Thank you. Heterogeneity and consumer taste and needs and the cost and quality of goods
and services are ubiquitous features of resource allocation.
But as long as these are publicly observable, markets can price, sort and match the variations efficiently.
For example for insurance which is what I'm going to concentrate on today, you can have an efficient insurance market
where there is no private information that allows people on one side of the market to improve on the prediction
of expected benefits based on public information.
If you have those circumstances then you can have competitive underwriting in which the prices of insurance contracts
are set at their actuarial value plus a competitively determined load and that market will operate efficiently.
And incidentally an essential aspect of a well-working insurance market of that form,
is that issues like the ability of insurers to re-price contracts or to cancel coverage if a buyer has a bad experience,
are causes that will themselves be negotiated in the competitive market as contract terms and they will be appropriately priced.
Now an example of an insurance market which does not satisfy these conditions is the market for health insurance.
And there are a number of reasons, it's really a perfect storm of problems of failure, of market failure.
There are various sources for this, one which I'll talk about subsequently is that there may be social sentiment for exposed equity or fairness and those can conflict with what would originally be a perfectly legitimate and efficient market outcome.
That is to say you can have an efficient market outcome which is socially unacceptable and the response to that
may be a factor to upset the market. Perhaps appropriately but nevertheless it's a problem to deal with.
Other issues in this market arise from asymmetric information. And they are the classic problems of adverse selection.
Where people are denied coverage or offered actuarially very unfair contracts because of the possibility
that they are bad risk, moral hazard where coverages becomes very expensive because providers lack incentives
to minimise treatment cost or withhold unproductive treatments. It's part of a principal-agent problem.
Performance risk in which insurers evade paying benefits by making contract enforcement costly.
A general problem in contract theory where you have asynchronous operations of the transaction.
And finally signalling and screening as a device used by market participants to avoid either being lumped in
together with high-risk peers or having to pay benefits to high-risk people.
Let me say first something about the problem of social unacceptability of market outcomes,
that's particularly an issue for health insurance.
So consumers and society have difficulty refusing or withholding treatment after bad health outcomes are realised.
There's a social sentiment for exposed equity and this can conflict with competitive underwriting.
A good example is if someone had kidney failure, they are very expensive to treat,
but social sentiment is that as a human right they are entitled to treatment at some affordable cost.
Now the problem of conflicts between socially acceptable, what's socially acceptable
and market outcomes could probably be taken care of
if consumers could acquire unconditional lifetime health insurance ex ante, before their health status is ever determined.
And if they chose not to buy health insurance they commit irrevocably to the consequences of having limited ability to pay.
But neither of those conditions are met in reality.
A consequence of that is that it's often the practice in health insurance and in other areas
to forbid competitive underwriting on the basis of some criteria with the objective of trying to mitigate market outcomes
that are deemed unfair. For example it's often in health insurance, a rule which prohibits discrimination on the basis of gender
or on the basis of pre-existing conditions.
Now from an economic point of view if the regulation requires these kinds of non-discrimination rules
and that results in coverage for high-risk consumers at less than their actuarial value
then the unintended consequence is that unless the market is subsidised, the premiums for the low-risk consumers
are going to have to rise above their actuarial value, they will be penalised.
And there is effectively an income transfer from the low-risk to the high-risk consumers.
And this in turn can induce a form of adverse selection, it's now not coming from asymmetric information
but simply from social regulation to try to ensure fair outcomes.
Very difficult to have the inter-personal transfers required to achieve this level of fairness in a system
that does not in itself introduce a substantial market distortion. So the type just mentioned.
So very careful regulation is needed to try to deal with these issues of social fairness.
Asymmetric information is the most common reason cited for failures in insurance markets
and particularly health insurance markets and they are these classic triumvirate adverse selection, moral hazard
and performance risk or counter-party risk.
There's a long history in economics and pre-economics of attention to these sources, this is not,
this is a very, very old subject and to partisans of market solutions who think carefully about it.
You need to think seriously about whether you're in a market situation where these problems can be overcome
or whether something of substance has to be done to overcome.
There's a lot of other literature on markets under incomplete or asymmetric information.
And I'm not going to spend time going through this but if you flash some names there you might recognise some of them.
