From a course by Fiona Carmichael of Birmingham Business School, University of Birmingham. The course puts economics concepts in context for Business Management undergraduates. In this lecture, concepts from economics are applied to the provision of healthcare. This is a selection from the hundreds of teaching and learning materials available from the Economics Network site at economicsnetwork.ac.uk

1. Application: Adverse selection and moral
hazard in the finance and supply of health
care

2. Objectives
 For you to be able to:
 Explain how problems of adverse selection arise in
relation to health insurance. Explain how the
problems associated with adverse selection in relation
to health insurance can be resolved. Explain why
equity issues may arise as a result of the solutions to
adverse selection employed by private insurance
providers. Explain how these equity issues can be
addressed.
 Explain how consumer and supplier moral hazard
arises in the context of health care provision. Using
examples, discuss how the problems associated with
moral hazard in health care provision can be
resolved.

3. Suggested background reading
 Allen et al. 2009. Managerial Economics. Norton. Chapters 14-15
 Kreps, D. M. 2004. Microeconomics for Managers. Norton Chapters
18-19 (16-17 provide more background)
 Frank, R. H. 2008. Microeconomics and behaviour. McGraw Hill.
Chapter 6
 Wall,S., Minocha, S. and Rees, B. 2010. International Business,
Pearson. Chapter 6
 Grimes, P, Register, C. and Sharp, A. 2009. Economics of Social
Issues, McGraw Hill. Chapter 15
 Rasmusen, E. 2007. Games and Information, Blackwell. Chapters 7-
9
 And any introductory Health Economic text you can access e.g.
Mooney, G., (2003) Economics, Medicine and Health Care, Dorset:
Prentice Hall

4. Sources of imperfect and asymmetric
information in health care markets
1. Health care finance: Health care providers (e.g.
insurers, government) are relatively
uninformed about a client’s health risk and
health related behaviour
2. The doctor-patient relationship: The
consumer/patient is relatively uninformed about
health care treatments but the health
practitioner is relatively informed
 Implies potential for moral hazard and adverse
selection - particularly in private health
insurance markets
 Problems vary depending on system

5. Different health care systems
 Pure market provision
 Health care is like any other good and demand and
supply respond efficiently to price - Embodies
consumer sovereignty in a decentralised market
 Private insurance based approach
 Private Insurance (or no insurance) and minimal state
control
 Employer or individual based insurance plus private
ownership of health care supply
 The USA (although some publicly funded health as well;
Medicare, Medicaid)

6. Different health care systems
 Public production, allocation and finance
 Aim is improvement of health for the population
 Health is a right and access is by need
 Universal medical care
 Public/tax financed - mostly free at point of service
 Earnings related social-insurance contributions
 Tax funding plus public ownership/control of health care supply e.g.
UK, Sweden, New Zealand
 Mixed public/private involvement e.g. private
provision but public finance
 government tax-based subsidies to a privatised system or
tax-based national insurance
 Compulsory cover through tax system supplemented by tax funding
plus some private sector involvement in supply of healthcare e.g.
Canada, Germany
 Singapore (some government subsidy through taxation)

7. Horses for courses?
 Different countries may not want the same
things from their health care system
 All have different advantages and
disadvantages
 The
US system has short waits but the UK
NHS is more equitable/accessible
 Life expectancy is more or less the same
 Women: 80.4 in the UK, 79.8 in the USA
 Men: 75.7 in the UK, 74.4 in the USA

9. Problems for all health systems
 Cost containment: Most countries (except the
UK) have seen an escalation in health
expenditure
 E.g. 2002 USA medical spending as a % of GDP was 14.6%;
Canada 9.6%; UK 7.7%; France 9.7%
 (OECD Health Data, www.oecd.org)
 Possible explanations:
 Availabilityof new and expensive technology
 Third-party payment due to asymmetric information
as well as uncertainty and risk

10. Adverse selection and moral
hazard in health-care
 Adverse selection due to imperfect
information about individual risks
 Consumer moral hazard as people can
influence the probability of ill health
 Producer/supplier moral hazard as doctors
do not bear the costs of treatment:

