In 2003, John Nyman published The Theory of Demand for Health Insurance. His principal contributions are (1) to replace the previously unexamined axiom of risk avoidance with the axiom of welfare maximization; (2) to uncover a misinterpretation in the literature on moral hazard, namely, the insurance payoff as a price reduction, rather than as an income transfer. The immediate consequence of these reformulations is to recognize insurance-induced health care utilization as resulting in an increase in social welfare. Despite its evident validity and enormous implications, Nyman’s work has received very little attention or recognition in the health economics literature. 1. Introduction Although it remains to be seen whether the US can bring its per capita health care costs into line with other industrial nations [1], the US, after nearly 100 years of effort, passed national health care legislation in 2010. The Affordable Care Act, as it is widely known, passed with expectations of eventually bringing the nation close to a state of universal health care coverage. The legislative and other debates leading up to passage covered a wide range of topics, but one important concept—health care moral hazard—was never explicitly encountered in the debate. The absence of moral hazard in the debate appears to be an aberration. For more than 40 years one of the central tenets of health care economics has been the presumption that universal coverage would induce a rather substantial degree of moral hazard and therefore would reduce national economic welfare correspondingly. Among economists, these tenets are rooted analytically in a framework known as welfare economics, the objective of which seeks the circumstances leading to improved or maximized human welfare. The nature of the framework and, more pointedly, the manner in which that framework has been mobilized to characterize the health insurance policy payoff results in a habitual conclusion that more insurance-induced health care utilization results in a decline in human welfare. Consistent with that result had been the omnipresent policy caution that extensions of health insurance coverage to the general population were to be avoided. In 2003, John Nyman published The Theory of Demand for Health Insurance [2] that uncovered a number of what he argued to be critical errors in the way in which the insurance payoff has been understood through the lens of welfare economics, and that the cumulative effect of these errors has been to introduce a decided bias in the formulation of health coverage policy. The book is
References
[1]
Perhaps the most deceptive is the term, “demand,” which, in ordinary parlance suggests an “unyielding insistence,” but in economic parlance indicates merely the consumer’s placid willingness to purchase certain quantities of a given commodity at various prices. Throughout this text, the expression “demand for health insurance” has no connection to legislative passage of extended or universal health insurance coverage. The analytical issues discussed have enormous implications for such policy issues.
[2]
For a more accessible version, see [11].
[3]
We use the terms strong and weak in this discussion in the philosophic logical sense of narrow or restrictive and broad or enabling, respectively.
[4]
Traditionally, risk and uncertainty have been used in technical economic discussions to connote distinct ideas about the unknown future. Risk was used to connote circumstances in which the range of outcomes, and their probabilities were “known”; uncertainty, when neither was “known.” In this discussion, as with the preponderance of the literature on this subject, the two terms are used interchangeably.
[5]
That is, a premium equal to the value of expected health care outlays faced and insured against.
[6]
There is a considerable level of disingenuousness in this argument and all of the related subsequent work. The clear implication of Pauly’s discussion is that there but for moral hazard virtually all Americans would be covered by lower cost health insurance coverage. Aside from the problem of determining the portion of the growth in per capita health care costs of the past 40 years attributable to moral hazard and that portion to demographic and technological changes and the general level of inflation, it seems rather clear that most of today’s 60 million uninsured and seriously underinsured cannot afford health insurance because of the cost relative to their income, independent of the premium elevation resulting from moral hazard.
[7]
In fairness, Arrow did note the troubling presence of moral hazard and the need for copayments to control them, but, until Pauly’s comment, did not suggest the possibility that insurance-induced overconsumption, rather than market failure might be responsible for large gaps in coverage.
[8]
Briefly, the reason argued for the theoretical decline in welfare is due to a distortion in the prices faced by insured persons. Because insured persons face prices for insured medical care that is well below the market prices for those services, they purchase much more of it than they would if they faced market prices and much less of other commodities, the prices of which are largely unchanged. According to this theory, consumers are presumed to purchase goods and services in amounts that are driven by the equalization of price ratios to the corresponding ratios of gratification intensity from the commodities in question. But because the prices faced by insured persons are not market prices, they are actually obtaining lesser levels of welfare than if everyone faced market prices.
[9]
This excess normally would be due to such things as inaccurately high actuarial claims estimates and insurance company administrative expenses, such as advertising, claims processing, and profit taking.
[10]
Indeed, though this is not part of Nyman’s argument, most holders of autoinsurance would never be able to cover out of pocket, or even borrow to finance, many of the costs of autoaccident liability events (and it is therefore, interestingly, obligatory); the same holds for small-owner business property coverage.
[11]
For which Daniel Kahneman, a psychologist, was awarded the Nobel Prize in Economic Science in 2002.
[12]
In a poignant but awkward hesitation, Arrow, coawarded the Nobel Prize in Economic Science in 1972 (the fourth year of the award), begins his discussion of “The Theory of Ideal Insurance” by stating that “The expected-utility hypothesis, due originally to Daniel Bernoulli [17], is plausible and is the most analytically manageable of all hypotheses that have been proposed to explain behavior under uncertainty. In any case, the results to follow probably would not be significantly affected by moving to another mode of analysis. It is further assumed that individuals are normally risk averters.”
[13]
That is, “broader,” “more inclusive,” and “less restrictive”.
[14]
This is not to suggest that all health care utilization, après Nyman, is efficient and appropriate. It is only to caution that what excesses do exist—and they are enormous in the US—is not a simple matter of price-reducing insurance.
[15]
Strictly speaking, this is not the usual textbook increase in income, since it can only be used to purchase covered health care services, not from the usual, broad panoply of consumer commodities. Yet, it is certainly a form of income, and it does enable the consumer to purchase more than without this transfer, and the consumer’s welfare is arguably greater—where the efficient outweighs the inefficient component—than in the absence of the coverage and the services this transfer affords.
[16]
Even within this new framework for understanding the insurance payoff, the old inefficient moral hazard is still present, but a lesser portion of the welfare effect of the utilization increase (see [2]).
[17]
Assuming that the absolute value of efficient moral hazard exceeds that of inefficient moral hazard.
[18]
Of course, everything is relative. Extending health care coverage to all Americans still depends on the increased benefits, calculated according to the new metric, to be greater than those benefits that result from spending a similar amount on other non-health areas of potential benefit.
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