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Healthcare takes centre stage, finally! 153

Given this uncertainty and variability at the individual level, pooling of healthcare expenditures
via health insurance can help to reduce healthcare risk at the macroeconomic level.

Information asymmetry

5.6 In healthcare markets, Arrow (1963) explained that buyers of information (patients) rarely
know the value of the information until after it is purchased and sometimes never at all. For
example, when individuals avail of a healthcare service like dermatology (i.e., skin care), they
may be able to readily evaluate the outcome. Therefore, for such services, low-quality providers
will have to reduce their price to remain competitive. In contrast, patients who must undergo
open-heart surgery may find it very difficult to evaluate its quality and have to therefore rely
on the reputation of the hospital/doctor as a proxy for the quality. For some services such as
preventive care and/or mental health, patients may never know for sure whether their provider
did a good job.

5.7 This principal-agent relationship between the patient (as the principal) and the healthcare
provider (as the agent) gets further complicated by factors that may influence this conflict of
interest. For instance, altruism among doctors – a trait that is highly commended and looked
for by patients – primarily serves to eliminate this conflict of interest. However, reimbursement
rates pre-negotiated with insurance companies, advertising, the private incentives for testing,
etc. can exacerbate this conflict of interest. For instance, C-sections in pregnancies, which are
more profitable for the hospital/physician, are overused (Guilmoto et al, 2019). Such non-price
features of healthcare can lead to obfuscation of price and/or significant price dispersions for the
same good/service.

5.8 Health insurance, which becomes desirable because of the uncertainty/variability in
demand, creates a second round of informational problems in healthcare markets. First, because
health insurance covers (some of) the financial costs that would be caused by poor health
behaviour, individuals may have less incentive to avoid them; this phenomenon is labelled ex-
ante moral hazard (Ehrlich and Becker 1972). Pauly (1968) argued about the role of ex-post
moral hazard in health insurance, which stems from the fact that the cost of an individual’s
excess usage of healthcare is spread over all other purchasers of insurance. This free-rider
problem causes the individual to not restrain his usage of care. Given the ex-ante and ex-post
moral hazard, incomplete insurance in healthcare is optimal. This prediction is consistent with
the idea advocated by Holmstrom (1979) that optimal insurance contracts should be incomplete
to strike a balance between reducing risk and maintaining incentives for the individual.

5.9 As Akerlof (1970) predicts, when little information is available on the quality of a product
prior to purchase, and the quality of the product is uncertain, quality deteriorates to the lowest
level in an unregulated market. While reputation can partially mitigate this market failure, the
design of healthcare systems must account for this market failure, which can otherwise lead to
loss of consumer faith and resultant under-investment in healthcare.

Hyperbolic tendencies

5.10 People tend to indulge in risky behavior that may not be in their self-interest. Examples
include smoking, eating unhealthy food, delay in seeking care, not wearing masks or keeping