11. Adverse selection in private health
insurance
 Adverse selection arises from the
information asymmetry about health risks
between the insurance company and the
insured person
 Insurance company (principal) only knows
average risk in a population
 Individual (the agent) knows more about own
health risk

12. Adverse selection in private health
insurance
 If insurance contracts/premiums based on
average risk (community ratings)
 only people of average or higher than average risk will
buy the insurance - more than averagely healthy
people will not buy expensive insurance
 Implies adverse selection
 putsthe insurance companies at risk of paying out
more than they receive
 Negative impact on profits as premiums based on average
risk not high risk of the people who actually buy the
insurance.

13. Solutions for the insurance companies
 Insurance companies use ‘screening’ methods
to identify high and low risk people e.g. base
premium calculations on medical examinations,
individual experience of ill-health, lifestyles
(smoking, occupation) and other characteristics
e.g. age, ethnicity, gender, wealth.
 This can lead to premiums that are too high for many
sick people (or those most at risk) to afford
 Highest premiums unaffordable by poorer people but
they are at the most risk so they are the people likely
to be charged higher premiums
 Implies rationing by price, income and risk
 Some people unable to acquire private insurance
because they are high risk and/or too poor

14. Rationing in a private market for health care:
no excess supply/demand at the equilibrium price
but this does not mean everyone is covered
Price
S = MC
D=
MWP
Uninsured demand
Pp due to rationing by price
Qp Quantity

15. Problematic side of private based
system like the one in the USA
 Coverage problems
 Morethan 20% of the US population are
without health care coverage
 Highest infant mortality rate of developed
countries.
Myths about the uninsured in the USA:
http://www.kff.org/uninsured/upload/myths-about-the-uninsured

16. Why, if at all, does it matter if
poorer and/or sicker people are
not covered by health
insurance?
If it does matter, what
possible solutions are there for
this coverage problem?

17. Why access to health care matters
 Poorer people are more likely to suffer from ill-
health – poverty as a cause of ill-health
 The poor tend to be ill more often and more severely
ill than the rich. They live shorter lives and are in
poorer health while they are alive
 “A boy born in Hackney, next to Newham, is more than twice
as likely to die in the first year of his life as a boy born in
Bexley, in the south-east suburbs.” Carvel, 2001
 A strong relationship between health and economic
status within and between countries
 “First and foremost there is a need to reduce greatly the
burden of excess mortality and morbidity suffered by the
poor” WHO, 1999

18. 2 way causality
 The links between poverty and ill-health
are not just one way
 Ill-health can cause or worsen poverty
 but if good health care reaches the poor, it can
help to relieve poverty
 Policy directed to health can therefore have positive
economic implications for individuals and countries
 Externality effects: Ill-health leads to a decline in
productivity and earnings

19. Why access to health care matters
--equity issues
 People are concerned about the health of
others and inequalities in health – more so
than inequalities in income
 A kind of externality - humanitarian overspill
 Leads to general support of a health-care system
that is redistributive or at least provides a safety
net
 Enabling people on low incomes to access more health-
care than they could afford to buy in a competitive health
care market
 Gives a role of government in health-care

20. Why access to health care matters -
global public health issues
 Externality effects of ill-health that extend
beyond national borders
 Transmission of diseases (e.g. HIV/AIDS,
tuberculosis, malaria)
 Heightened by travel but incidence and impact highest in
Sub-Saharan Africa, Middle East and India
 Threat of bio-terrorism
 The emergence of drug-resistant strains of disease
e.g. tuberculosis, Malaria and leprosy

21. Social insurance as a policy
solution to the coverage problem
 Potential for adverse selection in health care
and related coverage problems weakened by
public provision
 AS and related coverage problem  spread of
compulsory/universal social insurance schemes in
health:
 Social insurance schemes enable risk pooling - the state
insurse the ‘uninsurable’ by compelling universal coverage
 Reduces the risk of adverse selection
 The state = third party in the relationship between patients
and health practitioners

