Another interesting aspect of Arrow’s article is his view of the economics of information. He writes, “The value of information is frequently not known in any meaningful sense to the buyer; if, indeed, he knew enough to measure the value of information, he would know the information itself.” This quote reminded me of a similar insight from Austrian economist Israel Kirzner. This information problem, Arrow maintains, leads to market failure. He argues that we, as patients (buyers of medical care), don’t know enough to judge the experts (doctors) who provide it. Interestingly, though, he does not jump to the conclusion that the solution to this market failure is entirely governmental. He writes that the government is “usually implicitly or explicitly held to function as the agency which substitutes for the market’s failure.” He continues: “I am arguing here that in some circumstances other social institutions will step into the optimality gap.”

Particularly interesting is Arrow’s discussion of health insurance. He writes:

On a lifetime insurance basis, insurance against chronic illness makes sense, since this is both highly unpredictable and highly significant in costs. Among people who already have chronic illness, or symptoms which reliably indicate it, insurance in the strict sense is probably pointless.

He adds:

Hypothetically, insurance requires for its full social benefit a maximum possible discrimination of risks. Those in groups of higher incidence of illness should pay higher premiums.

Those quotes are simply sensible reasoning about insurance, and it is doubtful that Arrow was the first to come up with those ideas.

They are striking for a different reason, though: they completely undercut the case for laws against pricing insurance for pre-existing conditions, one of the key features of the ACA. That sensible reasoning was missing entirely from the arguments that proponents–and even many opponents–of the law made. Arrow also discusses the role of moral hazard in medical care: people with insurance have an incentive to use more medical care because the insurance company pays for most of it.

This is from my review of Moral Hazard in Health Insurance by Amy Finkelstein, with Kenneth J. Arrow, Jonathan Gruber, Joseph P. Newhouse, and Joseph E. Stiglitz. The review is the lead review in the Summer 2015 issue of Regulation.

An excerpt on Finkelstein’s essay:

Finkelstein builds her lecture around this latter insight. In particular, she discusses the two most famous health insurance experiments in U.S. history: the mid-1970s RAND HIE and the Oregon Medicaid experiment of 2008. Finkelstein distinguishes between two kinds of moral hazard that health insurance can give rise to: ex ante moral hazard and ex post moral hazard. Ex ante moral hazard occurs if someone, knowing he is insured, takes worse care of himself by, say, smoking, drinking excessively, or not exercising. Ex post moral hazard occurs if someone, knowing he is insured, uses more medical care because he does not pay the full cost. Finkelstein’s focus, like that of most other health economists who study the issue, is on the latter.

She finds strong evidence of ex post moral hazard in the Oregon experiment. Because of budget constraints, Oregon’s state government was unwilling to cover all people who were “financially but not categorically eligible for Medicaid.” Those people were financially eligible because their incomes put them below the poverty line, but categorically ineligible because they were able-bodied. The government held a lottery to choose 10,000 of those people–out of about 75,000 who applied–who would receive Medicaid coverage. She and other researchers then tracked the expenditures and health status of both the people who got Medicaid through the lottery and those who did not. They found, not surprisingly, that people who were spending “other people’s money” for health care spent more. Finkelstein writes: “Medicaid increases not only hospital admissions, as was just demonstrated, but also the probability of taking prescription drugs and of going to the doctor.” She concludes, “Medicaid increases annual medical spending by about 25 percent.” Interestingly, the main effect of the spending seems to have been on reducing depression rather than on improving physical health.

Finkelstein also argues that high-deductible insurance plans, which “were encouraged by the Health Savings Accounts Act of 2003,” are “theoretically optimal” when “there are risk-averse individuals and concerns about moral hazard.” She points out that this is an implication of Arrow’s 1963 article.