Overinsurance and Public Provision of Insurance

Overinsurance and Public Provision of Insurance: The Roles of Moral Hazard and Adverse Selection Author(s): Mark V.
Pauly Source: The Quarterly Journal of Economics, Vol. 88, No. 1 (Feb., 1974), pp. 44-62 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/1881793 . Accessed: 03/05/2013 14:15
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OVERINSURANCE AND PUBLIC PROVISION OF INSURANCE: THE ROLES OF MORAL HAZARD AND ADVERSE SELECTION *
MARK V. PAUJLY allocation of insuranceunder moral hazard, 45.I. The competitive II. "Competitive" equilibrium, 50.-III. Moral hazard and public provision, market,54.-V. Alterna52.-IV. Adverse selectionand the competitive overinand moralhazard from tive devicesfordealingwithadverseselection surance, 60.
inf orIn this paper I shall show that in the absence of perfect outcomein marketsfor insurancemay be mation the competitive not only as comparedto the infeasibleoptimumthat nonoptimal, but also compared were perfect, if information would have occurred to optimathat are feasible. turnsout to be some formof One solutionto this nonoptimality been suggested and such a solutionhas recently public intervention, has recently Akerlof or hintedat by severaleconomists.Specifically, public insurancemightproduce an imsuggestedthat compulsory overthe marketoutcome;' and Arrowhas said that comprovement pulsoryinsurancemightat least producea resultthat is as good as the marketoutcome.2 I shall demonstrate, however,that the advantage of public provisionlies in its abilityto generatea particularkind of informawere to be made tion. I shall then show that, if this information an optimal market outcomemay occur. (This available to firms, exactly to the usual notion outcomedoes not, however,correspond marketstrucof competitive equilibrium.) I concludeby examining tures that may have arisen to deal with the problemof imperfect in insurance. information I shall examinetwo cases in whichthe absence of information with the operationof insurancemarkets,or indeed, could interfere of any marketin risk. One is the case of "adverse selection,"in of the insome characteristics whichthe insurercannot determine
J. Green,and the G. Goldstein, *I would like to thankR. Kihlstrom, refereefor helpfulcomments.Research supportwas providedin part by University and the the Health Services Research Center of Northwestern Hospital Association. American "The Market for'Lemons': QualitativeUncertainty 1. George Akerlof, Vol. 74 (Aug. 1970),p. 494. thisJournal, and the MarketMechanism," "Politicaland EconomicEvaluation of Social Effects 2. KennethArrow, in The Analysisof Public Output,J. Margolis,ed. (New and Externalities," Press,1970),p. 11. York: ColumbiaUniversity
PUBLIC PROVISION OF INSURANCE
45
of the probabilityof sured that are relevantto the determination state of insured is assumed to know nature. Because the the future Arrow has a case of unequal discalled this these characteristics, in that the inis similar of information.3 The othercase tribution the present sureris assumed not to know or to be able to monitor in that the insuredalso (purchase-date) state of nature,but differs has the power and the incentiveto change this unobservablestate in responseto insurancecoverage. This is one kind of problemof moral hazard.4 Both of these situationsarise when the insurercan observethe outcome, but cannotobserveseparatelythe initial state and the action of nature. to mentiontwo obvious sorts of propositions It is worthwhile that are not the ones to be discussedin thispaper. It is obviousthat had or could obtain perfectinformation about if the government the purchase-datestate of the world,it could in principleprovide the optimal insurance,or at least achieve a resultsuperiorto that informed I shall assume of the imperfectly market. In what follows, information. It is also that the government does not possess perfect chose at random compulsoryinobvious that, if the government or differ surancepolicies that eitherare uniform over individuals,it a mightselect a set of policies that are Pareto optimalor represent Pareto optimal improvement over the marketoutcome. But there is no reason to expectthis sortof processto have, as it were,an exto that of the pected insuranceallocation that is obviouslysuperior and so thiscase also will notbe discussedin what follows. market,
I. THE COMPETITIVE ALLOCATION OF INSURANCE UNDER
MORAL HAZARD
I firstwish to considerthe case in which the insurancepurthe future chaser has controlover actions in the presentthat affect observethe state of nature,but in whichthe insurercannotdirectly insured'sactions. As has been noted in several places, an optimal solutionin this kind of "moral hazard" situationis forthe insured to retain some part of his losses.5 Thus, the optimal policy is one
3. Ibid. been treatedby 4. Moral hazard,in several of its forms, has recently and Kihlstrom and Pauly,and Spenceand Zeckhauser. See RichardKihlstrom Mark Pauly, "The Role of Insurancein the Allocationof Risk," American EconomicReview,Papers and Proceedings, Vol. 61 (May 1971),371-79; and and InMichael Spence and Richard Zeckhauser, "Insurance,Information, Vol. dividualAction,"American Economic Review,Papers and Proceedings, 61 (May 1971),380-87. (Helsinki: 5. See KennethArrow, Aspectsof the Theoryof Risk-Bearing Sdati6, 1965); Mark V. Pauly, "The Economics of Moral Yrj6 Jahnssonin
46
QUARTERLY JOURNAL OF ECONOMICS
