Moral hazard is an important and badly named idea in the economics toolkit. Important, because it identifies how certain arrangements can encourage inefficient or wasteful behavior. Badly named, because anyone hearing it for the first time would have no idea what it means. Luckily, it’s easy to understand.
Imagine you’re out to dinner with nine friends, so there are ten of you in total at dinner. Let’s say it’s been agreed that there will be one bill, and everyone will share the bill equally regardless of his or her individual orders. If you’re like me at all, you probably involuntarily winced a bit just reading that. You likely recognized that this situation creates moral hazard, even if you didn’t know the term.
Here’s the moral hazard problem. Imagine it comes time to order dessert. One member of the party is nearly full and knows he probably wouldn’t be able to finish a dessert order. Desserts are priced at $10, but given how full he is, he wouldn’t be willing to pay more than $5. In normal circumstances, since the price of the dessert is $10 but it’s valued at only $5, he wouldn’t place the order. But wait! Since the bill is being split evenly with the whole party, his marginal cost for ordering dessert is only $1 – the other $9 is paid for by the rest of the party. Suddenly, ordering dessert looks like a good deal – for him, anyway. Since most of the costs are paid by other people, a cost sharing system creates an incentive for someone to impose $9 in costs on the group to acquire something they only value at $5, at a cost of only $1 to themselves.
Of course, dear reader, you would never do such a thing at that kind of dinner party. Neither would I. Doing that would be behaving like (to use a technical term) a total jerk. If you’re with a small group of friends, in a face-to-face situation, you’re unlikely to act like a jerk in that way – you’d feel bad. So, in small groups, moral hazard can be offset by social norms and good manners. But in large groups, where the “others” who would bear the costs are faceless and anonymous to you, moral hazard rears its ugly head much more strongly, and people don’t feel like jerks anymore for engaging in what is fundamentally the same behavior.
Moral hazard is particularly strong in the health insurance market. Economist Amy Finkelstein has done some good work examining how it manifests. She looks at two different forms of moral hazard created by health insurance – ex-ante moral hazard, and ex-post moral hazard. Ex-ante moral hazard would occur if someone says, “Well, now that I have health insurance, I don’t need to put as much effort into taking care of myself.” According to her research, this is theoretically possible, but it doesn’t seem to be a big issue in practice. Ex-post moral hazard, by contrast, is the tendency to overconsume healthcare once insurance is acquired, because most of the costs are being paid for by someone else. Here, the evidence for moral hazard is much stronger – and the overuse of healthcare created by this incentive structure is one important factor driving up health care costs for everyone.
But there’s another kind of moral hazard as well – what Jonathan Gruber calls provider-side moral hazard. Here’s how he describes it: “This issue is best summarized in the saying that having a doctor tell you how much medical care to get is kind of like having a butcher tell you how much red meat to eat. What we face in the United States is a broken fee-for-service health care system where physicians and providers are paid based on how much care they deliver, not on how healthy they make you.” (What created this fee-for-service system with all its terrible incentives that Gruber rightly laments? Government regulation, with a hefty dose of lobbying and regulatory capture.)
All this came to mind recently when I received an email from my health care organization. This email encouraged me to check with my insurance company to see if I had reached my maximum out-of-pocket costs for health care this year. And if I had, according to this email, I should make sure to book as many medical appointments as I possibly can between now and the end of the year – after all, I won’t be paying anything additional for it! But it would create a lot of opportunities for the doctors to bill the insurance company. A more perfect example of both ex-post and provider-side moral hazard could hardly be asked for, or more shamelessly flaunted.
As it happens, I have in fact reached my out-of-pocket maximum for the year. And there are probably several things I could think of for which to see a doctor. But nothing I’d have gone to the doctor for if I had to pay even a trivial out of pocket expense. So I’m not planning on booking any appointments in response to this email. Unlike the hypothetical dinner party above, the additional costs would be paid by others who are faceless and anonymous to me, but still, the behavior is the same. The study of economics, and of classical liberal and libertarian philosophy, causes me to view my behavior with a more comprehensive mode of sympathy that I’ve written about before. Being comfortable with offloading the costs of my behavior onto faceless “others” doesn’t fit with the kind of person I want to be. They may not be my friends at a dinner party, but they should be respected all the same.
Kevin Corcoran is a Marine Corps veteran and a consultant in healthcare economics and analytics and holds a Bachelor of Science in Economics from George Mason University.
READER COMMENTS
Phil H
Dec 7 2022 at 9:21am
I agree that it’s an important concept, terribly misnamed. Because even though you apparently recognise how bad the name is, you’re still drawn into the *moralising* view of moral hazard. You’re still talking in moralistic terms of respect and being a jerk.
