ample justication,
that the truth, on balance, is just the reverse.
Substantively, in place of the decried always inecient
moral hazard is the additional services purchased by insureds,
whichmostwouldneverhavebeenabletoaord,thepur-
chase of which, when sick, is the new, posited reason for the
purchase of the insurance. In light of Nyman’s contribution,
prior estimates of the welfare loss due to moral hazard
[9]havebeenseverelyoverstated.Nymanconcludesina
careful theoretical-empirical analysis [2,page98]thatonly31
percent of insurance-induced utilization is welfare decreasing
inecient moral hazard; whereas 69 percent is ecient moral

ISRN Economics 5
hazard, income increases aording people throughout most
of the Nation’s income distribution the ability to purchase
otherwise unaordable—and arguably eective—care.
Nyman’s preliminary empirical exploration suggests the
possibility, and even likelihood that valuing the total of
ecient and inecient moral hazard leads to signicantly
positive net social benets.
In an eort to provide an empirical illustration of these
ideas, Nyman cites [2, page 110–114] credible recent studies
which reveal a 25% increased risk of mortality among the
uninsured, ages 25–65, a valid estimate of the value of an
additional year of life within that age interval of $100,000,
and excess per capita health care expenditures among the
insured of this age group (relative to those uninsured) of
$976 (1996). Based on these estimates, if coverage were
to be extended to the 40 million uninsured in 1996, the
year to which the estimates apply (now in 2013, several
million greater) Americans’ one-year welfare increases from
improved mortality alone would be valued at $123 billion, and
welfare reductions due to the traditional (inecient) moral
hazard (ofpurchasinghealthcareatpricesbeneathitscostof
production) would be valued at $39 billion, with a one-year
net social benet of $84 billion “or a welfare gain from moral
hazard that is more than three times its cost” and over $2,000
per uninsured person.
Nyman discusses a variety of qualications in using these
numbers, but concludes that the $84 billion estimate is a very
conservative one for the narrow question he addresses. For
those who believe that a proper estimate of net social benets
should be an important contributor to policy selection, this is
an extremely important nding.
If the prior work of Pauly, Feldstein, Newhouse, Manning,
and others was actually an impediment to improved coverage,
then Nyman’s work, if it stands up, should remove that
impediment. e diculty of measuring the eects of moral
hazard, however, is a barrier to overcoming this impediment.
Moreover, should these formulations and ndings hold up
upon further investigation, Nyman, 40 years later, reinstates
Arrow’s original conclusion that serious gaps in coverage
strongly suggest an important instance of market failure.
Following on that, economists should then trumpet the con-
sequent economic desirability of increased social nancing
for the achievement of universal—but not necessarily rst
dollar—coverage against health care expenses. Should these
formulations and ndings hold up, we may expect these
new preferences to be revealed in future polling of health
economists.
5. Consequences and Implications
e rst corollary of Nyman’s work is that the welfare impli-
cations of moral hazard are now reversed. In the traditional
formulation, insurance is seen to reduce the price of medical
treatments leading to distortions in patterns of consumer
purchase that unambiguously reduce welfare. According to
Nyman’s formulation, insurance provides income transfers
from the insurance pool to sick insureds, enabling them to
avail themselves of expensive, standards of care not otherwise
aordable for serious illnesses. Because this increase in
income enables the insureds to increase their purchases
of medical treatments at each price level, this leads to
general increases in welfare17. Practical implications of this
include a need to rethink and recalculate optimal copayment
levels, income tax exemption on employment-based health
insurance, and optimal insurance policy design. Following on
that is the implication that greater coverage or elimination of
the uninsured is not only good politics in some circles, but it
is also good economics in any circles18.
A nal implication is the appearance that something
other than mere analytic discourse is involved in this discus-
sion of the past 40 years. In the US a unique coincidence
exists of rather parlous health care coverage and a rather
aggressive economic doctrine which, in eect, tends to justify
that stinginess. Neither exists to any signicant degree in
other advanced countries19 . ere is no suggestion here of
a vulgarly conceived conspiracy to suppress doctrines that
wouldhavetheeectofuniversalizinghealthcarecoverage.
