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November 14, 2005
Paul Krugman: Health Economics 101.
Paul Krugman today gives us the simple answers to simple questions about health economics.I have to admit that while I understand his points I don’t think they point to the conclusion he desires.
He points to adverse selection which is indeed a problem with health insurance. However, it’s also a problem with any form of insurance. To say "adverse selection means we need a government run health system" is, as far as I can see, equivalent to stating that "adverse selection means we need a government run insurance system for everything". Perhaps someone can enlighten me as to why this is incorrect, if indeed it is?
Tax breaks to employer funded health insurance, yes, stupid. Abolish that for sure. But again, that doesn’t mean that the US has to have a single payer system, just that it might want to stop subsidizing the current one.
He also notes that 50% of health expenditures go on 5% of Americans, those unlucky enough to be severely ill. That might lead to Arnold Kling’s preferred solution, catastrophic care insurance, whether mandatory, standardised or governmental, but again, it’s hard to see it as proving the necessity of a single payer system along the lines of the NHS or Verterans Administration, things that Krugman has pointed to as desirable before.
Tag paul krugman
Several readers have asked me a good question: we rely
on free markets to deliver most goods and services, so
why shouldn't we do the same thing for health care?
Some correspondents were belligerent, others honestly
curious. Either way, they deserve an answer.
It comes down to three things: risk, selection and
social justice.
First, about risk: in any given year, a small fraction
of the population accounts for the bulk of medical
expenses. In 2002 a mere 5 percent of Americans
incurred almost half of U.S. medical costs. If you
find yourself one of the unlucky 5 percent, your
medical expenses will be crushing, unless you're very
wealthy -- or you have good insurance.
But good insurance is hard to come by, because private
markets for health insurance suffer from a severe case
of the economic problem known as ''adverse
selection,'' in which bad risks drive out good.
To understand adverse selection, imagine what would
happen if there were only one health insurance
company, and everyone was required to buy the same
insurance policy. In that case, the insurance company
could charge a price reflecting the medical costs of
the average American, plus a small extra charge for
administrative expenses.
But in the real insurance market, a company that
offered such a policy to anyone who wanted it would
lose money hand over fist. Healthy people, who don't
expect to face high medical bills, would go elsewhere,
or go without insurance. Meanwhile, those who bought
the policy would be a self-selected group of people
likely to have high medical costs. And if the company
responded to this selection bias by charging a higher
price for insurance, it would drive away even more
healthy people.
That's why insurance companies don't offer a standard
health insurance policy, available to anyone willing
to buy it. Instead, they devote a lot of effort and
money to screening applicants, selling insurance only
to those considered unlikely to have high costs, while
rejecting those with pre-existing conditions or other
indicators of high future expenses.
This screening process is the main reason private
health insurers spend a much higher share of their
revenue on administrative costs than do government
insurance programs like Medicare, which doesn't try to
screen anyone out. That is, private insurance
companies spend large sums not on providing medical
care, but on denying insurance to those who need it
most.
What happens to those denied coverage? Citizens of
advanced countries -- the United States included --
don't believe that their fellow citizens should be
denied essential health care because they can't afford
it. And this belief in social justice gets translated
into action, however imperfectly. Some of those unable
to get private health insurance are covered by
Medicaid. Others receive ''uncompensated'' treatment,
which ends up being paid for either by the government
or by higher medical bills for the insured. So we have
a huge private health care bureaucracy whose main
purpose is, in effect, to pass the buck to taxpayers.
At this point some readers may object that I'm
painting too dark a picture. After all, most Americans
too young to receive Medicare do have private health
insurance. So does the free market work better than
I've suggested? No: to the extent that we do have a
working system of private health insurance, it's the
result of huge though hidden subsidies.
Private health insurance in America comes almost
entirely in the form of employment-based coverage:
insurance provided by corporations as part of their
pay packages. The key to this coverage is the fact
that compensation in the form of health benefits, as
opposed to wages, isn't taxed. One recent study
suggests that this tax subsidy may be as large as $190
billion per year. And even with this subsidy,
employment-based coverage is in rapid decline.
