Journal of Health Economics 10 (1991) 41 l-132.

North-Holland

The doctor as double agent: Information

asymmetry, health insurance, and medical
care
Bike Blomqvist*
Department of Economics, University of Western Ontario, London, Canada, N6A SC2

Received March 1991, final version received August 1991

In a model incorporating uncertainty and state-dependent utility of health services, as well as

information asymmetry between patients/buyers and physicians/sellers, two types of equilibria
are compared: (1) when consumers have conventional third-party insurance and doctors are paid
on the basis of fee-for-service; and (2) when insurance is through an HMO which provides health
services through its own doctors. Conditions are found under which contractual or legal
incentives can overcome the information asymmetry problem and bring about an efficient
allocation of resources to health services provision.

Introduction

It has long been recognized that health services have special characteristics
that influence institutional arrangements in the market where they are
supplied [Arrow (1963)]. First, given the state-dependent nature of the
demand for health services, most of the cost of health care in modern
societies is covered through some form of (public or private) insurance.
Second, the relationship between the providers of medical services and their
patients is characterized by asymmetric information. The collection and
evaluation of diagnostic information can be performed only by trained
physicians, and cannot easily be separated from the provision of medical
treatment. Moreover, even with accurate diagnostic information, there is
considerable randomness in the relation between health care and health

*In working on this paper, I have benefttted from the comments and suggestions of Patricia
Danzon, Gregory Dow, James Feehan, Joel Fried, Ig Horstmann, David Laidler, and Peter
Welch. I would also like to acknowledge extensive discussions with Alan Slivinski on both
substantive and technical aspects of the model. The customary disclaimer applies in all cases.
Early versions of the paper- have been presented at seminars at the Universities of Western
Ontario, Windsor. and Waterloo; at the Stockholm School of Economics; and at the 1989
meetings of the Canadian Economics Association in Quebec City.

0167-6296/91/$03.50 0 1991-Elsevier Science Publishers B.V. All rights reserved

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 A. Blomqrist, Doctor as double agent 413

provides medical care to its clients through its own physicians (who typically
are salaried employees).3 The principal result is that, although a financing
mechanism such as that inherent in an HMO may bring about sonte
improvement in efficiency, in comparison to a system with conventional
insurance and fee-for-service remuneration, such a mechanism cannot by
itself overcome the problem of imperfect agency in a situation of information
asymmetry. Because there is a double agency problem, a second instrument is
needed as well. It is then shown that some type of performance guarantee or
liability rule may serve as such an instrument, even if the outcome of a
particular treatment episode can only be imperfectly observed.
In particular, the paper shows that under certain conditions, it is, in
principle, possible to design a system of performance guarantees that
overcomes the information asymmetry problem and leads to a pattern of
health services provision that is similar to what would result if consumers
had as much information as physicians do. In reality, guarantees are not, of
course, used in the medical care field. However, legal rules concerning
medical malpractice, imperfect as they are, may be interpreted as providing a
degeee of implicit guarantee. Moreover, other types of limited guarantees can
sometimes be given through voluntary contractual agreements.
Although the analysis yields results that may, indirectly, be of interest to
policy-makers concerned with the design of efficient mechanisms to provide
health insurance and health services, it must obviously be borne in mind that
they are derived in the context of a highly simplified model. Two particular
limitations may be worth emphasizing explicitly. First, I assume that health
insurance, whether of the conventional kind or in the form of HMO contracts,
is offered in perfectly competitive markets, on actuarially fair terms. Thus, the
problems that arise in the design of regulatory mechanisms or state-run
insurance schemes, as alternatives to imperfectly competitive private insur-
ance markets, are not considered; how to extend the analysis to these
alternative systems remains a task for future research. Second, there is no
recognition of the significance of the medical profession’s discipline codes and
ethics in providing incentives for physicians to refrain from exploiting their
information advantage. Yet, as noted by Arrow (1963), the unusual emphasis
on a strict professional code in the education of physicians can be seen as an
institutional response to this need. Although it may not be easy to
incorporate in a formal model, the professional code may in reality be an
important influence on the doctor-patient agency relationship, especially in

‘The idea that insurance through HMO-type organizations could play a crucial role in
enhancing competition and containing costs in the health care system has been forcefully
propounded by Enthoven (1980, 1978). It is also discussed in Sloan and Feldman (1978), and
emphasized in the comprehensive survey article by Pauly (1986), whose observation that ‘there
has been little satisfactory modeling of the choice between HMO and conventional insurance’ was
part of the motivation for this paper.
414 A. Blomqvist, Doctor as double agent

the case of HMO-type contracts where it may conflict with strictly economic
incentives.
The rest of the paper is organized as follows. In section 1, I specify the
basic model and consider the reference case with symmetric information
where the patient’s diagnosis is fully known by the patient and insurer as
well as by the physician. In sections 2 and 3, I consider the cases of fee-for-
service provision of medical care and conventional insurance, and that of
insurance through an HMO with salaried doctors, under conditions of
asymmetric information. In section 4, I discuss the possibility of overcoming
the information asymmetry problems through a ‘stochastic performance
guarantee’ when medical care is provided, and section 5, finally, contains a
brief summary and concluding comments.

