Moral Hazard in Health Insurance

103 Pages·2014·1.01 MB·English

by  Amy Finkelstein

MORAL HAZARD IN HEALTH
INSURANCE
KENNETH J. ARROW LECTURE SERIES
KENNETH J. ARROW LECTURE SERIES
Kenneth J. Arrow’s work has shaped the course of economics for the past sixty years so deeply that,
in a sense, every modern economist is his student. His ideas, style of research, and breadth of vision
have been a model for generations of the boldest, most creative, and most innovative economists. His
work has yielded such seminal theorems as general equilibrium, social choice, and endogenous
growth, proving that simple ideas have profound effects. The Kenneth J. Arrow Lecture Series,
supported by the Committee on Global Thought and the Program for Economic Research, highlights
economists, from Nobel laureates to groundbreaking younger scholars, whose work builds on
Arrow’s scholarship as well as his innovative spirit. The books in the series are an expansion of the
lectures that are held in Arrow’s honor at Columbia University.
Creating a Learning Society: A New Approach to Growth, Development, and Social
Progress, Joseph E. Stiglitz and Bruce C. Greenwald The Arrow Impossibility Theorem,
Eric Maskin and Amartya Sen Speculation, Trading, and Bubbles, José A. Scheinkman
MORAL HAZARD IN HEALTH
INSURANCE
AMY FINKELSTEIN
WITH
KENNETH J. ARROW,
JONATHAN GRUBER,
JOSEPH P. NEWHOUSE,
AND JOSEPH E. STIGLITZ
COLUMBIA UNIVERSITY PRESS | NEW YORK
Columbia University Press
Publishers Since 1893
New York Chichester, West Sussex
cup.columbia.edu
Copyright © 2015 Columbia University Press
All rights reserved
E-ISBN 978-0-231-53868-8
Library of Congress Cataloging-in-Publication Data
Finkelstein, Amy.
Moral hazard in health insurance / Amy Finkelstein.
pages cm. — (Kenneth J. Arrow lecture series)
Includes bibliographical references and index.
ISBN 978-0-231-16380-4 (cloth : alk. paper) —
ISBN 978-0-231-53868-8 (ebook)
1. Health insurance. 2. Moral hazard. 3. Risk (Insurance) I. Title.
HG9383.F56 2014
368.38’2—dc23
2014011303
A Columbia University Press E-book.
CUP would be pleased to hear about your reading experience with this e-book at [email protected].
Cover design: Noah Arlow
References to websites (URLs) were accurate at the time of writing. Neither the author nor Columbia
University Press is responsible for URLs that may have expired or changed since the manuscript was
prepared.
CONTENTS

Foreword by Joseph E. Stiglitz
INTRODUCTION
JOSEPH P. NEWHOUSE
MORAL HAZARD IN HEALTH INSURANCE: DEVELOPMENTS
SINCE ARROW (1963)
AMY FINKELSTEIN
COMMENTARY
JONATHAN GRUBER
COMMENTARY
KENNETH J. ARROW
COMMENTARY
JOSEPH E. STIGLITZ
DISCUSSION
ARROW (1963): UNCERTAINTY AND THE WELFARE ECONOMICS
OF MEDICAL CARE
KENNETH J. ARROW
Notes on Contributors
Index
FOREWORD
JOSEPH E. STIGLITZ

