The Economics of Moral Hazard: A Comment That Launched a Field
Comment. The word connotes a remark, a casual opinion, a reflexive response. But in 1968, Mark Pauly published a “Comment” in the American Economic Review that would become one of the most influential articles in health economics. Entitled, “The Economics of Moral Hazard: Comment”, it was a response to another classic by Nobel Prize winning economist Kenneth Arrow, who published “Uncertainty and the Welfare Economics of Medical Care” in 1963.
Arrow had considered why the market was not providing “optimal” (that is, complete) insurance coverage, given that many medical services were not covered by insurance and that many people had no health coverage at all. Pauly’s key insight was that full coverage may not be optimal under conditions of moral hazard, that is, when consumer demand for health care responds to the reduced marginal cost of care to the individual. As Pauly said in 1968:
(T)he response of seeking more medical care with insurance than in its absence is a result not of moral perfidy, but of rational economic behavior. Since the cost of the individual's excess usage is spread over all other purchasers of that insurance, the individual is not prompted to restrain his usage of care….It is possible to conclude that even if all individuals are risk-averters, some uncertain medical care expenses will not and should not be insured in an optimal situation.
Immediately following Pauly’s “Comment” in the American Economic Review was Ken Arrow’s simply titled response, “The Economics of Moral Hazard: Further Comment,” which began:
Mr. Pauly's paper has enriched our understanding of the phenomenon so called "moral hazard" and has convincingly shown that the optimality of complete insurance is no longer valid when the method of insurance influences the demand for the services provided by the insurance policy. This point is worth making strongly.
Mark Pauly’s key insight continues to resonate today in debates about universal coverage and cost containment. It is a gift that keeps on giving. Although he would not arrive at Penn until 1983, we take special pride in his early comment that propelled our field.