1. Health insurance and medical care under full information

For simplicity, I assume that the representative consumer’s utility in state i

is an additively separable function of ‘health’ hi and consumption cir where
i=O, 1 . . . n indexes the state of nature, and ni denotes the probability that the
i’th state will occur. Thus the consumer’s expected utility E is:

E=Cni(hi+~(~i)), i=O,l,...n. (1)

I assume that u’>O,u”<O,u’(O)= co. The value of the health index hi is given
by:

h,=h
(2)
hi=h(Zi-ei)<F;, i=l...n,

where ei is a parameter associated with the i’th state of nature, and Zi is the
quantity of health services consumed in state i. For simplicity, I assume that
health services are competitively supplied at a price of unity. I also assume
that the consumer knows the form of h( a), which has the properties:

h’ > 0, h” c 0, h’(0) = co, (3)

and that

8i-8i_l=6>0, i=Z...n. (4)

Thus, i=O denotes the state ‘well’, when the consumer needs no health
 A. Blomquist, Doctor as double agent 415

services, while i = 1. . . n denote states of progressively more serious illness

and greater need for health services.4 Note that a ‘worse’ state of nature can
be thought of as a downward shift in the function h(z) (a lower value of the
health status index for a given amount of z) or, equivalently, as a rightward
shift (a larger amount of z is needed to reach a given level of health); given
the way 0 is defined, the latter is the more natural interpretation here. Each
consumer’s income takes the common value y in each state.
In the full-information case, it is assumed that the patient’s state of health
Oi can be costlessly observed by both the patient and the insurer, as well as
by the physician. Given this, it is possible to enforce insurance contracts
which specify the amount of medical services that the insurer will pay for in
each state i.
If there is competition in the insurance market and the ‘load factor’ in
providing insurance is zero, the representative consumer will, in equilibrium,
hold a contract specifying a vector {zi=z(Bi)} and an insurance premium m
which yield the insurer a zero expected profit, while maximizing the
consumer’s expected utility. That is, the contract solves the following
problem:

max E=[C~~ih(zi-Oi)] +u(Y-m), (5)

mbit

s.t. m-&zi=O; Zi10, i=O...n. (6)

The first-order conditions can be solved to yield:

z,=o
(7)
h’(Zi-8J-t4’(y-WI)=O, i=l . ..n.

This is equivalent to the first-best solution with a complete set of contingent

markets for medical care, and serves as a point of reference for the following
analysis. Note that the patient is always ‘fully insured’ in this case, in the
sense that the marginal utility of consumption is the same in each state of
health.5

4A referee has pointed out that this formulation neglects the ‘investment dimension’ of the use
of health services, and also that consumption and health status may not be additively separable.
Although carrying out the analysis in an explicitly dynamic model with a more general utility
function would be more cumbersome, I am confident that it could be done, and that the
qualitative results discussed below would not change.
sin general, contingent markets that allows the patient to vary ttie amount of consumption of
other goods according to the state of nature would also be required in order for the first-best
solution to be attainable. In the special case considered here, where the utility of consumption of
other goods is independent of the state of nature, this is not necessary, however.
416 A. Blomqvist, Doctor as double agent

2. Fee-for-service and conventional insurance with asymmetric information

In this and the following sections, I turn to an analysis of situations that

more closely reflect the standard assumptions that usually are made regard-
ing the information structure in the markets for health insurance and health
services: that, through the initial diagnosis of a sick patient, physicians obtain
private information concerning the patient’s state of health. More specifically,
I assume that, although the patients know whether or not they are ill, they
cannot tell the value of 8. The doctor, on the other hand, is assumed to be
able to observe 0 accurately, at no cost. The insurer, in turn, is assumed to
be unable to observe 8, or even whether the patient is sick at all.
In this case, an insurance contract specifying a vector {z(0,)> will not be
viable, since it is in the patient’s interest to have the physician overstate the
seriousness of the illness to the insurer. When physicians are paid on a fee-
for-service basis, they have no reason not to comply with the patient’s
wishes; in fact, competition for patients will induce doctors to act solely as
their patients’ agents, with no regard for the interests of the insurer.6
One alternative in this situation is a conventional contract with premium
m which allows the patient to choose the amount Zi in each state of nature,
but which pays only a fraction (1 -rr) of the cost of the health services
actually purchased. Thus, d is a ‘co-insurance parameter’.
Suppose first that physicians, even though they deliberately mislead the
insurer, always tell the patient the truth about 0. (That is, they act as perfect
agents in one of their two agency roles.) Equilibrium in the system may then
be characterized as follows.
Consumption of non-health service goods in state i is

Ci=y-m-tSZi. (8)
Given m and et the consumer chooses a non-negative vector {zi} which
maximizes expected utility. Substituting (2) and (8) into (l), one obtains the
following necessary (and sufficient) conditions for a maximum:

z,=o
(9)
h'(Zi - et) -aU’(Ci) =O, i=l...n.
6The incentive for a physician to act as the patient’s agent may also be one important reason
why indemnity insurance (that is, payment by the insurer of a fixed sum of money to the patient
whenever he or she has been diagnosed with a specific disease) is not more common. For an
early discussion, see Pauly (1971); see also the comments in Pauly (1986).
A referee has pointed out that in reality, patients do not appear to want infinite amounts of
health services even in systems (such as Canada’s) where co-payments are zero. This may
perhaps be explained by the fact that consumption of health services always involves an
opportunity cost in the form of the patient’s own time or travel expense, even when explicit co-
payments are zero; this opportunity cost is not modelled here.
 A. Blotnquist, Doctor os double agent 417

