TCS Daily

How Economists Really View Health Insurance

By Arnold Kling - August 26, 2005 12:00 AM

"Policy is driven by more than politics, however. It is equally driven by ideas, and in the past few decades a particular idea has taken hold among prominent American economists which has also been a powerful impediment to the expansion of health insurance. The idea is known as moral hazard. Health economists in other Western nations do not share this obsession. Nor do most Americans. But moral hazard has profoundly shaped the way think tanks formulate policy and the way experts argue and the way health insurers structure their plans and the way legislation and regulations have been written.


...The reason the United States has forty-five million people without coverage is that its health-care policy is in the hands of people who disagree, and who regard health insurance not as the solution but as the problem."
-- Malcolm Gladwell


Is there such a thing as a class-action libel suit? In his much-discussed recent article in The New Yorker, Malcolm Gladwell made malicious, false, and defamatory statements about the economics profession.


Gladwell blames economists for the fact that millions of people lack health insurance. However, like most economists, I support everyone obtaining insurance against catastrophic health care costs. In fact, this is one area where I have thrown my libertarian principles out the window and advocated mandatory catastrophic coverage.


The main point of Malcolm Gladwell's article is that he believes that comprehensive health coverage is better than catastrophic insurance. He believes that without comprehensive coverage, people will undertake too little preventive health care, such as routine dental cleaning. This may or may not be correct. But the reason that economists disagree with Gladwell on this point has nothing to do with the concept of "moral hazard." In fact, "moral hazard" means that insurance companies would want to try to encourage more preventive care.


Gladwell's article is confused and distorted. Here, I will attempt to set things straight.


Two Issues Regarding Health Insurance


Gladwell's primary confusion, which is deliberate on his part, is between two issues regarding health insurance.


1. Should everyone have health insurance?

2. Should health insurance be catastrophic or comprehensive?


Catastrophic health insurance is a high-deductible policy that pays benefits only if someone suffers from a very expensive illness. It does not pay for smaller items, such as routine doctor visits, vision care, or for low-cost treatment of minor illnesses and injuries. In contrast, comprehensive coverage pays for all services from all health care providers, whether for major illnesses or not.


On issue (2), many economists favor catastrophic coverage as opposed to comprehensive coverage. Gladwell confounds this with issue (1), and accuses economists of opposing the idea that everyone should have health insurance. I have never seen an economist confuse these two issues. I have never seen an economist who was opposed to the whole idea of health insurance, which is what Gladwell implies.


Moral Hazard vs. The Law of Demand


Gladwell mixes up two economic concepts. One concept is moral hazard. The other concept is the law of demand.


The law of demand states that if you reduce the price of a good or service, then people consume more of it. Comprehensive health care coverage reduces the price that people pay for routine health care. The law of demand states that this will increase people's use of it.


Gladwell quotes Uwe Reinhardt, a well-known health care economist who occasionally gets carried away with his own rhetoric, as effectively denying that the law of demand applies in health care.


Uwe Reinhardt says. You always hear that the demand for health care is unlimited. This is just not true. People who are very well insured, who are very rich, do you see them check into the hospital because its free? Do people really like to go to the doctor? Do they check into the hospital instead of playing golf?


In the very next paragraph, Gladwell cites a famous study which showed that the law of demand applies to health care, and in fact people do spend less on health care if they have to pay for it themselves. Gladwell writes, "As you might expect, the more that people were asked to chip in for their health care the less health care they used."


In fact, if the law of demand did not apply to health care, then everyone would obtain whatever health care they needed, regardless of cost, and regardless of whether or not they had insurance. Frankly, I believe that even Uwe Reinhardt would, if pressed, agree that the law of demand applies to health care.


The term "moral hazard," narrowly defined, means the reduction in the incentive to mitigate risk that comes from having insurance. If the fact that you have auto insurance makes you feel relaxed enough to leave your car sitting outside with the doors open and the keys in the ignition, then that is moral hazard. Another example, which Gladwell gives, is that with fire insurance "you may be a little less diligent in clearing the brush away from your house."