But the place where moral hazard really kicks in is the place where it’s not a moral issue at all. No one in the healthcare centre acted immorally: the doctors and nurses provided as much care as they could; the managers managed as well as they could; and the marketers marketed as best they could. Everyone did the right thing. But they still produced that rather perverse result.
The problem with moral hazard is not so much the morals; people push back against that obtuse morality, as you do. The problem is the skewed incentives, which capital and organisations follow, because they are generally amoral.
Kevin Corcoran
Dec 12 2022 at 8:18am
I’m actually perfectly comfortable with the term carrying moral or normative implications. My objection to the term was and is simply that it is opaque. Telling a non-economist that there is a “moral hazard” issue simply doesn’t convey the problem very well. By contrast, if you tell a non-economist that there’s a problem due to “asymmetric information”, they’ll have a clear idea right away of what the problem is, even if the implications aren’t immediately obvious.
True, but part of the point was that in a system where, in the words of Gruber (hardly a right winger, to say the least!), when we face a “broken fee-for-service health care system where physicians and providers are paid based on how much care they deliver, not on how healthy they make you,” doctors and nurses providing as much care as they can is a bug, not a feature!
Unfortunately, people generally only do so in the smaller, face to face settings I described. When things are more anonymous, people tend not “push back” and are much more willing to impose large costs on others in order to gain personal benefits for themselves they value at only a fraction of that amount.
This is barely coherent to me – neither “capital” nor “organizations” follow incentives, because neither of those are agents capable of following incentives or carrying out actions. The phrase “such and such action was carried out by capital and organizations” is just a very misleading shorthand for “specific owners of capital and individuals within an organization carried out such and such action” – organizations and capital do not act or face incentives. A member of an organization with skewed incentives is still and individual choosing how to act. And I maintain that just because you’re incentivized to do something like offload the costs of your behaviors onto other people, that doesn’t make it right. And choosing not to do so is always an option – even when you can massively profit by doing otherwise, you can still choose to act decently.
Jim Glass
Dec 7 2022 at 11:41am
after all, I won’t be paying anything additional for it! But it would create a lot of opportunities for the doctors to bill the insurance company.
A whole bunch of years ago I took my parents to arrange their first Medicare-paid medical checkups. This was right after the AMA (or AHA, whichever) had issued a well-publicized opinion saying doctors should stop giving stress tests to detect heart problems to patients without risk factors, because they produced too many false positives. Those in turn caused extra “stress”, costly re-tests, etc.
So their doctor said: Let’s schedule their stress tests. I asked: What about that opinion? He said: I wouldn’t do it if they were paying for it or it was on insurance. I said: Huh? He said: Not all its positives are false positives, the test has some value. Not enough to pay for, but when it’s free that’s something for nothing, it might find something real.
I’m not cynical about their doctor’s motive. He believed he was doing the right thing for them (if not for the finances of Medicare). Maybe he was, I’m not sure. But it’s certainly easier to believe you are doing the right thing for someone else when it benefits you too.
Johnson85
Dec 7 2022 at 12:08pm
“‘Well, now that I have health insurance, I don’t need to put as much effort into taking care of myself.’ According to her research, this is theoretically possible, but it doesn’t seem to be a big issue in practice.”
This doesn’t surprise me as people are generally short sighted, but I am a little skeptical of the ability to measure this since it’s been basically forever since people had to worry about guaranteed financial consequences to their poor health decisions. If people had to pay a significant amount extra in insurance for being obese, I think you would see a lot of people try to adjust their lifestyle. Lots of people wouldn’t, just like lots of people don’t save for retirement or manage their money. But for lots of people, if they were looking at paying an extra $2,000 a year for the rest of their life in insurance, I think that would be enough to motivate them to lay off the carbs. Particularly among the affluent that do pay attention to their finances, I think a monthly “penalty” for being obese would probably be a reasonably effective incentive, even though it would be more rational for the health consequences to be a bigger incentive to people that are affluent and can afford and extra couple of hundred dollars a month in insurance costs.
vince
Dec 7 2022 at 12:21pm
Your post appeared after I sent mine. Obviously, I agree with you.
nobody.really
Dec 8 2022 at 11:21am
Recall that not all costs are denominated in dollars. Our society stigmatizes obesity and celebrates the slender figure, especially for women.
Moreover, plenty of people pay well in excess of $2000/yr trying to manage their weight. That doesn’t mean that if they had to pay an ADDITIONAL $2000/yr they wouldn’t make additional changes. But let’s acknowledge the costs people already bear.
vince
Dec 8 2022 at 2:14pm
That doesn’t apply to all subcultures in our society.
The issue is not whether they contribute. It’s whether their insurance premiums are being subsidized.
nobody.really
Dec 8 2022 at 4:56pm
This makes sense to me—but can we measure this? Maybe we could say that the premium paid to soldiers throughout history reflected the risk of injury—and with the growth of subsidized health care, that premium has declined? Maybe we could say that the growth of certain risky behaviors—skiing, skydiving—correlated with the growth of health insurance? But at the same time, risky behaviors such as smoking and driving without a seatbelt have declined; this undermines the thesis.
