1. Announcements HW #1 on the website 1/12/2015

2. How do we finance medical care? Federal expenditures in 2013: $586B in Medicare $265B in Medicaid (+ 1/3 rd in State spending) $248B in tax expenditures (1.5% GDP) 1/12/2015

3. Medical Insurance Markets Differ from those of other goods because the cost of providing insurance depends on the characteristics of the buyer. – Leads to Adverse Selection Generally, there is a lack of coverage against the long-term risk of becoming sick. – Multi-year health insurance markets don’t exist in the private market. – Long-term care insurance & disability insurance 1/12/2015

4. Why Have Health Insurance? 1/12/2015

5. Basic Model of Health Insurance 2 states – healthy, sick 1 disease, with probability p, and 1 cure at cost m Utility: U(x) where x=consumption Income y, exogenous, no borrowing or lending.  = insurance premium = pm (actuarially fair) Without Insurance: V N =(1-p)U(y) + pU(y-m) With Complete Insurance: V I = (1-p)U(y-  ) + pU(y-  ) = U(y-  ) Value of Insurance = 1/12/2015

6. Value of Health Insurance sick healthy 45 o y y y-m Uninsured 1/12/2015

7. Value of Health Insurance sick healthy 45 o y y y-m Uninsured Fair-odds line Slope = (1-p)/p 1/12/2015

8. Value of Health Insurance sick healthy 45 o y y y-m Uninsured Full Insurance y-  1/12/20158

9. Willingness to Pay sick healthy 45 o y y y-m Uninsured Full Insurance y-  Willingness to Pay 1/12/2015

10. Complications Model Simplifications More than 1 disease – cannot be fully monitored More than 1 treatment option, with varying costs Ex-ante unknown which treatment will yield the best health outcome (at least by the insurance company) Treatment not equivalent to cure Different marginal utilities of consumption when at different states of health Aspects of the Market Asymmetric Information Moral hazard 1/12/2015

11. Asymmetric Information: Adverse Selection Ex-ante knowledge gap – Individuals know health care demand, insurance company does not. What happens to the competitive equilibrium? – Rothschild & Stiglitz 1/12/2015

12. AverageFair- odds Low-RiskHigh-Risk Low-type fair- odds High-type fair- odds 45 o Sick Healthy 1/12/2015

13. No Pooling Equilibrium Exists High-Risk 45 o Sick Healthy Low-Risk b b ULUL UHUH 1/12/2015

14. A Separating Equilibrium 45 o Sick Healthy UHUH HH 1/12/2015

15. A Separating Equilibrium 45 o Sick Healthy ULUL UHUH HH LL 1/12/2015

16. A Separating Equilibrium 45 o Sick Healthy ULUL UHUH HH LL 1/12/2015

17. A Separating Equilibrium 45 o Sick Healthy ULUL UHUH HH LL 1/12/2015

18. Competitive Equilibria with Adverse Selection 2 types: Low, High High-type: – Full Insurance at actuarially fair price – Exerts a negative externality on low-types Low-type: – Incomplete Insurance 1/12/2015

19. Dynamic Adverse Selection: Death Spirals 2 plans: plan 1 is generous; plan 2 restricted Individuals sort: 50% to each. Average health of each group Next Period: Premiums in plan 1 increase more than the premiums in plan 2 because of the distribution of health care costs Individuals sort: 25% to plan 1; 75% to plan 2 Next period: Premiums in plan 1 increase more than the premiums in plan 2 Individuals sort: 5% to plan 1; 95% to plan 2…. 1/12/2015

20. Adverse Selection in Action Cutler and Reber (1998) "Paying for Health Insurance: the Trade-off Between Competition and Adverse Selection“ Harvard University Health Insurance – Paid a fixed percentage of employee’s health insurance costs – Move to paying a fixed AMOUNT (1995)  increased the cost of the most generous plan by over $500 a year  Employee paying the marginal cost of health insurance  Efficient selection of health insurance plans 1/12/2015

21. Harvard Health Insurance Costs HI Type (individual) Total Costs Employee Costs (old policy) Employee Costs (new policy) Difference Share enrolled PPO (most generous) $2773$555$1152$59716% HMO (Least generous) $1980$277$421$14484% Difference$793$278$731$453 1/12/2015

23. Plan Enrollment Changes 1/12/2015

24. LOTS of concern about dynamic adverse selection in the Exchange Did it happen in the first year? What would you look for? 1/12/2015

25. And Harvard’s health insurance changes continues to make the news... NYT, Jan 5, 2015: http://www.nytimes.com/2015/01/06/us/healt h-care-fixes-backed-by-harvards-experts-now- roil-its-faculty.html?_r=0 Fox News: Jan 6, 2015 http://www.foxnews.com/opinion/2015/01/06/ welcome-to-obamacare-2015-harvard-faculty- outraged-over-health-care-hikes/ 1/12/2015

26. Methods to Address Adverse Selection 1/12/2015

27. Agency Problems Supplier-Induced Demand – To be Discussed with Lou Moral Hazard or “Hidden Action” – People take worse care of themselves – People increase their consumption of medical care when it is subsidized – “substitution effect” – 2 nd best insurance design: trade-off risk-sharing and the costs of moral hazard. 1/12/2015

28. Solutions to the Agency Problems Supply-Side – Monitoring providers – Integrating medical insurance and providers – Payment methods – To be discussed in great detail after spring break Demand-Side – Make people pay something when they consume medical care. 1/12/2015

29. Co-Payments Full insurance: Pays actual costs of care = m Cost to the individual C(s) = 0 Removes all risk from the individual Moral Hazard Indemnity Policy: pays fixed M per diagnosis. C(s) = m-M Insurer takes the individual’s medical expenditure as a signal of true medical needs. 1/12/2015

30. Optimal Health Insurance with Co-payments Continuous array of illnesses, s, distributed f(s) Health: h=H(s,m) – Function of illness and medical costs – s determines optimal treatment – Insurer cannot observe s Ex-ante utility function: 1/12/2015

31. Second-Best Solution S is not fully monitored Insurance premiums for that year, and in future, are fixed Marginal Cost to consumer = c’(m) Solution: depends on the realized s Difference: when c’(m) < 1, people will over-consume medical care when sick, thus pay more in health insurance than optimal 1/12/2015

32. What does the optimal insurance plan look like? Copayments produce: – Increased efficiency of provision due to less overconsumption of medical care – Decreased welfare due to more exposure to risk 1/12/2015

33. Readings for discussion Chandra, Gruber and McKnight (2011) Kruger and Kuziemko (2011) 1/12/2015