Information Asymmetry Problem in Health Care System - Term Paper Example

Information Asymmetry Problem in Health Care system Introduction Economists have considered for ages asymmetric information in the market place as one of the major causes of market failure. In the presence of asymmetric information in any market, buyers and sellers of that market do not have same amount of information. This asymmetric information among buyers and sellers results in adverse selection by the market agents or creates the problem of moral hazards. The well-known economist Kenneth J. Arrow in his article on health care first paid attention on this issue of information asymmetry in market place in 1963. Later David Akerlof illustrated this situation elaborately in his famous work “The Market for Lemon” where he termed this situation as asymmetric information. He discussed this problem in the context of a used car market. He regarded the good car as peach and the bad cars as lemon. Akerlof argued that in a used car market a seller uses to have more information regarding the quality of a used car, i.e. the seller knows more accurately whether the car that he is selling is a peach or a lemon. But the buyer, on the other hand, uses to be in a more disadvantaged state as he posses less information regarding whether the car that he wants to buy is a peach or a lemon and hence the buyer can only make a guess whether the car would provide good service. (Akerlof, 1970; Arrow, 1963) Information asymmetry problem is not a problem of any particular market. In fact, most of the markets face this kind of informational problem, although degree of this problem differs from market to market. Typically when there exists information asymmetry problem in any market, it is mainly the sellers who possess more information about the product than the buyers during the process of transaction; however, in some cases the reverse can also take place. Health care system is not an exception and it also faces severe information asymmetry problem. Information asymmetry is present in the market of health care as well as in the market of health insurance. It would be quite interesting to look at the nature of information asymmetry in health care sector and how this problem can be dealt with to avoid any kind of market failure. (Arrow, 1963; Blomqvist and Leger, 2003) Information asymmetry in health care system In the national health care system of any country, the relationship between physician and patients is regarded as the key relationship that the health care market has to deal with. In the presence of information asymmetry there exists a gap between the patients and the medical service providers regarding the price of the product as well as its quality. In the presence of this asymmetrical information, it becomes very difficult to understate as well as interpret the performance level of medical service providers as well as of national health plans. In many empirical studies it has been found that in the healthcare system physicians use to have an informational advantage in the process of supplying health care services. In theory the physician-patient relationship is described as a principal-agent problem which deals with information asymmetry. However, the application of the principal agent theory in practice in healthcare sector is quite difficult as in practice there exist a number of complementary agents between patients and physicians. Insurance companies play the role of an important agent between medical service providers and patients. Insurance companies are also exposed to information asymmetry problem, but certain modifications in the traditional insurance model can help in reducing the level of information asymmetry that is inherent in the national health care system. (Blomqvist and Leger, 2003) Information asymmetry is used to be of two types – the problem of moral hazard and the problem of adverse selection. Among these two types of information asymmetry, moral hazard is the most prominent in health care sector. The Health economists like Arrow had used the term moral hazard to refer to the problems of contracting over the consumers’ health status. The presence of moral hazard causes market failure in health care industry of any country. In the health care sector, market failure is mainly caused by the difficulties of making appropriate contracts on any probable illness ex ante. In the presence of moral hazard problem, ideal insurance system that aims at providing shields to the consumers from the costs of the medical services, which are provided efficiently by their providers, becomes infeasible. When the ideal insurance system becomes infeasible in health care system, the health care sector of a country adopts the second best insurance system. This second best insurance system, however, does not fully cover the risks but only bears treatment expenses partly. But the problem with the presence of any kind of insurance scheme in health care system is that patients who do not have to pay full costs of their medical care in the presence of insurance may place inefficient demand for medical care. As a result, very often the cost of treatment becomes greater than the benefit obtained by the patient. This problem in health care sector is referred to as the problem of moral hazard which is very common in the health industry of any country. In the presence of moral hazard the health care system of a country cannot operate efficiently. The best way to control this moral hazard problem is to adopt appropriate modifications in insurance policies at the time of providing insurance schemes to