Health Insurance Theory: The Case of the Vanishing Welfare Gain

This year, Elizabeth is diagnosed with breast cancer. Without health insurance, Elizabeth would purchase a $20,000 mastectomy, including chemotherapy, which is the care that she needs to rid her body of the cancer. Because a mastectomy is a disfiguring procedure, she would consider purchasing a breast reconstruction procedure for an additional $20,000, but would choose not to do so because the competing claims on her income and resources make it too expensive. Fortunately, Elizabeth had purchased a contingent-claims insurance policy this year for $3,000 that paid her a $40,000 cashier's check when she was diagnosed with breast cancer, which is exactly enough to cover the cost of both procedures. With the extra ($40,000 - $3,000 =) $37,000 in income, Elizabeth chooses to purchase the additional $20,000 breast reconstruction. She is happy with her purchase because, while she could have spent the extra income on anything she wanted, she obtained the highest utility from the additional medical care. The standard translation of this scenario into economic theory is that Elizabeth's demand for medical care has shifted out because of the additional income. This shift would imply an increased willingness to pay at every price and result in a welfare gain equal to the additional consumer surplus for the original mastectomy, and also for the breast reconstruction. Now, consider what would have happened if the market had only offered insurance that paid off by covering the cost of any medical care that Elizabeth chose to purchase. Furthermore, to hold things constant and provide the starkest contrast, what if Elizabeth's premium remained $3,000 and her voluntary behavior with this policy was the same as her behavior under the contingent-claims policy, and $40,000 in checks were simply written to the providers for the exact same procedures? The conventional translation of this payoff mechanism and behavior is that it represents a reduction to zero of the price of medical care and a movement along the consumer's original uninsured demand curve (Pauly, 1968). Because the true marginal cost of the medical care has not changed, the additional consumption - that is, the moral hazard - is not worth the resources used to produce it and represents a welfare loss. That is, even though Elizabeth's behavior has not changed and she is equally happy with either insurance contract, the latter payoff mechanism results in a welfare loss. That the same behavior could be interpreted as a gain under contingent-claims insurance and a loss under price-payoff insurance suggests that conventional theory is flawed. This paper presents a new theory of the welfare effects of price-payoff insurance. It suggests that an important welfare gain has been missing from conventional theory. This gain is derived from the additional medical care that is generated from the income transfer (from those who remain healthy to those who become ill) that is contained in every insurance payoff. When this moral hazard gain is acknowledged and replaces the welfare loss that was hitherto ascribed to this moral hazard, the value of health insurance increases dramatically. Implications for public policy follow.