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.
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