OPTIMAL HEALTH-INSURANCE AND PROVIDER PAYMENT

We derive optimal insurance for patients and payment method for physic ians when neither the input decided by the patient (quantity of treatm ent) nor the input decided by the physician (effort) are contractible. The equilibrium in this third-best regime may sometimes be second bes t, in which both the physician input and the report of treatment are v erifiable. Otherwise, truthful reporting forces a third best, characte rized by provider ''prospective payment'' and suboptimal effort, while consumers' demand becomes excessive. We also analyze how ''profession al ethics'' alters the equilibrium. Finally, collusive reporting mecha nisms imply more stringent constraints, while competition among physic ians relaxes them.