Gladwell argues that the way that insurance companies mitigate moral hazard is by raising the deductible on insurance, but that is not really the purpose of high deductibles. High deductibles are used primarily to reduce the costs associated with non-catastrophic claims.


Instead, the most important way to mitigate moral hazard is through "riders," or provisions in the insurance contract. For example, the auto insurance company may include a "rider" that states that if you leave your car with the doors open and the keys in the ignition, then the insurance company will not compensate you for theft. Another way the auto insurance company fights moral hazard is by offering discounts to owners who install anti-theft devices. A fire insurance policy could include a rider that says that claims will not be paid in case of negligence, such as smoking in bed or failure to remove brush from around the house.


In health insurance, moral hazard means that if you believe that major expenses are covered, you have less incentive to obtain preventive care. In order to mitigate moral hazard, the health insurance company might want to include a rider that requires you to obtain regular checkups -- and even dental cleanings. It might offer discounts for non-smokers, people who exercise regularly, etc.


Thus, moral hazard would lead an insurance company in the direction that Gladwell presumably would favor -- to provide incentives for preventive care. I think that such incentives would be more widespread if health insurance contracts were more long-term and were designed by consumers and insurance companies with less interferences from state regulators.


Gladwell indicates his confusion on the issue of moral hazard by offering as another supposed illustration, "If your office gives you and your co-workers all the free Pepsi you want -- if your employer, in effect, offers universal Pepsi insurance -- youll drink more Pepsi than you would have otherwise."


That is not moral hazard. That is the law of demand.


Insulation vs. Insurance


The real disagreement between many economists and Gladwell concerns the concept of insulation, not insurance. It concerns the law of demand, not moral hazard.


Economists support the idea of health insurance. However, many of us believe that policies that pay for all health care services are not real health insurance. Insurance should protect people against catastrophic loss, but it should not insulate them from the cost of all health care.


Gladwell tries to simultaneously argue two points, which are mutually contradictory.


1) People have to obtain health care, so that raising the cost to them will not reduce their demand. Therefore, insulating them from the cost of treatment does not distort their use of medical services.


2) If people have to pay for their own preventive care, then they will not obtain sufficient care.


The first statement denies that the health care obeys the law of demand. The second statement applies the law of demand to health care.


As an economist, I believe that the law of demand applies in health care. I believe that if patients are insulated from the cost of health care, then they will err on the side of obtaining unnecessary CT scans, MRI's, and visits to specialists. They also will "err" on the side of obtaining useful preventive care.


In the United States, over 85 percent of health care expenses are paid for by insurance companies or governments. This is one of the highest rates of insulation in the world (based on OECD health data, but this particular table is not available on line). Even in Canada, the percent of health care costs paid out of pocket is slightly higher than in the United States. Americans' high rate of insulation, combined with the abundant availability of trained specialists and the latest equipment, accounts for the high level of health care spending in this country. I hope that for the most part this is cost-effective, but I believe that the issue deserves careful study.


Do people need to be insulated from the cost of preventive care in order to encourage them to get the appropriate amount of check-ups, dental cleanings, etc.? I believe that health care programs for the poor, such as Medicaid, ought to be structured to encourage preventive care. However, I do not believe that the rest of us have to be insulated from the cost of health care in order to choose to have our teeth cleaned.


People who want to see everyone in this country protected from catastrophic loss due to illness or injury should listen to economists. Not to Malcolm Gladwell.


1 Comment

How healthcare workers view health insurance
I realize this is an old post, but I came accross it via wikipedia.

Your economic analysis may be dead on, I am not an economist. But I am a physician and as such, an observer of human behavior regarding health care. So I will only say, please find someone you know who is a nurse, doctor, or almost any other healthcare provider, and run your theory by them and enjoy the responses.


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