goals of betweenthe conflicting that achieves "the optimaltrade-off a risk spreadingand providingappropriateincentives." furthering whenmoral hazard is presequilibrium I now showthat competitive to this optimal outcome. I shall then show ent does not correspond foran optimalsolutionto be reached requirements the informational via a market. Considera simplemodel in whichthereare assumed to be two no loss. In S2 possiblestates of the world. In S1 individuali suffers a loss equal to L dollars. By varyingthe level of some he suffers . The his probabilityof loss 7 7r(S2) activity,the insuredcan affect activitycosts one dollar per unit. The activityof zi of individuali it is is assumed not to be observableby the insurer.For simplicity, assumedthat all individualshave identicalwealthsand utilityfunctions and that, given a level of z, all are subject to identicallyand risks. distributed independently acThe level of activityz is measuredby the cost of preventive tivity,and it is assumed that only the cost matters. For the "prevention function"7rjir(zD, 7ir' is assumed to be negative, and 7" forsale dollars to be deliveredif S2 occurs. positive. Insurersoffer If individuali buys Xi dollars' worthof insuranceand if Pi is the total premium forthat insuranceand S0 his initial wealth,his final wealthwill be ifSi occurs; Wi1=Si -zi-Pi ifS2 occurs. -, _S.0-zj-Pj-L,+Xj under the assumptionof net worth Competitiveequilibrium, be requiresthat expectedprofits maximizationby insurancefirms, zero. Since tri is the probabilityof state 2 forperson i, this condition can be written as
(1 . i Y, Pi
The total amount of insurancepurchased by any individual Xi is only knowsthe assumednot to be observableby any firm.The firm amountit sold to the individual. A. Utility-Maximizing zi individualas solvingthe probWe can thinkof a representative
American EconomicReview,Vol. 58 (June1968),531-36; Hazard: Comment," Be"Medical Insurance: A Case Study of the Tradeoff RichardZeckhauser, Journalof Economic Theory,Vol. 2 and Incentives," tweenRisk-Spreading (March 1970), 10-26. op. cit.,p. 385. 6. Spence and Zeckhauser, as one in which 7. It wouldalso have been possibleto set up the problem of the losstheamountof theloss,but not the probability the insured affected state. producing
47
lem of how much insuranceto buy in two stages. First, he deterlevel of zi foreveryvalue of Xi. Then minesthe utility-maximizing value of Xi, given its associated he choosesthe utility-maximizing value ofP and of utility-maximizing zj. His expectedutilityis given by EU= (1-7ri(zi) ) u (S 0- Zi- P0 (2) + 7(zi) u(Si?-zj-Pj+Xj-L). With Xi and P given,foran interior solutionthat value of z maximizes EU, whichsatisfies (3) (1-iri)u'(1) +7riT'(2)= [uT(2)-u(1) l7ri/Dzi, where and
uM( =u(Si?-zi-pi)
u(2) =u(S-?-zj-Pj+Xj-Lj)
the price (in terms of expected marginal The left side represents ofthat zi on the side the effect utility) of additionalzj, and the right individual'sexpectedutilitylevel.8 Clearly if Xi= Li (full coverage) so that u(2) =u(1), a cornersolution is obtained, and optimal zi will be set equal to zero. It will also be truethat zi will be equal to zero forsome values of Xi less than Li. For at Xi= Li, the leftside of (3) becomesu' > O, while the rightside becomes zero. As Xi is reduced below Li, althoughthe individualis exposed to some of the loss, theremust be some range of values of Xi over whichthe rightside of (3) is still less than the left side. The amount of potentialloss borne by the individualover that range is still too small to make it worthwhile to spend anythingon prevention.Hence, over the range of corner solutions,a range that must exist as long as iu'> 0, it must be the case that Dzi/DXi=0. it will be truethatthe level of preventive activity But generally of inwill be reducedas more insuranceis bought,since the effect creased Xi is to reduce the effect on the individual's wealth of a of change in zi. It could also happen that Dzj/DXi>O if the effect increased insurancecoverage reduced expectedmarginal utility of wealth (by reducing t'e(2) more than it increased (1-7r)u'(1) in reducingu(2) -u(1)). to more than offset its effect sufficiently In what follows, I shall assume that zi dependson Xi, that however, Dzj/3Xj%0, and that the strictinequalityholds forsome values of xi.
"MarketInsurance, 8. See Isaac Ehrlichand GaryBecker, Self-Insurance, 1972), Vol. 80 (July/Aug. of PoliticalEconomy, Journal and Self-Protection," derivation. p. 639,fora similar
48
B. Moral Hazard I specifically assume that DP
azi
0. That is, no matter
Xi=Xi*
what the individual'slevel of zi, fora givenXi he will be chargedthe same premium. This. will be approximately true as long as there are large numbersof buyers,since the effect of each individual's variationin zi will changeI 7rgXi and hence Pi and :P, by only an infinitesimal amount. This is the essence of moral hazard in the model- that insuranceinduces the individualto alter his value of z because variationsin z, even thoughthey affect his expectedinsuranceclaims forany level of coverage,do not affect the premium he pays at all. C. Utility-Maximizing Quantityof Insurance Given that zi is set at the level given by equation (3) for any the utility-maximizXi so that z- zi(X), the individualdetermines ing quantityof insuranceXi to buy by maximizing EU, takinginto accountthe dependence of zi and Pi on Xi. The first-order condition becomes (4) 3PaXj [ (1- 7r)u (1) +7ruf(2)] (2)-riie + ar
i i
aXi
Zi [ (1 - j) uf(1)+7ru"(2)] u(2)(1) ]
Given (3), two termscancel,9so the finalform of the expression becomes1 (4')
/
e)zjax,
-=
Xi
(1 -7r) u.(1) + 7riW(2)
D. OptimalAmountof Insurance The amountof insurancethe individualwill buy therefore depends on DP/DXi. Were it possibleforthe insurer to observezi, the premium could be made to vary with zi and hence with m. Then it
1. One mightsupposethat this is the same expression that would have been obtainedby differentiating (2) partiallywith respectto Xi. However, the values givenof u(1) and u(2) in (4') are thosevalues givenby the utilitymaximizing value of z, not by any value of z.
