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Application: Adverse selection and moral hazard in the finance and supply of health care


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Title: Application: Adverse selection and moral hazard in the finance and supply of health care

Application Adverse selection and moral hazard
in the finance and supply of health care
  • For you to be able to
  • Explain how problems of adverse selection arise
    in relation to health insurance. Explain how the
    problems associated with adverse selection in
    relation to health insurance can be resolved.
    Explain why equity issues may arise as a result
    of the solutions to adverse selection employed by
    private insurance providers. Explain how these
    equity issues can be addressed.
  • Explain how consumer and supplier moral hazard
    arises in the context of health care provision.
    Using examples, discuss how the problems
    associated with moral hazard in health care
    provision can be resolved.

Suggested background reading
  • Allen et al. 2009. Managerial Economics. Norton.
    Chapters 14-15
  • Kreps, D. M. 2004. Microeconomics for Managers.
    Norton Chapters 18-19 (16-17 provide more
  • Frank, R. H. 2008. Microeconomics and behaviour.
    McGraw Hill. Chapter 6
  • Wall,S., Minocha, S. and Rees, B. 2010.
    International Business, Pearson. Chapter 6
  • Grimes, P, Register, C. and Sharp, A. 2009.
    Economics of Social Issues, McGraw Hill. Chapter
  • Rasmusen, E. 2007. Games and Information,
    Blackwell. Chapters 7-9
  • And any introductory Health Economic text you can
    access e.g. Mooney, G., (2003) Economics,
    Medicine and Health Care, Dorset Prentice Hall

Sources of imperfect and asymmetric information
in health care markets
  • Health care finance Health care providers (e.g.
    insurers, government) are relatively uninformed
    about a clients health risk and health related
  • The doctor-patient relationship The
    consumer/patient is relatively uninformed about
    health care treatments but the health
    practitioner is relatively informed
  • Implies potential for moral hazard and adverse
    selection - particularly in private health
    insurance markets
  • Problems vary depending on system

Different health care systems
  • Pure market provision
  • Health care is like any other good and demand and
    supply respond efficiently to price - Embodies
    consumer sovereignty in a decentralised market
  • Private insurance based approach
  • Private Insurance (or no insurance) and minimal
    state control
  • Employer or individual based insurance plus
    private ownership of health care supply
  • The USA (although some publicly funded health as
    well Medicare, Medicaid)

Different health care systems
  • Public production, allocation and finance
  • Aim is improvement of health for the population
  • Health is a right and access is by need
  • Universal medical care
  • Public/tax financed - mostly free at point of
  • Earnings related social-insurance contributions
  • Tax funding plus public ownership/control of
    health care supply e.g. UK, Sweden, New Zealand
  • Mixed public/private involvement e.g. private
    provision but public finance
  • government tax-based subsidies to a privatised
    system or tax-based national insurance
  • Compulsory cover through tax system supplemented
    by tax funding plus some private sector
    involvement in supply of healthcare e.g. Canada,
  • Singapore (some government subsidy through

Horses for courses?
  • Different countries may not want the same things
    from their health care system
  • All have different advantages and disadvantages
  • The US system has short waits but the UK NHS is
    more equitable/accessible
  • Life expectancy is more or less the same
  • Women 80.4 in the UK, 79.8 in the USA
  • Men 75.7 in the UK, 74.4 in the USA

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Problems for all health systems
  • Cost containment Most countries (except the UK)
    have seen an escalation in health expenditure
  • E.g. 2002 USA medical spending as a of GDP was
    14.6 Canada 9.6 UK 7.7 France 9.7
  • (OECD Health Data,
  • Possible explanations
  • Availability of new and expensive technology
  • Third-party payment due to asymmetric information
    as well as uncertainty and risk

Adverse selection and moral hazard in health-care
  • Adverse selection due to imperfect information
    about individual risks
  • Consumer moral hazard as people can influence the
    probability of ill health
  • Producer/supplier moral hazard as doctors do not
    bear the costs of treatment

