In 1963 the American Economic Review published “Uncertainty and the Welfare Economics of Medical Care” by economist—and later Nobel Prize winner—Kenneth Arrow. It became a classic. Much of the academic discussion of health care and health insurance since then has either built on or responded to one or more of his thoughts and insights in that article.

In 2012 Columbia University, where Arrow earned his doctorate in economics, decided to base that year’s Kenneth J. Arrow Lecture on his 1963 article. The invited lecturer, Amy Finkelstein of Harvard University, focused on one aspect of his work, the idea of “moral hazard.” Thus this book’s title. With an introduction by Harvard health care economist Joseph P. Newhouse, the book contains Finkelstein’s lecture and comments by Arrow (now at Stanford University), MIT’s Jonathan Gruber, and Columbia University’s Joseph E. Stiglitz, along with a reprint of Arrow’s original paper.

This short book is full of insights and useful information. The two most valuable parts are Arrow’s original paper and the Finkelstein’s lecture.

Whereas many economists will say that Arrow’s paper made the case for a highly interventionist health care policy, it is more nuanced than that. Indeed, parts of it can be read as arguing against some of the main provisions of the 2010 Patient Protection and Affordable Care Act (ACA, better known as Obamacare).

Finkelstein’s insights on moral hazard, along with her discussion of the Oregon Medicaid experiment, are the highlights of her chapter. She finds that, indeed, people do use more health care when they pay a lower price. She also makes a strong case for health savings accounts. The introduction by Newhouse points out that a low elasticity of demand for health care, which is what the famous RAND Health Insurance Experiment (HIE) found, can actually imply a high reduction in health care use in response to small price increases. In his comments, Stiglitz jumps from an assertion of market failure in health care to a presumption of government success.

Arrow’s original / Let’s start, as much of the health economics discussion does, with Arrow’s 1963 paper. It is valuable on so many levels. Early in the piece, he writes, “The causal factors in health care are many and the provision of medical care is only one.” That is an obvious point, but it is one that many people even today fail to acknowledge.

Arrow also discusses the economics of vaccination. He notes that in “an ideal price system,” those who fail to be immunized against a communicable disease could be required to pay those whose health is thereby endangered by the non-vaccinated, or else the vaccinated could pay the non-vaccinated to “undergo the immunization procedure.” I wondered, when reading this, whether Arrow was influenced by the late Ronald Coase’s 1960 Journal of Law and Economics paper “The Problem of Social Cost,” which gave rise to the “Coase Theorem.” (See “The Power of Exchange: Ronald Coase, 1910–2013,” Winter 2013–2014.)

Another interesting aspect of Arrow’s article is his view of the economics of information. He writes, “The value of information is frequently not known in any meaningful sense to the buyer; if, indeed, he knew enough to measure the value of information, he would know the information itself.” This quote reminded me of a similar insight from Austrian economist Israel Kirzner. This information problem, Arrow maintains, leads to market failure. He argues that we, as patients (buyers of medical care), don’t know enough to judge the experts (doctors) who provide it. Interestingly, though, he does not jump to the conclusion that the solution to this market failure is entirely governmental. He writes that the government is “usually implicitly or explicitly held to function as the agency which substitutes for the market’s failure.” He continues: “I am arguing here that in some circumstances other social institutions will step into the optimality gap.”

Particularly interesting is Arrow’s discussion of health insurance. He writes:

On a lifetime insurance basis, insurance against chronic illness makes sense, since this is both highly unpredictable and highly significant in costs. Among people who already have chronic illness, or symptoms which reliably indicate it, insurance in the strict sense is probably pointless.

He adds:

Hypothetically, insurance requires for its full social benefit a maximum possible discrimination of risks. Those in groups of higher incidence of illness should pay higher premiums.

Those quotes are simply sensible reasoning about insurance, and it is doubtful that Arrow was the first to come up with those ideas.

They are striking for a different reason, though: they completely undercut the case for laws against pricing insurance for pre-existing conditions, one of the key features of the ACA. That sensible reasoning was missing entirely from the arguments that proponents—and even many opponents—of the law made. Arrow also discusses the role of moral hazard in medical care: people with insurance have an incentive to use more medical care because the insurance company pays for most of it.

Elasticities / Finkelstein builds her lecture around this latter insight. In particular, she discusses the two most famous health insurance experiments in U.S. history: the mid-1970s RAND HIE and the Oregon Medicaid experiment of 2008. Finkelstein distinguishes between two kinds of moral hazard that health insurance can give rise to: ex ante moral hazard and ex post moral hazard. Ex ante moral hazard occurs if someone, knowing he is insured, takes worse care of himself by, say, smoking, drinking excessively, or not exercising. Ex post moral hazard occurs if someone, knowing he is insured, uses more medical care because he does not pay the full cost. Finkelstein’s focus, like that of most other health economists who study the issue, is on the latter.

