The economics of moral hazard revisited

Abstract

Pauly's (1968) [Pauly, M., 1968. The economics of moral hazard, Comment, American Economic Review 58, 531–537.] analysis of the welfare loss from insurance assumes that medical care consumption is not determined by income, but recent studies suggest it is. This study argues that (1) Pauly's analysis overstates the welfare loss because it includes the effect of income on consumption, (2) the relevant income effect is derived from income transfers from the healthy to the ill that occur when the probability of illness is less than 1, and (3) the welfare loss can be considered the transaction cost of insurance.