From these conditions, one may obtain n+ 1 demand functions zi(m, a).
From (9), (3) and (4), it is easy to show that, when a>O, the following
relations will hold:

Zi>Zi-l, U’(Ci)>U’(Ci_t), i=l...n. (10)

If insurance markets are competitive, the premium for a policy with a
given value of e will be

(11)
When the market is in equilibrium, the consumer will have a contract
(m,cr) which maximizes expected utility E, given an optimal choice of {Zi}. It
is straightforward to show (see the Appendix) that the solution implies
0~ C-C1. Thus this is the familiar solution in which patients are less than
fully insured, because continent markets do not exist, and under conventional
‘service benefit’ insurance, the incremental gains from more complete insur-
ance must be balanced against the moral hazard effect when patients do not
pay the full incremental cost of the medical care they receive [see for
example, Zeckhauser (1970), Arrow (1976)]. Note, however, that within the
framework employed in this paper, the non-existence of a set of contingent
markets is a consequence of the doctor-insurer agency problem: If a
mechanism could be found to make physicians tell the insurer the truth
about 8 (that is, to act as perfect agents in both their roles), contingent
contracts would be possible.’
In the preceding analysis, physicians were assumed to act as the patients’
agent: They were assumed to tell patients the truth about 8. However, as has
been extensively discussed in the literature, physicians may not in fact tell
patients the truth. A pervasive theme in the analysis of the market for
physician services is that fee-for-service doctors have an incentive to slant the
information they provide to their patients, partly in order to create addi-
tional demand for the services they provide.*
If physicians act as price takers in a strict sense (that is, if they can sell
whatever quantity of services they wish at a competitively determined market
price), they have no incentive to manipulate demand in this way [Pauly

‘Note that the contingent contracts could then be either in the form of a specitied set of
health services to be provided, or of the indemnity form (that is, guaranteeing the patient a
specific sum of money).
‘The leading proponent of the ‘demand creation’ idea has been Robert Evans (1974, 1984).
For useful expositions, see also Sloan and Feldman (1978). and Newhouse (1978). Some recent
theoretical and empirical work has suggested that the ability of physicians to manipulate
demand is less complete than was previously thought [McCarthy (1985)]. However, the majority
view continues to be that the physician’s informational advantage is a significant factor in the
health care system [Reinhardt (1985)]. For additional references, see Pauly (1986).
418 A. Blomquist, Doctor as double agent

(1980)]. However, if individual physicians have any degree of monopoly

power (or if the market price is fixed above its competitive level), they do
have an incentive to ‘induce demand’ rather than lower their prices, if
misrepresentation has no cost, psychological or otherwise.
Another reason why a physician may choose to exaggerate the value of 8
may be fear of legal liability. In particular, suppose physicians risk being held
liable for damages if they fail to sufficiently impress on patients the urgency
of obtaining a particular amount of medical services. Specifically, suppose
that, in state of nature i the ex post observed health outcome h, is a random
variable with mean h(zi-8,), and suppose that a physician will become liable
for damages if

(12)

where 0 is the value of 8 that the physician has communicated to the patient
(henceforth referred to as the ‘signal’), and Zi is the amount of health services
that the patient has chosen to consume.g To minimise the risk of being
held liable, the doctor’s best strategy is always to signal e^=e,, the worst
possible state of nature.
If consumers continue to believe that doctors are telling the truth, all of
them will always choose to consume z,, the solution to the n’th first-order
condition, when they are ill. In a competitive insurance market, equilibrium
will be that contract (m, a) which maximizes E, as before. But instead of (1 I),
the relevant constraint now is

m=(l-a)(l-X,)2,. ((13)

However, consumers may recognize the doctors’ strategy, and not believe
the signal e’=e,. Assuming consumers know the true probability distribution
of 0, their problem becomes that of choosing a single value of z, which
maximizes expected utility

(14)

The single first-order condition is

9With conventional insurance, it is the patient, not the doctor, who chooses zi. Thus in this
case the doctor can be held responsible only for the information provided, not for the amount of
services consumed.
For references to evidence concerning the significance of ‘defensive medicine’ as a response to
fear of litigation, see Danzon (1985, ch. 8).
loThe number 1 under the summation sign signifies that i ranges from 1. ..n in the
summation; unless otherwise indicated, i ranges from 0.. . n.
 A. Blomquist,
Doctoras double agent 419

Tni(h’(Z-ei)) -U(l-x,)U'(y-mmUZ)=O. (15)

[ 1

Solving this equation yields a demand function z = z(m, u) as before.

