The Economics of Moral Hazard

Further Comment

by Joseph P. Newhouse, V. D. Taylor

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A commentary on an article in the June 1968 [American Economic Review] pointing out that medical insurance reduces medical care price below marginal cost and thus acts as a subsidy. Hospital insurance has contributed to the overall inflation in medical costs by making the consumer responsible for only a small portion of the cost differences between hospitals, thus encouraging him to opt for more expensive care. A remedy would be to provide Variable Cost Insurance (VCI) that pays a hospitalized individual a lump sum for a predetermined quality level, which may be applied either to more or less expensive care. Insurance subsidization of the quantity of hospital services provided would still exist, but by removing the distortion in the consumer's choice of a hospital, VCI could importantly reduce the escalation of hospital costs. This scheme is relevant to the current policy debate over medicare and medicaid.

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