Adverse selection in private health insurance
  • Adverse selection arises from the information
    asymmetry about health risks between the
    insurance company and the insured person
  • Insurance company (principal) only knows average
    risk in a population
  • Individual (the agent) knows more about own
    health risk

Adverse selection in private health insurance
  • If insurance contracts/premiums based on average
    risk (community ratings)
  • only people of average or higher than average
    risk will buy the insurance - more than averagely
    healthy people will not buy expensive insurance
  • Implies adverse selection
  • puts the insurance companies at risk of paying
    out more than they receive
  • Negative impact on profits as premiums based on
    average risk not high risk of the people who
    actually buy the insurance.

Solutions for the insurance companies
  • Insurance companies use screening methods to
    identify high and low risk people e.g. base
    premium calculations on medical examinations,
    individual experience of ill-health, lifestyles
    (smoking, occupation) and other characteristics
    e.g. age, ethnicity, gender, wealth.
  • This can lead to premiums that are too high for
    many sick people (or those most at risk) to
  • Highest premiums unaffordable by poorer people
    but they are at the most risk so they are the
    people likely to be charged higher premiums
  • Implies rationing by price, income and risk
  • Some people unable to acquire private insurance
    because they are high risk and/or too poor

Rationing in a private market for health care
no excess supply/demand at the equilibrium price
but this does not mean everyone is covered
Uninsured demand due to rationing by price
Problematic side of private based system like the
one in the USA
  • Coverage problems
  • More than 20 of the US population are without
    health care coverage
  • Highest infant mortality rate of developed

Myths about the uninsured in the USA
Why, if at all, does it matter if poorer and/or
sicker people are not covered by health
insurance? If it does matter, what possible
solutions are there for this coverage problem?
Why access to health care matters
  • Poorer people are more likely to suffer from
    ill-health poverty as a cause of ill-health
  • The poor tend to be ill more often and more
    severely ill than the rich. They live shorter
    lives and are in poorer health while they are
  • A boy born in Hackney, next to Newham, is more
    than twice as likely to die in the first year of
    his life as a boy born in Bexley, in the
    south-east suburbs. Carvel, 2001
  • A strong relationship between health and economic
    status within and between countries
  • First and foremost there is a need to reduce
    greatly the burden of excess mortality and
    morbidity suffered by the poor WHO, 1999

2 way causality
  • The links between poverty and ill-health are not
    just one way
  • Ill-health can cause or worsen poverty
  • but if good health care reaches the poor, it can
    help to relieve poverty
  • Policy directed to health can therefore have
    positive economic implications for individuals
    and countries
  • Externality effects Ill-health leads to a
    decline in productivity and earnings

Why access to health care matters --equity issues
  • People are concerned about the health of others
    and inequalities in health more so than
    inequalities in income
  • A kind of externality - humanitarian overspill
  • Leads to general support of a health-care system
    that is redistributive or at least provides a
    safety net
  • Enabling people on low incomes to access more
    health-care than they could afford to buy in a
    competitive health care market
  • Gives a role of government in health-care

Why access to health care matters - global public
health issues
  • Externality effects of ill-health that extend
    beyond national borders
  • Transmission of diseases (e.g. HIV/AIDS,
    tuberculosis, malaria)
  • Heightened by travel but incidence and impact
    highest in Sub-Saharan Africa, Middle East and
  • Threat of bio-terrorism
  • The emergence of drug-resistant strains of
    disease e.g. tuberculosis, Malaria and leprosy

Social insurance as a policy solution to the
coverage problem
  • Potential for adverse selection in health care
    and related coverage problems weakened by public
  • AS and related coverage problem ? spread of
    compulsory/universal social insurance schemes in
  • Social insurance schemes enable risk pooling -
    the state insurse the uninsurable by compelling
    universal coverage
  • Reduces the risk of adverse selection
  • The state third party in the relationship
    between patients and health practitioners

