MODERN

Health
LABOR
Economics
ECONOMICS
THEORY ANDCharles
PUBLIC E.
POLICY
Phelps 126TH EDITION

CHAPTER
10
The Demand for Health
Insurance

23 November 2023 1
Learning Goals
• Discover the basic principles of people’s dislike for financial risk and how
they deal with it.
• Grapple with the complex “risk-aversion” model, hopefully winning at least
two falls out of three.
• Master the difference between the premium and the price for an insurance
policy, and learn the basics of insurance policy pricing.
• Integrate information on demand for medical care into the model of
demand for health insurance and understand how “moral hazard” losses
affect the demand for insurance.
• Learn how health insurance markets run the risk of “market failure” due to
asymmetric information and ways to avoid the problem.
• Understand the role of employer-based insurance in the United States and
the major effects of U.S. tax laws on the demand for health insurance.

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 10.1 The Demand for Health Insurance

• How does a consumer select health insurance?

The Source of Uncertainty

• Health and illness are somewhat random, and the rational response to illness is to
seek medical care, which creates a derived financial risk.
• With other types of insurance, or if no medical care is available, insurance attempts to
replace actual loss, as in the value of a painting or the value of lost stock of health.
• Health insurance instead insures against the financial risks associated with buying
medical care.

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 10.2 Reasons People Want Insurance

A Simple Indifference Curve Approach

• Assume a simple world with two random states.

• State 0 (the economic loss happens) occurs with probability p.
• State 1 (no loss) occurs with probability (1 – p).
• Consumer can shift income between these two states using an insurance that charges a
market-determined rate γ = –dI1/dI0.
• γ is the relative price of income between the good and bad states of the world.

• Figure 10.1 (next slide) shows the initial “endowment point” (E) at which the
consumer would be without insurance.
• Budget line AB allows shifting income from state 1 to state 0 at the rate γ (which is shown as
the slope of AB).
• The slopes of the indifference curves (U1, U2, … etc.) are such that income is more highly
valued in state 0 (or more precisely, the marginal utility of income is higher when income is
lower).

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 10.2 Reasons People Want Insurance

A Simple Indifference Curve Approach, continued

• The consumer optimizes at E*, where the budget line is tangent to the highest
possible indifference curve.
• Normalize the price of insurance γ relative to the underlying odds of the bad event p/(1 –
p).
• γ = [p/(1 – p)]γ*, where γ* is the “real” price of insurance and p/(1 – p) is the actuarially
fair odds of the risk.
• γ* is the “markup” the insurance company charges above the rate that actuarially fair
odds would suggest.
• If γ* = 1, the insurance is “actuarially fair.”

• People want to shift income from good

times to bad times, and will do so
more when the MU of income changes
rapidly with income (steeper
indifference curves) and when it is less
expensive (a flatter budget line).

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 10.2 Reasons People Want Insurance

A More Detailed Approach

• People who pay insurance companies more than the average loss they face are
called risk averse.
• Assume again that U = U(X, H), and that both goods have positive marginal utilities.
• Assume further that the marginal utility of income gets smaller as income increases, as
in Figure 10.2.
• With diminishing marginal utility of income, the consumer will always prefer a less risky
situation to a risk situation, and thus will be termed risk averse.

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 10.2 Reasons People Want Insurance
The Risk-Averse Decision Maker

• Suppose the person with the utility function shown in Figure 10.2 starts out with an
income I2 but knows that some externally generated risk (over which the person
has no control) may reduce this year’s income to I1.
• If this risky event occurs with probability f, then the statistical expected income of this
person is E(I) = fI1 + (1 – f)I2 = I*.
• In Figure 10.3 (next slide), let f = 0.4. If I2 = $20,000 and I1 = $10,000, then
E(I) = (0.4 × 10,000) + (0.6 × $20,000) = $16,000.
• What is the expected utility of a person confronting this risky gamble on income ?
• If the income level I2 occurs, then the utility associated with that, U(I2), measures the
person’s level of happiness; if I1 occurs, then similarly U(I1) is the right measure.
• The expected utility for the person with this risky income is fU(I1) + (1 – f)U(I2). In the
specific case we have used, E(U) = [0.4 X U(10,000)] + [0.6 X U(20,000)] = E(U).
• Because of diminishing marginal utility, U(20,000) is not simply twice U(10,000) but is
smaller.
• Expected utility E(U) of this risky income lies 60 percent of the way between U(10,000)
and U(20,000) on the vertical axis of Figure 10.3

