Moral Hazard in Health Care — Part 1

I recently reviewed Steven Horowitz’s excellent “The Price System and Distributive Justice” (link.) In this article, Horowitz considers the effect of price shocks in healthcare, and in the setting of natural disasters. He makes a good argument that the price system works in the case of natural disasters. His argument on healthcare costs is less compelling.

Missing is a discussion of two key mathematical concepts: variance, and cumulative risk of ruin.

Nobody shows up at the grocery store, not particularly hungry, and comes home with a bill for $200,000. But that does happen sometimes when you go to the doctor, and the same thing kinda happens when a hurricane blows through. So we would say that healthcare expenses have considerably more variance than food expenses.

Cumulative risk of ruin refers to the likelihood of going broke, something that can healthcare expenses can cause. If you’re playing a game that carries a risk of going broke, the longer you play the more likely you’re going to go broke. The greater the variance, the more likely you’re going to go broke. And the less money you start with, the more likely you’re going to bust out.

This is where the justice thing comes in. If you’re rich, you’re quite a bit less likely to go broke due to health care expenses; or if you do, it will be much later in the game.

The market can’t directly solve that problem. It can only indirectly solve the problem by offering products that insure against catastrophic loss.

For the most part, the market does a decent job. Life insurance is a great deal. Homeowner’s insurance is OK; it bothers me that we subsidize rich people building houses where they know for a fact there will be a hurricane eventually. But still, it’s OK.

Now, auto insurance is kind of problematic. I am of the opinion that people drive like lunatics. I’ve driven cars, motorcycles, and airplanes. With motorcycles, one mistake can cost you your life. In airplanes, one little mistake taxiing around the airport could result in out-of-pocket expenses in excess of $50,000, loss of license, and possibly even criminal charges. If any of those things were true for car drivers, I imagine people would be quite a bit more careful and cautious.

This is an example of what the insurance company calls moral hazard. Meaning, people take stupid risks, because they know there is no real consequence to any accident that occurs at less than about 30mph.

People do take risks with their health, although having insurance doesn’t change that. In healthcare, we define moral hazard as buying more health care than you need.

To give an example. What if you have the flu? I think most normal people would take an aspirin and go to bed. Some drive down to the emergency room, elbow their way in past people with gunshot wounds and broken bones, and demand a board-certified doctor instruct them to go home, take aspirin and go to bed. It’s not that they are taking an unreasonable risk. It’s that they are being irresponsible with money and resources. Which is no skin off their back, if they aren’t paying for it. That’s how we define moral hazard in healthcare.

There’s an argument for bringing market forces to bear on health care costs. Under some circumstances, your cat can get better care than you can, for less money. That’s the market at work. But, there’s no allowing for variance in that system. We don’t just put Grandpa to sleep because he’s too expensive to care for (yet). The cat may not be so lucky.

The real question is, what’s wrong with health insurance? And I would submit that moral hazard is one angle on that. And its an angle the government is uniquely unqualified to address. If anything, government policy makes it worse.

Next: Part 2, healthcare prices and insurance

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