What we have shown is that there is a serious scientic
question about the validity of the contemporary doctrine of
moral hazard, and that its popularity is greatest, nay, almost
uniquely held—in a country with the least generous health
care coverage, suggesting that the study of the doctrine of
moral hazard belongs not only in the eld of Economic
Science but also in that of the Sociology of Knowledge.
6. Response to the Argument
Despite what appears to be a major challenge, the response
to Nyman’s work by health economists appears to be one
of benign neglect followed by begrudging, albeit limited,
acceptance among some. Standard reviews of the book—
generally positive and summarizing Nyman’s work—have
appeared in four journals that can be considered peer-
reviewed, professional journals of economics, health care
policy, or insurance [20–23]. e book has not been reviewed
in some of the leading economic or health services journals
in which one would expect great interest, even if negative20.
Nyman’s theory has been the inspiration of a favorable article
in e New Yorker in August 2005 [24]21. It is explained in
at least two health economics textbooks that have achieved
several editions22,istaughtincollegeanduniversityhealth
economics or policy courses, and has spawned related theo-
reticalandempiricalwork[25,26].
e rst critical review concerning Nyman’s theory
appeared several years before his book’s publication.
Blomqvist [27], while directing an entire article in response
to an article by Nyman appearing earlier in the same journal
[13] embodying much of the argument in the book under
review, largely skirts the issues Nyman raises, damns with
faint praise, and otherwise dismisses the argument. A recent
article provides indirect empirical support of Nyman’s
measurement of ecient moral hazard by estimating that
inecient moral hazard does not contribute as much dead
weight loss to the economy as might be expected [28].
AnotherrecentarticlecitesNyman’sconceptofincome
transfer eect in unemployment insurance [29].

6ISRN Economics
On April 1, 2010, at a Book Forum at the American
Enterprise Institute, in Washington, DC, Mark Pauly
presented an overview of a book he had recently published
[30](http://www.aei.org/events/2010/04/01/emhealth-re-
form-without-side-eects-making-markets-work-for-indi-
vidual-health-insuranceem/), oering his views on health
care reform. ere were two discussants of Pauly’s book; the
rst was John Nyman. e moderator, in introducing Mr.
Nyman, said that “...he’s written quite extensively in the eld
of health policy, including challenging some of Mark’s earlier
theories of moral hazard...”towhichMr.Paulywasheard
to interject, “Well, we agree”. To this day, there has been no
published explanation of this comment of agreement.
Contrast the reception of Nyman’s work to the recent
resurrection of Arrow’s article [5]thatwaspublishedmore
than four decades ago. Arrow’s article provided the basis of a
special-issue tribute of the Journal of Health Politics, Policy,
and Law in 2001, with articles from many of the nation’s
leading health economists and a response by Arrow [31]. e
present paper attempts to call attention to how Nyman’s work
hasbeensooverlooked,whereasanarticle40yearsold—and
largely rejected within 5 years of publication—is the subject of
a captive journal issue. Arguably, John Nyman is no Kenneth
Arrow... at least not yet, and, certainly, Arrow is due his
tribute.
All of this is underscored by two recent presidential
addresses to leading economic groups. In his address to the
2006 meeting of the American Society of Health Economists,
Joseph Newhouse oers a retrospective on the tradeo
between moral hazard and risk avoidance since Zeckhauser
[14], though he also credits the earlier Arrow [5]andPauly
[7]. e content is brief and celebratory. No untoward ideas
are considered; neither Nyman nor his ideas are mentioned
or cited.
Martin Feldstein, in his address to the 2006 meeting
of the American Economic Association, oers a thoughtful,
undogmatic synthesis of his thinking aer 40 years study
of social insurance. Health insurance is treated only in
a 2-page section on Medicare, but not so short that the
analytical principles of risk avoidance and trading o risk
reduction against moral hazard could not be avowed. Again,
no contradictory ideas are acknowledged; neither Nyman nor
his ideas are cited.
erehasbeennoreviewanddiscussioninjournalsor
conferences as panel sessions, for example, of the American
Economics Association, Academy Health, or Health Services
Research. is lack of a full debate subsequent to the book’s
publication raises several questions. Why has not there been
more notice of the work and its implications for health
policy? Why have not the health policy and health economics
annual meetings, journals, and other publications presented
ordebatedthework?Ifitiswrong,itshouldbechallenged
in the usual arenas of scholarly debate. If the burden of
opinion aer open debate is that the work is found want-
ing, then it should be dismissed. Surely, standard scholarly
practice is to engage the argument and see where the dust
settles.
