Internalizing Behavioral Externalities: Benefit Integration, Health Insurance and Welfare

We show that profit-maximizing firms alter product design in the market for Medicare pre-
scription drug coverage to account for underutilization by consumers. We examine prescription
drug utilization under two types of insurance plans; using plausibly exogenous variation in cov-
erage, we document that plans that cover all medical expenses spend more on drugs than plans
that are only responsible for prescription drug spending, consistent with drug spending offset-
ting some medical costs. The effect is driven by drugs that are likely to generate substantial
offsets. Our supply side model confirms that differential incentives across plans can explain this
disparity. Counterfactuals show that the externality created by stand-alone drug plans is 405
million per year. Federal policies cannot internalize the offset effect without harming consumer
welfare.