One comment, I'm talking about health insurance here today specifically but many insurance markets and markets
in which, basically which depend on contracts, share many of the same problems.
Labour markets and markets for financial derivatives which are insurance contracts have problems
that are quite similar to those that arise in the health insurance market.
I'm going to remind you of some price theory that I believe everyone has seen in their first graduate class in economics
and these are some diagrams from Rothschild-Stiglitz, I would be cautious about putting up diagrams
but in this case you've all seen these before so I just want to remind you quickly of what happens in an insurance market
with asymmetric information. So here's a diagram with contingent commodities, the consumption of healthy or consumption of sick,
and there's an endowment point in which the person will have less resources to consume and will incur a loss,
if they're sick the loss is in red here, loss L, a 45 degree line that corresponds to equal consumption in either state.
The budget line in this case is the locust of actuarially fair trades, that is to say insurance contracts
which will break even for the insurer.
And when individuals are risk adverse, expect a utility maximisers, the slope of their indifference curve
at the 45 degree line gives the odds of being sick.
And if you have actuarially fair insurance there is an optimal contract, in this case located at a little arrow
from full insurance, you'll have full insurance, so that would be the point in which this particular consumer would locate.
Very standard analysis.
This works perfectly well if there's more than one class of consumers, you could have robust consumers, frail consumers,
frail consumers have a higher probability of getting sick and if they were, if their risk class were observable
then the market would simply offer 2 insurance contracts, F and R, each would get full insurance and at premiums
which reflect the actuarially fair cost of insuring against their losses.
Now suppose that the risk classes of the consumers is not observable, so that when an insurer offers a contract,
he does not know ex ante whether the buyer is robust or frail.
In this circumstance one possibility is that all consumers, both frail and robust would buy a contract
and in this case you may get an actuarially, a locus of actuarially fair contracts.
Which in this diagram is labelled the all-in break even contracts.
And that's simply an average of the break even budget lines for the 2 classes, the location of the average
will depend on how commonly people are robust or frail. In this diagram I've labelled what I call a candidate pooling contract.
This would be a contract which is break even for a competitive insurer, if it was in fact purchased by all people.
Detail on that, this is just a blow up so you can see a little better what's going on.
And that particular contract, pooling contract, P, is located at a point of tangency
between the robust consumer's indifference curve and the actuarially fair line or the break even line for pooled contracts.
And that contract P then has the property that robust consumers would choose not to move.
The higher risk consumers, the frail consumers would like to buy more of at that price but that's not,
in this case not being offered.
In the market there would be no incentive for an insurer to offer a broader coverage because only the frail would buy it
and it would not break even.
But this candidate cannot survive as a Nash equilibrium, the reason is that they are blocking contracts.
In this case it's noted in this diagram by a little blue dot.
And it's a contract located in the area which is better for the robust but worse for the frail.
So what would happen is in the existence of the contract P, if an insurance company now offered the blocking contract,
it could entice away all of the robust consumers from which it could then break even or better
and leave behind all of the frail consumers at P in which case P would no longer break even.
And equilibrium would break down. So this is the original Rothschild Stiglitz argument that a pooling equilibrium cannot exist.
Another possibility that they considered and that occurs in this markets is a so-called separating equilibrium
where each risk class will have its own policy and the policies now are positioned in commodity space in such a way
that the high-risk consumers will not be tempted to try to misrepresent themselves as robust consumers
and move to the contract being purchased by the robust group.
And in detail you get a diagram which looks like this, the frail consumers are getting full insurance
at a high premium, actuarially fair premium, the robust consumers are getting partial insurance
and with the location of that being such that R is not a utility improvement for the frail consumer
so they have no pause in it to move away from F to R.
Now in the diagram as drawn here note that the indifference curve of the robust consumers
does not intersect the all-in break even contract.
And if you do a little analysis as Rothschild and Stiglitz does do, this, the result is that F and R in this case
is a stable Nash equilibrium. However, and this is just a question of the proportions of consumers, frail and robust consumers
and the nature of the difference curves of the robust consumers, you could also have a situation
in which the indifference curve of the robust consumers through the separating contract R cuts the break even contract line.
In which case there's now a blocking pooling contract.