T
his book grew out of the fifth annual Kenneth J. Arrow Lecture that took
place in April 2012. This series honors one of Columbia’s most distinguished
graduates, Kenneth J. Arrow. Each year’s lecture focuses on the intellectual
developments that have arisen from one of his many seminal contributions to the
discipline. Over the past six years, the lecture series has covered a huge variety
of topics, just as Ken’s work has. The books in the Kenneth J. Arrow Lecture
Series are all based on one of these lectures.
The first lecture, which Bruce Greenwald and I delivered, followed up on
Ken’s 1962 paper on learning by doing.1 That lecture led to a book published in
2014 by Columbia University Press, Creating a Learning Society: A New
Approach to Growth, Development, and Social Progress.
The second Arrow lecture, by Nobel Prize winners Eric Maskin and Amartya
Sen,2 focused on Ken’s Ph.D. thesis, published as Social Choice and Individual
Values in 1951. Maskin and Sen’s lecture formed the basis of the second book in
the series, The Arrow Impossibility Theorem (2014). The third book,
Speculation, Trading, and Bubbles (2014), was based on a lecture by José A.
Scheinkman. Scheinkman considered Arrow’s fundamental work on general
equilibrium, where he introduced the concept of what is now called Arrow-
Debreu securities, revolutionizing thinking about financial markets.
The fourth lecture was on global warming, a subject about which Arrow has
felt passionately. He served with me on Working Group III of the 1995
Assessment of the International Panel on Climate Change (IPCC), and we wrote
a paper, together with several of our other colleagues in the working group, on
the effect of uncertainty on the appropriate rate of discounting, to take into
account the future costs of global warming.3 Sir Partha Dasgupta’s lecture,
“Persons and Time in the Welfare Economics of Climate Change,” further
pursued the question of the appropriate responses to the threat of global
warming. (The sixth Arrow lecture, delivered by Christian Gollier, also
considered the economics of discounting, and the books based on his lecture and
on Dasgupta’s are forthcoming.)
This volume presents the fifth annual Kenneth J. Arrow lecture, by Amy
Finkelstein, one of the country’s leading health economists and, like Ken, winner
of the John Bates Clark Award (Arrow received this honor in 1957; Finkelstein,
in 2012). It picks up on another classic Arrow paper, “Uncertainty and the
Welfare Economics of Medical Care,” published in 1963 (and reprinted in this
volume), in which he analyzed the implications of moral hazard—a concept that
had not yet entered into the mainstream economics literature—in the context of
health insurance. One of the reasons that the standard competitive model—the
formulation and analysis of which he himself had played such a pivotal role in—
did not provide a good description of the insurance market is moral hazard, the
fact that the provision of insurance attenuates incentives to avoid the insured-
against event.4 (Another is adverse selection. His 1965 Jahnsson lecture,
“Aspects of the Theory of Risk Bearing,” highlighted the importance of both of
these.) His 1963 paper was a seminal contribution both to the economics of
(health) insurance and to the theory of moral hazard. It launched two huge
bodies of literature. We were pleased that one of the major young contributors to
that literature accepted our invitation to deliver the fifth Arrow lecture.
The questions Ken raised are still front and center in one of today’s central
policy issues, the provision of health insurance. Prior to the passage of the
Affordable Care Act (commonly called Obamacare), more than 50 million5
Americans lacked health insurance. America’s poor health performance is
partially the result of this deficiency.
The talk provided an opportunity to connect some of these policy issues with
basic economic research.
Amy Finkelstein is Professor of Economics at MIT, Co-Director of the Public
Economics Program at the National Bureau of Economic Research, and Co-
Editor of the Journal of Public Economics, which I helped found many years
ago. Her research in public finance and health economics focuses on market
failures and government intervention in insurance markets and the impact of
public policy in the healthcare sector.
This volume includes not only Amy’s lecture but also the commentaries of its
discussants. The first is Jonathan Gruber, who is also a Professor of Economics
at MIT and Co-Director of the Healthcare Program at the National Bureau of
Economic Research. He has been involved in health economics for a very long
time and has won a number of awards for his work, including an Inaugural
Medal for Best Health Economist Age Forty and Under from the American
Society of Health Economists in 2006, and the National Institute for Health Care
Management Foundation Health Care Research Award in 2012. He has also
served as Deputy Assistant Secretary for Economic Policy at the Treasury
Department. He did important work on the Massachusetts Healthcare Reform,
which was the prototype for the Affordable Care Act.
I served as the second discussant.
Our third discussant is Ken Arrow himself. One of the wonderful aspects of
the Arrow Lecture is that Ken graciously agrees to comment on the talk, and that
is always an exciting moment, because it reflects both how he thought about the
problem many years ago and how thinking about these debates has evolved over
subsequent decades.
Joseph P. Newhouse has also graciously provided an introduction to this
volume, which provides context for the ensuing discussion. Newhouse was one
of the leaders of the famous RAND Health Insurance Experiment, and of the
landmark Oregon Health Insurance Experiment, which Amy discusses later in
this book. In 2014, he received the Victor R. Fuchs Lifetime Achievement
Award from the American Society of Health Economists, in recognition of his
pioneering work in the field.
I want to acknowledge Columbia University Press, the Program for Economic
Research, and the Committee on Global Thought for their support of the Arrow
Lecture Series, and Laura Morrison, Sasha de Vogel, and Robin Stephenson for
helping organize the event.
I also want to especially thank Ken for honoring us again with his attendance,
and Amy and Jon for sharing their work and thoughts.
1. Arrow, Kenneth J. “The economic implications of learning by doing.” The review of economic studies
(1962): 155–173.
2. Ken Arrow received the Nobel Prize in 1972; Amartya Sen, in 1998, and Erik Maskin, in 2007.
3. Published as Arrow, K. J., W. R. Cline, K. G. Mäler, M. Munasinghe, R. Squitieri, and J. E. Stiglitz,
1996: “Discounting.” In: Climatic Change 1995: Economic and Social Dimensions of Climate
Change, Second Assessment of the Intergovernmental Panel on Climate Change [Bruce, J. P., H.
Lee, and E. F. Haites (eds.)]. Cambridge University Press, Cambridge and New York, pp. 129–144.
4. An extreme form of moral hazard is that where the individual actually takes action to precipitate the
insured-against event.
5. See U.S. Census Bureau. “Income, Poverty, and Health Insurance Coverage in the United States:
2009,” Table 8, Issued in September 2010.
INTRODUCTION
JOSEPH P. NEWHOUSE

E
ach academic year, I teach the first session of a one-semester course in health
economics for second-year graduate students. The reading for that session
consists of two seminal works in health economics: Kenneth Arrow’s
“Uncertainty and the Welfare Economics of Medical Care” and Michael
Grossman’s The Demand for Health: A Theoretical and Empirical Investigation
(Arrow 1963; Grossman 1972).1 These two works have resulted in two largely
non-overlapping streams of the by-now vast health economics literature.
Arrow’s article led, somewhat belatedly, to a literature on the functioning of
markets for medical services and health insurance.2 Grossman’s book led to a
literature on determinants of the health status of the population, only one
determinant of which, as both Arrow and Grossman emphasized, is medical care.
The real-world context for Arrow’s 1963 article was the growing clinical
capabilities of medical care and the concomitant acceleration of medical care’s
claims on the economy’s resources.3 The economics context was general
equilibrium theory, which considered the existence and properties of competitive
equilibrium (Arrow and Debreu 1954). Among the stringent requirements for the
efficiency of competitive markets were the existence of a market for all
products, including markets for risk, and the availability of information about
costs and benefits. Arrow focused on the shortcomings of medical markets,
especially incomplete markets for risk bearing and the imperfect information
available to doctors, patients, and potential insurers.
Arrow emphasized that markets to insure all medical risks could not exist, in
part because what a consumer sought from visiting a physician was information
about the cause of a medical problem and its appropriate treatment. Because it
was practically impossible to enumerate all possible contingencies and a fixed
amount the policy would pay for each, an insurance contract specifying a payoff
could not exist. In other words, markets to insure against these risks did not
exist, and so an efficient outcome was unattainable. Furthermore, Arrow argued