e response of the leadership of the eld perhaps can
be best understood within the sociology of knowledge that
explains changes in science [32]. Half a century ago Kuhn
introduced a new way of thinking about these changes, which
is called the theory of scientic revolutions [33]. Nyman’s
theory does not appear to t within the widely understood
notion of Kuhn’s scientic revolution. Kuhn’s notion views
the various scientic disciplines as based on fundamental
ideas and assumptions. At critical points in the development
of the disciplines some of those ideas or assumptions are
thought, generally by newer practitioners of the eld, to be in
some types of theoretical or empirical errors. Even in those
cases where the new ideas are revealed to be superior to
what they are challenging, the process of its adoption is oen
protracted.
Clearly Nyman is not in any way challenging the fun-
damentals of welfare economics,thoughthatcompartment
of the larger economic enterprise has taken its licks over
the years. On the other hand, the Friedman-Savage (risk
aversion) formulation of the demand for insurance has been
settled economic doctrine for more than 5 0 years, and Nyman
pointsoutthatitisinapplicabletothecircumstancesofhealth
insurance coverage anywhere. Premiums paid for health
insurance policies for the majority of the population are not
the actuarial equivalent of what they would be paying where
they are uninsured. As such the theory is seriously awed.
As a result the insurance payo has been misinterpreted as a
reduction in the price of the covered services rather than as an
income transfer from the insurance fund to the sick insured.
ewelfareimplications,asdiscussedpreviously,arereversed
with major policy implications.
Nyman’s reinterpretation of the insurance payo clearly
presents a challenge to the health care moral hazard anal-
ysis that has been a fundamental element of health eco-
nomics doctrine for almost 50 years. And as in other elds
and sciences, the withdrawal of previously dominant, now
awed ideas from scientic discourse is indeed a protracted
process.
7. Conclusions and Reflections
JohnNymanhas,inasense,“revolutionized”theeconomic
theory of the demand for health insurance [25]. His principal
contributions are (1) to replace the previously unexamined—
and awed—axiom of risk avoidance with that of welfare
maximization; (2) to uncover a serious error or misinterpre-
tation in the literature on moral hazard, namely, the practice
of his predecessors to characterize the insurance payo as
a price reduction, rather than as an income transfer (and a
lesser price reduction). e immediate consequence of these
reformulations is to recognize insurance-induced health care
utilization as, on balance, resulting in an increase in social
welfare,not,asarguedbyothersforthepast40years,an
unambiguous reduction in welfare.
Acknowledgment
e views expressed in the article are solely the authors’ view
andnottheUSDepartmentofHealthandHumanServices.

ISRN Economics 7
Endnotes
1. Perhapsthemostdeceptiveistheterm,“demand,”
which, in ordinary parlance suggests an “unyielding
insistence,” but in economic parlance indicates merely
the consumer’s placid willingness to purchase certain
quantities of a given commodity at various prices.
roughout this text, the expression “demand for health
insurance” has no connection to legislative passage of
extended or universal health insurance coverage. e
analytical issues discussed have enormous implications
for such policy issues.
2. For a more accessible version, see [11].
3. We use the terms strong and weak in this discussion in
the philosophic logical sense of narrow or restrictive and
broad or enabling, respectively.
4. Traditionally, risk and uncertainty have been used in
technical economic discussions to connote distinct ideas
about the unknown future. Risk was used to connote
circumstances in which the range of outcomes, and
their probabilities were “known”; uncertainty,when
neither was “known.” In this discussion, as with the
preponderance of the literature on this subject, the two
terms are used interchangeably.
5. at is, a premium equal to the value of expected health
care outlays faced and insured against.
6. ere is a considerable level of disingenuousness in
this argument and all of the related subsequent work.
e clear implication of Pauly’s discussion is that there
but for moral hazard virtually all Americans would be
covered by lower cost health insurance coverage. Aside
from the problem of determining the portion of the
growth in per capita health care costs of the past 40
years attributable to moral hazard and that portion to
demographic and technological changes and the general
level of ination, it seems rather clear that most of today’s
60 million uninsured and seriously underinsured cannot
aord health insurance because of the cost relative to
their income, independent of the premium elevation
resulting from moral hazard.
