Insurance and Innovation in Health Care Markets

Innovation policy often involves an uncomfortable trade-off between rewarding innovators sufficiently and providing the innovation at the lowest possible price. However, in health care markets characterized by uncertainty and insurance, society may be able to ensure efficient rewards for inventors and the efficient dissemination of inventions. Health insurance resembles a two-part pricing contract in which a group of consumers pay an up-front fee ex ante in exchange for a fixed unit price ex post. This can allow innovators to extract sufficient profits — from the ex ante payment — but still sell the good at marginal cost ex post. As a result, we show that complete, efficient, and competitive health insurance markets lead to perfectly efficient innovation and utilization, even when moral hazard exists. Conversely, incomplete insurance markets lead to inefficiently low levels of innovation. Second, an optimally designed public health insurance system can solve the innovation problem by charging ex ante premia equal to consumer surplus, and ex post co-payments at or below marginal cost. When these quantities are unknown, society can almost always improve static and dynamic welfare by covering the uninsured with contracts that mimic observed private insurance contracts.