Economic Research Initiative on the Uninsured Working Paper Series BENEFICIAL MORAL HAZARD AND THE THEORY OF THE SECOND BEST

Economic analysis of health insurance markets has long noted that insurance increases consumption of heath care services because it shields individuals from the true price of care. The additional consumption attributed to insurance is often labeled as “moral hazard” and, in standard economic models, is considered to result in welfare loss. The cost associated with additional consumption provides one argument against expanding coverage. This article examines the welfare consequences of moral hazard and brings together several arguments suggesting that in many cases the additional consumption could be welfare enhancing. Since conditions for maximum economic efficiency fail to hold in the market for medical care, the concept of the theory of the second best is important; in this case, the market distortions caused by insurance may increase welfare by mitigating the averse consequences of other distortions. We focus on three efficiency-related reasons why insuranceinduced consumption may improve welfare: (1) insurance can offset market power; (2) insurance can remedy some externalities; and (3) insurance can mitigate problems associated with mis-information that results in many types of care being underutilized. We also focus on one distributional reason, the idea that insurance can facilitate desired income transfers between healthy and sick states of the world. These arguments strengthen the case for expanding coverage. Yet, the cost of additional consumption associated with expanding coverage must be addressed, even if it enhances aggregate economic welfare. More sophisticated benefit packages may be able to minimize the cost of additional consumption associated with coverage by limiting detrimental moral hazard, while maximizing access to the health care services that provide substantial value.