7. In fairness, Arrow did note the troubling presence of
moral hazard and the need for copayments to control
them,but,untilPauly’scomment,didnotsuggestthe
possibility that insurance-induced overconsumption,
rather than market failure mightberesponsibleforlarge
gaps in coverage.
8. Briey, the reason argued for the theoretical decline
in welfare is due to a distortion in the prices faced by
insured persons. Because insured persons face prices for
insured medical care that is well below the market prices
forthoseservices,theypurchasemuchmoreofitthan
they would if they faced market prices and much less
of other commodities, the prices of which are largely
unchanged. According to this theory, consumers are
presumed to purchase goods and services in amounts
that are driven by the equalization of price ratios to the
corresponding ratios of gratication intensity from the
commodities in question. But because the prices faced by
insured persons are not market prices, they are actually
obtaining lesser levels of welfare than if everyone faced
market prices.
9. is excess normally would be due to such things
as inaccurately high actuarial claims estimates and
insurance company administrative expenses, such as
advertising, claims processing, and prot taking.
10. Indeed,thoughthisisnotpartofNyman’sargument,
most holders of autoinsurance would never be able to
cover out of pocket, or even borrow to nance, many
of the costs of autoaccident liability events (and it is
therefore, interestingly, obligatory); the same holds for
small-owner business property coverage.
11. For which Daniel Kahneman, a psychologist, was
awarded the Nobel Prize in Economic Science in 2002.
12. In a poignant but awkward hesitation, Arrow, coawarded
the Nobel Prize in Economic Science in 1972 (the fourth
yearoftheaward),beginshisdiscussionof“eeory
of Ideal Insurance” by stating that “e expected-utility
hypothesis, due originally to Daniel Bernoulli [17], is
plausible and is the most analytically manageable of all
hypotheses that have been proposed to explain behavior
under uncertainty. In any case, the results to follow
probably would not be signicantly aected by moving
to another mode of analysis. It is further assumed that
individuals are normally risk averters.”
1 3 .  a t i s , “ b r o a d e r,” “ m o r e i n c l u s i v e ,” a n d “ l e s s r e s t r i c t i v e ”.
14. is is not to suggest that all health care utilization, apr`
es
Nyman, is ecient and appropriate. It is only to caution
that what excesses do exist—and they are enormous
in the US—is not a simple matter of price-reducing
insurance.
15. Strictly speaking, this is not the usual textbook increase
in income, since it can only be used to purchase covered
health care services, not from the usual, broad panoply
of consumer commodities. Yet, it is certainly a form of
income, and it does enable the consumer to purchase
more than without this transfer, and the consumer’s wel-
fare is arguably greater—where the ecient outweighs
the inecient component—than in the absence of the
coverage and the services this transfer aords.
16. Even within this new framework for understanding the
insurance payo, the old inecient moral hazard is still
present, but a lesser portion of the welfare eect of the
utilization increase (see [2]).
17. Assuming that the absolute value of ecient moral
hazard exceeds that of inecient moral hazard.
18. Of course, everything is relative. Extending health care
coverage to all Americans still depends on the increased
benets, calculated according to the new metric, to be
greater than those benets that result from spending a
similar amount on other non-health areas of potential
benet.
19. Michel Grignon, Personal Communication.

8ISRN Economics
20. Journal of Health Economics, Health Economics, Euro-
pean Journal of Health Economics, and Journal of Risk and
Uncertainty,andtheAmerican Economic Review.
21. Ironically, even in e New Yorker, and by as notable
a writer as Malcolm Gladwell, none of Nyman’s actual
contributiontothepolicydiscussionisincludedinthe
article.
22. One text is Health Economics: theory, insights, and
industry studies, by Rexford Santerre and Stephen Neun,
published by South-Western/Cengage Learning, now in
its h edition. e other text is e Economics of Health
and Health Care, by Sherman Folland, Allen Goodman,
and Miron Stano, published by Prentice Hall, now in its
sixth edition.
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