Wages, Benefits, and Worker Sorting Under Asymmetric Information

The 2010 The Patient Protection and Affordable Care Act significantly alters the incentives underlying employment-based insurance in the U.S. In order to better understand these significant changes in the health insurance market, we introduce a new model of the employment-based insurance (ESI) system that explores how firms choose the mix of wages and benefits that make up worker compensation. The model emphasizes the distinction between risk heterogeneity (workers have different risk types) from simple preference heterogeneity (workers of the same risk type have different willingness-to-pay for insurance).

Current models of ESI typically treat insurance as a homogeneous product offered as a tax- preferred fringe benefit. But the reality of marketplace offerings suggest there are several other aspects of ESI that might be empirically important: the generosity of coverage (eg. high-deductible versus traditional), the number of plans available from a given employer, and the level of the employer subsidy. A key goal of our model is to provide a framework for examining these important features of the ESI market. 

Our model blends insights from two rich theoretical and empirical literatures which until now have not had much interaction. First, we use insights on wage determination from labor economics. This is usually the starting point for most current models of ESI. But then we also incorporate work on insurance model with asymmetric information characterized by the model presented by Rothschild and Stiglitz (1976). The result is a model that is familiar and intuitive yet is more flexible and descriptive of the complex set of choices facing firms and workers. The theoretical approach is to treat all firms as being simultaneously 1) a firm producing goods for the output market, and also 2) a de facto insurance company where profits are earned as the difference between the value produced by employees and the full cost of hiring them, including the provision of insurance. Firm-specific human capital allows firms to benefit from providing ESI to employees and essentially creates in insurance firm with market power of the type envisioned in the Rothschild & Stiglitz framework.

Our primary aim is a rigorous development of the formal model. We will then apply it to explore some ongoing puzzles. These include “job-lock" where the bundling of insurance and employment may lead to sub-optimal outcomes, and the effects of mandated benefits. We show that the added richness of the model allows for alternative outcomes that previous work has neglected. We will then extend the basic model to explore other theoretical puzzles such as how firms weigh the interests of various workers in determining the optimal contract.

The empirical part of the paper examines the differences in demographic composition between U.S. and Canadian firms. The idea is that U.S. firms have an incentive to account for the demographics of their workforce due to the provision of health insurance while their Canadian counterparts have no such incentive due to the existence of universal health insurance through the government.