Beneficial Moral Hazard and the Theory of the Second Best

By Frick, Kevin D.; Chernew, Michael E. | Inquiry, Summer 2009 | Go to article overview

Beneficial Moral Hazard and the Theory of the Second Best


Frick, Kevin D., Chernew, Michael E., Inquiry


This article examines the welfare consequences of moral hazard, and brings together several arguments suggesting that, in many cases, the additional consumption associated with health insurance could be welfare enhancing. Since conditions for maximum economic efficiency fail to hold in the market for medical care, the theory of the second best is useful. 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 that are associated with misinformation and result in the underutilization of many types of care. These arguments strengthen the case for expanding coverage.

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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, Pauly (1968) presented the seminal analysis of this phenomenon in 1968. 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, have devoted considerable attention to quantifying the changes in utilization and expenditures associated with greater coverage (Manning et al. 1987), and the results have been used to estimate changes in welfare (Feldman and Dowd 1991).

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 that are associated with misinformation and result in many types of care being underutilized. We also focus on one distributional reason: the idea that insurance can bring about desired income transfers between healthy and sick states of the world.

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The effects of the extra consumption on economic welfare is important for policy debates. Specifically, more than 46 million Americans lack health insurance coverage (Fronstin 2007). One consistently raised argument against expanding coverage is that the coverage will induce wasteful spending (e.g., create 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 uninsured people and on making insurance more generous for those who are in high-deductible or high-coinsurance plans.

This paper discusses: 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. …

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