partly shield consumers from the risks of illness. (Albert Ma and Riordan, 2001; Stigler, 1961) Moral hazards problem affects both the medical service providers and the medical insurance providers. As far as the medical service providers are concerned, they face inefficient demand for their products from the partly insured patients as these patients used to ask more services than what is required. Medical care givers very often find it quite difficult to adjust their supply with the excess demand as a result the health care market deviates from its equilibrium position. Some times the amount of demands for medical services becomes so large that it automatically leads to market failure. On the other hand, in case health insurance providers, they face over expenditures, which result in loss in profit and force the insurance providers to operate inefficiently. (Albert Ma and Riordan, 2001; Akerlof, 1970; Arrow, 1963) Although moral hazard is the most prominent problem in health care system of a country, adverse selection, another form of information asymmetry, do also the insurance providers face a common problem in the health care system. People have a tendency to insure themselves against illness if they come to know that there is a high probability of deterioration in their health status in future. As a result, there creates asymmetric information in the health insurance market as for an insurer it is not possible to find out who is at high risk and who is at low risk, while the buyers use to have good information regarding the level of risk. Insurer can only estimate the aggregate amount of risk by taking into account all people who are seeking insurance. Hence, a health insurance company is not capable of charging different premium rates for people with different risk, but can charges only a single average premium rate for all people. Since, different people have different level of risks and have complete information about their own risk as well, those people who are at high risks are more likely to purchase this type of insurance scheme as it is under priced in relation to their risk level. (Akerlof, 1970; Arrow, 1963) In a national health care system, if distribution of information becomes asymmetrical and the prevailing insurance system in the health industry charges an average rate of premium for all, then a large section of population who are at low level of health risks would be left uninsured against their risks of illness. It would in turn bring in inefficiency in the health care market. (Arrow, 1963) Akerlof, in his article “The Market for Lemons”, had suggested two possible solutions through which the problem of information asymmetry in any market can be dealt with to ensure efficient functioning of the market. These two solutions are screening and signaling. National health insurance system of any country can utilize these two solution methods to deal with information asymmetry in healthcare system. In case of signaling, the group, which possesses more information regarding the risk associated with the product to be transacted in the market, needs to take the initiatives to signal their types to the other party so that asymmetry in information can be resolved. In the context of health care market, therefore, the consumers of insurance needs to provide signal to the insurance providers about their risk types. On the other hand, in case of screening, the underinformed party in the market can use some strategy to induce the over informed party to reveal their types. For example, the party, which has less information, can provide a set of choices to the other party in such a way that the choices of the people belonging to the overinformed party in the market depend on their private information. In case of health care market, if the national healthcare system wants to resolve the information asymmetry problem through health insurance providers, then the best strategy to adopt would be screening as the insurance providers are the under informed part in the health care market. (Akerlof, 1970; Spence, 1973; Stigler, 1961) How health insurance system can use screening device to reduce the adverse effects of screening on the health care system can be discussed with the help of an example as follows. Let us start with an assumption that in a country a particular illness costs $50,000 per episode. Now suppose that the population of the country is composed of two types of people- healthy and sick. Also suppose these two types of people have the following characteristics: Type Percent of Population Risk of Illness Willingness to pay premium Healthy People 90% 1/1000 $100 Sick People 10% 1/100 $750 Given the information about each type of people in the table above, it is now possible to calculate average cost of insurance for healthy people. Given the value of their health risk and the total cost of illness, average cost of insurance for healthy people will be equal to (1/1000)*($50,000) = $50. Similarly, average cost to insure for sick people can also be calculated. Given the value of their health risk and the total cost of illness, average cost of insurance for healthy people will be equal to (1/100)*($50,000) = $500. Now the insurance company is at an information ally disadvantaged state in the market. It is not possible for an insurance company to accurately measure the health risks of an insurance seeker unless the person himself/herself reveals his/her risk type. Under such situation, the company can only charge an average rate of premium to all risk seekers irrespective of their risk types. Now since in the above table 90 percent of the population