Beneficial Moral Hazard and the Theory of the Second Best

Moral hazard has the potential to correct inefficiencies in health insurance markets. In many cases where consumption of health care services increases, the cost of those services does not exceed their value.

The term "moral hazard" refers to the notion that insurance encourages overconsumption of health care services. In light of the theory of “second best,” this paper reviews arguments that moral hazard leads to increased benefits when economic conditions are less than optimal. The authors consider the effects of moral hazard when insured individuals make uninformed decisions and demand for services is perfectly inelastic. They build on the conclusions of previous analyses of “second best” with respect to how moral hazard leads to more efficient consumption of health care services.

Key Findings:

  • The prices that providers set for health care services are less than efficient because the quantity of health care consumed at those prices are not socially efficient.
  • Increased health care coverage facilitates the redistribution of income, allowing individuals to obtain services that they otherwise could not afford.

Various factors, including health care provider price setting, contribute to distortions and inefficiencies in health insurance markets. This paper reviews analyses of how moral hazard compensates for inefficiencies and increases the economic benefits of insurance markets.