The authors derive optimal insurance for patients and payment method for physicians when neither the input decided by the patient (quantity of treatment) nor the input decided by the physician (effort) are contractible. The equilibrium in this third-best regime may sometimes be second best, in which both the physician input and the report of treatment are verifiable. Otherwise, truthful reporting forces a third best, characterized by provider 'prospective payment' and suboptimal effort, while consumers' demand becomes excessive. The authors also analyze how 'professional ethics' alters the equilibrium. Finally, collusive reporting mechanisms imply more stringent constraints, while competition among physicians relaxes them. Copyright 1997 by American Economic Association.
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