  • Moral hazard in health care provision and finance
  • Consumer moral hazard
  • Supplier moral hazard

Consumer Moral Hazard
  • Consumer moral hazard arises because insurance
    (private and social) reduces the cost of
    consuming health care at the point of
  • As the cost of consumption falls, the cost of
    being ill is reduced
  • incentives to reduce the risk of falling ill are
  • people take risks with their health through
    health related (bad) behaviour
  • Smoking, driving recklessly, poor diet, less

Consumer Moral Hazard
  • Less personal investment in health implies higher
    consumption of health care than if there were no
  • Socially inefficient outcome
  • Higher costs for private (and public) health
    insurance companies lower profits (higher taxes)

Measures to counter consumer moral hazard
  1. Insurance based
  2. Insurance organisation based
  3. Non-price rationing (state provision)

1. Insurance based solutions
  • Co-payments, coinsurance and deductibles - The
    insured person pays some fraction of the cost of
    the procedure - out of pocket expenditures.
  • Co-payments flat rate charges (e.g.
  • Coinsurance ( share of total cost)
  • Deductibles (e.g. excesses)
  • Limitations Fixed maximum coverage schemes the
    financial exposure of the insurer is fixed.
  • E.g. life time coverage limited
  • The insured have an incentive to ensure that
    costs remain within the agreed value as excesses
    will have to be met by them.
  • Evidence from health insurance experiments have
    found that utilisation is reduced by some of
    these kinds of methods

Evidence relating to hospital use and different
payment schemes RAND Health Insurance Experiment
  • Randomized families to health insurance plans
    that varied cost sharing from none ("free care")
    to a catastrophic plan that approximated a large
    95 family co-insurance deductible (with a
    stop-loss limit of 1,000 in late-1970s dollars -
    scaled up for the low-income population).
  • The participants in the large-deductible plan (95
    percent coinsurance) used 25-30 percent fewer
    services than those in the free-care plan.
  • 23 percent less likely to be hospitalized in a
  • Substantial reductions in use were found among
    all income groups
  • But how did this impact on health?

Evidence relating to health status RAND Health
Insurance Experiment
  • For most people enrolled in the RAND experiment
    (mainly typical of Americans covered by
    employment-based insurance) the variation in use
    across the plans appeared to have minimal to no
    effects on health status.
  • But for those who were both poor and sick (might
    be covered by Medicaid or lacking insurance) the
    reduction in use was harmful.
  • E.g. Hypertension was less well controlled among
    that group, sufficiently so that the annual
    likelihood of death in that group rose
    approximately 10 percent.

Impact of the RAND Health Insurance Experiment
  • There is still a debate over the appropriate role
    for patient cost sharing whether any reduction
    in use induced by increased cost sharing was
    among "necessary" or "unnecessary" services and
    therefore whether it adversely affected health.

Alternative solutions to consumer moral hazard
Managed care agreements
  • Insurers enter into volume discount contracts
    with specific providers.
  • Insured must pay extra to use non-preferred
    providers e.g. US arrangements.
  • Managed Care Plans (Health maintenance
    organisations, HMOs) and Preferred provider
    agreements (PPOs)
  • Fairly comprehensive care but either
  • all care is delivered through the plans network
    e.g. in HMOs primary care physicians authorise
  • coverage greater (costs lower) e.g. when when
    using the PPOs provider network

Alternative solutions to consumer moral hazard
Non-price rationing (public finance/provision)
  • No patient is refused access to health care
  • But
  • Capacity is fixed leading to waiting lists for
    certain therapies.
  • People pay a time cost which should discourage
    unnecessary use.