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 10.2 Reasons People Want Insurance
The Risk-Averse Decision Maker, continued
• Certain income Ic that would create utility of E(U) is found by moving across the graph at
U = E(U) until coming to the utility–income curve and then dropping down to the income axis
to find the corresponding income.
• This “certainty equivalent” income Ic is less than $16,000, shown as $13,000 in Figure 10.3.
• The difference between the certainty equivalent and the average income is called the risk
premium.
• The maximum that risk-averse persons are willing to pay to avoid this risk, if they made
decisions in such a way as to maximize expected utility.

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 10.2 Reasons People Want Insurance
The Risk-Averse Decision Maker, continued

• How far can Ic go below E(I)?

• Depends on how fast the person’s marginal utility of income diminishes as
income rises.
• Graphically, the more tightly bent the graph of utility versus income, the more
the person dislikes risk.
• A perfectly risk-neutral person has a utility function plotted versus income that
is a straight line.
• The more the person dislikes risk, the bigger the gap between Ic and E(I).
• The risk premium [(E(I) – Ic)] a person will willingly pay to avoid a risky gamble
is directly proportional to the variability of the gamble and to a specific
measure of how rapidly marginal utility declines as income increases.
• The welfare gain that people receive from an insurance policy is simply any
difference between the risk premium they would willingly pay and the amount
the insurance company charges them for risk bearing.

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 10.3 Choice of the Insurance Policy
• Consider a policy with a consumer coinsurance rate C that pays (1 – C) percent of
all the consumer’s medical bills, leaving the consumer to pay C percent.
• An insurance company must charge an insurance premium that at least covers the
expected benefits it will pay out plus any administrative expenses.
• Suppose the insurer knows the distribution of medical expenses that a person confronts for the
coming year.
• The insurance contract says that the insurer will pay (1 – C)pmm if the consumer buys m
units of medical care at a price pm each.
• Suppose that the consumer might buy N different amounts of medical care during
the year (for example, each corresponding to one of N different illnesses the
consumer might acquire) and that each one of these would occur with probability
fi(i = 1, … N).
• Expected benefit payment from the insurance company to the consumer is
𝑁

𝐸 𝐵 = ෍ 𝑓𝑖 1 − 𝐶 𝑝𝑚 𝑚𝑖 = 1 − 𝐶 𝑝𝑚 𝑚∗
𝑖=1
where m* is the expected (average) quality of care.

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 10.3 Choice of the Insurance Policy

• A difficulty is that the amount of m that people select depends on the

coinsurance of their health insurance plan.
• Insurance company cannot assume that m* is the same, even for consumers who
choose the same plan.
• When the consumer actually gets sick or injured, the medical care demanded
depends on the coinsurance C previously chosen.
• The dependence of m on C has is sometimes described as “moral
hazard.”
• However, it is a predictable response of a rational consumer to the reduction of a
price.
• This price response by consumers is somewhat of an unwanted side effect of
insuring against the risks of health loss by paying for part or all of the medical care,
people buy when they become sick.
• The effects of the insurance coverage on demand for care feed back
on the demand for insurance itself.
• The demand curve slopes downward, so the marginal value of a particular amount of m
consumed falls as the total amount of m rises.

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 10.3 Choice of the Insurance Policy
• Because health insurance reduces the price of medical care, it induces
people to buy some care that creates less marginal value than it actually
costs to provide the care.
• The induced demand due to the health insurance coverage creates a welfare loss in the
market for medical care.
• The insurance policy breaks the link between the costs of care and the price charged for
it because the health insurance is paid for, no matter which illness the person actually
gets and no matter what amount of medical care the person buys.

• This welfare loss from buying more medical care offsets the welfare gains that
consumers get by reducing the financial risks.
• The choice of the best coinsurance rate C balances these two ideas—reduction of
financial risk versus the effects of increasing demand for care (Zeckhauser, 1970).

