The Theory of Demand for Health Insurance

by John A. Nyman

Overview

Why do people buy health insurance? Conventional theory holds that people purchase insurance because they prefer the certainty of paying a small premium to the risk of getting sick and paying a large medical bill. Conventional theory also holds that any additional health care that consumers purchase because they have insurance is not worth the cost of producing it. Therefore, economists have promoted policies—copayments and managed care—to reduce consumption of this additional, seemingly low-value care.

This book presents a new theory of consumer demand for health insurance. It holds that people purchase insurance to obtain additional income when they become ill. In effect, insurance companies act to transfer insurance premiums from those who remain healthy to those who become ill. This additional income generates purchases of additional high-value care, often allowing sick persons to obtain life-saving care that they could not otherwise afford.

Regarding risk, the new theory relies on empirical studies showing that consumers actually prefer the risk of a large loss to incurring a smaller loss with certainty. Therefore, if consumers purchase insurance, it is not because they desire to avoid risk. Instead, the new theory suggests consumers simply pay a premium when healthy in exchange for a claim on additional income (effected when insurance pays for the medical care) if they become ill.

Health insurance is substantially more valuable to the consumer under the new theory. The new theory moreover implies that copayments and managed care—central health policies of the last 30 years—were directed at solving problems that largely did not exist. Because these policies either reduced the amount of income transferred to ill persons or limited access to valuable health care, they may have done more harm than good. The new theory also provides a solid theoretical justification for insuring the uninsured and for implementing national health insurance.

Product Details

ISBN-13:	9780804744881
Publisher:	Stanford University Press
Publication date:	11/01/2002
Edition description:	1
Pages:	216
Product dimensions:	6.00(w) x 9.00(h) x 0.80(d)

About the Author

John A. Nyman is Professor of Health Services Research and Policy at the University of Minnesota.

Table of Contents

	Preface	xiii
1.	Introduction	1
	Controversies	1
	Overview of the New Theory	2
	Overview of the Book	3
	Intuition	5
	Notes	7
2.	Conventional Theory and Anomalies	8
	History	8
	von Neumann-Morgenstern (vNM) Utility Function	12
	Conventional Expected Utility Theory	16
	The Moral Hazard Welfare Loss	19
	Anomalies	21
	Moral Hazard Is Welfare Decreasing	21
	Contingent-Claims Insurance Payoffs Have No Income Effects	22
	Consumers Prefer Certain Losses	24
	Risk Preferences Derive Only from Diminishing Marginal Utility	25
	Insurance at Current Coverage Parameters Is Welfare Decreasing	26
	Summary	27
	Notes	29
3.	New Theory	30
	Overview	30
	Model	30
	Graphical Model	34
	Decision to Purchase Insurance	37
	Extreme Cases and Examples	38
	Contingent-Claims versus Price-Payoff Insurance Contracts	41
	The Physician and Substitutability of Medical Care for Other Goods and Services	43
	Payoffs, Treatment Costs, and Full Coverage	44
	Adverse Selection and Moral Hazard	44
	Welfare Consequences at the Margin	46
	Summary	47
	Note	48
4.	Expected Utility Theory from a Quid Pro Quo Perspective	49
	Overview	49
	Expected Utility Theory Respecified	49
	Derivation of the Quid Pro Quo Specification	53
	Prospect Theory	54
	Focusing on the Insurance Contract	56
	Additional Considerations	58
	Importance and Implications	60
Appendix	The Gain Specification	63
	Note	66
5.	Access Value of Health Insurance	67
	Introduction	67
	Model	68
	Prevalence of the Access Motive	70
	Access Valuation of a Given Procedure	71
	Estimating Willingness to Pay	72
	Valuing Outcomes	73
	Specific Disease Example	74
	Access Value from Cost-Utility League Tables	75
	Access Value Using the NMES	77
	Charity Care	78
	Importance of the Access Motive	79
	Note	80
6.	Welfare Loss from Moral Hazard	81
	Ex Post Moral Hazard	81
	Pauly's Moral Hazard Welfare Loss	82
	Overview of the Rest of the Chapter	84
	Taxonomy of Price Change Decompositions	84
	Hicksian Decomposition Holding Utility Constant	85
	Friedman/Slutsky Decomposition Holding Real Income Constant	86
	New Decomposition Holding Nominal Income Constant	87
	Welfare Loss from Insurance	88
	Mathematical Expression of the Welfare Loss	90
	Marshallian Demand Curve Price Effect	91
	Hicksian Demand Curve Price Effect	91
	New Demand Curve Price Effect	92
	Estimating the Welfare Loss from the Price Effect	92
	Coinsurance Rate	93
	Marshallian Price Elasticity of Demand	93
	Medical Care Spending Share	95
	Income Elasticity of Demand	97
	Estimates of the Relative Welfare Loss	98
	Implications	99
	Notes	101
7.	Welfare Gain from Moral Hazard	102
	Overview	102
	Moral Hazard as Specific Health Care	103
	Evaluating Moral Hazard	107
	An Estimate of the Welfare Gain	109
	Literature on Health Insurance and Health	110
	Estimating the Welfare Gain	112
	Refinements of the Analysis	114
	The Welfare Gain from Moral Hazard Diagrammatically	116
	Conclusions	118
	Notes	120
8.	Why Health Insurance Is Sometimes Not Purchased	122
	Introduction	122
	Charity and Medicaid	123
	Risk	126
	Risk and the Very Poor	126
	Digression on Gambling and Insurance	128
	Separating Risk Preferences from the Bernoulli Utility Function	133
	Loading Fees and Premiums	136
	Price-Related Moral Hazard	137
	Adverse Selection	139
	Physician-Induced Demand	140
	Conclusions	140
	Notes	142
9.	Policy Implications	143
	Cost Containment	143
	Cost Sharing	144
	Coinsurance and Moral Hazard	145
	Calculating the Effect of Coinsurance on Efficient Moral Hazard	147
	Rice's Theory	149
	Managed Care	151
	A Price-Reduction Strategy	152
	Optimal Health Insurance Design	153
	Insuring the Uninsured	155
	The Case for Intervention: Medicare	156
	The Case for Tax Subsidies	157
	Technology Growth as Moral Hazard	159
	Conclusions	161
	Notes	162
10.	Conclusions	164
	The Theory Summarized	164
	The Price-Payoff Mechanism, The Value of Health Care, and National Health Insurance	166
	Potential Weaknesses	167
	Different Income Elasticities for the Healthy and Ill	167
	Blank Check Argument	169
	Consumer's Income Payoff Test	170
	Health Care for the Healthy	170
	Limitations	171
	Future Empirical Work	172
	A Cautionary Word	174
	Intuition Revisited	177
	Notes	179
	References	180
	Index	195

Editorial Reviews

This book thoroughly and critically re-examines two core beliefs in health economics: that health insurance induces individuals to overconsume care and that the demand for insurance is primarily driven by individuals' desire to avoid risk. It concludes that much of the increase in health care expenditures associated with insurance does not diminish welfare and that individuals' desire to increase their ability to afford health care when they fall ill is an important motivator for the purchase of health insurance. These ideas, though perhaps controversial, offer important insights to scholars and teachers working in this area and have important ramifications for policy makers and health care purchasers as they strive to constrain health care cost growth.”—Michael Chernew, University of Michigan

“This is a compelling and modern treatment of the demand for health insurance written by a leader in the field. The book is concise yet comprehensive, carefully researched, and clear. It is must reading for anyone interested in understanding alternative theories of the demand for health insurance, as well as the policy implications of these alternative theories.”—John A. Rizzo, The Ohio State University

From the Publisher