has been assumed to be healthy, then the average cost of insurance per person is 0.90·$50 + 0.10·$500 = $90. If the insurance provider can charge only the value of its cost to insure, then in this case the company will charge $90 to all irrespective of their risks. In an competitive environment it is not possible for an insurance providers to charge a price higher than its costs. Now given the amounts that two types of people are willing to pay for to cover their health risks, it can be said that in this case every one will be wiling to pay the rate that the company is going to charge, i.e. $90. As everyone is capable of insuring themselves against there health risks, this can be referred to as an equilibrium situation. The case where same rate of insurance will be charged to all is referred to as a pooling equilibrium. But this kind of situation does not hold all the time in the heath care sector. (Akerlof, 1970; Stigler, 1961) To examine how the market deviates from its equilibrium setting can be explained as follows: Let us make some modifications in the table presented above. The revised table is as follows: Type Percent of Population Risk of Illness Willingness to pay premium Healthy People 80% 1/1000 $100 Sick People 20% 1/100 $750 Now, as presented in the table above, 80 percent of the population is healthy. As a result, average cost to insure per person becomes 0.80·$50 + 0.20·$500 = $140. As given in the table, the healthy people are willing to pay only $100. Therefore, in this case, although unhealthy people will be ready to pay $140 to cover their risks, health people will not buy this insurance at this rate. As a result no pooling equilibrium will exists in the health care sector. In this case, only sick people will buy insurance policy and the entire portion of the population who are healthy will be left uncovered against their health risks. Thus even though in a full information world the insurance company will be ready to provide them with insurance at that rate which they will be willing to pay, in the presence of information asymmetry the healthy people will remain uninsured leading to an inequilibrium condition. (Akerlof, 1970; Stigler, 1961) Now to solve this problem, the national insurance system of a country can adopt a screening device to reveal the risk types of the consumers. Suppose that the insurance provider to resolve the information asymmetry problem decides to offer two different policies. The first policy is a general insurance policy, which costs $240. The second insurance policy, on the other hand, offers an insurance, which costs $70 to anyone who will be able to pass a physical test. Also suppose that the cost of physical test for healthy people is $20 while that for sick people is as high as $200 as to pass physical test they have to bribe the doctors. Now the interesting thing to be noted is whether this kind of screening device is able to form an equilibrium condition in the healthcare market. In the new condition, healthy be people will not buy the first policy which costs $240 as they are willing to pay only $100 to cover their health risks. But they will ready to pay $70+$20=$90 that they would require to buy the second insurance policy. On the other hand, sick people will not be ready to buy the second policy as it would cost them $200+$70 = $270 which is more than what they would require to pay to buy the first policy ($240). Thus, the healthy people will buy the second policy and the sick people will buy the first policy and no one will remain uninsured and an equilibrium condition will be reached. This type of equilibrium is however refereed to a separating equilibrium as not a single rate is charged for all. (Akerlof, 1970; Stigler, 1961) Conclusion Information asymmetry is not good for any market. If forces the market to move from its equilibrium position. As a result the market fails perform efficiently and this kind of inefficiency eventually leads to market failure. The same is true for health care system of a country. In the health care market information asymmetry emerges when health care receivers do not deliberately reveal their risk types. This creates huge problem for the health care providers as well as to the health financing system. The market of health insurance becomes inefficient which in turn causes inefficiency in the entire health care system. But the national health insurance system can resolve this issue by taking appropriate policy. Adoption of an appropriate screening device helps in revealing the risk types of the people to the health acre and health finance providers, which in turn bring in efficiency in the health care system. Reference: 1. Blomqvist, A. and Leger, P.T. 2003. Information Asymmetry, Insurance and Decision to Hospitalize. Available at http://www.fas.nus.edu.sg/ecs/pub/wp/wp0305.pdf [accessed on 25th July, 2009]. 2. Arrow, K.J.1963. Uncertainty and the Welfare Economics of Medical Care. American Economic Review, 53:941-69. 3. Baumgardner, J. 1991. The interaction between forms of insurance contracts and types of technical change in medical care. Rand Journal of economics, 22:36-53 4. Akerlof, G. A. 1970. The Market for Lemons: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics, 84 (3): 488–500. 5. Stigler, G. J. 1961. The Economics of Information. Journal of Political Economy, 69 (3): 213–225. 6. Spence, M. 1973. Job Market Signaling. Quarterly Journal of Economics, 87 (3): 355–374. 7. Albert Ma, C. and Riordan, M. H. 2001. Health Insurance, Moral Hazard, and Managed Care. Available at www.columbia.edu/~mhr21/ma.pdf [accessed on 25th July, 2009].   Read More