3z,/Dxi=0, so the two terms dropout as well,and (4') is obtained.
9. If a cornersolutionoccurs and the equality in (3) is not satisfied,
49
is easy to show that, if the premiumwere actuarially fair,the insured would set Xi = L and choose that level of zi at which LD),r/?zil1, i.e., the level at which the reductionin expectedloss just equaled thepriceof z. But sincezi is unobservable, thisoutcome is not possible. A second-best optimum is possible if the total amount of insurancepurchased by an individual can be observed. It would involve a trade-off betweenrisks and incentives. In the generalcase the problemis one in the calculus of variations,in the sense that what must be chosen is a price functionP (Xi), which induces the individual to buy that amount of insurancethat will yield the optimal pattern of insurancepayments.2 In the special case being investigatedhere, the optimal functionP (Xi) can be obtained more simply. The intuitivenotion is that optimalityrethe marginalprice of insuranceto an individualequal quires setting to the change in his expected claims resultingfroman increment in insurance. While the actual change in his expectedclaims as a function of zi cannotbe observed, the changein his expectedclaims as his coveragechanges can be seen if his total coverageis observable. Consider an individual who purchases a given amount of insuranceX*. The premiumto be chargedto him that is consistent with zero expectedprofits forinsurers is = r(X*) . P (X) = rX*, where7r (5) Here the subscripton the probabilityis dropped,since the probabilityis the same forall individualswho have the same amount of insurance. (Since all individuals are identical,they will purchase identicalamountsof insurancegivena price schedule,so that satisfactionof (5) for all values of X* is equivalent to satisfactionof (1).) To determinethe optimal schedule of marginal premiums individual DP/DX in (4'), the expectedutilityof the representative in (2) is maximizedsubject to the zero-profit constraint.Substitutionof7rX forPi in (2) and setting the derivativeequal to zero yields the necessaryoptimality condition, 7ru'(2) r+X___ (1 -7r)u'(1) +"' (2) 3X Hence, the optimalscheduleP(X) is givenby settingDP/D)X equal
(4"),,
to r+X at
OX
2. Spence and Zeckhauser use the calculusof variations in a moregeneral model to determine the optimalinsurance benefit function. Their model also differs somewhat from thisone sincetheyallow z to affect, not V(L), but the actual loss L. See Spenceand Zeckhauser, op cit.,p. 383.
50
QUARTERLY JOURNAL OF ECONOMICS II. "COMPETITIVE" EQUILIBRIUM
I shall show in this section that the optimal quantity that is described in the previous section may not be that chosen when competitionbetween insurance firmsexists. The potential nonoptimalityof competition arises preciselybecause the competitive DP/DX, the premiumper unit of insurance,may well not be that givenby equation (4"). Indeed, it will definitely not be that given by (4") forall values of X at whichDz/DX <0. There are assumed to be many firmsand free entryinto the industry.Each unit X of insuranceis sold at a price p, which is, as far as the purchaseris concerned, unaffected by the amount of insurancehe buys. Why this should be so, even thoughthe probabilityof loss in fact varies withthe amountof insurancebought,is relatively easy to see. When an individualbuys moreinsurance, his expectedlosses rise. But the onlyway he can be identified as having largerexpectedlosses is if theinsurer can determine the total amount of insurancehe has bought. In our model the insurerknows how muchinsurancehe has sold the individual,but he does notknowhow muchthe individual has boughtfromothers. If a seller should try to adjust by increasing pricewiththe quantitypurchasedfrom him, the insured would rationallyonlybuy the first unit from the insurer, at the lowerprice,and buy the otherunits fromotherinsurers. Inwho sells an individualadditional insurancewould deed, an insurer also wish to conceal the fact fromotherinsurers.By his doing so, the changein total premium resulting from the additional insurance will be less, and the individualwill be likely both to buy more insuranceand to buy it fromthe sellerwho is willingto help conceal the fact of sale. Given the assumptionthat p is constant for any individual, D3P/DXbecomes simplyp, which is the same for all i. Condition with DP/DXj replaced by p. The equilibrium (3) is satisfied p, and hencethe equilibrium Xi forany personi in the world of identicals, is that level of p that satisfiesthe zero-profit condition (1). It is easy to see that equilibrium p is givenby
X 7rjXj
(6)
p=
Since Xi will be the same forall fora givenp, this can be simplified to
(6a) p = r.
X.
If individualsdiffered so that the amount of X purchasedby each

7r's applicable to each individual'spurchase.
