Question

Economist disagree about the likely extent of moral hazard in the health care system. What are 2 arguments/evidence to suggest that moral hazard does exist? What are 2 arguments/evidence to suggest that moral hazard does not exist?

Answer 1

Moral hazard is a bit of a misnomer. There are no normative, morality-based elements to the economic sense of moral hazard. Instead, moral hazard means that a situation exists where one party has an incentive to use more resources than otherwise would have been used because another party bears the costs. The aggregate effect of moral hazard in any market is to restrict supply, raise prices and encourage overconsumption.

Moral hazard is often misunderstood or misrepresented in the health insurance industry. Many argue that health insurance itself is a moral hazard since it reduces the risks of pursuing an unhealthy lifestyle or other risky behavior.

This is only true if the costs to the customer, or the insurance premiums and deductibles, are the same for everyone. In a competitive market, however, insurance companies charge higher rates to riskier customers.

Moral hazard is largely removed when prices are allowed to reflect real information. The decisions to smoke cigarettes or go skydiving look different when it means premiums can increase from $50 per month to $500 per month.

Insurance underwriting is crucial for this very reason. Unfortunately, many regulations designed to promote fairness end up clouding this process. To compensate, insurance companies raise all rates

Restricting costs, mandating employer coverage and requiring minimum benefits further drive a wedge between the consumer and the real cost of health care. Premiums have predictably spiked since passage of the Act, consistent with economic theory about moral hazard.

Economists also viewed moral hazard negatively because, under the conventional theory, the additional health care spending generated by insurance represents a welfare loss to society. ¹When people become insured, insurance pays for their care. In economists’ view, insurance is reducing the price of care to zero. When the price is reduced in this way, consumers purchase more health care than they would have purchased at the normal market prices—this is the moral hazard. But because consumers purchase care when the price drops to zero that they would not have purchased at the market price, economists interpret this behavior as revealing that the value of this care to consumers is less than the market price. The additional care, however, is still costly to produce. The difference between the high cost of the resources devoted to producing this care (reflected in the high market price) and its low apparent value to insured consumers (reflected in the low insurance price) represents an inefficiency. Thus, health care spending increases with insurance, but the value of this care is less than its cost, generating an inefficiency that economists call the “moral-hazard welfare loss.”

Moral hazard is of economic interest because it creates an obstacle to the consumption-smoothing purpose of insurance. Insurance is valuable because it creates a vehicle for transferring consumption from (contingent) states with low marginal utility of income (e.g., when one is healthy) to states with high marginal utility of income (e.g., when one is sick). The first best insurance contract would equalize marginal utility across different states; the existence of moral hazard makes it infeasible to obtain the first best.

The existence, magnitude, and nature of the moral hazard response is thus a key input into the optimal design of private or public health insurance contracts. This is a natural reason for the study of moral hazard to attract the considerable theoretical and empirical attention that it has. However, moral hazard in health insurance has also attracted academic and policy interest for the potential it raises that higher consumer cost-sharing could help reduce the high—and rising—levels of healthcare spending as a share of GDP in most developed countries. This has prompted, for example, policy interest in high-deductible health insurance plans in the United States as a way of reducing aggregate healthcare spending levels. The majority of healthcare spending, however, is accounted for by a small share of high-cost individuals whose spending is largely in the “catastrophic” range where deductibles and co-payments no longer bind.