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 10.3 Choice of the Insurance Policy
A Specific Example

• Consider a very simple world in which only two illnesses might occur (with
probability f1 and f2).
• Because probabilities must add to 1, “not getting sick” has probability (1 – f1 – f2).
• Assume that a consumer selects a specific insurance policy with C = 0.2.
• For illness 1, the insurance plan
induces the consumer to buy m2
of care, but an uninsured
consumer would buy m1.

• The welfare loss generated by this

purchase is indicated by triangle A
in Figure 10.4. Similarly, if illness 2
occurs, demand is m4 (versus m3
for a consumer without
insurance), and the welfare loss is
shown as triangle B.

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 10.3 Choice of the Insurance Policy
A Specific Example, continued

• The medical spending associated with the risk of illness is a distribution that has
outcomes m2 (with probability f1) and m4 (with probability f2), and Thus, the
expected insurance benefit is pm (f1m2 + f2m4)(1 – C).
• If C = 0.2, pm = $500 per hospital-day, m2 = four days in the hospital, m4 = nine days in the hospital,
f1 = 0.3, and f2 = 0.1, then the expected benefit to be paid by the insurance company is
$500[(0.3 × 4) + (0.1 × 9)] × (0.8) = $840.
• The total insurance premium is the expected benefit (the $840) plus any “loading fee” for risk bearing.
• If the loading fee is 10 percent, then the actual premium charged will be $924, of which $840 is
the expected benefit and $84 is the insurer’s fee for risk bearing, profits, and administrative
costs.

• The net welfare gain to the consumer depends on two things: the amount of the
risk premium (willingness to pay for risk reduction) and the size of the triangles A
and B.
• If triangles A and B have areas equivalent to $200 each, then the expected welfare loss in purchasing
medical care is (0.3 × $200) + (0.1 × $200) = $80.
• Suppose this risk premium were $220.
• The consumer would be willing to pay $220 (risk premium) plus $840 (expected benefits) = $1,060 for
the insurance policy, minus the $80 in “moral hazard” welfare losses, for a net of $980.
• If the insurance company actually charges $924, then the consumer gains $980 – $924 = $56 in
welfare from the risk reduction.

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 10.3 Choice of the Insurance Policy
Effects of the Medical Care Demand Elasticity on the Demand for Insurance

• A key idea in the health insurance problem is that the expected “moral hazard” loss
($80 in the example) depends directly on the elasticity of demand for medical care.
• If the demand curve were very inelastic, then there would be very little change in demand due to the
insurance coverage, and the expected welfare loss would be much smaller.

• The more price responsive (price elastic) the demand for medical care is, the less
desirable it is to insure against that risk with “normal” types of health insurance.

• Figure 10.5 shows welfare losses with different elasticities.

• Optimal coinsurance balances the two

types of losses:

𝑚𝑜𝑟𝑎𝑙 ℎ𝑎𝑧𝑎𝑟𝑑 𝑙𝑜𝑠𝑠

• C* =
(𝑚𝑜𝑟𝑎𝑙 ℎ𝑎𝑧𝑎𝑟𝑑 𝑙𝑜𝑠𝑠+𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚)

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 10.3 Choice of the Insurance Policy
Patterns of Insurance Coverage

• The model implies that:

1. demand for insurance should be higher the more that financial risk (variance) confronts
the consumer; and
2. demand for insurance should be lower the more price elastic is the demand for the
type of medical care being insured.
• One simple test asks what portion of the population carries health insurance
against specific risks such as hospital care, surgical procedures, etc.
• Results compare well with the expected utility model.

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 10.3 Choice of the Insurance Policy
The Price of Insurance

• The price of an insurance policy is not simply the premium paid because that premium
includes the average expense of something that the consumer would have to pay for
anyway (medical care).
• The price of insurance itself is just any markup above those expected benefits that the
insurance company adds.
• If the expected benefits are E(B) = (1 – C)pmm*, then the insurance premium (the
amount actually paid by the consumer each year) can be defined as R = (1 + L)(1 –
C)pmm*
• The price of insurance is L, the “loading fee” of the insurance company above expected
benefits.
• If L = 0, the insurance is “free” in the sense that there is no charge for risk bearing or
administration of the insurance plan.
• Since demand is downward sloping, at higher loading fees (higher L), the consumer will
select a higher coinsurance rate (C) and the portion paid by the insurance company (1 –
C) will be smaller.
• The “price of insurance” comes, as usual, from the meeting of demand and supply for
the service.
• Insurance that is priced so that R = E(B) is called “actuarially fair” insurance.