Rationing under social provision excess demand
at the administered price, Pa ? waiting lists
S inelastic as determined by state
Excess demand Waiting lists or time based
Pc Pa
Unmet demand
Qp Q
Rationing under social provision can also lead to
a private market for health care - a useful
safety valve for the state system?
Revenue to private system
Qpr lt Q - Qp
Provider moral hazard
  • Provider moral hazard derives from the
    infrastructure of modern health care, where a
    third party (insurance or state) pays for the
    health care provided by the doctor.
  • The payer may have different priorities to either
    the doctor or patient.
  • Systems will reflect the payers utility
    function e.g. maximising population health gain
  • Impacts on pay contracts (for medics) e.g.
    treatment fees

Implications of third party payment
  • If doctors are paid a fee for services by a third
    party (insurance company or government - not the
    patient) then the marginal cost of health care is
    free to the patient and doctor is not
    constrained by patients ability to pay
  • Moral hazard can arise because
  • Information asymmetry between doctor and the
  • The doctor does not know the cost of medical care
  • The doctor has a financial or similar incentive
    to increase consumption of health care e.g. fee
    for service arrangements,
  • Can lead to supplier induced demand (SID) demand
    higher than socially efficient

Supplier Induced Demand (SID)
  • Supplier induced demand is the amount of demand
    created by doctors, which exists beyond that
    which would have occurred in a market in which
    consumers are fully informed. Donaldson Gerard
  • Supplier induced demand exists when the
    physician influences a patients demand for care
    against the physicians interpretation of the best
    interest of the patient. McGuire, T. (2000)

Diagrammatic illustration
  • E0 Initial equilibrium
  • Following an increase in overall supply (to S1)
    due to an increase in funding (new doctors or
    hospitals etc), doctors increase demand (to D1)
    to maintain (or increase) target income.
  • E1 resulting equilibrium

Q0 Q1
  • SID (excess demand) can lead to
  • Higher service costs and fees rising health care
  • Higher usage of new and expensive technology
  • Potentially less of a problem when there are
    state imposed spending limits (as e.g. in the UK,
  • The NHS is cheap by international standards and
    health outcomes not that much different - supply
    side incentives to economize through budgets and
    method of doctor payment (Doctors are not paid
    directly for medical activity)

Questions to consider1. What sort of health
system is in place where you are (or where you
come from)? and 2. how does this system
address potential problems of adverse selection
and moral hazard?3. what are the advantages and
disadvantage of this system?
Policy implications Social insurance as an
alternative to market provision
  • Market failures in health care due to asymmetric
    information lead to problems associated with
    moral hazard and adverse selection
  • Also other market failures due to
  • Externalities Uncertainty Economies of scale
    Entry barriers leading to a near monopoly of
    control by medical practicioners
  • Explains the spread of compulsory and universal
    social insurance schemes in health provision
  • Reduces the risk of adverse selection the state
    can insure the uninsurable by compelling
    universal coverage - risk pooling
  • Reduces some moral hazard problems the state can
    act as a third party in the relationship between
    patients and health practitioners

Does this approach imply an idealised view of
public system
  • its guiding principle the improvement of the
    health of the population at large it allows
    selective access according to effectiveness of
    health care in improving health (need). It seeks
    to improve the health of the population at large
    through a tax financed system free at the point
    of service. It allows public ownership of the
    means of production subject to central control of
    budgets it allows some physical direction of
    resources and it allows the use of
    countervailing monopsony power to influence the
    rewards of suppliers.
  • Culyer, Maynard and Williams, 1981

Criticisms of the UK NHS
  • Consumers have no choice (the NHS is a monopoly)
  • But patients can change doctors and ask for
    second opinions
  • Spends too much on bureaucracy
  • Spending is low by international standards
  • Rationing problems not enough resources are
    allocated to the NHS leading to waiting lists
  • Funding has risen and is now budgeted to reach
    9.4 of GDP
  • Allocation problems
  • The way it allocates resources to different
  • Perverse incentives, over-centralisation, lack of
    accountability and inflexibility
  • The way resources are allocated to different
    geographical regions
  • Equalisation or by need? The latter is currently
    the aim