51
thenp would equal a weightedaverage of the at a givenp differed, Dir for any X at which Since 7r is clearly less than 7r+-X8 ax equilibriumcan well be charit followsthat competitive
i3<O
Dir
of insurancerelativeto the secondacterizedby an overproduction by an underbest optimumand, what is perhaps more important, activity (increase in moral hazard) even relative use of preventive to that optimum. In general,thereis no reason to expect competitive equilibrium to be optimal. Note that in the optimalcase the actual curve of supply prices per unit of insurancethat would face the individual is an upwardslopingcurve and the individual adjusts to a curve marginalto it, to be case each individualbelieves himself while in the competitive supply supplycurveat p, whilethe aggregate facedwitha horizontal the increase of 7r and p with inreflecting curve is upward-sloping, creased insurance. In the optimal case, of course,the marginalcurve need not be is, by assumption, upward-sloping.The value of D7r/Dz continually continuouslydecreasing in absolute amount with z, but, since Dz/DX will eventuallybecome zero over some range of X-L, the termXir/D3z(Dz/DX) can increaseor decrease. were actuarially fair Indeed, it would appear that if premiums and if individuals continueto purchase any insurance,they would in this "competitive"worldto the extentof buyingfull overinsure model,DP/DX = p = 7r. coverageagainstthe loss. In the competitive yields u'(2) = Substitute p forX and DP/DX in (4'). Simplification This implies that u'(1) = u'(2), which is (1-p) u'(1) +pu'(2). possible,givenriskaversion,onlyif X =L. Hence, one can conclude at all will buy as manydollars that a personwho buys any insurance of coverageX as his potentialloss L whenp =ir, even ifmoralhazard exists. He may, of course, decide to buy no insurance. Although in the level of coveragewould induce an individualto inreduction crease preventive activitythat would reduce his expectedloss, such would not affect exceptby an infinitesimal a reduction his premium activamount,but would requirehim to pay the cost of preventive ity, so he will not voluntarilyreduce coverage. Moreover,he will activityto zero. reducethe level of preventive in risk aversion,theywould still all buy Even if people differed full coverage if they purchased any coverage at all when p = i. If
52
therewas some loading,so that p = (1 +x)w, X>O, and people differedin risk aversion,the premiumactually charged would be a weightedaverage of the probabilitiesof loss of those who bought insurance. At this premium, people would purchase different quantitiesless than L. For rational decisionsthe individual'spremiumshould vary as
muchas possible withhis expected loss.3
librium,because price is uniformover the quantity of insurance bought,it does not vary at all with the individual's expectedloss. The effect of his behavioron the premiumis spread over all other insurancepurchasers, because the insurerdoes not know which one of his customers has moreinsurance than the others. If a particular sellertriesto varythepremium chargeda buyerwithpurchasesfrom that seller,each buyerwill buy one unit from each seller. At the second-bestoptimumdescribedby (4"), the extentto which the marginalreductionin expected losses produced by preventiveactivityexceedsthe cost of preventive activityis just offset by the risk-reduction benefitsof additional coverage. The "competitive"outcome,on the otherhand, may involve the purchase of insurancewhose risk-reduction benefitsare not even great enough to coverthe increment in expectedloss engendered by the purchase of that insurance. Each individualis inducedto buy this excessive insurance because he supposesthathis purchaseswill notappreciably affect the premium per unit. But when all individualsthus increase purchases, the marketpremium per unit does rise by an appreciable amount.
ANDPUBLIC PROVISION III. MORAL HAZARD
But in competitive equi-
It is clear that, in this worldof identicalinsurancepurchasers, the optimal resultwould be producedby a law that requiredindividuals to buy exactlythe numberof units of public insurance, say X*, which would have been purchased had premiumsvaried with purchasesin the way given by (4"). Many alternativequantities less than this amountwould also represent Pareto optimalimprovein pomentsover competitive equilibrium.Even if people differed tentialloss or riskaversion, make them uniform provision stillmight betteroff. Note that the criticalelementhere is that insurancepurchases
3. See Kenneth Arrow,"Uncertainty and the Welfare Economics of Medical Care," American Economic Review, Vol. 53 (Dec. 1963), 941-73; and Mark Pauly, "The Welfare Economics of Community Rating," Journal of Risk and Insurance, Vol. 37 (Sept. 1970), 407-18.
