On the value of a checkup: Adverse selection, moral hazard and the value of information

It is widely held that insurance discourages people from taking diagnostic tests since such tests can turn up information that leads to uninsurability. We develop a model in which some consumers are initially informed of their risk type and others are uninformed, and there is a treatment option. People decide whether to be tested, uninformed insurers offer contracts, and consumers select their contract and chose treatment. We show that testing is encouraged when information status and test results are restricted. Because the private value of information revealed by the test is positive, the uninformed take the test when the subsequent insurance market attains a Rothchild-Stiglitz equilibrium. The positive private Value stems from the treatment option. We also show that the social value of information revealed in diagnostic tests is positive with or without a treatment option. Thus, market mechanisms provide optimal incentives for acquiring hidden knowledge when there is a treatment option.