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 10.4 Insuring Preventative Services

• Some preventative services, such as vaccinations, reduce the risk of adverse

health events occurring (primary prevention).
• Some preventative measures reduce the severity of a disease once it is
underway, such as treatment for diabetes (secondary prevention).
• Generally predictable in terms of cost and relatively low cost.
• One answer might be that it is not necessary to insure predictable, low cost things.
• But prevention can reduce the costs of more expensive treatments that would be
required if the illness did occur.
• Also reduces welfare loss created by insurance by reducing overall medical
spending.
• Effect should be greatest when health insurance is complete (C=0) and/or price
elasticity of demand is large.

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 10.4 Insuring Preventative Services
• Figure 10.6 shows the interplay of these issues.
• Vertical axis shows estimates of benefits of prevention spending (percentage of
income spent on prevention).
• Along the horizontal axis the coinsurance rate changes from C = 0 (full coverage)
to C = 1 (no insurance).
• When there is little to no insurance (C = 1 or nearby), the demand for prevention is high,
and the demand elasticity η has little effect on the optimal level of prevention. In this
situation, prevention and medical spending are pure substitutes—less insurance
coverage increases the optimal amount of prevention.

• When insurance coverage is high

(C=1), the demand for prevention
is high because it prevents
overuse.
• The demand for prevention is
lowest at middle levels of health
insurance coverage.

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 10.4 Insuring Preventative Services
Insurers’ and Employers’ Incentives to Cover Prevention

• Health insurers have an interest in prevention, but they do not

share in the elimination of welfare losses to consumer
• To the extent that they can reduce medical spending (and hence
premiums), or to the extent that competition leads them to cover
prevention because consumers want that coverage, their interests at
least partly coincide with those of consumers.
• Insurers’ incentives to subsidize prevention also differ greatly
depending on the preventive activity.
• Many preventive activities have most of the “payoff” into the future.
• Then neither the insurer nor the insured individual has strong
incentives for prevention.

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 10.4 Insuring Preventative Services
Insurers’ and Employers’ Incentives to Cover Prevention,
continued

• When insurance is offered through employment groups that

are experience-rated to the group or self-insured by the
employer, employers often include “wellness plans” in their
human-relations portfolio.
• Reduce the time and financial cost of employees seeking preventive
care and share in the gains through not only reduced health care costs
but also reduced absenteeism or reduced work performance due to
sickness.
• Employers may have stronger incentives to provide preventative
coverage because the insurer has two ways to “lose” the customer
(new job or changing insurer) while the employer has the risk only that
the person will change jobs.

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 10.5 Insurance Market Stability: The Question of Self-
Selection

• The problem of market stability hinges on the difference in

information held by buyers of insurance (consumers) and
sellers of insurance (insurance companies).
• The buyers know more about their own health than the sellers.
• The risk exists that insurance companies will put an insurance plan
into the market that uses one set of actuarial projections about the
costs of insured people but ends up attracting a special subset of the
population with unusually high health care costs.
• “Self-selection,” or “adverse selection.”

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 10.5 Insurance Market Stability: The Question of Self-
Selection

A Simple Model of Selection and Self-Identification

• Insurance companies may find it in their interest to market sets of plans causing
people to self-identify their “type” (sickly versus healthy) through their selection of
insurance.

• Figure 10.7 shows a budget line

showing the tradeoffs between other
goods and insurance coverage.

• Optimal insurance occurs at the

tangency of the consumer’s
indifference curve with the budget
line.

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 10.5 Insurance Market Stability: The Question of Self-
Selection
A Simple Model of Selection and Self-Identification, continued

• Now assume that there are two types of people, “healthy” and “sickly.”
• If the insurer could identify the groups, it would charge them different premiums.
• If the insurer cannot identify the groups, then it will only sell “healthy” policies in the set
leftward of E*, or sickly people will buy these policies, causing the insurer to lose.

