Are Invisible Hands Good Hands? Moral Hazard, Competition, and the 2nd Best in Health Care Markets

Date of Original Version



Working Paper

Abstract or Description

The nature and normative properties of competition in health care markets have long been the subject of debate. In this paper we consider what the optimal benchmark is in the presence of moral hazard effects on consumption due to health insurance. Moral hazard is widely recognized as one of the most important distortions in health care markets. In general, economic analysis suggests that marginal-cost pricing leads to static Pareto optimal allocations. In health care markets, however, moral hazard due to health insurance leads to excess consumption, in the sense that insured individuals will consume medical services past the point where the marginal utility of an additional service is equal to its marginal cost (Arrow, 1963; Pauly, 1968). Since health insurance pays for part or all medical expenses, insured individuals face a price that is lower than the market price and consume more of the medical good than is optimal. Therefore it is not obvious that competition or marginal cost pricing is second best optimal given this distortion. The principal claim of this paper is that most of economists’ intuition regarding the welfare effects of price changes in markets not distorted by moral hazard applies quite well to markets where decision-making by consumers is distorted by moral hazard. In particular, lower prices are better for consumers than are higher prices. Furthermore, the gain to consumers from lowering price from supra-marginal cost levels to marginal costs outweighs the loss of profit to the medical industry. Finally, the usual method of computing consumer’s surplus by integration under the demand curve is still appropriate in markets with moral hazard.