Assuming that suppliers of insurance correctly infer consumers’ behaviour
(i.e., know the demand function z(m,a)), competition among insurance firms
will in this case produce a policy (m,a) which solves the following problem:

maxE, s.t. m-(1-x,)(1-a)z=O. (16)

nI.b

As before, it is straightfoward to show that the optimal policy has O<a< 1

(see the Appendix).”
Let variables with superscript 0 denote the equilibrium when physicians
provide patients with accurate information; let superscript 1 (2) denote
equilibrium values when doctors always signal i?=f3,, and patients do (do
not) believe them.
We can then prove the following:

Proposition 1. Under the assumptions in this model, we have E”> E’ and

Et > E’. Moreover, if

z(m2, 0’) >C7rizi(mz, a’), (17)

where z(m, a), and zi(m,o) are the demand functions corresponding to (IS) and
(9), then E” > E2.

To prove E” > E’, it is sufficient to note from (9) that at the equilibrium
(m’,a’), the consumer can increase utility in each state of nature (except the
n’th) by decreasing z,; thus expected utility increases and the solution
remains feasible in the sense that the insurance premium m is sufficient to
pay for the average consumption of health services. Similarly, to prove

“Since, in this case, the patients end up spending the same amount on health services
whenever they are sick (regardless of the true severity of the illness), it might seem that a better
alternative would be an indemnity contract under which the patient would collect a fixed sum of
money whenever they became sick (i.e., in every state of nature other than i=O). This alternative
is ruled out, however, by the assumption that, even though either the patient or the physician
knowns whether or not the patient actually is ill at all, the insurer does not. Thus as long as
physicians continue to act as the patients’ agent, indemnity contracts will not be feasible.
420 d. Blomqvist, Doctor as double agent

E2 >E’, it is sufficient to note that the left-hand side of (15) is negative at

(m’,~~,zi), so that expected utility can be increased by decreasing health
services consumption in each state. Finally, to prove E”> E’, note that at
(m2,cr2,z2), utility can be increased in each state by either decreasing or
increasing zi, and (17) guarantees that the solution remains feasible.
In general, it is to be expected that provision of additional information will
raise utility; the only surprising part of Proposition 1 is that a condition such
as (17) is needed to rule out the possibility that consumers collectively might
be better off when doctors provide no information than when they provide
accurate information (that is, to guarantee that E”> E’). The explanation
appears to lie in the second-best nature of the optimum with conventional
insurance. If provision of more information raises average consumption of
health services, this exacerbates the welfare losses associated with the moral
hazard problem; if this effect is stronger than the ‘reallocation gain’ that
results from the additional information, there may conceivably be a net loss.
In reality, however, it is probable that (17) does hold: With risk-averse
consumers, the consumption of health services in the absence of information
can be expected to be close to what would be consumed in the most serious
states of illness when information is available.

3. Prepayment contracts of the HMO-type under asymmetric information

For purposes of the present analysis, the term ‘HMO’ is used to denote an
insurer which provides health services to its clients through its own
physicians (that is, physicians who are employed by the insurer). From the
viewpoint of the present paper, the significance of this type of arrangement is
that, as the insurer’s employees and thus with some stake in its economic
success, physicians have some incentive to act according to its interests.i2 In
the following, I will assume that HMO physicians act as their employer’s
perfect agents; that is, that an HMO-type mechanism removes one of the two
agency problems referred to above.
When they are ill, clients (subscribers to the plan) approach the HMO for
medical care. Generally, real-world HMO contracts do not specify any co-
payment by the individual consumer (i.e., the parameter r~ in the previous
section is zero). However, I assume in this paper that the HMO contract
specifies (perhaps implicitly) an upper limit on the amount of health services
that the consumer is entitled to received in state i. With zero co-payment, the
consumers will always utilize this amount, and in this subsection, Zi= z(e,),

“In some cases, physicians’ incentives to act as actual HMO agents are strengthened through
profit-sharing arrangements, or through internal monitoring systems.
 A. Blomqcist, Doctor 0s double agent 421

will denote this upper limit. Thus, an HMO contract will be characterized by
a premium level m and a vector (zi} representing the amounts of health
services that the consumer will receive in each state of nature.13
Now suppose there is asymmetric information, in the same sense as in the
previous section, so that doctors but not patients can observe the value of 8.
In the absence of any kind of performance guarantee or legal liability rule,
the equilibrium strategy for the HMO (and thus for a physician that acts as
its perfect agent) is always to signal O,, the ‘least serious’ state of nature, and
provide zl, whether or not consumers believe the signal.
If consumers do not believe the signal, the only equilibrium contract
involves a single value of z in each state of nature. Competition among HMOS
will lead to an equilibrium where the feasible pair (m,z) maximizes the
representative consumer’s expected utility, i.e., solves the problem

m~:XE=n,h+[~nih(z-oi)]+U(1.-“‘)
(18)
s.t. m-(l-7L,)z=O.

The first-order conditions for a maximum in this case may be combined to

yield:

(19)

Let variables with superscript 3 denote the solution to this problem.

Clearly, E3 will be less than the expected utility in the full-information case
discussed in section 1 above. However, we also have:

Proposition 2. Under the assumptions of this model, E3 > E2.

