The Theory of Demand for Health Insurance

The Theory of Demand for Health Insurance, by John A. Nyman, 2003, Stanford Economics and Finance, Stanford, California: Stanford University Press. This book exposes a new theory of demand for health insurance. Not only is this theory really new (even radically new), but it is highly welcome as well. If this theory is taken seriously by health economists, the dialogue will be easier and more fruitful between them and physicians, policy makers, health services researchers, and even the general public. To tell it in a nutshell, this book provides a much more realistic theory of demand for health insurance than the one economists routinely use, but without dropping the core of the normative economic approach of demand. In a way, it is an elegant solution to a long-lasting controversy opposing the welfarist conventional conception of demand for health insurance, which takes the demand for health care of the uninsured as the "true" willingness to pay for health care, on one hand, and the extra-welfarist approach, which takes the guidelines written by medical experts as the "norm" of health-care consumption, on the other hand. Not only is the solution elegant, it is well written and the author provides several examples to illustrate the theoretical considerations, which helps the reader to understand the key concepts. What does the new theory have to say? First, consumers do not demand (health) insurance in order to reduce financial uncertainty; the conventional theory assumes that, due to the concavity of the utility of wealth, individuals always prefer a certain financial loss to an uncertain one of the same expected magnitude. An abundant literature has shown, however, that this assumption is contradicted by empirical results (in experiments, individuals prefer uncertain losses) and yields paradoxical results. Here, Pr. Nyman uses a result (due to Rabin, 2000; Rabin and Thaler, 2001), which is not specific to health insurance, but applies to attitudes toward risk in general: there is no link between the shape of the utility function of wealth and the attitude toward risk. Second, consumers demand (health) insurance because they exhibit a concave utility of wealth, even if this concavity is not related to risk aversion. To understand the crux of the idea, it is useful to decompose it in sequence: when deciding to buy an insurance contract, I voluntarily forgo part of my income. In case I am ill (or the event occur), my income first decreases by the amount of health-care (damage repairing) expenditures needed to treat the illness (repair the damage caused by the event); however, due to being insured, I then receive an income transfer that raises my income above this lower level. If the utility of wealth is concave, and if the income transfer is greater than the premium (i.e., if the probability of the event is lesser than one), I derive more expected utility from the income transfer when ill than I lost utility from the forgone income (the premium). 1 It can even be shown that the lesser the probability, the greater the gain. Third, the normative consequences of this alternative motive of demand for health insurance depart dramatically from the traditional ones. Formally, if one uses the same utility function of wealth, both theories predict the same demand for insurance. But they disagree on how to interpret a specific feature of insurance for health care, namely, the firmly established empirical fact that the insured spend more to treat their illnesses than the uninsured.2 Both theories agree on the fact that this overconsumption of the insured stems from the price pay-off mechanism specific to health insurance: while most insurances provide a lump sum of money if the event occurs (one speaks of "contingent claims contracts"), health insurance usually pays off by reducing the price of health care. Both theories also agree on the cause of this specificity, which turns around the difficulty for an insurer to monitor precisely the lump sum cost of a given illness. …