Lect 15: Market Failures: Adverse Selection & Moral Hazard

Insurance

Insurance is a risk-pooling mechanism where risks are combined across a group, making overall risk more predictable and payable by the group.
It involves paying a premium for coverage, allowing claims up to a certain level if an event occurs.

Excess: The initial amount you pay before claiming coverage.
Deductible: The initial amount you pay, reducing the coverage level.
Coinsurance: The proportion of the claim you pay after the deductible/excess.
Co-payments: Specific fees for services used.

Two major problems in insurance markets arise from information asymmetry.
- Adverse selection: The problem of who chooses to buy insurance.
- Moral hazard: Problems with behavior after insurance is purchased.
Perfect information requires sellers to know the cost of providing care.
Public systems eliminate adverse selection but exacerbate moral hazard.

Community rating: Offering the same contract to everyone. It leads to adverse selection because:
- Premiums are based on the average person.
- Low-risk individuals opt-out because it's not worthwhile.
- High-risk individuals find it worthwhile and opt-in.
This results in insurers covering a higher-risk pool and potentially losing money as good risks drop out.
Example: Blue Cross plans in the U.S. experienced losses due to the Affordable Care Act.

Insurers can't distinguish between high-risk (high cost) and low-risk (low cost) buyers.
Offering one contract tailored to the worst risks:
- May be unaffordable for the highest-risk group, potentially eliminating the market.
- Is undesirable for the lowest-risk group, leaving many uninsured.
Offering multiple contracts:
- Requires each group to select the contract fitting their risk profile.
- High-risk individuals get full coverage at a high price.
- Low-risk individuals get limited coverage at a lower price.
- Higher-risk people might choose lower-risk coverage but find it insufficient.
- Results in under-insurance for both higher and lower risk individuals.

Insurers may identify risk likelihood based on:
- Age, gender, ethnicity, smoking status
- Some factors are observable, others may be part of the contract.
This can lead to 'cream skimming,' targeting the lowest-risk individuals.
Some of these practices are ethically questionable.

Insurance can reduce the incentive to take care of oneself, leading to poorer health outcomes.
Moral hazard arises when individuals change their behavior once insured.
Insurers end up with higher-risk patients and lose money.

If treatment is costless after insurance:
- Little incentive to take care of oneself.
- Increased spending on healthcare and worse health outcomes.
- Costly waste of resources.

Moral hazard isn't specific to health insurance; it's about reduced treatment costs.
Likely greater when some availability options are limited.
Limited ability to allow access by health behaviours in a public system.
Tax is taken from people as taxpayers, not as patients – lower taxes because you’ve not used services would be unusual.
Limited co-payments are possible, but e.g. aren’t levied for secondary care in NZ.
Demand management strategies, especially in secondary care.

Number of suppliers/buyers: Often limited providers for specialist services/insurance.
Same product produced by all sellers: Lots of quality differences and variation in practice.
Everybody knows the value: Supplier-induced demand, moral hazard, adverse selection.
The same good can only be used by one person: Never in public health; externalities elsewhere (e.g., vaccinations).
All people are motivated only by their own wellbeing: Hopefully better than this.
Free entry and exit: Patents, professional standards & licensure.

Incentives can change behavior, potentially crowding out intrinsic motivations.
Removing financial incentives can reduce good practice behaviors.
Example: Morales et al (2023) found that 10/16 quality of care indicators worsened in Scotland (payments removed) after 3 years compared to England (payments not removed). DOI: https://doi.org/10.1136/bmj-2022-072098

Externalities are factors beyond the buyer and seller that affect value.
- Production externalities: Value created or destroyed during production.
  - Positive: Innovation from basic research.
  - Negative: Pollution.
- Consumption externalities: Value created or destroyed during consumption.
  - Positive: Herd immunity from vaccination.
  - Negative: Increased risk from second-hand smoking.
In an inefficient market:
- Too much produced (negative externalities): Introduce tax.
- Too little produced (positive externalities): Introduce subsidy.
Public health measures like vaccinations are often subsidized due to positive externalities.

Many buyers and sellers: Often only one company/patent holder, or limited providers for specialist services/insurance
The same product produced by all sellers: Lots of quality differences and variation in practice
Everybody knows the value of the good/service to buyers and sellers: Supplier induced demand, moral hazard, adverse selection
The same good can only be used by one person: Never in public health; externalities elsewhere (e.g. vaccinations)
All people are motivated only by their own wellbeing: Hopefully better than this
Free entry and exit: Patents, professional standards & licensure.

Not inherently, but it experiences failures in nearly every market area.
Failures (e.g., limited suppliers) arise from attempts to ensure quality and innovation.
Complexity is a major factor.
Healthcare is treated as special because markets can't guarantee efficiency, and efficiency isn't always the priority.
Governments intervene in healthcare to varying degrees; all governments intervene (even the USA’s).