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 10.5 Insurance Market Stability: The Question of Self-
Selection
A Simple Model of Selection and Self-Identification, continued

• Sickly people will now self-identify and buy a different policy.

• Healthy people are worse off because they cannot reach their highest indifference curve
with the restricted policy choice.
• “Separating equilibrium”
• One alternative solution previously adopted by some state governments was to
require “community rating” for insurance, charging everyone an average price
based on the mix of healthy and sick people in a community.
• In Figure 10.10 (next slide), both healthy and sickly people are made better off relative to
the separating equilibrium.
• Healthy people receive higher utility from the new plan choice.
• Sickly people shift to more coverage at a lower cost than they would have had
otherwise.

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 10.5 Insurance Market Stability: The Question of Self-
Selection
A Simple Model of Selection and Self-Identification, continued

23 November 2023 26
 10.5 Insurance Market Stability: The Question of Self-
Selection
Preexisting Conditions in the ACA

• The Affordable Care Act (ACA) prohibited insurers from pricing insurance based
on preexisting conditions or limiting or refusing coverage for these conditions.

• The ban on using preexisting conditions in insurance also enables insurance

markets to function for risks that have not yet been identified by individuals, most
notably “time bombs” lurking in our genetic makeup.
• Ashkenazi Jews carry a heightened risk of Tay-Sachs disease, cystic fibrosis, and
numerous others, such that an estimated one in four of such individuals is a carrier of
one or more genetic diseases.
• A specific gene variant increases the risk of nicotine addiction for people who begin to
smoke and increases the risk of lung cancer and peripheral artery disease among
smokers
• Both the 1997 HIPAA law and the PPACA preclude use of genetic information in
insurance underwriting

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 10.5 Insurance Market Stability: The Question of Self-
Selection
Transactions Costs as a Basis for Stability

• Sometimes the “community-rating” solution emerges without any

government regulation.
• Within any single employer group, the costs of buying insurance outside of the
group greatly exceed those of plans within the group, making switching very
unlikely (high transactions costs).
• Virtually all employers have a “community-rating” scheme within their firms, at least
nominally, providing the same health insurance coverage for everybody working in
the firm at the same price.
• Because the employment group is brought together for some purpose other than
buying insurance, insurers rarely worry about the problem of bad risks chasing
good risks.
• A key to making this system work is that the work group must all use the same insurance
plan, so the preferences of the “median” worker dominate the choice of plan.

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 10.6 Income Tax Subsidization of Health Insurance
• The employer’s share of health insurance peaked at about 80 percent of total
premiums in the early 1980s, then began to decline slowly, partly in response to
changes in the magnitude of tax subsidies.

• Employer payments for health insurance are not taxed as income to the employee but
remain a deduction for the employer.
• Makes health insurance cheaper than any other good or service the employee might buy because the
employer purchases the health insurance with before-tax dollars.
• Costs only (1 – t) as much as other goods, where t is the employee’s marginal tax rate.
• Suppose the insurer pays a share s of the total premium cost, and the employee pays (1 – s).
• Defining the expected insurance benefits as B and the loading fee as L, the premium can be defined
as R = (1 + L)B.
• The insurance costs the employee (1 – s)R for the employee’s share and s(1 – t)R for the employer’s
share, which is not reported as taxable income.
• The subsidy is the marginal tax rate t on the employer’s share.
• The effective cost of the insurance is R = (1 + L)(1 – st)B.
• The subsidy t applies not only to the loading fee, but rather to the entire portion of the policy paid by
the employer.
• The most recent data available show that (on average), s = 0.76.
• For many persons (particularly those purchasing coverage for only the worker), s = 1, i.e., the employer
pays the entire insurance premium.

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 10.6 Income Tax Subsidization of Health Insurance

• The U.S. tax system has many components affecting the marginal income tax rate
t, including federal income taxes, federal Social Security (FICA) taxes (which have
an income cap), the Medicare payroll tax (which is uncapped), plus any state and
local income taxes.
• See Box 10.2 in the text for discussion of complexity of calculating marginal tax rates in
the U.S
• An online supplement to this book (see ww.routledge.com/cw/phelps) provides further
detail.