53
the insurancecould also are limited. If the limitcould be enforced, would know,by virtue since each firm firms, be sold by competitive boughtby the inofthelaw, the amountofinsurance oftheexistence dividual. It is also worthnotingthat if the law requiredthe purchaseof at least X* units,but individuals could buy supplementary insurwould have no advantage public provision ance in a privatemarket, over the marketsolutionand indeed would not alter thingsat all. For the premiumper unit at X* would be p*, and private firms insuranceat that rate. The law would conwould be willingto offer each personhad boughtat least X* units, that vey the information about marginalpurchases. but would conveyno information is available. Supoptimality way of reaching But an alternative on the total amount of were providedwith information pose firms purchaser.Eitherthis insurancealready boughtby each prospective or a law (assumingit was could be provideddirectly, information enforceable) could require the purchaserto provide correctinforwhichhe had purchased from mationon total purchasesto all firms on the magnitudeof Xi, firmscould insurance. With information the probcoveragethat reflect calculate premiumsfor incremental would ability1r(Xi) associated withthat level of Xi. Since all firms per would chargethe same premium knowthe level of Xi, all firms unit. If we also assume that potential purchasersknow the entire optimalscheduleP(X) (i.e., knowthe scheduleof marginalprices), level of X chosenby each therewill be a unique utility-maximizing purchaser. At this level, (4") will be satisfied (though (4") may, upward-sloping, if the curve of marginalprices is not continuously be satisfied forothervalues of X). It is, of course,possiblethat the quantitywill be X =L. In such a case because utility-maximizing 37r/DXequals zero, "competitive"equilibriumand optimalitywill coincide. But it may well also happen that 37r/DX> 0, so that only the schedule7r+XD3w/DX will lead to optimalpurchases. on the entire This discussion does suggest that information scheduleof possiblemarginalpremiums DP/DX needs to be known to produce and customers for a market-likearrangement by firms to have information optimality. It is not in generalsufficient only preof the currently on the values of DP/DX in the neighborhood vailing premium. marIf, as noted above, both public provisionand competitive to existside by side, coverageare permitted ketingof supplementary Supon total purchaseswill be needed for optimality. information
54
plementary purchasesraise the probabilityof loss and hence raise the expectedloss of the purchaserwithinthe public programas well as the loss in any private insurance. For optimalitythe individual would have to bear the cost of his increaseduse of bothkinds of insurance. This meansthat,even if thepublic insurance wereprovided through generaltaxes,foroptimality a premium forpublic insurance should be assessed on those who buy supplementary coverage.4 In conclusion,one should note that the failure of competitive equilibrium to be optimal occurs because a person who buys more insuranceis, in effect, changingthe probabilitiesof states of nature he faces. Thus dollars to be deliveredif S2 occurs are really different "commodities," dependingon the level of insurance coverage. It is not clear whethercompetitivemarketswould necessarilybe optimal if sellers had information on total purchases,since sellers mightbe able to price discriminate over units. But this seems unlikely,and so optimality will probablyoccur.5
IV. ADVERSE SELECTION AND THE COMPETITIVE MARKET
Moral hazard can be thought of as arisingfroman asymmetry of information: the insuredknows his level of preventiveactivity, but the insurer does not. This kind of asymmetry is a moregeneral phenomenon, however. It can occur even when the insuredhas no controlover the probabilityof futurestates because even in that situationthe insurer may not be able to determine the presentstate of the worldwith respectto a potentialinsured. It should be emphasized that this asymmetry need not be the result of mendacity on the part of the insured;if thereare some aspects of the insured's conditionwhich cannot be proved by objective evidence that the insurer will accept, it does not matterwhethera particularinsured or not. So longas somepeople lie, the insurer tellsthetruth will have to assumethat any giveninsuredmay lie.
4. For example, Martin Feldstein and I have recently proposed national health insurance that includes deductibles and co-insurance, the purpose of which is to limit quantitative and qualitative overuse. See Martin Feldstein, "A New Approach to National Health Insurance," The Public Interest, No. 23 (Spring 1971), pp. 93-105; and Mark Pauly, An Analysis of National Health Insurance Proposals (Washington- American Enterprise Institute, 1971). The above analysis suggests that, if individuals are permitted to buy supplementary coverage, they should be required to pay an additional premium for the public insurance. Indeed, given the average pricing policies followed by many hospitals, the premium should probably be above the cost of additional use explicitly attributable to persons with supplementary coverage. 5. Suppose sellers tried to discriminate. If they earned positive profits, new firmswould enter, and price would fall. If they earned zero profitsbut offeredthe consumer an all-or-nothingarrangement,new firmscould enter and make positive profitsby reducing the quantity required to be taken.
55
withoutmoral hazard has information The case of differential by Akerlof contexts, recently been discussed,in two quite different of public with respectto the efficacy and Arrow. Their conclusions to correctmarket failurewill be discussed later. But intervention firstit is importantto investigatethe propertiesof competitive underadverse selection. equilibrium sectioncan be adapted to deal The modelused in the preceding that a loss of L dollarswill occur be the probability withthis.Let wrG to a type-G ("good-risk") individual. Let 7rB be the probability that a similar loss will occur to a type-B ("bad-risk") individual. Let type-Gand type-B individualsbe identicalin all respectsexcept for the value of 7t. If insurersare expected-valuemaximizersand in a worldof the eventsoccurring to each individualare independent, p* per dollar to be paid premiums perfect knowledgetwo different when a loss occurs would be charged in competitiveequilibrium, would costs or loading. These premiums transactions again ignoring be given by (7a) (7b)