Now the pooling contact cannot itself be an equilibrium, we already know that.
But it's enough to block the separating equilibrium and in this case no Nash equilibrium in this market will necessarily exist.
So the conclusions of that classic study are that when consumers know their risk class
and insurers cannot distinguish risk classes and in a competitive market any contract
which is defined by its premium and its coverage that can be offered, then either there's a separating Nash equilibrium
in which robust consumers are only partially insured or there's no Nash equilibrium at all.
It's also known from literature about the same time that if the risk classes are very closely spaced
or in the worst case a continuum of risk classes, then there is no Nash equilibrium, it will always break down.
It is possible that there are Non-Nash or high-order of conjecture equilibria in these markets,
that is a result of Wilson but I'm not going to concentrate on that.
So what I do in the paper that I'm discussing today is ask the following question, if you have an insurance market
like the health insurance market with asymmetric information where the market either unravels or achieves
a very inefficient separating equilibrium what kinds of market organisations or regulations
can be used to mitigate the effects of asymmetric information and achieve stability and relative or some second order efficiency.
As a general problem, this is a problem of applied mechanism design and you can consider 3 kinds of elements,
consumer, insurer and/or market interventions to control either a selection.
Other problems that don't show up in Rothschild Stiglitz but are present in this market,
incentive designs to control moral hazard from consumers and from providers of health services.
And finally capital and conduct requirements to control performance or counter-party risk.
I'm going to, because I have limited time, I'm going to give you one extremely simple regulatory scheme
which solves the adverse selection problem.
Suppose that you regulate this market by restricting the kinds of coverage that contracts offered in the market can provide.
Specifically a considered fixed coverage regulation.
It says that if there's a loss capital L associated with sickness then the only contracts
that will be allowed by the regulators in the market will be ones that cover a specified share Theta of that loss.
Once a coverage level is specified, the contract terms are specified, then the premiums can then be determined competitively
in the market.
So consider a market like that, suppose you have competitive insurers, suppose you have free entry and exit of insurers
and initially, I'm going to go to the best case first.
Suppose you have fixed coverage at a level that would obtain the same pooled contract that previously
we said could not be a Nash equilibrium because it was blocked.
And now if we just go back to the case of the pooled equilibrium we'll see that this simple regulation
is enough to restore Nash equilibrium within this regulated market.
The contracts that are now allowed effectively, the contract that's allowed is a contract which corresponds to P,
competition would allow other contracts which are identical to that in terms of the loss covered but would vary in premium.
And those correspond to a 45 degree line which is just a fine translation of the 45 degree line.
So along that line labelled fixed coverage, various premiums, those are the contracts that could exist in this market.
It's very easy to see, elementary to see that P is in this case, has to be a Nash equilibrium, it has to exist,
effectively the intersection of the all-in-breakeven contract line, actuarially fair contracts
and the fixed coverage line determine the Nash equilibrium.
And with a little, just a little geometric argument you can easily convince yourself
that there are no longer any possible blocking contracts.
So in this case there is no adverse selection by restricting the kinds of contracts that can be offered.
You manage to corral all consumers to purchase this, blocking contract that was shown here, I'm sure the contract
that was shown here that cannot be blocked was not one with full coverage but it could have been.
One could actually have full coverage and in that case the robust consumer would actually prefer a little less,
the frail consumer would prefer a little more.
But with no ability of the insurers to modify contract terms or offer alterative contract forms.
There is no possibility that they could block.
Now one has to be, if one were to use this device, one has to be rather careful about where one locates the fixed
or minimum coverage level. If you have a lower level of minimum coverage than at P you get back into situation
where you can have non-existence of equilibrium or you can have a separating equilibrium.
In that case the robust consumers are either at the coverage limit or you're actually back into the case
of a classic Rothschild-Stiglitz separating equilibrium.
But the main point here is essentially in this case by regulating the kinds of products that are offered in the market
one is able to bring adverse selection under control.
And in fact it's very difficult although there are many, many ways to regulate an insurance market,
it's very difficult to avoid the problem of adverse selection, at least with a continuum of risk classes of consumers,
without some kind of regulation of product form.
Essentially of the kinds of contracts that are, on which competition is permitted.