Does the alternative suggest an idealised view of
private system
  • ..guiding principle consumer sovereignty in a
    decentralised market, in which health care is
    selective according to willingness and ability to
    pay. It seeks to achieve this sovereignty by
    private insurance it allows insured services to
    be available freely at time of consumption it
    allows private ownership of production and has
    minimal state control over budgets and resource
    distribution and it allows the reward of
    suppliers to be determined by the market.
  • Culyer, Maynard and Williams, 1981

Rationing and allocation are problems (all types
of systems)
  • Conflict between maintaining quality and
    incentives to cut costs being cost effective
  • Conflict between limited resources and coverage -
    implies a need for some kind of rationing
  • Even more of a problem if also trying to maintain
    universal coverage and if rationing is not by
    price then who receives treatment and when?

Rationing problems under social provision
  • Limited resources in public health care systems
    mean that policymakers need to address allocation
  • For instance, should public health care systems
    fund cosmetic surgery or very expensive surgery
    that leaves patients with low life expectancy?
  • What are the consequences of this kind of funding?

Case study 1
  • Jake and Bunty both need kidney transplants but
    there is only enough capacity to treat one of
    them, even though both will die quickly if
  • How would you decide which patient to treat?
  • What information would you ask for before making
    a decision?

  • Suppose you know that Jake is younger than Bunty
    but Jake is heavier drinker

Case study 2
  • Jessie and Rosie both need medical treatment.
    Jessie requires a relatively cheap hip
    replacement but Rosie requires expensive heart
    surgery. Capacity is limited and it is only
    possible to treat one of them over the short-term
    (6 months). Rosie will die quickly if untreated.
    Jessie wont die but she is in severe pain.
  • How would you decide which patient to treat?
  • What information would you ask for before making
    a decision?

  • Suppose you know that Rosie is older and has
    other health issues but Jessie is otherwise

Criteria for rationing
  • The Fair Innings argument
  • Younger people given priority in health care
  • Consistent with QALY maximisation
  • Responsibilities (Etzioni, 1988)
  • Smokers given lower priority in health care
  • Social contracts and fairness (Rawls, 1972)
  • Health care goes to people because they need it
    a needs approach
  • Inconsistent with QALY maximisation
  • First come first served subject to budgets
  • A lottery

Economics based criteria - micro level efficiency
  • The cost/quality/coverage conflict suggests there
    is a role for economic evaluation to maximise the
    use of limited resources
  • E.g. health economic evaluation methods such as
    Quality Adjusted Life Years (QALYs)
  • Multidimensional measure/index of health that
    combines quantity of life (life expectancy) with
    quality of life in a single index

Criteria for rationing applied to case study 1
  • QALY maximisation and the Fair Innings argument
    would dictate that in case study 1Jake would have
    priority if he were younger (assuming that either
    patient would have a similar quality of life)
  • But isnt Buntys claim just as legitimate? Would
    we have to give Jake priority? What if Jake was
    only a few years/weeks younger than Bunty?
  • As Jake is a heavier drinker the
    responsibilities argument would favour Bunty
  • but what if he only drinks a little more than
  • Nevertheless, resource constraints mean equal
    rights to treatment cannot be recognised
    choices have to be made

Final points and questions is any kind of health
care system is optimal?
  • How should health care systems balance the
    ever-increasing benefits provided by scientific
    research, the costs of provision and the
    protection of human rights?
  • New drugs, equipment and treatments are solutions
    to health problems but they are expensive
  • Poorer people can be excluded under private
    insurance but there are limited resources in
    publicly funded systems
  • No health care system is perfect.
  • The problems of health systems in different
    countries are to some extent predictable outcomes
    of their chosen health-care strategy

Test your understanding
  • Try to answer the following
  • In the context of health care insurance explain
    how adverse selection problems can arise and how
    they could be resolved.
  • Explain how consumer and supplier moral hazard
    can arise in the context of health care
    provision. How can the associated problems be
  • How can and how should health care be rationed?

Extra material on the advantages and
disadvantages of different health care systems
for background only
Questions to consider
  1. What are the advantages/disadvantages of public
    health care systems?
  2. What are the advantages/disadvantages of private
  3. What would be your preferred health care system
    and why?

