MORAL HAZARD IN HEALTH INSURANCE KENNETH J. ARROW LECTURE SERIES KENNETH J. ARROW LECTURE SERIES Kenneth J. Arrow’s work has shaped the course of economics for the past sixty years so deeply that, in a sense, every modern economist is his student. His ideas, style of research, and breadth of vision have been a model for generations of the boldest, most creative, and most innovative economists. His work has yielded such seminal theorems as general equilibrium, social choice, and endogenous growth, proving that simple ideas have profound effects. The Kenneth J. Arrow Lecture Series, supported by the Committee on Global Thought and the Program for Economic Research, highlights economists, from Nobel laureates to groundbreaking younger scholars, whose work builds on Arrow’s scholarship as well as his innovative spirit. The books in the series are an expansion of the lectures that are held in Arrow’s honor at Columbia University. Creating a Learning Society: A New Approach to Growth, Development, and Social Progress, Joseph E. Stiglitz and Bruce C. Greenwald The Arrow Impossibility Theorem, Eric Maskin and Amartya Sen Speculation, Trading, and Bubbles, José A. Scheinkman MORAL HAZARD IN HEALTH INSURANCE AMY FINKELSTEIN WITH KENNETH J. ARROW, JONATHAN GRUBER, JOSEPH P. NEWHOUSE, AND JOSEPH E. STIGLITZ COLUMBIA UNIVERSITY PRESS | NEW YORK Columbia University Press Publishers Since 1893 New York Chichester, West Sussex cup.columbia.edu Copyright © 2015 Columbia University Press All rights reserved E-ISBN 978-0-231-53868-8 Library of Congress Cataloging-in-Publication Data Finkelstein, Amy. Moral hazard in health insurance / Amy Finkelstein. pages cm. — (Kenneth J. Arrow lecture series) Includes bibliographical references and index. ISBN 978-0-231-16380-4 (cloth : alk. paper) — ISBN 978-0-231-53868-8 (ebook) 1. Health insurance. 2. Moral hazard. 3. Risk (Insurance) I. Title. HG9383.F56 2014 368.38’2—dc23 2014011303 A Columbia University Press E-book. CUP would be pleased to hear about your reading experience with this e-book at [email protected]. Cover design: Noah Arlow References to websites (URLs) were accurate at the time of writing. Neither the author nor Columbia University Press is responsible for URLs that may have expired or changed since the manuscript was prepared. CONTENTS Foreword by Joseph E. Stiglitz INTRODUCTION JOSEPH P. NEWHOUSE MORAL HAZARD IN HEALTH INSURANCE: DEVELOPMENTS SINCE ARROW (1963) AMY FINKELSTEIN COMMENTARY JONATHAN GRUBER COMMENTARY KENNETH J. ARROW COMMENTARY JOSEPH E. STIGLITZ DISCUSSION ARROW (1963): UNCERTAINTY AND THE WELFARE ECONOMICS OF MEDICAL CARE KENNETH J. ARROW Notes on Contributors Index FOREWORD JOSEPH E. STIGLITZ T his book grew out of the fifth annual Kenneth J. Arrow Lecture that took place in April 2012. This series honors one of Columbia’s most distinguished graduates, Kenneth J. Arrow. Each year’s lecture focuses on the intellectual developments that have arisen from one of his many seminal contributions to the discipline. Over the past six years, the lecture series has covered a huge variety of topics, just as Ken’s work has. The books in the Kenneth J. Arrow Lecture Series are all based on one of these lectures. The first lecture, which Bruce Greenwald and I delivered, followed up on Ken’s 1962 paper on learning by doing.1 That lecture led to a book published in 2014 by Columbia University Press, Creating a Learning Society: A New Approach to Growth, Development, and Social Progress. The second Arrow lecture, by Nobel Prize winners Eric Maskin and Amartya Sen,2 focused on Ken’s Ph.D. thesis, published as Social Choice and Individual Values in 1951. Maskin and Sen’s lecture formed the basis of the second book in the series, The Arrow Impossibility Theorem (2014). The third book, Speculation, Trading, and Bubbles (2014), was based on a lecture by José A. Scheinkman. Scheinkman considered Arrow’s fundamental work on general equilibrium, where he introduced the concept of what is now called Arrow- Debreu securities, revolutionizing thinking about financial markets. The fourth lecture was on global warming, a subject about which Arrow has felt passionately. He served with me on Working Group III of the 1995 Assessment of the International Panel on Climate Change (IPCC), and we wrote a paper, together with several of our other colleagues in the working group, on the effect of uncertainty on the appropriate rate of discounting, to take into account the future costs of global warming.3 Sir Partha Dasgupta’s lecture, “Persons and Time in the Welfare Economics of Climate Change,” further pursued the question of the appropriate responses to the threat of global warming. (The sixth Arrow lecture, delivered by Christian Gollier, also considered the economics of discounting, and the books based on his lecture and on Dasgupta’s are forthcoming.) This volume presents the fifth annual Kenneth J. Arrow lecture, by Amy Finkelstein, one of the country’s leading health economists and, like Ken, winner of the John Bates Clark Award (Arrow received this honor in 1957; Finkelstein, in 2012). It picks up on another classic Arrow paper, “Uncertainty and the Welfare Economics of Medical Care,” published in 1963 (and reprinted in this volume), in which he analyzed the implications of moral hazard—a concept that had not yet entered into the mainstream economics literature—in the context of health insurance. One of the reasons that the standard competitive model—the formulation and analysis of which he himself had played such a pivotal role in— did not provide a good description of the insurance market is moral hazard, the fact that the provision of insurance attenuates incentives to avoid the insured- against event.4 (Another is adverse selection. His 1965 Jahnsson lecture, “Aspects of the Theory of Risk Bearing,” highlighted the importance of both of these.) His 1963 paper was a seminal contribution both to the economics of (health) insurance and to the theory of moral hazard. It launched two huge bodies of