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Wrapping

UP. Wrapping. Insurance. Moral Hazard. Demand. With health insurance, the amount of expenditures may depend on whether you have insurance. Suppose that probability of illness is 0.5. Suppose demand for care (if sick) is P 1 Q 1 . Actuarially fair policy would cost 0.5* P 1 Q 1. Price.

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Wrapping

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  1. UP Wrapping Insurance

  2. Moral Hazard Demand • With health insurance, the amount of expenditures may depend on whether you have insurance. • Suppose that probability of illness is 0.5. • Suppose demand for care (if sick) is P1Q1. • Actuarially fair policy would cost 0.5*P1Q1. Price P1 Exp. Premium Q1 Quantity

  3. Moral Hazard Demand • What if demand was somewhat elastic? Price • If insurer charges 0.5*P1Q1, it will lose money. • Why, because expected payments are P1Q2. P1 Exp. Premium New Premium • What if insurer charges 0.5*P1Q2? • Customer may not buy insurance. Q1 Q2 Quantity

  4. Why pay $2,250 for event w/ probability of 0.5. May self insure. Moral Hazard – Some Numbers Demand • Suppose that P1 = $500, Q1 = 5, and Q2 = 9. Price • If insurer charges 0.5*P1Q1, or $1,250, it will lose money. • Why, because expected payments are P1Q2 = $4,500 P1 Exp. Premium New Premium • What if insurer charges 0.5*P1Q2 = $2,250? • Without insurance, if ill, people would spend $2,500. Q1 Q2 Quantity

  5. Moral Hazard • Why? • Two dimensions to insurance • Premium against risk. Customer wishes to insure against this. • Extra resource cost due to moral hazard. The risk was P1Q1. Customer may not be willing to pay more to insure against that risk!

  6. Let’s Review Coinsurance 40 • Suppose a visit costs $20. • BUT, insurance pays 50%. 40 Effective demand 30 30 Money Price 20 20 Effective Price Money price demand 10 10 Visits

  7. What Does Moral Hazard Do? Demand Demand w/ insurance • It makes us spend too much on medical care. Price • At P1, we buy Q1 and spend E1. • With insurance, we pay LESS than full price, so we buy Q2, spend E2. This is P1 (Q2 - Q1) more than we spent before. • Why is it too much? P1 Exp. Q1 Q2 Quantity

  8. What Does Moral Hazard Do? Demand Demand w/ insurance • Why is it too much? We paid P1 (Q2 - Q1) more. Price • The demand curve tells us what the care is worth to us. So the additional (Q2 - Q1) is worth: P1 Exp. Wasted Value • The “wasted” expenditures are: Q1 Q2 Quantity

  9. For the Entire Economy it’s WORSE Demand w/ insurance Demand Price • Why is it too much? We paid P1 (Q2 - Q1) more. P2 • The demand curve tells us what the care is worth to us. So the additional (Q2 - Q1) is worth: Producer Surplus P1 Wasted Exp. Value Supply • The “wasted” expenditures are: Q1 Q2 Quantity

  10. Area of Triangle = ½ * b * h Area of Trapezoid = ½ * h * (b1 + b2) Calculating Demand w/ insurance Demand Price Let: Q1 = 10, Q2 = 12, Q3 = 14 P1 = 10 P2 = 12 E1 = 100 E2 = 144 PS = ½ * 2 * (10 + 12) = 22 Val = ½ * 2 * (10 + 7) = 17 Loss = ½ * 5 * 2 = 5 P2 Producer Surplus P1 Wasted Exp. Value Supply Q1 Q2 Q3 Quantity

  11. Who pays for health insurance? • It is important to relate health insurance benefits to the wage rate that workers are paid. • The simplest way is to examine the supply and demand for labor, in the absence of insurance, and then institute health insurance and see what happens.

  12. Who pays? S • Consider a labor market with a typically downward sloping demand for labor D, • and a typically upward sloping supply of labor S. • The demand for labor is related to the marginal productivity of workers. Employers will hire the workers as long as the value of their output (marginal revenue product) is greater than or equal to the wage that employers must pay them. Wage rate W1 D L1 Employees

  13. Who pays? S • The supply of workers is related to the wage in this industry relative to other industries. • Workers will choose to work in this industry as long as the wage they can earn exceeds their opportunities in other jobs. • The equilibrium wage is W1 and the equilibrium quantity of labor demanded and supplied is L1. Wage rate W1 D L1 Employees

  14. Who pays? S • Now suppose that workers in the market negotiate a health insurance benefit worth $z/hour at that margin, and costs employers exactly $z/hour to provide. • What happens? • Employers who before were willing to pay W1per hourfor workers, will now pay W1less $z. Other points on the demand curve will shift downward in a similar manner, so the demand curve will shift downward by exactly $z to D. Wage rate W1 D z D L1 Employees

  15. Who pays? S • What will happen to the supply curve? • Since the workers were willing to supply various amounts of labor at various wage rates according to the supply curve before, now that they are receiving a benefit worth $z, they will offer their labor for $z less. • Hence, the supply curve will shift downward by exactly $z to S. S Wage rate z W1 D z D L1 Employees

  16. Who pays? S • New equilibrium is at L1, W2. • What is the result? The net wage remains the same, but the money wage falls by $z. • The equilibrium wage has fallen to W2 or by exactly the amount of the benefit. • Workers have taken their benefits in lower money wages, and the same number of workers L1 is employed at the same net wage. S Wage rate z W1 Benefits W2 Wage Bill D z D L1 Employees

  17. Who pays? S • By assuming that the marginal benefit was worth exactly what it cost to provide, the previous example ignored the moral hazard involved in health insurance. • Recall that for many types of health care, fractional coinsurance leads consumers to consume health care past the point at which marginal benefits equal marginal costs. • This provides benefits that, on average, may be worth less to the workers than what they cost to provide. S Wage rate z W1 W2 D z D L1 Employees

  18. Who pays? S • Suppose, for example, that workers negotiate subsidized coverage for prescription drugs. This benefit might induce workers to purchase drugs beyond the point at which marginal benefits equal marginal costs. • If the average benefit is worth $b/hour, or lessto the workers than the $z/hour that it costs to provide, then the new supply of labor curve S will have fallen by less than the demand for labor (still D, reflecting what it costs to provide the benefit). b S Wage rate z W1 W3 W2 D z D L2 L1 Employees

  19. Who pays? S • Our new equilibrium yields wage W3, which is higher than W2. • The net wage (W3 + z) is higher than the original equilibrium wage W1 (without insurance). • Not surprisingly, employers react to the higher net wage by reducing employment in the industry from L1 to L2. b S Wage rate z W3+z W1 W3 W2 D z D L2 L1 Employees

  20. Minimum Wage In MI, minimum wage is $7.40/hr. What happens with “mandated benefits?” Workers can’t take pay cut even if they wish to. It is likely that this will lead to unemployment L1 – L2. Wage rate S $7.40 D D L2 L1 Employees

  21. So … who pays? • Fundamentally, the employees pay for insurance, in the form of lower money wages. • Some may pay in the form of unemployment.

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