Another interesting aspect of Arrow’s article is his view of the economics of information. He writes, “The value of information is frequently not known in any meaningful sense to the buyer; if, indeed, he knew enough to measure the value of information, he would know the information itself.” This quote reminded me of a similar insight from Austrian economist Israel Kirzner. This information problem, Arrow maintains, leads to market failure. He argues that we, as patients (buyers of medical care), don’t know enough to judge the experts (doctors) who provide it. Interestingly, though, he does not jump to the conclusion that the solution to this market failure is entirely governmental. He writes that the government is “usually implicitly or explicitly held to function as the agency which substitutes for the market’s failure.” He continues: “I am arguing here that in some circumstances other social institutions will step into the optimality gap.”
Particularly interesting is Arrow’s discussion of health insurance. He writes:
On a lifetime insurance basis, insurance against chronic illness makes sense, since this is both highly unpredictable and highly significant in costs. Among people who already have chronic illness, or symptoms which reliably indicate it, insurance in the strict sense is probably pointless.
He adds:
Hypothetically, insurance requires for its full social benefit a maximum possible discrimination of risks. Those in groups of higher incidence of illness should pay higher premiums.
Those quotes are simply sensible reasoning about insurance, and it is doubtful that Arrow was the first to come up with those ideas.
They are striking for a different reason, though: they completely undercut the case for laws against pricing insurance for pre-existing conditions, one of the key features of the ACA. That sensible reasoning was missing entirely from the arguments that proponents–and even many opponents–of the law made. Arrow also discusses the role of moral hazard in medical care: people with insurance have an incentive to use more medical care because the insurance company pays for most of it.
This is from my review of Moral Hazard in Health Insurance by Amy Finkelstein, with Kenneth J. Arrow, Jonathan Gruber, Joseph P. Newhouse, and Joseph E. Stiglitz. The review is the lead review in the Summer 2015 issue of Regulation.
An excerpt on Finkelstein’s essay:
Finkelstein builds her lecture around this latter insight. In particular, she discusses the two most famous health insurance experiments in U.S. history: the mid-1970s RAND HIE and the Oregon Medicaid experiment of 2008. Finkelstein distinguishes between two kinds of moral hazard that health insurance can give rise to: ex ante moral hazard and ex post moral hazard. Ex ante moral hazard occurs if someone, knowing he is insured, takes worse care of himself by, say, smoking, drinking excessively, or not exercising. Ex post moral hazard occurs if someone, knowing he is insured, uses more medical care because he does not pay the full cost. Finkelstein’s focus, like that of most other health economists who study the issue, is on the latter.
She finds strong evidence of ex post moral hazard in the Oregon experiment. Because of budget constraints, Oregon’s state government was unwilling to cover all people who were “financially but not categorically eligible for Medicaid.” Those people were financially eligible because their incomes put them below the poverty line, but categorically ineligible because they were able-bodied. The government held a lottery to choose 10,000 of those people–out of about 75,000 who applied–who would receive Medicaid coverage. She and other researchers then tracked the expenditures and health status of both the people who got Medicaid through the lottery and those who did not. They found, not surprisingly, that people who were spending “other people’s money” for health care spent more. Finkelstein writes: “Medicaid increases not only hospital admissions, as was just demonstrated, but also the probability of taking prescription drugs and of going to the doctor.” She concludes, “Medicaid increases annual medical spending by about 25 percent.” Interestingly, the main effect of the spending seems to have been on reducing depression rather than on improving physical health.
Finkelstein also argues that high-deductible insurance plans, which “were encouraged by the Health Savings Accounts Act of 2003,” are “theoretically optimal” when “there are risk-averse individuals and concerns about moral hazard.” She points out that this is an implication of Arrow’s 1963 article.
READER COMMENTS
ThomasH
Jun 22 2015 at 10:31pm
I would call using more health care because one’s insurance reduces the marginal cost a straight incentive effect, not a “moral” hazard. Getting sick, or not wearing seat belts because you have insurance is a moral hazard.
Also I think you miss the point that ACA was not solely aimed at a more efficient allocation of health care (it had little to do with health care although getting more people out of “employer provided” insurance and into exchanges ought to help a bit); it was an in kind income transfer. Given that, covering pre-existing conditions makes sense.
I agree that the 2003 plan if funded with partial tax credits rather than deductions could have been an alternative to an ACA type scheme.
