Beneficial moral hazard and the theory of the second best

Abstract

This article examines the welfare consequences of moral hazard, and brings together several arguments suggesting that, in many cases, the additional consumption associated with health insurance could be welfare enhancing. Since conditions for maximum economic efficiency fail to hold in the market for medical care, the theory of the second best is useful. We focus on three efficiency-related reasons why insurance-induced consumption may improve welfare: 1) insurance can offset market power; 2) insurance can remedy some externalities; and 3) insurance can mitigate problems that are associated with misinformation and result in the underutilization of many types of care. These arguments strengthen the case for expanding coverage.