ECON 2030: Microeconomic Policy

Topic 4: Information failures and health insurance

Dr. Ian A. MacKenzie

University of Queensland

Semester 2, 2018
Overview and feedback: lecture structure

I Missing markets and market power:

I Topic 2: Environmental policy (externalities)
I Topic 3: Competition policy (imperfect competition)
I Topic 4: Information failures and health insurance
(asymmetric information)
I Equity:
I Topic 5: Redistribution
I Redistribution I: Measurement & Concepts
I Redistribution II - Work Incentives and the Labour-Leisure
Model
I Topic 6: Taxation
I Taxation I - Background and Incidence
I Taxation II - Efficiency
I Realism:
I Topic 7: Political economics
Objectives

I To understand the nature of the market failure in health

insurance.
I To develop analytical tools to analyse choice under
uncertainty.
I To understand the issue of adverse selection and potential
solutions.
I To understand the issue of moral hazard and potential
solutions
Choice under uncertainty

I Example 1:
I Emily has annual income of $50,000.
I 1 in 10 chance (i.e. 10%) of getting sick each year, costing
her $30,000 due to medical bills and lost income, leaving
only $20,000 income.
I Expected value (EV):
I The average value over all possible uncertain outcomes,
with each outcome weighted by its probability of occurring.
I EV=(probability of outcome 1 * Payout in outcome 1) +
(probability of outcome 2*Payout in outcome 2) +...+
(probability of outcome n*Payout in outcome n)
Calculating EV

I Example 2: draw cards from deck of cards

I If draw heart receive $12
I If draw spade, diamond or club lose $4
I Example 3:
I Calculate the expected value of lottery ticket that costs $10
but offers the chance to win $50,000 with probability 1%.
An example: male life table (2010-12)

Age survival prob No of lives (100,000) life expectancy

1 0.999654 99,588 80.06
16 0.999699 99,379 64.55
21 0.999388 99,124 59.70
30 0.999174 98,519 51.04
40 0.998662 97,516 41.51
50 0.997132 95,687 32.20
70 0.983255 82,577 15.31
100 0.687451 1,548 2.46

Source: Commonwealth of Australia

Attitudes towards risk

I If choosing between two options with the same EV

I Risk averse: choose the option with the lower risk
I Risk neutral: indifferent
I Risk loving: choose the riskier option
I Implications of risk aversion:
I willing to pay to avoid risk (choose lower EV option, with
lower risk)
I will choose more risky option if increase in EV is
sufficiently large
I degree of risk aversion differs across people
Expected utility

I expected utility = the average utility over all possible

uncertain outcomes, calculated by weighing the utility for
each outcome by its probability of occurring.
I EU = (probability of outcome 1 * utility in outcome 1) +
(probability of outcome 2 *utility in outcome 2) +... +
(probability of outcome n * utilityin outcome n)
I Choose the option which maximizes EU
Expected values

(a) are calculated as the average value.

(b) are calculated over all possible outcomes.
(c) are weighted by the probability of an event occurring.
(d) All of the above.
(e) None of the above.
Health Insurance

I Suppose that Emily can buy insurance that will cover her
expenses in case of illness.
I Actuarially fair insurance premium = 3,000
I premium equals expected payout/loss
I On average, insurance company profit =0
I for simplicity ignore other costs
I With actuarially fair insurance, a risk averse person buys
full insurance.
Risk aversion and insurance

I Risk premium = the amount above the actuarially fair

premium that a risk-averse person is WTP to purchase
insurance
I Loading fee = the difference between the premium an
insurance company charges and the actuarially fair
premium level
Objectives

I To understand the nature of the market failure in health

insurance. 4
I To develop analytical tools to analyse choice under
uncertainty. 4
I To understand the issue of adverse selection and potential
solutions.
I To understand the issue of moral hazard and potential
solutions
Market failure in the health insurance market

I Asymmetric information
I A situation in which one party engaged in an economic
transaction has better information than the other party.
I Consumers are usually better informed about their own
health than are insurers.
I Market for lemons
Example
Consequences

I Adverse selection occurs when a firm offers an insurance

policy to the market and finishes up with consumers who
are most likely to benefit from it (Abelson, p.62).
I Result: underinsurance, complete collapse (“death spiral”)
I Solution? Experience rating—screen customers and charge
different premiums based on risk profiles, or deny
coverage.
Policy responses

I Policy Responses to Insurance Market Failures

I Do nothing
I Mandate a level of private insurance
I Subsidise private insurance
I Provide full or partial public insurance Suncorp
I Provide social assistance to those in need
Objectives

I To understand the nature of the market failure in health

insurance. 4
I To develop analytical tools to analyse choice under
uncertainty. 4
I To understand the issue of adverse selection and potential
solutions. 4
I To understand the issue of moral hazard and potential
solutions
Insurance and Moral Hazard

I Moral hazard = when obtaining insurance against an

adverse outcome leads to change in behaviour that
increase the likelihood of the outcome.
I Fundamental trade-off between avoiding risk and
incentives
I welfare gain from lowering risk exposure
I incentive problem: do not bear full MC of choice e.g.
coinsurance copaymentAudit Commission
I By lowering marginal cost, the individual consumes an
inefficiently high level of the medical service.
I Flat-of-the-curve medicine = MB becoming small
I The size of the DWL depends on the elasticity of demand
for medical services.
Example

I Let demand for the GP be given by Q = 10 − P where Q is

the number of GP visits. Let us assume that the MC of
supply is initially zero.
I What is the equilibirum number of GP visits
I Suppose a copayment of $7 was established, what is the
new equilibrium level of GP visits
Discussion

When states make car insurance mandatory for all drivers, it

A raises premiums for everyone because it brings bad drivers
into the pool.
B raises premiums for high-risk drivers.
C prevents high-risk drivers from selecting out to the
detriment of low-risk drivers.
D may lower premiums for all drivers to the extent that it
keeps low-risk drivers in the pool.
E increases the amount of information available to insurers
about the population.
Australian health care

Source: Abelson (2012)

Details
I Government pays over $50 billion p.a. for health services.
I Public hospitals and medical services largely free of
charges. Medicines heavily subsidised.
I Australian Government funds these programs except for
hospitals that are run and partly paid for by the states.
I Medicare - near universal system for financing health
services from tax revenues.
I Private insurers: community rating = charging uniform
insurance premiums for people in different risk categories
within a community
I Health
I Private health insurance fell from 50% before introduction
of Medicare in 1974 to about 35% in 2007. Government
pays 30% of private insurance premiums (now means
tested for high income individuals or households).
Private health care

I Private insurance initiatives

I 30% subsidy on premiums
I Medicare levy surcharge (2%) on high earners without
private insurance
I lifetime cover penalty if take up health insurance after the
age of 30
Australian health care: equity

I Health care is available to all in principle.

I However health outcomes and service availability are not
equal.
I The differential availability reflects:
I Equity/efficiency trade-off in supply of hospital services.
I And capitalisation of public service availability in real
estate prices.
Australian health care: efficiency

I Lack of user charges creates excessive and inefficient use of

resources, especially for doctors and medicines.
I Private health insurance policies. Issues with
I community rating,
I Government subsidies
I Co-payments
I Cost containment policies
I Effective with pharmaceuticals
I Less effective with doctor supply
I Commonwealth-state funding and management.
I Division of services leads to cost shifting
I New funding arrangements for hospitals may increase
efficiency