Beneficial Moral Hazard and the Theory of the Second Best

Abstract

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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“…In general, it is not possible to disentangle the substitution and income effects without the use of a structural model, something of great interest, but beyond the scope of the current analysis. Second, to the extent price exceeds marginal cost for some pharmaceuticals, increased utilization may be welfare improving (Frick and Chernew, 2009).…”

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“…An orthodox economic approach to this question implicitly compares the consumer surplus generated by the actual health care market (with all its acknowledged imperfections) with the consumer surplus that would have been generated by a perfectly competitive market (Peacock & Richardson 2007). A second approach to this question argues that moral hazard means those with insurance will consume more health care than if they were uninsured -and that the overall effect of such additional consumption on economic welfare is negative (Frick & Chernew 2009). Neither of these approaches explicitly address any negative impacts of overconsumption, but appeal directly to orthodox notions of consumer surplus.…”

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