I'm going to, I have about 3 minutes left, I'm going to just give you a quick list of some of the kinds
of regulatory techniques that are used, I'm not even going to describe how they work, some work well, some work less well.
My research program is to try to determine exactly which ones work best and it's kind of the insurance market equivalent
of determining the optimal voting rule, the question is among all the forms of regulation,
are there regulatory devices which are in some sense second best.
On the consumer side you can have coverage mandates, you can require people to buy insurance,
you can subsidise their premiums perhaps through using vouchers. If they have low income you can subsidies their premiums.
And for the control of moral hazard you can have co-payments, you can have what are called reference price benefits
which say that the, for any given condition the insurance pays the least cost effect available therapy and anything above that
the consumer is on their own, that has some very nice automality properties from the standpoint of getting
the incentive structure for consumers right.
And you can have various kinds of prohibitions on over insurance, something that's really necessary
when moral hazard is a problem and something which is markedly missing from the derivatives market,
the market for financial insurance where people were able to greatly over-insure with disastrous results.
You can regulate insurance, contract control, fixed or minimum coverage, that's the case that I already discussed
and various kinds of contract entry restrictions. You can have premium regulation, generally does not work very well.
You can have limits on administrative load, also a little bit invasive but may be necessary.
You can have operating subsidies.
That is to say a lot of the cost of the benefits or some portion, share of them are provided through public funds,
not through premiums.
And those can be effective and the reason that such operating subsidies can be effective is that with sufficient subsidy
then the premium that any consumer sees will be at least as favourable as the actuarially fair contracts.
So they have no reason not to buy the insurance and the result will be that you will get pooling equilibrium
with adequate subsidies.
You can have enrolment controls which have the effect of eliminating wasteful screening and signalling activities,
you can have rescission control, that's to say non-cancellation policies.
You can have risk adjustment which is an ex ante way of trying to correct an insurer's benefit obligations
for the risk characteristics of its clientele. Experience adjustment which does the same thing, ex post.
There are principal-agent problems and infinite horizon problems in all of these.
There's reinsurance which is essentially another way of subsidising insurance companies particularly against high-risk people.
To control moral hazard you can use capitation, what's called accountable care incentives which is to reward
on the basis of outcomes, not on the basis of procedures.
You can have capital requirements and controls on benefit management to try to control counter party risk.
You can also intervene at the level of the market, you can reorganise these markets as single payer
or government managed markets and in effect that's a direct and perhaps heavy handed way
of being able to do management of contract form, restricting the contracts that are offered.
You can have dual public private systems in which the public system is charged with being an exemplar or a competitive limit
on an otherwise private market by setting reference contracts and premiums.
And finally a device that's actually interesting for economists to study,
you can use various kinds of incentive compatible bidding mechanisms as part of an industry subsidy to try
to avoid some of the problems, adverse incentive problems there.
One final comment and that is that there are a number of behaviour considerations in insurance markets that have to do
with what consumers think and what they believe about their risk.
Individual risk perceptions may be inaccurate, there are very few market mechanisms that would discipline individuals
if they make mistakes about their own risk.
One is they misperceive their average risk, second they misperceive the dispersion, possible dispersion risk,
how much risk there really is. Both of those things can really foul up the operation of an insurance market
even if there were no other problems of asymmetric information and so forth.
If individuals cannot get it right, markets can go south.
There's actually an important comment here which has much broader application,
which is that our whole theory of efficient markets and the rational in economics for the use of markets
is predicated on the assumption that consumers can do their part of the bargain, can respond in their own self-interest,
can respond to incentives and can give signals through demand and through voting with their feet
that are necessary to drive that market to efficient allocations.
If consumers fail to do these things then you can get bad results from a market.
That doesn't necessarily mean that the government can do it better, but it does mean that private markets are not doing it well.
This is all I'm going to have time for today, perhaps there'll be a few more slides this afternoon.
I got you up to the late '70's in this problem but work goes on and there are very interesting economic issues
in applied mechanism design in this area and I would encourage you to, those of you who have some interest in this topic
to read in particular about the US market for prescription drug insurance which is a controversial innovative
and surprisingly successful attempt to use mechanism design theory to design a private market
that does a reasonably good job in research allocation in the health area.
Thank you very much.