22. Moral hazard in health care provision
and finance
Consumer moral hazard
Supplier moral hazard

23. Consumer Moral Hazard
 Consumer moral hazard arises because
insurance (private and social) reduces the
cost of consuming health care at the point
of consumption.
 As the cost of consumption falls, the cost of
being ill is reduced
 incentives to reduce the risk of falling ill are reduced
 peopletake risks with their health through health related
(bad) behaviour
 Smoking, driving recklessly, poor diet, less exercise

24. Consumer Moral Hazard
 Less personal investment in health implies
higher consumption of health care than if
there were no insurance
 Socially inefficient outcome
 Higher costs for private (and public) health
insurance companies – lower profits (higher
taxes)

25. Measures to counter consumer
moral hazard
1. Insurance based
2. Insurance + organisation based
3. Non-price rationing (state provision)

26. 1. Insurance based solutions
 Co-payments, coinsurance and deductibles - The
insured person pays some fraction of the cost of the
procedure - out of pocket expenditures.
 Co-payments: flat rate charges (e.g. prescriptions)
 Coinsurance (% share of total cost)
 Deductibles (e.g. excesses)
 Limitations: Fixed maximum coverage schemes; the
financial exposure of the insurer is fixed.
 E.g. life time coverage limited
 The insured have an incentive to ensure that costs remain within the
agreed value as excesses will have to be met by them.
 Evidence from health insurance experiments have found
that utilisation is reduced by some of these kinds of
methods

27. Evidence relating to hospital use and
different payment schemes: RAND Health
Insurance Experiment
http://www.rand.org/health/projects/hie/
 Randomized families to health insurance plans that
varied cost sharing from none ("free care") to a
catastrophic plan that approximated a large 95% family
co-insurance deductible (with a stop-loss limit of $1,000
in late-1970s dollars - scaled up for the low-income
population).
 The participants in the large-deductible plan (95 percent
coinsurance) used 25-30 percent fewer services than
those in the free-care plan….
 23 percent less likely to be hospitalized in a year
 Substantial reductions in use were found among all income
groups
 But how did this impact on health?

28. Evidence relating to health status:
RAND Health Insurance Experiment
 For most people enrolled in the RAND
experiment (mainly typical of Americans covered
by employment-based insurance) the variation in
use across the plans appeared to have minimal
to no effects on health status.
 But for those who were both poor and sick
(might be covered by Medicaid or lacking
insurance) the reduction in use was harmful.
 E.g.Hypertension was less well controlled among that
group, sufficiently so that the annual likelihood of
death in that group rose approximately 10 percent.

29. Impact of the RAND Health Insurance
Experiment
 There is still a debate over the appropriate
role for patient cost sharing… whether any
reduction in use induced by increased cost
sharing was among "necessary" or
"unnecessary" services and therefore
whether it adversely affected health.

30. Alternative solutions to consumer moral
hazard: Managed care agreements
 Insurers enter into volume discount contracts
with specific providers.
 Insured must pay extra to use ‘non-preferred
providers’ e.g. US arrangements.
 Managed Care Plans (Health maintenance organisations,
HMOs) and Preferred provider agreements (PPOs)
 Fairly comprehensive care but either
 all care is delivered through the plan’s network e.g. in
HMOs primary care physicians authorise services
 coverage greater (costs lower) e.g. when when using the
PPO’s provider network

31. Alternative solutions to consumer moral
hazard: Non-price rationing
(public finance/provision)
 No patient is refused access to health care
 But…………
 Capacity is fixed leading to waiting lists for
certain therapies.
 People pay a time cost which should discourage
unnecessary use.