7rB p*B '7rG p*G
If the value of L is the same for both types,both would buy exactlyL dollars of coverageat actuarially fair premiums. the two types of Now suppose that insurerscannot distinguish premium to all. Suppose also people and so must chargea uniform of individuals of each type in the population that the proportion is known and that as purchasersthey are distributedrandomly charging chooseto buy fromfirms amongfirms.Suppose customers the lowestpremium forany quantityof insurance. Finally, suppose exas long as industry that firms are willingto enterthe industry their customers, are positive. (If firmscan identify pected profits on will provide information loss experienceof groupsof customers of risks in theirgroup of customers, but we the actual proportions want to ignorethis.) obtainswhen For any set of firms, equilibrium , 7rBB +:, 7rGXG (8) per unit premiumis the lowestpremium Thus, the equilibrium PE that satisfies (9)
PE=B
y. .7BXB (PE) +:E
B+G
a, XB(PE) +
B
G G
7GXG(pAE)
XG(PE)
whereXB (PB) is the quantityof X chosen by a type-B individual
56
QUARTERLY
JOURNAL OF ECONOMICS
when faced with a premium PE. It may happen that thereis more than one premium that satisfies(9). However,since it has been assumedthat customers will purchasefromfirms that offer the lowest premium, only that premium represents an equilibrium I assume that even when PB is below p,*B, it does not fall so low that infinite amountsof insuranceare demanded. Alternatively, one mightassume that thereexistsa loading to cover transactions and administrativecoststhat keeps even the premium forbad riskshighenough to precludethe possibility of infinite purchases. The premiumpp is determined as follows: There will be an excess of payments by type-G individuals over their actuarially fairpremium(i.e., over what theywould have paid if theyhad been chargedp*G) and a deficiency fortype-Bindividuals. As PE increases fromp*G, the sum of excess paymentsby type-G individuals will increaseto a point,reach at least one interior maximum, and decline if demand curves are negativelysloped and eventuallystrikethe in paymentfortype-B individuals y-axis. The sum of deficiencies will increasecontinuously as p falls and at an increasing rate if the demand curve is linear. Equilibriumwill be reached at a point at which the sum of excess paymentsequals the sum of deficiencies. Multiple solutionsto (9) are possible because theremay be a value of PE at which excess payments (by type-G individuals) are increasingand whereexcess paymentsequal deficiencies, and again a value of PE at which excess paymentsare declining where equality occurs. But only the lowest pB qualifies as an equilibriumif it is assumed that consumers buy fromfirms with the lowest premium per unit. Note that there may be no premiumthat satisfies (9), given the formof the demand function Xi(p). If for every p the sum of excess paymentsis less than the sum of deficiencies, no PE will equate gains and losses, and type-G individualswill be driven out of the market. Both of these possibilitieshave been noted by Akerlof. Arrowrestricted to situationsin which his. consideration type-Gindividualscontinue to make some purchases. Does XG(PE) necessarilyrepresent a second-bestPareto optimum? Akerlofclearlythinksthat it does not.
On a cost benefit basis medicare [an example of compulsory public insurance] may pay off; for it is quite possible that every individual in the market would be willing to pay the expected cost of his medicare and buy insurance, yet no insurance company can affordto sell him a policy, for at any price it will attract too many "lemons."' 6. Clearly, if customers are assumed not to know or to be offeredall possible actuarially fair premiums,public interventionthat leads to firmsoffering and customers buying at the lowest fair premium will improve things. 7. Akerlof,op. cit., p. 494.
57
Arrow is more circumspect, but comes to a similar, though weaker,conclusion.

An equilibrium will be reached which is, in general, between those corresponding to A [good risk] and B [high risk] separately but closer to the latter. Such an insurance arrangementis not, of course, Pareto efficient.It is not a priori obvious in general that this free-marketsolution is superior to compulsory insurance even though the latter is also not Pareto efficient because it typically disregards individual differences in risk-aversion.'
Compulsoryprovision could be interpreted as involving (1) identical purchases and (2) the quality to be chosen by a median individual.9 Two alternativemodels of compulsoryprovisionare possible, as noted in the earlier section. In one the individual is directedto buy a specifiedamount of insuranceand no more. In the second,he is freeto supplement his compulsory with voluntary purchases. We shall analyze each of these models in turn. We suppose that thereare moretype-G individualsthan there are type-H individuals. Under the assumptionof identical preferences,with a premiumof PE per unit, equilibriumXG will be less than XB. The amount of compulsory insurancewill be chosen by type-G individuals under majority rule. This might make both them and the type-H individuals betteroffif the utility losses to risk-averse type-H individuals from buying less insurance is, at equal consumption, more than offset by the reductionin premiums occasioned by a reductionin the proportion theirpurchasesare of total insurancepurchases. Suppose type-G individualsfixpurchasesat X1 units,whichis the amounttheyboughtat a priceof PEOand is an amountless than the X0 units type-B individualswere buying at the premiumPEo. Reduction in purchases by type-B individuals necessarilyreduces of purchases by type-B indipE, say, to Pv1, since the proportion viduals declines. Type-B individualswill be betteroffif the reduction in total premiumexceeds the value of the reductionin insurance benefits.That is, theywill gain whenthe following inequality holds fora type-B individual: (10)
= (X0-Xi) PEO+X1(PEo-PEN) XOPEOX1PE1 X. dx ur'(2)
fs (1t-e irB) t (e) + erBue(2) The firstterm in the second expressionon the left of the in8. Arrow, "Political and Economic Evaluation of Social Effects and Externalities," p. 11. 9. The latter assumption is not critical to the normative argument about whetherthe governmentcouldimprove things; some other device by which the quantity of insurance is selected could be considered.
