Moral hazard: It's the supply side, stupid!

In 1963, Kenneth Arrow noted that many Americans lacked health insurance. He attributed this to market failures associated with incomplete and asymmetric information – market failures that public health insurance could correct. Five years later, Mark Pauly struck back. He argued that being uninsured might not stem from market failure. It could result, instead, from moral hazard. Insurance reduces the price the individual has to pay for care. The individual responds by using more care – a type of moral hazard. When this increases the actuarially fair premium above the maximum the individual is willing to pay, he remains uninsured. There will be a loss of economic value, Pauly argued, if the government provides insurance that costs more than uninsured individuals are wiling to pay for it. But Pauly didn’t stop there. He argued that economic value is lost whenever insurance causes individuals to use care whose production cost is higher than they would be willing to pay if they were uninsured. He recommended higher cost sharing, even for individuals willing to pay for comprehensive coverage. It took another 30 years, but in 1999, John Nyman challenged Pauly’s analysis. Pauly saw insurance as a mechanism to reduce the price the patient pays for care. But, Nyman argued, health insurance is better understood as a scheme to redistribute income from healthy individuals to sick ones. Pauly measured the value of care by the patient’s willingness to pay for it when uninsured. But the value should be measured by willingness to pay after the income transfer has taken place. From this standpoint, increases in deductibles and copays over the past few decades look like bad policy. Nyman is insightful about why people buy health insurance. However, he, like Pauly, understands moral hazard as a demand-side phenomenon. Yet there is no evidence that demand-side moral hazard is an important cause of America’s high health care costs relative to the other wealthy democracies. Instead, one of the most important issues is what might be termed, “supply-side” moral hazard. Third party payment removes the discipline that the demand curve would otherwise exercise over the prices charged by imperfectly competitive health care providers. Other wealthy democracies have responded to this problem with measures to regulate prices, an obvious solution to a serious problem that the United States has been reluctant to adopt.