I'm not an opponent of markets. On the contrary, I've
spent a lot of my career defending their virtues. But
the fact is that the free market doesn't work for
health insurance, and never did. All we ever had was a
patchwork, semiprivate system supported by large
government subsidies.
That system is now failing. And a rigid belief that
markets are always superior to government programs --
a belief that ignores basic economics as well as
experience -- stands in the way of rational thinking
about what should replace it.
November 14, 2005 in Health Care | Permalink
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Comments
I think that we should dispense up front with the notion that there is a clear cut way of determining "how chronic" problems should be before we suggest collective provision as an alternative to private provision. Markets for health care are very complex. The OECD has some interesting recent working papers on comparative performance of different systems - accessible on-line.
All insurance markets suffer information problems (moral hazard, adverse selection etc), but the essence of Krugman's position is that these problems are so acute in the health sector that private markets are so chronically inefficient that government risk pooling would be better. A useful academic reference on the sources of inefficiencies in the market for health insurance is Kenneth Arrows old, but very good paper "Uncertainty and the Welfare Economics of Medical Care”. Its very readable and provides a good catalogue of the reasons why markets for health insurance have particularly chronic information problems compared to other markets.
As Krugman notes, the nature of private insurance markets is to try to guauge risk accurately and charge appropriate premiums. As the difference in costs between healthy and ill people is big, firms providing insurance have a big incentive to go very far to assess these likelihoods and screen out bad risks. So there are expensive administration costs. Overheads.
The "benefit" of all this admin/screening is to widen differentials in premiums between those likely to become ill and those less likely to become ill. So it widens spreads in the market. But as peoples tendency to become ill is not so price sensitive, the effect of this greater price dispersion on overall efficiency is limited. In other words, the screening and admin costs are pretty much add-ons - deadweight losses - when you look at the system as a whole. Because in the end someone picks up the tab for treating the ill anyway - all the screening really does is determine who it will be. Better to dispense with all this - so the argument goes - and just average across the market (roughly speaking) via some form of collective provision.
A second argument for collective provision is that if the screening is highly effective, it would lead to some people either not getting insurance at all (those with chronic or terminal illness) or only getting it at premiums that are prohibitive. The idea is that the private sector - quite naturally - will aim to cherry pick the good risks. Because one does not generally choose chronic illness, so the argument goes, this is an undesirable distributional impact. Collective provision allows insurance or treatment of such people where the market would not, or would do so only at prohibitive prices.
People who advocate some form of collective provision sometimes do so for efficiency reasons , but just as often - perhaps more often - it is put forward for equity reasons - the precise balance depending on the commentator. The precise rationale is hard to distinguish at times, because in markets for health the two things are very often jointly determined. The US market driven system has very high standards at the top end, but is not particularly cost effective on average. The result is that many can't afford full coverage. So - the "best in the world" for some. Not so good for a lot of others. Krugman picks up on both the cost effectiveness and distributional aspects in his missive. Which he cares more about I dunno.
Posted by: rjw | Nov 14, 2005 4:00:48 PM
Adverse selection is a much more important problem for medical insurance than, say, motor insurance
or property insurance.
The medical insurer is at huge risk of someone who has a condition, or knows that he is very likely to get it, obtaining insurance.
The insurer has to screen such people out. This imposes extra costs on the system, for medicals etc. They also will generally not cover chronic conditions, so there has to be another healthcare provider who does this.
The same situation does not arise with other insurance. While people know they might be high risk drivers, or live in a bad area, there is no equivalent of the pre-existing condition.
A further problem with medical insurance is that a market can only operate for healthy people.
Ill people cannot change policy, as they cannot obtain new cover.
Market incentives, thus, do not operate towards providing the insurance products that most users
would like.
This is not in the least surprising-it often happens in markets where there is asymmetric information.
James C
Posted by: james C | Nov 16, 2005 9:38:36 AM