• The Congressional Budget Office (CBO, 2005) estimated the average (over all
filed income tax returns) of the effective marginal tax rate (t in the above
discussion).
• Figure 10.11 (next slide) shows the distribution in more detail.

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10.6 Income Tax Subsidization of Health Insurance

• The average of the effective marginal tax rate is about 35 percent, and thus the U.S. tax
system subsidizes about a third of employer-paid premiums.
• Combining that with the average share paid by employers yields about a 25 percent
subsidy on health insurance.

23 November 2023 31
 10.6 Income Tax Subsidization of Health Insurance

• Most economists believe that the employer’s share of insurance premiums is

eventually passed back to employees in the form of lower wages than would
otherwise exist.

• The primary advantage of paying workers with health insurance rather than
“dollars,” of course, is the assistance given by the tax system.
• Each $1,000 paid as insurance premiums brings with it a tax reduction to the
worker of $1,000t. If t = 0.33, then the “bonus” is $333 for each $1,000 of
income shifted from wages or salary to health insurance.

• The magnitude of this tax subsidy has become truly staggering.

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10.6 Income Tax Subsidization of Health Insurance

23 November 2023 33
 10.6 Income Tax Subsidization of Health Insurance
• Of the individual payments of $258 billion in 2010, $179 billion went toward the
employee’s share of employer-group plan premiums.
• Total cost of the employer-group plans to $737 billion in 2010, 75.7 percent of which was paid by
employers, and hence escaped taxation.

• 30 percent of the total individual insurance payments ($258 billion in 2010) went toward nongroup
insurance, and the remaining 70 percent were payments toward employer-group insurance.

• The total dollars escaping income taxation represent a significant fraction of the U.S.
economy.
• In 2010, federal income tax receipts from individual taxpayers amounted to $1.5 trillion, and Social
Security taxes about another $1.1 trillion.

• Using an average MTR of 30 percent, the $558 billion in employer premium payments represent $167
billion in foregone income taxes.

• About 11 percent of the actual income taxes collected, and an even larger proportion of Social
Security and Medicare taxes.

• Other choices could be made with those foregone tax revenues.

23 November 2023 34
 10.6 Income Tax Subsidization of Health Insurance
• What puts any limit at all on the demand for insurance in this setting?
• The group plan is a compromise over the interests of many workers, some of
whom have different preferences than others.
• Because every worker in the group pays the average premium (over all
workers) regardless of age or health habits, younger workers will find an
extremely generous health insurance plan too expensive for their preferences,
even with the tax subsidy.
• Because they “vote” on the plan, they help constrain the choice.

• The other natural limit for health insurance is the welfare loss generated
by extending coverage too far.
• As C approaches zero (full coverage), the welfare loss caused by
overpurchases of medical care increases.
• Even with a tax subsidy for insurance, it is usually preferable to quit before full
coverage is reached.

23 November 2023 35
 10.6 Income Tax Subsidization of Health Insurance

Revisiting the Fictitious Insurance Purchase Example

• In the earlier example, with a moderately risk-averse consumer, the net gain
from purchasing the hypothetical insurance policy was $56.
• What if the policy is purchased through a group insurance plan, and the
consumer’s marginal tax rate is 0.3?
• Tax liability drops by 0.3 times the insurance premium—0.3 × $924 = $277.20.
• Much larger than the net benefit from insurance itself.
• May make insurance purchases attractive when they would not have been
chosen previously.
• Changes in risk aversion and in the tax rate change optimal choices.

23 November 2023 36
 10.7 Empirical Estimates of the Demand for Insurance

Income Effects

• In most studies using individual data, estimated income elasticities are generally
positive, but less than 1 for almost any measure of insurance chosen.
• Measuring the “correct” income is difficult for insurance chosen in a group setting
because the median worker’s income presumably is more important than any
other worker’s income.
• Aggregate data (such as Phelps, 1986b; Long and Scott, 1982; Woodbury, 1983)
avoid this problem.
• Generally, the income elasticity of demand for insurance (as measured by premiums) in
such studies is more than 1, and it may be closer to 2.