literature. We were pleased that one of the major young contributors to that literature accepted our invitation to deliver the fifth Arrow lecture. The questions Ken raised are still front and center in one of today’s central policy issues, the provision of health insurance. Prior to the passage of the Affordable Care Act (commonly called Obamacare), more than 50 million5 Americans lacked health insurance. America’s poor health performance is partially the result of this deficiency. The talk provided an opportunity to connect some of these policy issues with basic economic research. Amy Finkelstein is Professor of Economics at MIT, Co-Director of the Public Economics Program at the National Bureau of Economic Research, and Co- Editor of the Journal of Public Economics, which I helped found many years ago. Her research in public finance and health economics focuses on market failures and government intervention in insurance markets and the impact of public policy in the healthcare sector. This volume includes not only Amy’s lecture but also the commentaries of its discussants. The first is Jonathan Gruber, who is also a Professor of Economics at MIT and Co-Director of the Healthcare Program at the National Bureau of Economic Research. He has been involved in health economics for a very long time and has won a number of awards for his work, including an Inaugural Medal for Best Health Economist Age Forty and Under from the American Society of Health Economists in 2006, and the National Institute for Health Care Management Foundation Health Care Research Award in 2012. He has also served as Deputy Assistant Secretary for Economic Policy at the Treasury Department. He did important work on the Massachusetts Healthcare Reform, which was the prototype for the Affordable Care Act. I served as the second discussant. Our third discussant is Ken Arrow himself. One of the wonderful aspects of the Arrow Lecture is that Ken graciously agrees to comment on the talk, and that is always an exciting moment, because it reflects both how he thought about the problem many years ago and how thinking about these debates has evolved over subsequent decades. Joseph P. Newhouse has also graciously provided an introduction to this volume, which provides context for the ensuing discussion. Newhouse was one of the leaders of the famous RAND Health Insurance Experiment, and of the landmark Oregon Health Insurance Experiment, which Amy discusses later in this book. In 2014, he received the Victor R. Fuchs Lifetime Achievement Award from the American Society of Health Economists, in recognition of his pioneering work in the field. I want to acknowledge Columbia University Press, the Program for Economic Research, and the Committee on Global Thought for their support of the Arrow Lecture Series, and Laura Morrison, Sasha de Vogel, and Robin Stephenson for helping organize the event. I also want to especially thank Ken for honoring us again with his attendance, and Amy and Jon for sharing their work and thoughts. 1. Arrow, Kenneth J. “The economic implications of learning by doing.” The review of economic studies (1962): 155–173. 2. Ken Arrow received the Nobel Prize in 1972; Amartya Sen, in 1998, and Erik Maskin, in 2007. 3. Published as Arrow, K. J., W. R. Cline, K. G. Mäler, M. Munasinghe, R. Squitieri, and J. E. Stiglitz, 1996: “Discounting.” In: Climatic Change 1995: Economic and Social Dimensions of Climate Change, Second Assessment of the Intergovernmental Panel on Climate Change [Bruce, J. P., H. Lee, and E. F. Haites (eds.)]. Cambridge University Press, Cambridge and New York, pp. 129–144. 4. An extreme form of moral hazard is that where the individual actually takes action to precipitate the insured-against event. 5. See U.S. Census Bureau. “Income, Poverty, and Health Insurance Coverage in the United States: 2009,” Table 8, Issued in September 2010. INTRODUCTION JOSEPH P. NEWHOUSE E ach academic year, I teach the first session of a one-semester course in health economics for second-year graduate students. The reading for that session consists of two seminal works in health economics: Kenneth Arrow’s “Uncertainty and the Welfare Economics of Medical Care” and Michael Grossman’s The Demand for Health: A Theoretical and Empirical Investigation (Arrow 1963; Grossman 1972).1 These two works have resulted in two largely non-overlapping streams of the by-now vast health economics literature. Arrow’s article led, somewhat belatedly, to a literature on the functioning of markets for medical services and health insurance.2 Grossman’s book led to a literature on determinants of the health status of the population, only one determinant of which, as both Arrow and Grossman emphasized, is medical care. The real-world context for Arrow’s 1963 article was the growing clinical capabilities of medical care and the concomitant acceleration of medical care’s claims on the economy’s resources.3 The economics context was general equilibrium theory, which considered the existence and properties of competitive equilibrium (Arrow and Debreu 1954). Among the stringent requirements for the efficiency of competitive markets were the existence of a market for all products, including markets for risk, and the availability of information about costs and benefits. Arrow focused on the shortcomings of medical markets, especially incomplete markets for risk bearing and the imperfect information available to doctors, patients, and potential insurers. Arrow emphasized that markets to insure all medical risks could not exist, in part because what a consumer sought from visiting a physician was information about the cause of a medical problem and its appropriate treatment. Because it was practically impossible to enumerate all possible contingencies and a fixed amount the policy would pay for each, an insurance contract specifying a payoff could not exist. In other words, markets to insure against these risks did not exist, and so an efficient outcome was unattainable. Furthermore, Arrow argued