58
equality is less than the integral,since the value of a unit of X at X0 was equal to PEo and increasesas the quantityis reducedto X1, but it is clearlypossibleforthe inequalityto hold if the secondterm large. is sufficiently is shownin Figure of this argument demonstration A geometric I. The curve is a type-B person's demand curve for dollars to be deliveredin state 2. Suppose that purchases are fixed (by vote of thetype-Gindividuals) at X1 units,the amounttype-Gpersonswere type-B individualsto buy X0 at the buying,instead of permitting per unitpaid by hold the premium premium pE,. If we conceptually type-B people constantat PEo, subsidy paymentsfromthe type-G people would decline by the amount of area FCDE. But in order to satisfy (9), PE would have to decline (with X0(PEo) replaced by is reXI) because the weightof the type-B individuals'experience duced. Suppose it declinedto p.E. This level of pE is chosenso that in subsidypayarea pR0EGpB1 is less than area FCDE, the reduction ments fromthe G's. It is also chosen so that the sum of areas
-TT p
pz4rrB_\FC
HX
PEO
PEI
L~~~~EO
I R
-
~
Gl
x
O
xl
X0 Xs
~~~Xl
FIGURE
X1EDXO and PBEGPB1 (i.e., PR,0X0-PElXl) is greater than the sum by the inteof areas X1EDXO and HDE (i.e., the area represented gral in (10)). Such an outcomeis clearlya possible solutionto (9) since as little and is one in whichtype-B individualsare betteroff, surplus,would be sufficient as HDE, the amountof lost consumers' to compensatethem for the compulsoryreductionto X1 in their purchases,while they actually receive a reductionin premiumsof

PEoEGPEl.
59
mentsfor OX1 of insurancefalls by the remaining part of FCDE. In effect, permitting individuals to limit the purchases of type-G type-B individualsbringsabout a reductionin the purchase of insuranceby the B's, whoseinsurance was worthless than its cost. By sharingthe benefitsof this reductionin welfarecost, both groups can gain. What if type-B individuals can buy additional insurance beyondthe compulsory amount? In this simplemodel only type-B people would be willingto buy such supplementary insuranceif the compulsory amountchosen by the type-G personswas the amount that maximized a type-G person's utility. Since type-G persons would not supplement forthe the compulsory coverage, the premium supplementarycoverage would representthe experience only of type-B individualsand so would settleto equilibriumat p*B. The amount of insuranceserves as a perfectindicatorof what type of person an individual is, even thoughhis type cannot be observed directly. The compulsory minimumpurchase precludesthe possibilitythat a type-B person,by buyingonly a small amountof insurance froma given seller,induces the seller to think that he is really an individualwho buys small amountsof insurancein total. The law here performs a useful function.Because of the existence of the law, each seller knows that every prospectivebuyer has at least a minimum amount of insurance,so that any purchaseof insurancefrom him providesevidencethat the buyeris really a highinsurancepurchaserand therefore a bad risk. Thus the function of the law is reallyto provideinformation on total insurance.Here, in contrastto the moral hazard case, uniform compulsory provision is still useful. If information on total purchases were provided directlyto firms, it is easy to see that (XB (PE), XG (PE) ) mightwell no longer constitute a competitive equilibrium.For, if some uniform quantity smaller than XB (PE) really represents a Pareto optimal improvementover competitive equilibrium, firms that restrict purchasesto that quantitycould increaseprofits.It is obviousthat,if bothtypes of persons preferthe formerallocation to the latter, a firmthat offered such an allocation could make profits. It is worthwhile to note also that, if thereare moretype-B individualsthan type-Gindividualsso that type-B individualschoose the quantityof insurance, then compulsory uniform insurance, with or without will notrepresent supplementation, a Pareto improvement over the competitiveimperfect information solution. Compulsion
off too,sincetheir totalpayType-Gpeopleare better
60
in this case would requiretype-G individualsto buy even more insurancethan they choose at PE and to pay an even largersubsidy. But thereis anotherpoint worthnotingas well. Althoughtype-G individuals would, in such a situation,want to bribe type-H inpurchase less insurance,relevanttypes dividuals to let the former of individualscannot be identified.Thus, althoughthis movement one is not a Pareto opsolutionto a compulsory a competitive from to a Pareto optimalpoint, a movement timal one,it mightrepresent equilibriumis not Pareto superior so that in this sense competitive insurance. to the compulsory
DEVICES FOR DEALING WITH ADVERSE V. ALTERNATIVE
SELECTION AND MORAL HAZARDFROMOVERINSURANCE
proIt may also be that thereare ways otherthan compulsory As noted,if inPareto optimal improvements. vision of producing thetotal amountof insurancean individualhas surerscan determine bought,they will notice that individualswith certain quantitiesof insurance (e.g., those who buy more coverage) have a larger loss per dollar of coveragethan thosewho buy otherquantities.Indeed, in the precedingmodel in whichtherewere only two kinds of perex post, indicator, sons,the quantityof insuranceboughtis a perfect of whichtype of individuala personis. This suggeststhat insurers may alter premiumrates to vary with the amount of insurance purchased. This can be done in two ways: (1) The buyer may be faced with a schedule in which,say, premiumrates rise with purchases. (2) Insurersmay fixa quantityand total price. If method (1) is chosen,insuredswill, of course, adjust to a marginalprice, ratherthan the average price schedule. But even by to inhibitsome "overpurchasing" such a device may be sufficient type-B individuals. Method (2) could be accomplished if insurers offeronly a limitedrangeof policies and do not permitduplication.' In practice may be a way of achievingquantity it appears thatgrouppurchasing he musttake a quanlimitation.If a personbuys groupinsurance, He cannotbuy predetermined. titythat is, so faras he is concerned, additional insuranceat the group rate. Of course,group purchas1. In an interestingrecent paper, Rothschild and Stiglitz show that a competitive equilibrium may sometimes not exist if insurers have informationon total purchases. Such informationis necessary for the market to achieve an optimal equilibrium, but it is not sufficient. See M. Rothschild and J. E. Stiglitz, "Equilibrium in Insurance Markets: The Economics of Imperfect Information" (processed), 1973.
