Medical Insurance Coverage and Health Production Efficiency

ABSTRACT Conventional economic theory predicts that medical insurance coverage causes an inefficient production of health because of ex ante and ex post moral hazard effects. However, no research has empirically examined the magnitude of the inefficiency. This study empirically examines the impact of medical insurance on the technical efficiency of health production at the metropolitan level. The underlying health production function allows for preventive care, curative care, and behavioral factors. Data envelopment analysis determines relative technical efficiency. The multiple regression results indicate that insurance coverage generates inefficiency but the efficiency loss appears to be relatively small on the extensive margin. INTRODUCTION Among various issues, high medical care costs dominate much of the political debates taking place during the recent presidential election. Given that medical costs now comprise 16 percent of gross domestic product, the attention seems to be well deserved. However, many health economists and policymakers are not entirely convinced that the medical spending represents an economic burden on society. For example, Cutler and McClellan (2001) show that the aggregate benefits of just two major medical technologies outweighed all medical care costs during the last two decades. While medical care may pay for itself on average, conventional theory suggests that medical insurance may generate inefficiencies at the margin because of both ex ante and ex post moral hazard effects (Ehrlich and Becker, 1972; Breyer and Zweifel, 1997). Ex ante moral hazard refers to the effect of insurance on preventive actions taken before states of sickness occur, such as healthy lifestyles, preventive care, or early detection of diseases. In contrast, ex post moral hazard captures the size of the financial loss or cost of treatment because of insurance coverage and may show up in terms of longer hospitals stays and additional visits to health-care providers. If preventive and curative services are substitutes in the production of health, the theory generally views medical insurance as lowering the out-of-pocket price of curative inputs relative to the price of preventive inputs and thereby distorting the choice of inputs. Prevention declines, the probability of sickness rises, and an increased consumption of medical care occurs. The medical costs of maintaining a given level of health increase as a result. For example, Newhouse (1993) finds that households in low coinsurance health plans received more medical care yet possessed virtually the same level of health as those households in high coinsurance plans, ceteris paribus. Because of "nine limiting conditions," however, some researchers note that medical insurance may not have a major impact on the efficiency of health production (Crew, 1969; Schlesinger and Venezian, 1986; Pauly and Held, 1990; Kenkel, 2000; Nyman, 2003; Dave and Kaestner, forthcoming). First, health-care providers may possess market power. The resulting restriction of output negates the typical ex post moral hazard effect of medical insurance towards overconsumption. Second, the ex ante moral hazard effect may be small because medical insurance does not completely cover the utility loss associated with sickness (pain and suffering). Third, preventive inputs may remain attractive because the choice of health inputs actually involves completely preventing versus incompletely curing illness. The attractiveness of preventive inputs, however, is limited by the fact that prevention can never reduce the probability of illness to zero. Fourth, medical insurance premiums may be risk-rated. While that might be true for individual medical insurance plans, it is not true for the employer-sponsored and public medical insurance plans that cover most people in the United States. Fifth, health insurers such as managed care organizations (MCOs) may invest directly in prevention to reduce the probability of a loss. …