32. Rationing under social provision : excess
demand at the administered price, Pa →
waiting lists
S: inelastic as determined by state
Price
Excess demand
D = MWP = Waiting lists or
time based
rationing
Pc
= Unmet demand
Pa
Qp Q* Quantity

33. Rationing under social provision can also lead to a
private market for health care - a useful safety
valve for the state system?
Price
S = MC
D=
MWP
Revenue to
Pp private system
Qpr < Q* - Qp Quantity

34. Provider moral hazard
 Provider moral hazard derives from the
infrastructure of modern health care, where a
third party (insurance or state) pays for the
health care provided by the doctor.
 The payer may have different priorities to either the
doctor or patient.
 Systems will reflect the payer’s utility function; e.g.
maximising population health gain
 Impacts on pay contracts (for medics) e.g. treatment fees

35. Implications of third party payment
 If doctors are paid a fee for services by a third party
(insurance company or government - not the patient)
then the marginal cost of health care is ‘free’ to the
patient and doctor is not constrained by patient’s ability
to pay
 Moral hazard can arise because:
 Information asymmetry between doctor and the patient
 The doctor does not know the cost of medical care
 The doctor has a financial or similar incentive to increase
consumption of health care e.g. fee for service arrangements,
 Can lead to supplier induced demand (SID); demand
higher than socially efficient

36. Supplier Induced Demand (SID)
 “Supplier induced demand is the amount of
demand created by doctors, which exists
beyond that which would have occurred in a
market in which consumers are fully
informed.” Donaldson & Gerard (1992)
 “Supplier induced demand exists when the
physician influences a patient’s demand for
care against the physicians interpretation of
the best interest of the patient.” McGuire, T.
(2000)

37. Diagrammatic illustration
•E0 = Initial
equilibrium
£
•Following an increase
in overall supply (to
S1) due to an
S0
S1 increase in funding
(new doctors or
hospitals etc),
doctors increase
E1 demand (to D1) to
E0 maintain (or
increase) target
D1 income.
D0 •E1= resulting
equilibrium
0 Q0 Q1 Q

38. Implications
 SID (excess demand) can lead to:
 Higher service costs and fees: rising health
care costs
 Higher usage of new and expensive
technology
 Potentially less of a problem when there are state
imposed spending limits (as e.g. in the UK,
Canada)
 The NHS is cheap by international standards and health
outcomes not that much different - supply side incentives
to economize through budgets and method of doctor
payment (Doctors are not paid directly for medical
activity)

39. Questions to consider:
1. What sort of health system is in
place where you are (or where you
come from)?
and;
2. how does this system address
potential problems of adverse selection
and moral hazard?
3. what are the advantages and
disadvantage of this system?

40. Policy implications: Social insurance
as an alternative to market provision
 Market failures in health care due to asymmetric
information lead to problems associated with moral
hazard and adverse selection
 Also other market failures due to:
 Externalities; Uncertainty; Economies of scale; Entry barriers
leading to a near monopoly of control by medical practicioners
 Explains the spread of compulsory and universal social
insurance schemes in health provision:
 Reduces the risk of adverse selection: the state can insure the
‘uninsurable’ by compelling universal coverage - risk pooling
 Reduces some moral hazard problems: the state can act as a
third party in the relationship between patients and health
practitioners

41. Does this approach imply an
idealised view of public system
…its guiding principle the improvement of the health
of the population at large; it allows selective access
according to effectiveness of health care in improving
health (need). It seeks to improve the health of the
population at large through a tax financed system free at
the point of service. It allows public ownership of the means
of production subject to central control of budgets; it allows
some physical direction of resources; and it allows the use
of countervailing monopsony power to influence the
rewards of suppliers.”
Culyer, Maynard and Williams, 1981

42. Criticisms of the UK NHS
 Consumers have no choice (the NHS is a monopoly)
 But patients can change doctors and ask for second opinions
 Spends too much on bureaucracy
 Spending is low by international standards
 Rationing problems: not enough resources are allocated
to the NHS leading to waiting lists
 Funding has risen and is now budgeted to reach 9.4% of GDP
 Allocation problems
 The way it allocates resources to different treatments
 Perverse incentives, over-centralisation, lack of accountability and
inflexibility
 The way resources are allocated to different geographical
regions
 Equalisation or by need? The latter is currently the aim

43. Does the alternative suggest an
idealised view of private system
• “..guiding principle consumer sovereignty in a
decentralised market, in which health care is
selective according to willingness and ability to pay. It
seeks to achieve this sovereignty by private
insurance; it allows insured services to be available
freely at time of consumption; it allows private
ownership of production and has minimal state
control over budgets and resource distribution; and it
allows the reward of suppliers to be determined by
the market.”
• Culyer, Maynard and Williams, 1981

44. Rationing and allocation are
problems (all types of systems)
 Conflict between maintaining quality and
incentives to cut costs; being cost effective
 Conflict between limited resources and coverage
- implies a need for some kind of rationing
 Even more of a problem if also trying to maintain
universal coverage and if rationing is not by price then
who receives treatment and when?

