Insurer and Provider As the Same Firm: HMO'S and Moral Hazard. Author's Reply

Abstract

Since it was not my intention to make a social welfare argument on behalf of combining the insurer and provider role in health care, Doherty's comment provides the impetus for a needed expansion of the theoretical literature in the insurance economics field. His contribution is quite different, however, from the one which he proposes. With a minor adjustment, his framework of analysis can be used to demonstrate a point which is both antecedent to his and in fact quite profound. And that point, which will be demonstrated below, is that an economically rational individual, once having a full-coverage insurance policy in hand, may modify his or her behavior in a way that reduces the demand for medical care. Since Pauly originally used a moral hazard argument to refute Arrow's call for greatly increased government provision of insurance [1, 2], it has been assumed in the literature that the only exception to the moral hazard argument would occur if the demand for medical care were perfectly inelastic (i.e., zero moral hazard). Research in the field has therefore been either empirical (i.e., estimating demand elasticities), organization (i.e., suggesting mechanisms or incentives for minimizing moral hazard), or market-failure oriented (i.e., the search of positive externalities to justify full-coverage insurance). The basic proposition-that the holding of full-coverage insurance will lead to an increased demand for medical care-has not been subject to question. After all, since holding insurance reduces the price at the point of service, and since medical care is generally assumed to be a normal good, how could anyone question the law of demand? To demonstrate that the holding of insurance has implications that we have not completely sorted out, I have taken the liberty of redrawing Doherty's diagram. The benefit curves are now, from left to right, reduction in suffering (S), reduction in lost income (Y), and reduction in future medical bills (B).