23 November 2023 37
 10.7 Empirical Estimates of the Demand for Insurance
Price Effects

• The effects of the price of insurance on demand constitute an important question for public policy because
of the way the income tax system subsidizes health insurance purchases.
• Aggregate data usually provide price elasticity estimates (using variation in the marginal tax rate
through time as a price change) in the neighborhood of –1.5 to –2.
• When the size of the work group is used to generate price variation, the estimates are also typically
large, in the range of –1.
• Other studies use differences in the marginal tax across households to determine the effect of price
on insurance demand and get smaller estimates (about –0.2).

• The tax cuts initiated by the Reagan Administration reduced the desirability of extensive insurance
because they reduced the tax subsidy for almost all working persons.
• In the early 1980s, 90 percent of the under-65 population had private health insurance coverage, and
by the early 1990s, the figure had fallen to 72 percent.
• By 1991, the comparable numbers were 219 million citizens under the age of 65, 158 million of whom
(72 percent) had private health insurance, nearly 90 percent of which came through employer groups.
• There was an absolute loss of 17.5 million persons with insurance during a time when the under-65
population increased by 44 million people.

23 November 2023 38
 10.8 The Overall Effect of the Tax Subsidy on the Health
Sector
• The cumulative effects of the federal income tax subsidy of health insurance could
be very large.
• The subsidy produces a secondary effect in the market for medical care because the
increases in insurance coverage in turn increase the demand for medical care.
• The leverage that this interaction can generate has the potential for substantially altering
the shape and size of the health care system.
• One study (Phelps, 1986b) estimated that employer-group health insurance premiums
would only be about 55 percent as large today if the tax subsidy were not in effect.

• If private health insurance had (from the beginning) contained higher coinsurance
or deductibles (without the tax subsidy), the structure of Medicare would probably
reflect that difference as well.
• Medicare was clearly patterned after private health insurance when it was instituted in
1965, with essentially full coverage for hospital care and a “major medical” type of
insurance for doctor services, with a $50 deductible and a 20 percent coinsurance.
• Private insurance with greater cost sharing probably would have led to public insurance
with more cost sharing as well.
• In the aggregate, it seems possible that the health sector would be at least 10–20
percent smaller without the tax subsidy for health insurance.
• 1.5–3.0 percent of the gross national product.

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 10.9 “Optimal” Insurance

• According to the expected utility model, a consumer seeking to maximize

expected utility will select a policy with full coverage above a deductible, when
the losses are truly random.
• The size of the deductible increases as the loading fee increases.
• The optimal policy has a coinsurance feature included when the insurance company, as
well as the consumer, is risk averse.
• Taking into account the effect of coinsurance on demand for medical care, Keeler et al.
(1988) estimated the expected utility among a variety of insurance policies, based on the
RAND HIS results.
• The “best” plans all contain a coinsurance rate of about 25 percent and an initial
deductible of $100–300, comparable to deductibles of $200–600 in 2010 dollars.

• Most current health insurance plans that pay for doctor services out of the
hospital have about this structure.
• In a survey of employers, only 5 percent of covered employees had plans with no
deductibles, and more than half had deductibles in excess of $150 by 1990.
• The theory of demand for insurance, coupled with the empirical results from the HIS,
suggests that consumers would be better off with less complete coverage.
• Elimination of the income tax subsidy would certainly move people in that direction.

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 10.10 Other Models of the Demand for Insurance

• The model of expected utility maximization has problems in terms of precise predictions
about how people behave in settings containing uncertainty.
• Challenges have come from the discipline of psychology, most notably from Kahneman
and Tversky and the prospect theory model.
• A model in which deviations from “today’s” world affect behavior.
• Everything is viewed in terms of “where you are.”
• People prefer risk (are willing to accept gambles) for degradations in their well-being but
are risk averse with regard to improvements.
• A key part of these authors’ approach is that the basis from which one views the problem
(the perspective) alters the decision and the apparent attitudes toward risk.
• For example, standard expected utility theory predicts that people will not participate in
lotteries because the expected value is and the gamble involves risk.
• In prospect theory, consumer response to a financial gamble depends on the weights and
the frame of reference.
• Because people overweigh low-probability events, Lotto-like gambles will seem more
attractive.

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