To prove this, consider the subsidiary problem of finding a contract

‘% reality HMO contracts do not, of course, specify limits on the amounts of services for
specific illnesks. However, empirical evidence [Luft (1981), Manning et al. (1984)] makes it clear
that the amounts of services used by persons covered by HMO contracts on average are
substantially below those used by persons with conventional insurance, even though HMOS
typically do not require any co-payments from their patients. (Even if HMO doctors were to
systematically understate their patients’ need for health services, with zero copayments one
would still expect patients to use large amounts of services if they were free to do so.) This
suggests that HMO~ do in fact impose implicit limits on the services provided in each state of
nature. The idea of implicit contractual limits is also consistent with the notion that, because of
the information asymmetry, decisions concerning the use of all kinds of health services are
effectively made by physicians, not by patients.
422 A. Blomqcist, Doctor as double agent

consisting of a triple (m, 6, z) which maximizes E (as defined by (14) subject

to the constraint in (16)). The first-order conditions, corresponding to the
derivatives of the relevant Lagrangean with respect to m and C, may be
written

n,u’(y-m)+(l -q)u’(y-m-az)-i.=O, (20)

zu’(y-m-oz)-lz=O, (21)

where I is a Lagrange multiplier. These equations cannot be satisfied at any

value of cr other than zero. In particular, the derivatives will be non-zero at
the values (m2,02,z2), that is, the values that maximize utility under
conventional insurance. Thus, the solution to this subsidiary problem yields a
higher expected utility than is attainable under conventional insurance.
Moreoever, with cr= 0, the subsidiary problem is identical to problem (18).
Intuitively, the reason an HMO contract yields a higher expected utility in
this case is that even though it does not overcome the problem of
information asymmetry between doctor and patient, it does eliminate the
morazl hazard effect associated with the fact that under conventional
insurance, the patient does not pay the full cost of the medical services
consumed. Under an HMO contract, this moral hazard problem is eliminated
by the prior limitation on the amount of care that will be provided in the
case of each illness.
Another way of interpreting Proposition 2 is to note that under the
assumptions here, an HMO-type contract is equivalent to an indemnity
contract that pays out a given amount of money whenever the patient is ill,
regardless of the severity of the illness. As explained in footnote 11, an
indemnity contract of this type will not be feasible under conventional
insurance, since the insurer cannot directly observe whether or not the
patient is ill at all. Under HMO-type insurance, however, the HMO-employed
physicians are assumed to provide the insurer (the HMO) with accurate
information, making the equivalent of this type of indemnity contract
feasible.

4. A stochastic performance guarantee

None of the mechanisms that have been considered so far effectively
overcomes the fundamental information asymmetry problem in the market
for medical care, namely that between doctor and patient. Under conven-
tional insurance and fee-for-service, doctors do not have an incentive to act
as perfect agents for either the patient or the insurer; their best strategy is to
reveal their information about 8 to neither. In the HMO-type case, they are
 A”. Blomquisr, Doctor as double agent 423

assumed to act as perfect agents for the insurers, but in that capacity, their
equilibrium strategy again is to withhold true information from the patient.
In this section, I consider an alternative institutional mechanism that may
be employed as an incentive on HMO physicians to act as their patient’s
agent, namely liability rules that apply in cases where the outcome of a
medical treatment episode is significantly worse than expected.
Since the true value of 0 is assumed to be known only to the doctor, any
guarantee or liability rule will not in general be effective if it is based solely
on the value of z, the amount of health services actually provided, in relation
to t?, the value of 8 stated by the doctor. Moreveover, even though it may be
possible to observe the ultimate outcome of a treatment episode, if the
outcome (the patient’s state of health) depends on intervening factors other
than 0 and z (which, for simplicity, is assumed to be fully and costlessly
observable), evidence on z and the outcome is not sufficient to infer the
precise value of 19.
However, even if is is not possible to predict exactly what a person’s health
status is going to be following a particular illness episode, information may
be available about the probability of different outcomes, given 8 and z. In this
case, some kind of performance guarantee or liability rule based on the
observed outcome may be possible, even though it will be an imperfect one
in the sense that the seller (the HMO) will sometimes be held liable even
though its agent has in fact fulfilled its contract. Specifically, I will assume
that, even though it is assumed impossible to ascertain directly whether or
not an HMO has broken a contract of the form zi=z(Bi), there is a stochastic
performance guarantee under which it will be held liable (be deemed to have
broken its contract), and a penalty assessed, if the outcome of a particular
episode of diagnosis and treatment falls sufficiently far below what would
have been expected if the contract had been fulfilled.‘4
In particular, detine

&=h(Zi-BJ-h, (22)

where fi is the random variable corresponding to the ex post observed health

outcome introduced in (12) above; by the definition of & E has mean zero.
141n the literature on malpractice law, a distinction is made between ‘process-oriented’ and
‘outcome-oriented’ criteria. In the former, the question whether a physician will be found guilty
is decided on the basis of direct evidence concerning what he or she actually did in treating the
patient. In the latter, the kind considered in the text, the decision is made in substantial measure
on the basis of evidence concerning what the outcome (in terms of the patient’s health) was. Even
though in reality, the process-oriented approach predominates in malpractice legislation in
North America, it would nevertheless appear that in situations where ex post information about
diagnosis and treatment is costly and unreliable, the outcome-oriented approach could
potentially be more effective. Recommendations for legislative reform along these lines have been
made by some legal scholars. For a particularly clear exposition of the issues involved here, see
the commentary by H.E. Frech III on the papers by Epstein and Calabresi in Rottenberg (1978).
424 k. Blomqcist, Doctor as double agent