45. Rationing problems under social
provision
 Limited resources in public health care systems
mean that policymakers need to address
allocation problems
 For instance, should public health care
systems fund cosmetic surgery or very
expensive surgery that leaves patients with
low life expectancy?
 What are the consequences of this kind of
funding?

46. Case study 1
 Jake and Bunty both need kidney
transplants but there is only enough
capacity to treat one of them, even though
both will die quickly if untreated.
 How would you decide which patient to treat?
 What information would you ask for before
making a decision?

47.  Suppose you know that Jake is younger
than Bunty but Jake is heavier drinker

48. Case study 2
 Jessie and Rosie both need medical
treatment. Jessie requires a relatively
cheap hip replacement but Rosie requires
expensive heart surgery. Capacity is
limited and it is only possible to treat one
of them over the short-term (6 months).
Rosie will die quickly if untreated. Jessie
won’t die but she is in severe pain.
 How would you decide which patient to treat?
 What information would you ask for before
making a decision?

49.  Suppose you know that Rosie is older and
has other health issues but Jessie is
otherwise healthy

50. Criteria for rationing
 The ‘Fair Innings’ argument
 Younger people given priority in health care
 Consistent with QALY maximisation
 Responsibilities (Etzioni, 1988)
 Smokers given lower priority in health care
 Social contracts and fairness (Rawls, 1972)
 Health care goes to people because they need it: a
‘needs’ approach
 Inconsistent with QALY maximisation
 First come first served subject to budgets
 A lottery

51. Economics based criteria -
micro level efficiency
 The cost/quality/coverage conflict
suggests there is a role for economic
evaluation to maximise the use of limited
resources
 E.g.health economic evaluation methods
such as Quality Adjusted Life Years (QALYs)
 Multidimensional measure/index of health that
combines quantity of life (life expectancy) with
quality of life in a single index

52. Criteria for rationing applied to case study 1
 QALY maximisation and the Fair Innings argument would
dictate that in case study 1Jake would have priority if he
were younger (assuming that either patient would have a
similar quality of life)
 But isn’t Bunty’s claim just as legitimate? Would we have to give
Jake priority? What if Jake was only a few years/weeks younger
than Bunty?
 As Jake is a heavier drinker the responsibilities argument
would favour Bunty
 but what if he only drinks a little more than Bunty?
 Nevertheless, resource constraints mean equal rights to
treatment cannot be recognised – choices have to be
made

53. Final points and questions: is any kind
of health care system is optimal?
 How should health care systems balance the ever-
increasing benefits provided by scientific research, the
costs of provision and the protection of human rights?
 New drugs, equipment and treatments are solutions to health
problems but they are expensive
 Poorer people can be excluded under private insurance
but there are limited resources in publicly funded
systems
 No health care system is perfect.
 The problems of health systems in different countries are to
some extent predictable outcomes of their chosen health-care
strategy

54. Test your understanding
 Try to answer the following:
 In the context of health care insurance explain how
adverse selection problems can arise and how they
could be resolved.
 Explain how consumer and supplier moral hazard can
arise in the context of health care provision. How can
the associated problems be resolved
 How can and how should health care be rationed?

55. Extra material on the
advantages and disadvantages
of different health care systems
– for background only

56. Questions to consider
1. What are the advantages/disadvantages
of public health care systems?
2. What are the advantages/disadvantages
of private systems?
3. What would be your preferred health care
system and why?