Larry
Jun 22 2015 at 11:51pm
Prepaid health care is not the same as insurance. We have the former, not the latter. If we had insurance, the insurer who covered you in the year you were diagnosed with diabetes would pay all the bills not just that year but lifetime. Other than transition costs, there would be no preexisting conditions to underwrite.
David R. Henderson
Jun 23 2015 at 12:02am
@ThomasH,
I would call using more health care because one’s insurance reduces the marginal cost a straight incentive effect, not a “moral” hazard. Getting sick, or not wearing seat belts because you have insurance is a moral hazard.
That’s fine. No one has a monopoly on meaning. But you might want to read my review to see what I say about how Amy handles that.
Hazel Meade
Jun 23 2015 at 10:16am
Arrow also discusses the role of moral hazard in medical care: people with insurance have an incentive to use more medical care because the insurance company pays for most of it.
This assumes that the price of insurance won’t adjust to account for excess use. For instance, in the individual market the insurer could (at least prior to the ACA) raise your premiums to account for the average number of times you visited the doctor per year, and the costs of the sort of tests you were getting (i.e. precautionary cat scans). They wouldn’t necessarily always do this, but they COULD, and in theory your base premium cost would adjust to be in line with your average “routine” medical expenses.
However, with employer-based insurance, because every employee pays the same, people could be confident that their premiums wouldn’t depend directly on how much they used the insurance.
So this is really a moral hazard of group insurance specifically, not insurance in general. Note that this hazard continues to exist with community rated insurance. If you know that the burden is going to be spread out to everyone else’s premiums, you have an incentive to use more resources.
RPLong
Jun 23 2015 at 12:00pm
I’m not sure why using one’s insurance plan according to the rules of that plan is a moral hazard. Is increased consumption of health care goods and services morally wrong?
I can come up with a list of reasons why increased health care expenditures might place an economic burden on various stakeholders, but are we now suggesting that the purchase and consumption of goods and services is immoral if it raises costs and/or prices for other individuals in the marketplace? If so, can someone point to a market activity that does not have this kind of moral hazard?
Transfer payments cannot supply as much health care to recipients as they would otherwise choose to purchase if they had the money; and when they are given the money, they use it to purchase more health care. Is this immoral?
There is something disturbing about using moral language to discuss health care consumption. Some health care is for making sick people healthy, some is for making healthy people healthier, and some is for making uncurable people less miserable. Are we trying to make some of these categories morally impermissible? Which of these kinds of health care expenses is morally wrong?
I don’t mind debating whether the government should spend more money on health care or less, but that discussion should be about how much money the tax base can afford to spare, not about how much and which kind of health care consumption is “moral.”
David R. Henderson
Jun 23 2015 at 12:10pm
@Hazel Meade,
This assumes that the price of insurance won’t adjust to account for excess use.
No, it assumes that it’s insurance. If you cause your insurance company to spend an extra $1000 and it responds by raising your premium by $1000, this is not insurance.
I’m not sure why using one’s insurance plan according to the rules of that plan is a moral hazard. Is increased consumption of health care goods and services morally wrong?
No, it’s not. And there’s no necessary connection between moral hazard and morality. “Moral hazard” is simply a term from the insurance industry. Contrary to what appears, there’s no necessary moral connotation.
RPLong
Jun 23 2015 at 12:28pm
Prof. Henderson – You’re right, it looks like the term relates to the insurance industry in a way I didn’t realize. My mistake.
To make matters worse, some better Googling reveals that I may have been talking myself into a point that has already been made much more effectively by John Nyman.
Note to self: Read more, comment less. 🙂
Hazel Meade
Jun 23 2015 at 4:57pm
@David R. Henderson
If you cause your insurance company to spend an extra $1000 and it responds by raising your premium by $1000, this is not insurance.
Er. Yes, it is. It is REAL insurance. If you deliberately crash your car, first of all, that not an insurable event, and if you attempt to collect, it is fraud. If you CAUSE (as in deliberate action) your health insurance company to spend an extra $1000, they would be totally within their rights to raise your premiums to account for that.
Moreover, auto insurers regularly increase people’s premiums based on their accident history. If they covered regular maintainance, like health insurers do, then they would almost certainly charge people more who got maintainance more often than the manufacturers recommendation.
The premise of your statement assumes that people are making deliberate choices to consume more health care. In any other insurance market, nobody would insure that.
Comments are closed.