Moral hazard and health care

Moral hazard is the term generally given to a situation where an individual does something that they normally would not do if they bore all the risk. There are many cases of moral hazard: For example, banks that lever up and take excessive risks but have implicit government guarantees are engaging in moral hazard.

The new health care plan that is making its way through the house prevents insurers from denying coverage based on a pre-existing condition. This is a great idea, but with it comes a moral hazard problem. Healthy people have the incentive to not get insurance until they get sick. Then they are guaranteed that they will be accepted into a plan. This doesn't just include the currently uninsured either. I have health insurance, but maybe I should drop my coverage and wait until I get really sick before reinstating it? I could save a huge amount. The economist, Martin Feldstein talks about the problem here.

The writers of the bill thought of this problem. Well sort of. They decided to impose a tax penalty on anyone who didn't get insurance. Brilliant! Except that the penalty is significantly less than the actual cost of insurance, so the problem does not go away.

I don't really want to get political here, but it seems to me that the problem with politicians is that they didn't take enough (or any) economics in school. In fact, if they had just read the book "Freakonomics" they would have seen an example of a very similar situation. I don't recall the exact details, but the basic story recounted in the book was that a day care center had a problem with parents being late to pick up their kids. To try to discourage this behavior, the day care center imposed a fine for each 30 minutes that the parents were late. The problem was that the fine was too low - well below the actual cost of child care. So instead of discouraging the behavior, more parents chose to be late and just pay the fine.

The solution to the health care moral hazard is simple. Make the penalty as much as the cost of insurance and force the non-insurers into a plan.

HT: Greg Mankiw's blog