Friday, November 29, 2013

REPOST: Moral Hazard vs. Adverse Selection

Back in 1992, Nobel Laureate Peter Diamond proposed a solution to the adverse selection problem in health care. The NY Times reprinted an old editorial by Professor Diamond based on an article in Econometrica :

The core of the problem is that insurance companies can pick and choose their customers. They tailor policies to attract low-risk individuals, leaving those who are -- or are about to be -- chronically ill to fend for themselves or else pay huge fees.

To solve this adverse selection problem, Professor Diamond would eliminate worker-based coverage and replace it with a government-determined risk pools:

First the government divides the entire population into many large groups. Then, the government creates a Federal Health Insurance System (HealthFed), modeled on the Federal Reserve System, ... There would be redistribution between groups and pricing of alternatives to reflect optimal social insurance principles.

But any solution to the adverse selection problem would also exacerbate the moral hazard problem, so vividly described by my colleague Larry Van Horn

I start each day with my morning “cocktail” of an ACE inhibitor, Beta blocker, and Statin - all grossly subsidized by my health plan. I pay the same monthly premium as every other employee at my workplace with a family health plan. My wages have been reduced to fund the insurance premium behind the scenes, so I never know how much was taken from me. I know the only way to get my money back is to consume the services and drugs.

To solve the moral hazard problem, make consumers face the consequences of their risky behavior, with, e.g., with polices that have big deductibles.

My take away: Democrats are concerned with adverse selection, and want to increase consumption of health care; Republicans are more focussed on moral hazard, which would reduce consumption of health care. Pick your poison.


  1. If I could only choose 1 I would go with adverse selection. You do not want to restrict those who need it from getting it. It is possible to have a middle ground. Simply charge larger premiums and put caps on it.

  2. My choice would be from a moral hazard prospective because those of us without health insurance would take better care of ourselves if we knew we would have to pay more for not making health conscience decisions. By being more aware of our choices in regards to our health, we will be less likely to take risks with our health.

    What I mean is if you know you do not have health insurance, you are more likely to take your vitamins, exercise more and make healthy diet choices. You will make a conscience effort to take the necessary precautions in order to stay out of the doctor’s office. With the same concept, you are more likely to skip the preventative tests if you are forced to pay for them (which can be very costly). So, in effect, we as the general public are faced with a seemingly doubled edged sward.