Let the density function of E be J(E). Suppose an HMO is deemed to have

broken its contract if (12) holds, that is, if

h(Zi_8)-h^>y, (12)

where 0 is the HMO'S signal, and that the HMO will then have to pay a
penalty F. Also define

P = prob(s > y); (23)

P is then the probability that an HMO will be ‘falsely convicted’ (i.e., that it
will have to pay the penalty F even if it has accurately stated f?=O, and
provided the contractually specified Zi), and y, the ‘conviction criterion’, is a
parameter that reflects the degree of certainty required by the courts in order
for the HMO to be held liable under the guarantee.
Under certain conditions, this type of performance guarantee will induce
HMOs to always signal the true value of 8=tIi. Consider an HMO that is
offering a contract with premium m, and suppose the vector {zi) is chosen so
that the conditions (7) are satisfied

z,=o
(7)
h’(Zi- ei) - u’(y - m) = 0, i=l...n.

Under such a contract, the expected health outcome 6 is a constant, say h’,
for all i=l . . .n. Consider now a patient who arrives with parameter 8i. The
expected cost C to the HMO of telling the truth and providing the
contractually agreed zi equals

C=Zi+P.F. (24)

Suppose now the HMO tries to reduce the expected cost by falsely under-
stating the seriousness of the patient’s illness15 by signalling t?=fIi_ r, and
providing Zi-l. By doing so, it saves on the cost of health services. But it
also increases the probability of having to pay a penalty; specifically, the
probability now becomes P,, given by

P, = prob(s > y-), (25)

where

151t is assumed that conviction occurs with probability I if the contract is obviously violated
in the sense that less than the specified zi is provided, for a given signal.
 A. Blomqoist, Doctor as double agent 425

Y-=Y+(h(Zi_,-Bi)-h’). (26)
We have P,> P. The impact on expected cost, denoted by AC,, is given by

AC,=(Zi_,-Zi)+F(P,-P). (27)

If this expression is greater than zero, HMO physicians will not understate the
seriousness of a patient’s illness. However, it is now possible that the
expected cost will be lower if the HMO ooerstates the value of 19~and
‘overprovides’ health services. Though this increases the cost of services, it
also reduces the probability of a penalty to P,< P, where

P,=prob(s>y+), (28)

and

Y+=Y+(h(Zi+l_8i)-h’). (29)

By reasoning similar to above, one can write the impact of this strategy on
expected cost, AC,, as

ACx=(Zt+1 - Zi) + F( P, - P). (30)

If this expression is negative, the HMO’S equilibrium strategy will be to

overprovide services. Moreover, it is clear that it may be in the HMO’S
interest to ‘overtreat’ by more than (zi+i -zi), for example, if F is sufficiently
large.
However, if conditions are such that AC; and AC, are both positive, the
equilibrium strategy is for HMO physicians to tell the truth and offer
contracts (m, {zi}) which satisfy the first-order conditions (7) with m =k, with
ZJ given by

Ijl=C7liZi + FP( 1 -no).

We may now state

Proposition 3. For any value of the conviction criterion y there exists an F

which will induce HMO physicians to tell the truth if the density function f(e) is
decreasing in the range y- s E~;Y+.

Since zi + 1- Zi=Zi-zi- 1E AZ for all i in the relevant range, a sufficient

condition for the existence of an F that always renders AC,>O, AC,> 0 is
that
426 A. Blomquist, Doctor as double agent

l E

0 Y- Y 7”
Fig. 1

(P,-P)>(P-P,). (32)

This inequality may also be written

j_ f(W=- j* f(4dE. (33)

‘I

Since f(s) is (by assumption) decreasing in the relevant range, a sufficient

condition for (33) to hold is that (r-r-)l(r’ -7). This inequality, in turn, is
always satisfied since h” < 0.
Fig. 1 provides an illustration; in the figure, area A is P,- P, area B is
P-Pp,.
Consider, finally the question of the representative consumer’s expected
utility, E4, under this type of HMO contract. We have

Proposition 4. Ifall fines are paid to the government, and the government
pays a subsidy of FP( 1 -no) on HMO contracts, then an equilibrium with HMO
contracts is equivalent to the first best solution, and E4 =E*, the expected
utility at the first-best optimum.