61
ers also permitfortuitous collectionsof low-riskindividualsto get lower rates than in an all-inclusivegroup,and thereare many interestingproblemsin determining(a) how a group decides how much insurance to buy and (b) how individuals move between of this sort are analogous groups.2In many ways, fringebenefits to a local public good and may deserveseparate treatment. When people vary in risk aversenessas well as probabilityof expectedloss, the quantityof insuranceboughtat a givenpremium is no longera perfect indicatorof the probabilityof loss. Someone may buy a large amountof insuranceeitherbecause his probability of loss,knownto him (and possiblyaffected by him) but not to the insurer, is below the probabilityon the basis of whichthe premium was calculated, or because he is very risk-adverse.Still, if we asof of attitudestowardriskis independent sumethat the distribution of probabilitiesof loss, people who buy more inthe distribution surance will tend, on the average, to have larger expected losses than thosewith less insurance. The positiveimplication of this is the same as that drawnfrom the simplermodels; insurancecompanieswill attemptto vary premiumswith coverage of a given event, and group purchases may be explainedas a usefulway of generating information. The normative implicationsare less clear. On the average, such arrangements may make people better off,as might compulsoryprovision. It would be very difficult to avoid makingsomeoneworse off. Only if we are willing to take as a criteriona kind of maximizationof average welfare,where one has an equal chance of being a gainer
2. In particular, it may be worthwhile to consider the role of adverseselectionand moralhazardin the choiceof healthinsurance policiesby groups. Supposethatthere are differences between groups in theextent of moralhazard, but individuals are identicalwithingroups.For example, in some individuals groups might feela stronger moralimperative, as Arrow has suggested, against overuseof care,or supplyrestrictions in an area might hinderadditionaluse. See KennethArrow, "The Economicsof Moral Hazard: Further Comment," American EconomicReview,Vol. 58 (June 1968). 537-39. One would expect, ceterisparibus,that those groupsforwhommoralhazard is low would buy morecoverage. The relationship betweencoverageand usage that would be observed wouldunderstate theeffect thatcoverage wouldhave on usageif coverage were chosen exogenously.Low-coverage groupswould, because of greatermoral hazard,increase usage moreif coverage wereincreasd thanwouldthosegroups observedto have higher coverage.This meansthat one cannoteven guessat theamountof bias in the measurements of the effect of coverage on usage that have been attempted by RichardRosett and L. F. Huang, P. Feldstein, and others.See RichardN. Rosett and L. F. Huang, "The Effect of Health Insuranceon the Demand forMedical Care,"unpublished paper,Dec. 1970; and Paul Feldstein, "The Demand for Medical Care," in Report of the Commission on the Costs of Medical Care (Chicago: American Medical Association, 1964).
62
or a loser,mightsuch arrangements make sense. In some "constitutional" stage,forexample,this mightbe appropriate. In this sense, the preceding discussiondoes serveto explain and providea welfare of information on basis, even if onlya weak one,forpublicprovision total insurancepurchases.
NORTHWESTERN UNIVERSITY

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Overinsurance and Public Provision of Insurance: The Roles of Moral Hazard and Adverse Selection Author(s): Mark V.

PUBLIC PROVISION OF INSURANCE

QUARTERLY JOURNAL OF ECONOMICS

PUBLIC PROVISION OF INSURANCE

QUARTERLY JOURNAL OF ECONOMICS

B. Moral Hazard I specifically assume that DP

0. That is, no matter

(1 -7r) u.(1) + 7riW(2)

9. If a cornersolutionoccurs and the equality in (3) is not satisfied,

PUBLIC PROVISION OF INSURANCE

QUARTERLY JOURNAL OF ECONOMICS II. "COMPETITIVE" EQUILIBRIUM

If individualsdiffered so that the amount of X purchasedby each

PUBLIC PROVISION OF INSURANCE

QUARTERLY JOURNAL OF ECONOMICS

muchas possible withhis expected loss.3

But in competitive equi-

PUBLIC PROVISION OF INSURANCE

QUARTERLY JOURNAL OF ECONOMICS

PUBLIC PROVISION OF INSURANCE

whereXB (PB) is the quantityof X chosen by a type-B individual

PUBLIC PROVISION OF INSURANCE

Arrow is more circumspect, but comes to a similar, though weaker,conclusion.

QUARTERLY JOURNAL OF ECONOMICS

PUBLIC PROVISION OF INSURANCE

off too,sincetheir totalpayType-Gpeopleare better

QUARTERLY JOURNAL OF ECONOMICS

SELECTION AND MORAL HAZARDFROMOVERINSURANCE

PUBLIC PROVISION OF INSURANCE

QUARTERLY JOURNAL OF ECONOMICS

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