57. Advantages of public health systems
not related to asymmetric information
 Most social insurance schemes also redistribute
from the rich to the poor through income related
payments
 They promote equity in health care
 E.g. by promoting early diagnosis as treatment is mostly free
 may enhance fairness in society
 But if individual choice is weighted more highly
then this is better served under a privately
funded or perhaps a mixed system

58. Other specific and tangible advantages
of public health systems
 They Avoid the need for safety-net facilities
 They promote universal coverage and by doing so
improve health and productivity of the population through
accessibility
 Weakens the link between poverty and ill health if health care is
provided on the basis of need rather than income
 By delivering health care to low-income people – more than they could buy
 Evidence
 Countries that rely more on private insurance (e.g. the USA, Switzerland)
have regressive health care financing systems overall
 Health care finance is more unequal than pre-tax incomes: people on low
incomes buy less insurance but pay on average a higher proportion of their
income for it
 More variation in countries where there is social insurance:
 In France and the UK health care finance is progressive; in Germany and the
Netherlands it is regressive

59. Other specific and tangible advantages
of public health systems
 Cheaper admin costs as no need to verify
eligibility
 Give provider monopsony power to the
provider to enable lower costs/charges
 E.g. monopsony power of NHS keeps prices low
(e.g. drugs, equipment)

60. Resource/service cost determination under
competition on buyers side
Price
D = MWP
S = MC
Pc Expenditure or
Resource costs
under competition
Quantity
Qc

61. Resource/service cost determination
under competition and monopsony
Price MC
D = MWP
S = AC
Expenditure or
Resource costs
Pm
under monopsony
Quantity
Qm

62. Less tangible advantages of
public health systems
 Titmuss (1970) described the establishment of the UK
NHS in the following way:
 “The most unsordid act of British social policy in the twentieth
century has allowed and encouraged sentiments of altruism,
reciprocity and social duty to express themselves; to be made
explicitly and identifiable in measurable patterns of behaviour by
all”
 He showed that supplying blood through voluntary
donation was more effective/more efficient than the
commercial alternative
 Behaviour characterised by altruism has wider positive effects?
 Public health systems encourage altruism; A kind of positive
caring externality?

63. Disadvantages of public health
systems
 Medical practitioners don’t face up to resource
constraints; provider moral hazard remains an
issue
 Need better incentives to be efficient – but how?
 Market? Community?
 People’s expectations of the health service are
unrealistic
 Redistributive social insurance schemes may be
perceived negatively
 Compels coverage of low risk and rich people (as well as high
risk people)

64. Example of more market based
system: the USA
 Primarily a private enterprise based health care
system but four public health care funding
streams:
 Medicare – health care funding for the elderly
 Federal health care funding
 Medicaid – health care funding for the poor
 Collaboration between Federal Government and the States.
 Veterans Administration Health Care
 Federal Government funding for veterans of the armed
services.
 Health insurance for federal and state employees.

65. Problematic side of USA system
 As well as coverage problems as already
discussed
 More than 20% of population without health
care coverage
 Also too expensive – perhaps due to
consumer and supplier moral hazard
 highestutilisation of high tech health care.
 More than 17% of GDP spent on health care.

66. Alternative more mixed systems;
Canada
 National Health Insurance system with universal
coverage
 Collaboration between provincial and national
governments.
 75% of health care expenditure Province/territory administration
of comprehensive and universal care supported by grants from
federal government
 Hospitals are private institutions but budgets approved
by provinces
 Most physicians are in private practice but paid by
provinces on nationally agreed fee-for-service base
under negotiated fee schedules
 System is generally seen as less costly and more
effective than the US system

67. Some comparative statistics
Which system is the most successful?

68. Theoretical appendix: SID can also imply
reductions in demand in response to changes in
funding
£ •E0 = Initial
equilibrium
S1
•Following a
S0 reduction in supply
S2 (funding); doctors
reduce demand to
E1 maintain target
E0 income. E1 = resulting
E2
equilibrium
D2 •Following an increase
D0 in supply doctors
increase demand to
D1 maintain target
0 Q income. E2=
resulting equilibrium