With the subsidy, the net premium paid by the consumer equals CniZi.
 A. Blomquisr, Doctor as double agent 427

The equilibrium contract, therefore, is the solution to the problem defined by

(5) and (6), which produces the first-best optimum.
In interpreting this result, it should be kept in mind that the expected
utility that is used as the criterion in the maximization does not take into
account the stochastic nature of the health outcome, given 8i and Zi as
described in (22). If we do take this element of uncertainty into account, it
should be recognized that an efficient system of contracts or legal liability
rules should provide both an appropriate degree of incentive on health
services producers, and also function as an insurance scheme for patients. It
would then not generally be efftcient for all fines to be paid to the
government, and the nature of the optimal solution would have to be
modified.
Propositions 3 and 4 hold for any value of the ‘conviction criterion’ y
which is consistent with the condition that f(s) is decreasing in the relevant
range, as stated in Proposition 3. However, the size of the fine F that is
necessary to ensure that (27) is positive depends on the choice of y, since y
determines P and P,. For the required fine to be small, y should be chosen
so that the difference (Pu- P) is large; that is, it should fall in a range where
f(s) is decreasing rapidly.
The analysis above has abstracted from the fact that any system of
contract enforcement or litigation requires resources. In reality, enforcement
of a penalty rule of the type discussed here is likely to involve substantial
costs: A large amount of resources may be needed both to establish what
outcomes could reasonably be expected in a particular case (the parameters
of the probability distribution f(e)), and to observe accurately the patient’s
ex post state of health. Once these costs are recognized, Proposition 4 will
not, of course, remain strictly valid. The costs of enforcement (which will be
borne by consumers either through higher insurance premiums or through
the tax system) will reduce expected utility below that of the first-best
optimum even if it leads to full information revelation. Alternatively,
consideration of enforcement costs may mean that it is second-best efficient
to accept a system which leads to only partial elimination of the losses due
to imperfect agency. l6
It is worth observing that the logic in this section could, in principle, be
applied to the problem of using a stochastic penalty rule to induce fee-for-
service doctors to provide accurate signals and supply a contractually agreed
amount of health services under conventional insurance as well. As pre-

16The cost of litigation may be a consideration in choosing 1, the ‘conviction criterion’ in the
text. If there is a fixed cost associated with each claim, it is desirable to choose 7 so as to make
P relatively small, which implies that F would have to be relatively large. (In a similar vein, the
relationship between legal costs, the size of the penalty, and the probability of conviction, was
emphasized in the early work by Becker (1968) on the economic analysis of an efficient system of
crime deterrence.)
428 A. Blomqvist, Doctor as double agent

viously noted, the fee-for-service method of payment gives physicians a

comparatively strong incentive to act in the patient’s interest (contrary to the
case of HMO doctors). Thus, under fee-for-service the penalty rule would
serve the function of giving doctors an incentive to provide accurate
information to the third-party insurer. In other words, the incentive functions
of the payment method and the penalty rule would be reversed, in
comparison with the previous analysis. However, the penalty rule that would
be required in the fee-for-service case would involve lining physicians when
their patients’ health was significantly better than would be expected, given
the information and health services provided. Needless to say, such a rule
would be difficult to enforce. On the other hand, recent initiatives with so-
called Preferred Provider Organizations (PPOS), or with insurance policies
that specify mandatory second opinions before major surgery, may be seen as
alternative attempts by conventional insurers to overcome the doctor-insurer
information asymmetry problem, to make them more competitive with HMO-
type organizations. Under PPO arrangements, insurance covers only treat-
ment by physicians who have entered into a contract with the insurance
company to abide by certain rules designed to hold down the cost of care.
More generally, PPOS can be seen as attempts by insurers to reduce the losses
from their imperfect agency relationship with doctors, by means of increased
monitoring and more careful contract formulation. Although this process is
costly, it is of course possible that this solution (fee-for-service in combi-
nation with an appropriate intensity of contract monitoring by conventional
insurers) is more efficient than HMO-type contracts in combination with a
penalty rule of the type outlined above, if the costs of administering the latter
kind of rule are high enough.

5. Summary and concluding comments

The analysis in this paper focusses on what has long been recognized as a
central problem in the design of a well-functioning health services system:
that of overcoming the high degree of information asymmetry between
buyers and sellers. Although many analysts have noted that this asymmetry
gives rise to a potential agency problem in the doctor-patient relationship, an
important insight is that the inefficiency of the conventional contract
structure (conventional third-party insurance and fee-for-service remune-
ration of doctors) is due not just to this problem, but also to the fact that
there is a further information asymmetry (and thus a second agency problem)
between doctors and the providers of health insurance.
Thus, even if doctors can be induced to act as perfect agents for their
patients, first-best indemnity-type contracts (or complete contingent con-
tracts) are ruled out as long as the information asymmetry between doctors
and insurers has not been resolved. Conversely, although an insurance
 A. Blomqvist, Doctor as double agent 429