Advantages of public health systems not related
to asymmetric information
  • Most social insurance schemes also redistribute
    from the rich to the poor through income related
  • They promote equity in health care
  • E.g. by promoting early diagnosis as treatment is
    mostly free
  • may enhance fairness in society
  • But if individual choice is weighted more highly
    then this is better served under a privately
    funded or perhaps a mixed system

Other specific and tangible advantages of public
health systems
  • They Avoid the need for safety-net facilities
  • They promote universal coverage and by doing so
    improve health and productivity of the population
    through accessibility
  • Weakens the link between poverty and ill health
    if health care is provided on the basis of need
    rather than income
  • By delivering health care to low-income people
    more than they could buy
  • Evidence
  • Countries that rely more on private insurance
    (e.g. the USA, Switzerland) have regressive
    health care financing systems overall
  • Health care finance is more unequal than pre-tax
    incomes people on low incomes buy less insurance
    but pay on average a higher proportion of their
    income for it
  • More variation in countries where there is social
  • In France and the UK health care finance is
    progressive in Germany and the Netherlands it is

Other specific and tangible advantages of public
health systems
  • Cheaper admin costs as no need to verify
  • Give provider monopsony power to the provider to
    enable lower costs/charges
  • E.g. monopsony power of NHS keeps prices low
    (e.g. drugs, equipment)

Resource/service cost determination under
competition on buyers side
Expenditure or Resource costs under competition
Resource/service cost determination under
competition and monopsony
Expenditure or Resource costs under monopsony
Less tangible advantages of public health systems
  • Titmuss (1970) described the establishment of the
    UK NHS in the following way
  • The most unsordid act of British social policy
    in the twentieth century has allowed and
    encouraged sentiments of altruism, reciprocity
    and social duty to express themselves to be made
    explicitly and identifiable in measurable
    patterns of behaviour by all
  • He showed that supplying blood through voluntary
    donation was more effective/more efficient than
    the commercial alternative
  • Behaviour characterised by altruism has wider
    positive effects?
  • Public health systems encourage altruism A kind
    of positive caring externality?

Disadvantages of public health systems
  • Medical practitioners dont face up to resource
    constraints provider moral hazard remains an
  • Need better incentives to be efficient but how?
  • Market? Community?
  • Peoples expectations of the health service are
  • Redistributive social insurance schemes may be
    perceived negatively
  • Compels coverage of low risk and rich people (as
    well as high risk people)

Example of more market based system the USA
  • Primarily a private enterprise based health care
    system but four public health care funding
  • Medicare health care funding for the elderly
  • Federal health care funding
  • Medicaid health care funding for the poor
  • Collaboration between Federal Government and the
  • Veterans Administration Health Care
  • Federal Government funding for veterans of the
    armed services.
  • Health insurance for federal and state employees.

Problematic side of USA system
  • As well as coverage problems as already discussed
  • More than 20 of population without health care
  • Also too expensive perhaps due to consumer and
    supplier moral hazard
  • highest utilisation of high tech health care.
  • More than 17 of GDP spent on health care.

Alternative more mixed systems Canada
  • National Health Insurance system with universal
  • Collaboration between provincial and national
  • 75 of health care expenditure Province/territory
    administration of comprehensive and universal
    care supported by grants from federal government
  • Hospitals are private institutions but budgets
    approved by provinces
  • Most physicians are in private practice but paid
    by provinces on nationally agreed fee-for-service
    base under negotiated fee schedules
  • System is generally seen as less costly and more
    effective than the US system

Some comparative statistics
Which system is the most successful?
Theoretical appendix SID can also imply
reductions in demand in response to changes in
  • E0 Initial equilibrium
  • Following a reduction in supply (funding)
    doctors reduce demand to maintain target income.
    E1 resulting equilibrium
  • Following an increase in supply doctors increase
    demand to maintain target income. E2 resulting

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