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Outline
Moral hazard in insurance markets. Principal-agent models. Optimal contracts. If we have time, well also cover:
The impact of AI on health. And current issues in health policy.
Reading
Varian, Chapter 37 MKR, Chapter 17 (second half) Additional reading (if desired):
Frank Cowell, Microeconomics: Principles and Analysis
Chapter 11, especially 11.4
Moral hazard is hidden behaviour. Because an individual cant be monitored, they may choose to act in a way which is undesirable for the other party. To overcome this incentives must be introduced to motivate individuals to act in the interest of the other party. This brings us into the world of principal-agent models.
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is the premium. is how much insurance I take out. and are my incomes in the bad and good states, respectively.
FOC : 1 = +
Will people ever perfectly insure in an internal solution?
But
= But we already said this was impossible in an internal solution. Thus, either:
+ means +
Consumers will not make any effort, so = 0, but = 0 implies = = 1, so consumers are indifferent about how much insurance they purchase. OR Consumers will not insure, and will choose the optimum level of effort given this.
Designing incentives
You want someone to do something for you, but you cannot fully observe what they do, how do you pay them to get the best results?
You must ensure that their incentives are aligned with your objectives. Generally youd want their pay to increase with their effort.
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We assume:
> 0 for all (increasing effort increases expected profits), and
We assume:
> 0 for all (increasing effort reduces utility). 0 = 0 (exerting no effort costs nothing).
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How do we calculate the minimum wage the agent would accept when = ?
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Suppose also then that profits are risky, i.e. has a positive variance.
For simplicity we will assume the variance of profits is equal to . If no effort is undertaken, profit is zero, but also has zero variance.
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Two conditions:
Participation constraint:
The agent must prefer providing to her outside option. I.e. + 2 = + 1 Always optimal for the principal to set = 1 + .
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As the agent gets more risk averse (i.e. increases), or the variance of profits increases (i.e. increases), the optimal choice of decreases, and the firm will take on more and more of the risk.
Principal will usually want to set > 0 and > 0, in order to both reduce the agents risk (encouraging participation), and to incentivise them to perform effort.
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Reading on health
An interesting letter from Economists to Obama can be found at: http://economix.blogs.nytimes.com/2009/11/17/economists-letterto-obama-on-health-care-reform/ Also http://www.washingtonpost.com/wpdyn/content/article/2009/07/27/AR2009072701905.html Analysis of NHS reforms (magazine article) http://cep.lse.ac.uk/pubs/download/cp323.pdf
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Individuals would like to be insured, but have hidden information about how likely they are to be sick.
Those who are most likely to be sick will demand more insurance. Adverse selection.
Individuals behaviour influences how likely they are to be sick, insurers cannot observe this.
Moral hazard.
Individuals do not have full information about the type of treatment that would be best for them.
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It must also be the case that any actions an individual (or his doctor) takes to change his risk are fully observable to the insurer.
The failure of this assumption leads to moral hazard.
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Moral hazard
Insured individuals May not be as careful as they could be with their health. However, this is less likely than in other insurance markets as individuals experience discomfort if they are ill. Copayment of costs could help to reduce this problem. Insured individuals and doctors have no incentive to consider the costs of medical care if they are being paid by the insurance company.
Evidence of a massive amount of price dispersion in the pharmacy market (Sorenson 2001, Ohlen & Smith 2011). The latter paper finds a coefficient of variation for the price of some drugs of 64%.
This can be overcome if insurers, doctors and pharmacies are combined into the same organisation.
Risk that incentives could move too far into the other direction, so that the doctor would have an incentive to under-provide care?
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International comparisons
At least prior to Obamas reforms the private US system had some predictable problems.
Large costs, because doctors have no incentive to keep them down. Some individuals could not afford insurance at this high cost. Huge diversity of provision, many are getting great care, others none at all. Life expectancy is highly unequal.
Despite being a private system it is still very costly to the tax payer, almost half of spending is public money. This is because the public sector is only insuring the highest risks (Medicare).
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Health Outcomes over Time 1970 1980 1990 2000 LE IM LE IM LE IM LE Canada 72.9 18.8 75.3 10.4 77.6 6.8 79.7 Germany 70.4 22.5 72.9 12.4 75.2 7 78.4 Sweden 74.7 11 75.8 6.9 77.6 6 80.2 USA 70.9 20 73.7 12.6 75.3 9.2 77.2 UK 71.9 18.5 73.2 13.9 75.7 7.9 78.5 LE is life expectancy. IM is infant mortality, deaths per 1000 live births.
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Stopping insurers using certain pieces of available information was bad for them. But forcing all individuals to have health insurance was good for them. (Even low risk people must purchase the same mid-premium policy.) Should substantially help with the adverse selection problem. Bad for moral hazard though?
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A constant complaint against the NHS is that a lack of competition reduces quality and inflates costs.
In fact the UK looks quite good on costs, although could do better. Evidence suggest that previous market-based reforms have been beneficial and more could be done (ending national pay-deals).
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Summary
Weve observed several important models of AI with striking real world implications for:
Quality choice Price setting Education Compensation schemes Insurance markets and health reform There are many others.
Hopefully the tools we have learned will help you to think about how other similar problems are resolved.
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