Health insurance and the income effect

Frequently, when I mention to a trained economist that I do not have a degree in economics I am told that is probably to my advantage. I haven’t been brainwashed. They’re joking, but only partly.

I got a sense of the benefits of missing the indoctrination when I read about John Nyman’s theory of demand for health insurance. I saw it first in Health Economics: Theories, Insights, and Industries Studies, by Santerre and Neun. It was explained as an alternative to the standard theory. (A key implication of the standard theory is that all care that is valued below marginal cost is “inefficient” moral hazard.)

That surprised me. To me Nyman’s theory, or at least some elements of it, is intuitive, even obvious. I believed it before I even knew about it. I could not imagine it not being the standard theory. Thing is, I didn’t really know what the standard theory was. Such were the benefits of studying physics and statistical image and signal processing. Not a peep about demand for health insurance in those classes.

I’m now reading Nyman’s book, The Theory of Demand for Health Insurance. Here’s his first description of one of the problems with the standard theory that his addresses:

[The conventional theory] ignores the fact that many expensive procedures would be unaffordable without insurance, especially for those households with low incomes and low net worths. For example, a person with a $50,000 net worth would not be able to afford to purchase a $300,000 liver transplant procedure. The patient may be too ill or the illness may be too urgent to save the difference, and banks may be reluctant to lend money for the transplant because of the risk that the borrower will not be able to pay off the debt. For expensive, lumpy procedures like this, a consumer without insurance may receive only minimal palliative care, even though with insurance the consumer would have access to the appropriate expensive procedure.

I would not make too much of the dollar values in this passage. They’re just illustrative. For less well off individuals and families, a $100 office visit or a $1,000 minor procedure could be as out of reach as a $300,000 transplant is to a $50,000 net worth household. Would we call the provision of Medicaid to such poor families the source of moral hazard in such cases? If so, why do the poor experience moral hazard for the same services that the wealthy may pay for out-of-pocket, which by definition is not moral hazard care? Is moral hazard income dependent? Should it be?

There is an income effect to insurance that is crucial to recognize. Labeling every bit of use that an individual would not have purchased with his own money as “inefficient” moral hazard really misses a key point. So does failing to recognize that one individual’s catastrophic range is not the same as another’s. To some $1,000 or even $100 really is a lot of money, money that could improve their health, even save their lives. To others $100 or $1,000 is next to nothing.

Again, what’s the cost of “efficiency”? Are we even sure that’s what we’re buying?

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