2. Wrapping UP Insurance

3. Let’s Review Moral Hazard With health insurance, the amount of expenditures may depend on whether you have insurance. Suppose that probability of illness is 0.5. Suppose demand for care (if sick) is P 1 Q 1. Actuarially fair policy would cost 0.5*P 1 Q 1. Quantity Price Demand Q1Q1 P1P1 Exp. Premium

4. Moral Hazard What if demand was somewhat elastic? Quantity Price Demand Q1Q1 P1P1 Exp. Premium If insurer charges 0.5*P 1 Q 1, it will lose money. Why, because expected payments are P 1 Q 2. Q2Q2 What if insurer charges 0.5*P 1 Q 2 ? New Premium Customer may not buy insurance. May self-insure.

5. Moral Hazard Why? Two dimensions to insurance –Premium against risk. Customer wishes to insure against this. –Extra resource cost due to moral hazard. The risk was P 1 Q 1. Customer may not be willing to pay more to insure against that risk!

6. Let’s Review Coinsurance Suppose a visit costs $20. BUT, insurance pays 50%. Visits Money Price Effective Price 40 30 20 10 20 30 40 Money price demand Effective demand

7. What Does Moral Hazard Do? It makes us spend too much on medical care. Quantity Price Demand Q1Q1 P1P1 Exp. At P 1, we buy Q 1 and spend E 1. With insurance, we pay LESS than full price, so we buy Q 2, spend E 2. This is P 1 (Q 2 - Q 1 ) more than we spent before. Why is it too much? Demand w/ insurance Q2Q2

8. What Does Moral Hazard Do? Why is it too much? We paid P 1 (Q 2 - Q 1 ) more. Quantity Price Demand Q1Q1 P1P1 Exp. The demand curve tells us what the care is worth to us. So the additional (Q 2 - Q 1 ) is worth: Demand w/ insurance Q2Q2 Value The “wasted” expenditures are: Wasted

9. For the Entire Economy it’s WORSE Why is it too much? We paid P 1 (Q 2 - Q 1 ) more. Quantity Price Demand Q1Q1 P1P1 Exp. The demand curve tells us what the care is worth to us. So the additional (Q 2 - Q 1 ) is worth: Demand w/ insurance Q2Q2 The “wasted” expenditures are: Wasted Supply Value

10. Who pays for health insurance? It is important to relate health insurance benefits to the wage rate that workers are paid. The simplest way is to examine the supply and demand for labor, in the absence of insurance, and then institute health insurance and see what happens.

11. Who pays? Consider a labor market with a typically downward sloping demand for labor D, and a typically upward sloping supply of labor S. The demand for labor is related to the marginal productivity of workers. Employers will hire the workers as long as the value of their output (marginal revenue product) is greater than or equal to the wage that employers must pay them. Employees Wage rate D S W1W1 L1L1

12. Who pays? The supply of workers is related to the wage in this industry relative to other industries. Workers will choose to work in this industry as long as the wage they can earn exceeds their opportunities in other jobs. The equilibrium wage is W 1 and the equilibrium quantity of labor demanded and supplied is L 1. Employees Wage rate D S W1W1 L1L1

13. Who pays? Now suppose that workers in the market negotiate a health insurance benefit worth $z/hour at that margin, and costs employers exactly $z/hour to provide. What happens? Employers who before were willing to pay W 1 per hour for workers, will now pay W 1 less $z. Other points on the demand curve will shift downward in a similar manner, so the demand curve will shift downward by exactly $z to D. Employees Wage rate D S W1W1 L1L1 z D

14. Who pays? What will happen to the supply curve? Since the workers were willing to supply various amounts of labor at various wage rates according to the supply curve before, now that they are receiving a benefit worth $z, they will offer their labor for $z less. Hence, the supply curve will shift downward by exactly $z to S. Employees Wage rate D S W1W1 L1L1 z D z S

15. Who pays? New equilibrium is at L 1, W 2. What is the result? The net wage remains the same, but the money wage falls by $z. The equilibrium wage has fallen to W 2 or by exactly the amount of the benefit. Workers have taken their benefits in lower money wages, and the same number of workers L 1 is employed at the same net wage. Employees Wage rate D S W1W1 L1L1 z D z S W2W2

16. Who pays? By assuming that the marginal benefit was worth exactly what it cost to provide, the previous example ignored the moral hazard involved in health insurance. Recall that for many types of health care, fractional coinsurance leads consumers to consume health care past the point at which marginal benefits equal marginal costs. This provides benefits that, on average, may be worth less to the workers than what they cost to provide. Employees Wage rate D S W1W1 L1L1 z D z S W2W2

17. Who pays? Suppose, for example, that workers negotiate subsidized coverage for pre- scription drugs. This benefit might induce workers to purchase drugs beyond the point at which marginal benefits equal marginal costs. If the average benefit is worth $b/hour, or less to the workers than the $z/hour that it costs to provide, then the new supply of labor curve S  will have fallen by less than the demand for labor (still D, reflecting what it costs to provide the benefit). Employees Wage rate D S W1W1 L1L1 z D z S W2W2 b W3W3 L2L2

18. Who pays? Our new equilibrium yields wage W 3, which is higher than W 2. The net wage (W 3 + z) is higher than the original equilibrium wage W 1 (without insurance). Not surprisingly, employers react to the higher net wage by reducing employment in the industry from L 1 to L 2. Employees Wage rate D S W1W1 L1L1 z D z S W2W2 b W3W3 L2L2 W 3 +z

19. So … who pays? Fundamentally, the employees pay for insurance, in the form of lower money wages. Some may pay in the form of unemployment.