I can think of two examples when concerns for long-term health consequences drove decisions—and neither of them were obviously influenced by the presence of insurance. First, I know people who declined to join a football team due to concerns about the long-term health consequences. Also, a friend works as a union glazer (glass installer). At the beginning of his career, the union taught him to take care to protect his back from strain—and this often meant sharing a load that, as a young man, he would have been able to bear himself. This may have been union sandbagging—but he’s been able to stay at that job for 30+ years.
vince
Dec 7 2022 at 12:17pm
The email anecdote was a great punchline. Another moral hazard with health insurance is obesity. I’ve long wondered why so few policies charge extra for that voluntary state. They charge extra for an involuntary state–age.
Thomas Lee Hutcheson
Dec 7 2022 at 12:23pm
We really need to break the link between health insurance and employment. Give folks a tax credit for purchasing health insurance and count on insurance companies to offer value for money plans. ACA was a baby step in that direction, but we need to go much farther.
vince
Dec 7 2022 at 1:58pm
Agree completely. It creates an extra layer of overhead that’s unrelated to the purpose of the business–unless it’s an insurance company.
Johnson85
Dec 7 2022 at 6:10pm
We do, but it is actually really hard to have functioning health insurance markets. Once people get sick, insurance companies have to be stuck with renewing them, which is easy enough to require that policies have guaranteed renewal as long as there is no break in coverage. But that leaves an opportunity for new companies to lure away still healthy people with better pricing, which means you have to have some financial responsibility regulations. And then you do need some flexibility for insurance companies to manage and modify plans, but how do you make sure they don’t use that as an avenue to make their plans more costly and less desirable for sick people?
Maybe I’m missing something, but it seems like it’s going to be hard in the current political reality. Now if we increased the supply of physicians and other providers and dropped regulation that strangles non-traditional competition, and stopped subsidizing demand, maybe this would be less of a problem.
Floccina
Dec 7 2022 at 4:41pm
Seeing that we libertarians have been routed in this battle should we instead be looking for a way to reward people who economizes. Dean Baker has propose giving half of the saving to medicare recipients who get care for less that the Medicare reimbursement rate but, since some care can safely be forgone, I think a better idea would be to have the Government fund health saving accounts for people and at certain ages they would get to keep the balance.
Example:
Bill
Dec 7 2022 at 4:58pm
This post brought to mind Russ Roberts’ “If You’re Paying, I’ll Have Top Sirloin” piece from years ago:
https://russroberts.info/article/if-youre-paying-ill-have-top-sirloin/
David Seltzer
Dec 8 2022 at 6:12pm
Bill, Russ is still being considerate. As for me, If you’re paying, I have the large bone-in filet.
Mactoul
Dec 7 2022 at 8:30pm
Medical care isn’t free for the customer even though it may not cost him in money terms. Medical tests are stressful and sometimes risky. You have to visit hospitals which are typically not the nicest place to be in. You have to wait quite a bit for appointments.
I don’t think most people would be tempted to take medical care just because it is free.
nobody.really
Dec 8 2022 at 11:04am
I agree in general. I suspect few people get recreational colonoscopies. (Not that there’s anything wrong with that….)
But I try to remember to look at things at the margin. When you reduce the cost of something, people will tend to consume more of it. So yes, few people would pursue medical treatments for NO purpose, even if the treatments are free—but people who have declined to pursue a treatment due to cost might make a different decision if the costs were shifted to someone else. A friend maxed out his health care deductible and so finally elected to have surgery for a minor foot defect that had afflicted him since childhood. Now he walks with less discomfort than before. Good for him—but if he had not considered this a sufficient problem to justify the various costs of seeking a remedy, seeking a remedy now seems like a misallocation of resources (from a societal perspective).
Floccina
Dec 8 2022 at 11:22am
Funny that you used Colonoscopy as an example. It seems that a recent RCT showed no significant benefit.
MarkW
Dec 9 2022 at 3:51pm
Yep, I saw that and am of an age where my PCP is suggesting I get my first colonoscopy. It seems like close to a no brainer to take a stool test first and get the colonoscopy only if necessary based on the outcome (e.g. what they do in Canada and Europe). But wait! If you get a colonoscopy after a a failed cologuard test, the colonoscopy is no longer a screening and you may get charged an arm and a leg for it (whereas the screening colonoscopy would have been fully covered). I need to figure out how my insurance handles this. We do not live in a sane world.
Kevin Corcoran
Dec 12 2022 at 8:50am
Luckily, we don’t need to wonder whether or not this is the case – there’s already a great deal of research on this question, and it confirms that the consumption of medical care does, in fact, follow the law of demand. That is, as the cost of medical care falls, people use more of it. And when it’s “free”, people use far more of it. Finkelstein discusses this in her book, plus there’s also the results of the Oregon Medicaid test and the famous RAND Corporation study as well.
