We consider two-part pricing of a service offered to risk-averse buyers subject to independent demand uncertainty. Buyers subscribe to the service before the uncertainty resolves. Vendors maximize profit by balancing between insuring buyers against the uncertainty and reducing ex-post deadweight loss. We introduce the concepts of felicitous goods, for which the total and marginal benefits are positively correlated, and distress goods, for which the total and marginal benefits are negatively correlated. The profit-maximizing two-part price includes a usage charge greater than the marginal cost of service for felicitous goods, while the usage charge is less than the marginal cost for distress goods. We discuss how our analytical model could improve pricing practices in the IT services outsourcing industry. Further, using the Zagat Survey, we tested our analytical predictions on pricing by New York restaurants. For two diners on their first date, a major uncertainty is whether they would like each other. If they do, they would prolong the meal by ordering appetizer, soup, and dessert, while if not, they might just do with a main course. We found that, among “singles scene ” and “romantic ” restaurants, the prices of appetizer, soup, and dessert were 6-20 % higher relative to main courses than among “business dining ” restaurants. This is not consistent with alternative explanations of restaurant pricing.

We consider two-part pricing of a service offered to risk-averse buyers subject to independent demand uncertainty. Buyers subscribe to the service before the uncertainty resolves. Vendors maximize profit by balancing between insuring buyers against the uncertainty and reducing ex-post deadweight loss. If demand is uncertain, the profit-maximizing two-part price includes a usage charge greater than the marginal cost of service. If buyers are subject to sufficiently large exogenous losses and demand is uncertain, the usage charge should be less than the marginal cost. The higher the buyers ’ degree of risk aversion, the greater should be the difference between the usage charge and marginal cost. We discuss how our analytical results could improve pricing practices in IT services outsourcing and bank lines of credit. Further, using the Zagat Survey, we tested our analytical predictions on pricing by New York restaurants. For two diners on their first date, a major uncertainty is whether they would like each other. If they do, they would prolong the meal by ordering dessert, while if not, they might just do with a main course. We found that prices of desserts were relatively higher in “singles scene ” than “business dining” restaurants. This disparity was not consistent with various alternative explanations of restaurant pricing.

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Summer Institute and Stanford GSB for helpful comments. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

We are grateful to the National Institute on Aging for funding (1R01AG021940). For many helpful comments and suggestions, we thank seminar participants at the 2007 NBER Summer Institute Health Care session. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.

This paper applies ideas from mechanism design to model procurement of prescription drugs. We present a mechanism for government-funded market-driven drug procurement that achieves very close to full static efficiency – all members have access to all but at most a single drug – without distorting incentives for innovation. Prescription drugs are an essential component of modern healthcare. In the U.S. drug spending has skyrocketed in recent years – while in 1980 it amounted to $12 billion, less than 5 % of total health care expenditures, in 2006 that number has increased to $216.7 billion, over 12 % of total expenditures. The Center for Medicare and Medicaid Services (CMS) currently projects drug spending to rise to $446.2 billion in 2015, approximately 2.2 % of projected U.S. GDP. 1 Those statistics suggest that even minor efficiency improvements in the drug procurement process can lead to significant welfare gains. Lessons learned from markets for typical healthcare services such as doctor consultations and hospital stays are largely not applicable to markets for prescription drugs. In contrast

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Dan Wood for excellent research assistance. We are grateful for the medical expertise of Scott Lee, who directed the effort to code risk heterogeneity for diseases in our sample. We are especially indebted to the editors and referees for extensive suggestions which substantially improved the paper. Snyder gratefully acknowledges funding for research assistants provided by the Dartmouth College Presidential Scholars Program. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

It is well known that pooled insurance coverage can induce a form of ex-ante moral hazard: people make ine ¢ ciently low investments in self-protective activities. This pa-per identi…es another ex-ante moral hazard that runs in the opposite direction: it causes people to choose ine ¢ ciently high levels of self-protection. This other ex-ante moral hazard arises through the impact that self-protective activities have on the reward for innovation. Lower levels of self-protection and the associated chronic conditions and behavioral patterns such as obesity, smoking, and malnutrition increase the incidence of many diseases for an individual. This increases the individuals consumption of treatments to those diseases, which increases the reward for innovation that an innova-tor receives. By the induced innovation hypothesis, which has broad empirical support, the increase in the reward for innovation in turn increases the rate of innovation, which bene ts all consumers. As individuals do not take these positive externalities on the innovator and other consumers into account when deciding the level of self-protective activities, they each invest an ine ¢ ciently high level in self-protective activities. In the quantitative part of our analysis we show that for obesity the magnitude of this positive innovation externality roughly coincides with the magnitude of the negative Medicare-induced health insurance externality of obesity. The other ex-ante moral hazard that we identify can thus be as important as the ex-ante moral hazard that has been a central concept in health economics for decades. The quantitative …nding also implies that the current Medicare-induced subsidy for obesity is approximately opti-mal. Thus the presence of this obesity subsidy is not a su ¢ cient rationale for soda taxes, fat taxesor other penalties on obesity.