Health insurance theory: the case of the missing welfare gain

An important source of value is missing from the conventional welfare analysis of moral hazard, namely, the effect of income transfers (from those who purchase insurance and remain healthy to those who become ill) on purchases of medical care. Income transfers are contained within the price reduction that is associated with standard health insurance. However, in contrast to the income effects contained within an exogenous price decrease, these income transfers act to shift out the demand for medical care. As a result, the consumer’s willingness to pay for medical care increases and the resulting additional consumption is welfare increasing.