Question

Can taxing de merit goods solve moral hazard/adverse selection in the health care market?

what will this mean for allocative efficieny?

Explain your answer and use a model to explain what will happen to the market

Answer 1

Demerit goods are harmful to the individuals and to the society as a whole when consumed. They are perceived to be more feely available in a free market economy and hence the public authorities feel the need to restrict their consumption as they perceive that demerit goods can be over consumed and lead to mass addiction for those goods.

Cigarettes, tobacco based products, alcohol, Junk foods like fried food and so on are tempting to consume , easy to eat—since they are called fast foods—made easily and packed conveniently so that consumption becomes easier, are model examples for demerit goods.

The governments generally resort to taxing as a policy tool to restrict the consumption of demerit goods, although the elasticity of demand for such goods remains inelastic ( non responsive to price changes ) and hence tax revenue from such goods is consistent to the government , however, taxing decisions are taken in the larger interests of the society’s welfare rather than merely from the point of view of the government and its revenue sources.

It is a known fact that moral hazard or the generally observed behaviour of people who inspire of being insured are willing to take higher risks, this is especially found to be visible or experienced in the health care arena. A medical visit undertaken to get treated for a disease or an illness ( could be serious or trivial) implies that we have placed our health and thrust in the hands of an outsider whom we perceive knows much better or better still can diagnose the problem and state the solution as well as provide the means to solve it ( in the form of a treatment).

This is a classic case of moral hazard- here the medical visit proves that unless we are as such express ourselves as unable to take care of ourselves and hence need guidance and direction towards our welfare. If the medical visit where not in favour of our welfare , or the doctor is unable to diagnose or treat us efficiently, then it could lead to mis allocation of our resources.

In case of adverse selection , the buyer may not receive the complete information about the product or service. The information may be deliberately with held as to bring about a desired outcome as perceived by the seller, aimed to promote his own interest , not the buyer’s welfare. Lets say, there is some information regarding a health insurance scheme that has not been disclosed to the purchaser of a health insurance policy, since if such information is provided then the premiums might not be profitable for the insurance companies to operate. If in case the person is hospitalised then premiums for healthy policy holders to will rise, leading to such a situation that healthy policy holders may not be willing to come forward to take insurance policies. Such mass decisions will spell catastrophe for the insurance companies especially health insurance sector. This may lead to cave-in of markets , leading to mis allocation of resources.

In both these cases allocative efficiency is not achieved. Allocative efficiency is a situation where the costs of production take into account not only the private benefits and costs of the individual producer but also the benefits and costs to the community at large as a result of the production of goods and services.

Consumers in general are prone to information failure in the consumption of such goods and hence may be tempted to consume easily .This brings into discussion the morality of making such decisions. If the individual feels that the community is better informed that his or her personal knowledge then then the individual consumer will be guided by the community’s choices for various buying decisions.

In a perfectly competitive market allocative efficiency can be achieved:

Quantity(units)	Price($)	MC($)
10	10	2
20	10	4
30	10	6
40	10	8
50	10	10
60	10	12
70	10	14

In the above table , the price column shows the valuation placed by the consumer for the commodity or service, as long as P = MC the commodity or service can be produced, the ideal level of production for allocative efficiency to occur would be at 50 units of output where P=MC. At points above it the valuation placed by the consumer is more while at points below it the cost of producing it is more than the valuation placed by the consumer, thereby the producer does not benefit from further producing it.

This however does not always happen in an imperfect real world market where there are market failures and moral hazards. It should be noted that a perfectly competitive market is a mythical situation .