She finds strong evidence of ex post moral hazard in the Oregon experiment. Because of budget constraints, Oregon’s state government was unwilling to cover all people who were “financially but not categorically eligible for Medicaid.” Those people were financially eligible because their incomes put them below the poverty line, but categorically ineligible because they were able-bodied. The government held a lottery to choose 10,000 of those people—out of about 75,000 who applied—who would receive Medicaid coverage. She and other researchers then tracked the expenditures and health status of both the people who got Medicaid through the lottery and those who did not. They found, not surprisingly, that people who were spending “other people’s money” for health care spent more. Finkelstein writes, “Medicaid increases not only hospital admissions, as was just demonstrated, but also the probability of taking prescription drugs and of going to the doctor.” She concludes, “Medicaid increases annual medical spending by about 25 percent.” Interestingly, the main effect of the spending seems to have been on reducing depression rather than on improving physical health.

Finkelstein also argues that high-deductible insurance plans, which “were encouraged by the Health Savings Accounts Act of 2003,” are “theoretically optimal” when “there are risk-averse individuals and concerns about moral hazard.” She points out that this is an implication of Arrow’s 1963 article.

Newhouse’s short introduction makes a very important point. The RAND HIE, in which he was a central player, found that the elasticity of demand for medical care is about 0.2. That doesn’t sound large, implying that a 10-percent increase in prices paid by patients will cause only a 2 percent decline in the amount of health care purchased. Newhouse, however, explains its significance is quite large. While his explanation is too involved to explain fully here, one example he gives will help relate his idea. Given that most insured people pay such a small amount of the bill (while insurance pays the rest), a small increase in the amount of the copay can be a large percentage increase of the copay. Consider an increase from a $5 copay for a drug to a $10 copay. That is a 100 percent increase and, with an elasticity of 0.2, the quantity of drugs demanded should fall by 20 percent.

Cost drivers / Unfortunately, Finkelstein, in referring to Newhouse’s famous 1992 Journal of Economic Perspectives paper “Medical Care Costs: How Much Welfare Loss?” discussing the various factors behind the explosion in U.S. health care spending, repeats a mistake that Newhouse made in that paper. I hasten to add that the Newhouse paper is one of my 10 favorite health economics articles ever. Nevertheless, by not performing a simple multiplication, he minimizes the role of factors other than technology in driving spending.

In the 1992 article, Newhouse considers the role of population aging (older people use substantially more health care than younger people), increased insurance (the less people pay out of pocket, the more health care they buy), and increased income per capita (as people’s income increases, their use of health care increases). He finds the effect of each of those factors to be low, but he doesn’t consider them together. The correct way to consider the combined effects of those factors is to multiply them, not add them. So, for example, if aging causes a 15 percent increase in spending per capita, and increased insurance causes a 50 percent increase in per capita spending, the combined effect is not a 65 percent increase, but a 72.5 percent increase (1.5 × 1.15 – 1 = 0.725.) Adding in the role of income means that the three factors together, using Newhouse’s estimates, account for a 193 percent increase in health care spending per capita from 1950 to 1990. This is 39 percent of the overall increase in health care spending per capita.

Newhouse is probably still right that the most important factor in increased spending is increased technology. But most readers of his article would probably be surprised to learn that his own data imply that almost 40 percent of the increased health care spending is not due to increased technology. One such reader, I believe, is Finkelstein. When she writes, “Technological change in medicine is the driving force behind the growth in health care spending,” she overstates. It is probably the main driving force, but it is not the driving force.

Other commenters / The main contribution of Gruber’s comment is his pointing out that the change in the way Medicare paid hospitals—basing it on diagnosis rather than cost—reduced the average length of hospital stays of the elderly by a whopping 15 percent within a year. Gruber claims that this reduction had “no effect on elderly care.”

Stiglitz makes the strong claim that because of market failures in health care that result from asymmetries in information, “there are always interventions that could make some individuals better off without making others worse off.” Unfortunately, he does not tell us what those interventions are. “There is a need for government,” he writes, but he does not consider how well or badly government works.

In discussing health maintenance organizations, he claims that although the reputation of HMOs is important, “we know that reputation mechanisms don’t work very well.” I don’t know that.

One thing that struck me in the 1963 Arrow paper is the good will he displays toward those with whom he disagrees. He thanks the University of Chicago’s Reuben Kessel, for example, for helpful comments and gives him credit in a footnote, even while fundamentally disagreeing with Kessel’s view of the American Medical Association as a monopoly creator. To her credit, Finkelstein also seems to have a generous view of those who might disagree with her. That is heartening.