mechanism such as that inherent in an HMO-type contract structure may

resolve the problem created by the information asymmetry between doctor
and insurer, it does not yield an efficient solution unless the HMO can be
induced to also (through their physicians) act as the patients’ agent. As
shown in the paper, this could, in principle, be accomplished through some
type of performance guarantee or liability rule.
Recognition that financing mechanisms and liability rules (for example,
those contained in medical malpractice legislation) are inextricably inter-
twined in determining the efficiency of the system as a whole, may contribute
to a better understanding, and ultimately, better policies and legal rules, in
this area. In particular, the last section of the paper suggests that an efficient
system might be one in which cost containment is accomplished through
some type of prepayment mechanism (such as in HMO contracts), while the
patients’ interests are protected through carefully designed liability rules,
perhaps in combination with improved methods of quality monitoring and
control.
Existing rules concerning medical malpractice can, to some extent, be
regarded as a form of statutory rules designed to protect patients against
substandard care. The analysis in the paper would thus suggest that
organizations such as HMOS, in which there is an incentive to underprovide
care, should suffer from a relatively high frequency of malpractice claims,
compared to doctors in conventional practice. In assessing this prediction,
however, certain complicating factors must be born in mind. First, in the
paper it is assumed that the quantity z of services actually performed can be
accurately and costlessly observed. In reality, it must be recognized that this
assumption is not fulfilled. When it is not, malpractice litigation may arise as
often in cases where fee-for-service doctors have overstated the quantity of
services actually performed, as in cases where the issue is whether the
seriousness of a person’s illness has been understated (the problem empha-
sized in this paper). Second, when HMO-type organizations compete with
conventional insurers, they may recognize that in order to overcome patients’
suspicions that they will ‘undertreat’ (because of the financial incentives they
are subject to), they may have to be especially careful to avoid malpractice
suits and adverse publicity. As a result, they may end up imposing especially
high standards on their physicians.
An interesting alternative that may also be used by HMO~ to avoid the
possibly high cost of malpractice litigation is for them to ‘contract out’ of the
provisions of malpractice law, for example, by asking their subscribers to
give up their right to sue for malpractice and instead agree to submit
potential claims to some form of arbitration. But as Danzon has observed,
the desire to reduce litigation cost may not be the only reason for this:
Another reason may be that the standards of medical care implicitly defined
by malpractice law are higher than those that HMOS wish to offer their
430 A. Blomqvist, Doctor as double agent

patients. Unless HMOs and their subscribers are able to voluntarily ‘contract
out’ of the standards defined by malpractice law, HMOS may not be able to
offer this lower standard of care, even if this is what patients want.”
Needless to say, the notion that HMOS compete by offering contracts that
imply lower standards of care than those chosen by patients insured through
conventional contracts, is perfectly consistent with the approach taken in this
paper, as is the idea that the provisions of voluntary arbitration contracts
may create the type of incentive structure that is necessary for HMOs to
successfully overcome the ‘double agency’ problem.”

Appendix

With conventional insurance, and with patients having accurate infor-

mation on 19~,the equilibrium contract in a competitive insurance market
solves the following problem:

max Q[I?+ u(Y-mm)]+C ?Ti[h(Zi - Oi) + U(y-m_0Zi)]

1

s.t. m-(1 -a)&Zi=O,

where Zi= Zi(m,(T).

The necessary first-order conditions can be written

(A.11

-[CniU’(Ci)Zi] +lb[CniZi-(l -b)C7tiZig] =O, (A-2)

where ZijE dZi/dj,j=m,a, and 1>0 is a Lagrange multiplier.
“Danzon (1985, p. 144) puts it well: ‘The potential saving that may be offered by lower-cost
providers, such as [HMO~] or outpatient clinics, cannot be realized if all are held to the
standards that have developed under the unrestricted fee-for-service system’. See also ibid. p.
212, and the interesting paper by Bovbjerg (1975) cited there. Posner (1977, p. 127) also
recognizes that malpractice laws partly serve the purpose of implicitly defining a contract
between the physician and the patient.
IsAnother factor that may influence the effectiveness of malpractice legislation as an
instrument for overcoming the effects of information asymmetry, is the existence of malpractice
insurance. As has frequently been noted in the literature, malpractice insurance may blunt the
incentive on physicians to produce high quality care; in the case analyzed in the text, it would
thus reduce the disincentive on HMOS to undertreat their patients, decreasing the effectiveness of
malpractice law as a device for making HMO~ behave in accordance with their implicit contracts.
However, if this moral hazard problem is severe, the expected value of the fines imposed on an
HMO that does fulfill its contract, may become small relative to the cost of the malpractice
insurance premium of an HMO that offers the same type of contract. If the HMO is a large
enough organization so that it is not ‘too’ risk averse, and if the fines F discussed in the text are
not ‘too’ large, HMO~ would tend to self-insure, which would mean that the desirable incentive
properties of the malpractice rules would be preserved.
 A. Blomquist, Doctor (IS double agent 431

In view of (9) and condition (3) in the text, equilibrium requires a>O. On
the other hand, with C= 1, substitution of (A.l) into (A.2) produces

- C~7Liu’(ci)zil + [C~iu’(ci)l[Cnizi] <Ov

where the inequality follows from (10) in the text. Thus the optimal CJmust
be between 0 and 1.
When patients do not have information concerning Bi, the optimal
contract solves (16) in the text, with z = z(m, a). The first-order conditions are

-~ou’(y-m)-(l-n,)u’(y-m-~z)+i.[1-(1-~TCO)(1-~)~,]=0, (A.4)

-z~u’(y-m-oz)+;c[z-(1-a)z,]=0, (A.5)

where zj = az/aj, j = m, CT.

As before, (15) and the conditions (3) imply that a>O. On the other hand,
with C= 1, substitution of I from (A.4) into (AS) implies that (AS) is
negative, since u’(y-m-z) > u’(y-mm). Thus, we have 0 <C-C 1 in equali-
brium, as before.

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