Or if you prefer anecdotes to data, the always interesting Scott Alexander has described this phenomenon in his own experience with the medical system:
Knut P. Heen
Dec 8 2022 at 6:32am
I think moral hazard is a good term. The idea is that there are two types of people, moral people and opportunistic people. Hazard refers to the idea that you are gambling on the type of person if you do not take precaution (by fixing the incentives).
The main problem with insurance in general is that people do not understand the point of insurance. The point is to insure against low probability events with very bad outcomes. Administration costs make insurance against high probability events too costly. You have to self-insure against high probability events.
Jim Glass
Dec 8 2022 at 7:57pm
The main problem with insurance in general is that people do not understand the point of insurance. The point is to insure against low probability events with very bad outcomes.
The really basic issue is that people don’t grasp those probabilities — they are terrible at understanding risk. This is really clear in insurance industry data. Everybody knows they will have all those “routine” costs, so everybody wants benefits covering eyeglasses — but nobody thinks they will ever need long-term care that can bankrupt them (confirmed by consumer surveys), so long-term care insurance is grossly under-purchased. This is why Medicare covers doctors visits from the first dollar — but if you have a stroke and wind up in a nursing home (average cost > $100k/yr.) you are on your own. What the voters want, the politicians give.
(Of course people are idiots not just about insurance risk – if they choose something it’s safe, if not it’s dangerous. The funniest thing I ever saw in a PBS documentary was an obese woman leaning on her car as she waved her cigarette at the horizon, saying “That nuke plant over there is going to kill us all.”)
Roger McKinney
Dec 8 2022 at 9:30am
Insurance companies understood this and fought against healthcare insurance until the 1960s. They caved because wage controls made it the only way for companies to compensate employees more than what the state allowed.
Kevin Corcoran
Dec 12 2022 at 8:52am
Agreed – the book I liked to in the “government regulation” link describes how the insurance companies were dragged kicking and screaming into the health care space – creating a now bloated and powerful entrenched interest that wouldn’t have existed, but for the attempted state management of health care payments.
David Seltzer
Dec 8 2022 at 6:35pm
Kevin: I suspect considerable competition between providers reduces the opportunity for moral hazard. In our small town in Georgia, there are at least fifteen veterinary small animal providers within a ten mile radius. In my case, I deal directly with the DVM. Prices for services are posted and compared to competing providers in the area. I receive a 15% discount for being a military veteran. There is little or no incentive to upsell or offer additional services I don’t want because there is no third party payer. It seems the $31 billion veterinary industry has done better than our current healthcare providers.
Jim Glass
Dec 8 2022 at 6:35pm
“Well, now that I have health insurance, I don’t need to put as much effort into taking care of myself.” According to her research, this is theoretically possible, but it doesn’t seem to be a big issue in practice.
I don’t know about health care, but the Peltzman Effect is well documented as to safety equipment, “feeling safer” reduces caution and increases accidents. E.g., seat belts and anti-lock brakes increase accident rates. Not necessarily enough to increase injuries on net, there’s still a net safety benefit from them, but somewhat.
A study of NASCAR over time found “a 10% improvement in NASCAR automobile safety results in approximately a 2% increase in reckless driving”. Peltzman himself said: If you want people to drive really safely put a long sharp spike in the middle of every steering wheel.
Jim Glass
Dec 8 2022 at 7:17pm
For all the talk about problems, it’s informative to look at success.
Very arguably the most successful health care system in the world is Singapore’s. Health care spending is less than half the OECD average, 4% of GDP (versus 9.5%, USA 18%), while providing world-top quality care for all, poor and rich on equal basis — good enough to attract 500,000 visitors-seeking-treatment from other countries annually (a lot of voting by feet!) including heads of state. That cost-benefit ratio is tough to beat.
What’s the magic trick? It very uniquely is a centrally planned, universal-coverage system which applies substantial socialization of cost through very strong market mechanisms. Everybody pays significant out-of-pocket cost for everything, service providers compete on price for customers in real markets, their prices for services are transparent and published (try getting that out of a US hospital), etc. Here’s a video describing it. The ‘centrally planned strong markets’ combo is enough to drive economic ideologues of all stripes batty.
That’s why for all its well-known success the system’s formula has not travelled well to other countries. National health care systems are adopted through politics. Polities leaning “socialized” cherry pick the central planning components and ignore the market ones, those leaning “markets” do the reverse. (Which is how committees tasked to design race horses produce camels — with the USA having a six-humped camel.)
In Singapore itself it’s all held together by the closest thing to a “benevolent” single-party dictatorship — not a concept likely to travel well to other countries either. But it’s an interesting case.
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