The economics of health care and health insurance.

• Author: Schansberg, D. Eric
• Position: Essay

Almost everyone agrees that the status quo in the markets for health care and health insurance is suboptimal with respect to (a) access to health care and health insurance; (b) affordability to individuals and cost to taxpayers; (c) the unfortunate connection of health insurance to employment--and thus, problems with portability; (1) and (d) inequities in the available subsidies. To deal with some of these problems, recent reform efforts--most notably, the Affordable Care Act of 2010 (called "ObamaCare")--have focused almost exclusively on dramatically increasing government involvement. (2)

The political debate on health care and health insurance often begins with the assertion that both now operate as "free markets." (3) This claim is easy to refute by pointing to the proportion of spending in the health care sector by the government and the scope of government regulation in each arena. But it also raises a number of questions about the market for health care--how it currently operates; how it would likely operate with many more regulations; and how it would likely operate in a far less regulated environment. In particular, to what extent do health care and health insurance naturally deviate from the competitive norm?

To address these questions, this paper lays out the theoretical ways in which the markets for health care and health insurance might differ from the competitive model and then weighs the available empirical evidence. In brief, what are the potential difficulties inherent in the provision of health services, and what does the academic literature say about the extent of those concerns in practice?

How Competitive Are the Markets for Health Care and Health Insurance?

The competitive model is the standard by which markets are judged: many buyers and sellers; limited barriers to entry; and reasonable levels and symmetry of information for market participants. Competitive markets typically produce efficient social outcomes. Despite this efficiency, consumers and producers may turn to political markets to distort economic markets in their favor. But here the question is: How far do the market characteristics and outcomes in health care and health insurance naturally deviate from the competitive model?

First, there are many service providers in health care, resulting in a high elasticity of demand for individual physician services. (4) That said, the market for general practitioners and common specialties is more competitive than the market for rarer specialties or hospital services. (5) Likewise, the market for health care services in a city will be more competitive than in a rural setting. (6) But with transportation and communication costs declining substantially over the past thirty to fifty years, this distinction has diminished in importance. Finally, competition is also (naturally) lessened to the extent that consumers perceive health care services to be heterogeneous and are reluctant to change providers.

Second, natural and artificial barriers to entry are significant. A high level of training is required to provide most health care services. Doctor offices can be set up with modest fixed costs, but hospitals have tremendous fixed costs. The American Medical Association is a cartel that limits labor supply--directly in terms of the number of doctors and indirectly by seeking restrictions on other service providers. Even so, the barriers are small enough to generally allow for significant competition between doctors.

In the market for health insurance, consumers have access to relatively few providers. There are significant natural barriers; the endeavor requires substantive start-up costs. But the artificial barriers are also significant because government regulations severely limit the number of insurance providers available to consumers and the terms under which insurance is available. As such, James Robinson (2004) uses the Herfindahl-Hirschman Index and finds significant market concentration rates in the market for health insurance.

That said, David Hyman and William Kovacic write as "anti-trust enforcers" and note that market concentration "does not, standing alone, indicate the presence of problematic (anticompetitive) behavior" (2004, 25). They also question the geographical definition of markets used by Robinson and point to most antitrust complainants' self-interested pursuit. Nevertheless, a less-regulated insurance market would clearly result in lower overhead costs, more health insurance providers, and increasing competition.

Third, we call draw inferences about the level of competition from profitability. Health insurance companies in particular have received withering criticism about their profits along with the claim that these profits can explain runaway health care costs. In fact, however, health insurance profits are quite modest. Because health insurance companies are large, their profit levels are impressive in dollar terms, but their rates of return are unexceptionable in percentage terms (4.52 percent for the ten largest companies from 2010 to 2012). (7) And even if the rates of return were much higher, they certainly could not explain chronically increasing health care costs. (8)

Information Problems

Profound information limitations or significant information asymmetries can challenge the equity and efficiency of market outcomes. Information problems can lead to a range of inadvertent inefficiencies and purposeful shenanigans. (9) In this, they are akin to monopoly power in that one party can use its superior knowledge to take advantage of another party. As for the provision of health care and health insurance by markets, there is particular concern about the "moral-hazard" problem and "adverse selection" as subsets of asymmetric information. (10)

Let's start by noting that "public" information can be "difficult." For example, if an insurer knows that I have a chronic health condition, it will want to charge me a higher premium to compensate for the higher expected costs. Or if it is known that a hospital does a poor job in treating a certain condition, then patients will be more reluctant to trust their care to that provider.

From an objective view, however, the more troubling issue is "private" information--information held by one party but not available to another. For example, doctors generally know much more about health than patients. Moreover, health care knowledge may often be difficult for consumers to "learn by doing" and may not be commonly conveyed to other consumers. Kenneth Arrow (1963) points to ethical restrictions on doctors and the importance of generalized trust in the profession. Beyond that, reputations convey information about service providers and allow some level of market discipline (Satterthwaite 1979; Pauly and Satterthwaite 1981).

Consumers still face an information disadvantage in this realm, but the gap has narrowed in recent years, especially with the easy availability of low-cost information through the Internet. Beyond that, consumers face similar disadvantages in other markets and are generally capable of using market signals and relatively low- cost information to navigate markets without systematic abuse.

In terms of health insurance, patients generally know more than insurance providers about their health going into the contract and even within the contract. Insurers have a strong incentive to close this gap, but such efforts are themselves imperfect and costly. (11)

This information asymmetry, precontract, can lead to "adverse selection." For example, all things equal, I am more likely to pursue insurance if there is a higher probability that I will rely on that insurance. (12) This information asymmetry, postcontract, can also lead to the moral-hazard problem. For example, I am more likely to behave in a way that will trigger an insurance payment once I have the insurance in hand. My incentives are changed in a way not easily monitored and enforced by the insurer. Both the adverse-selection and moral-hazard problems can put insurers in a difficult position and make it important for them to find low-cost information and monitoring devices to limit these concerns and mitigate the subsequent costs.

Liran Einav and Amy Finkelstein note that "adverse selection exists in some markets but not in others" (2011, 115). They provide an excellent overview of the "textbook model" of adverse selection in insurance, noting the policy prescriptions that obtain: mandating coverage, subsidizing insurance, or community ratings. Then they add administrative costs and heterogeneous preferences for risk to the model, resulting in the potential for overinsurance from these public policies. Finally, they extend the model to describe the potential for "advantageous selection," where preferences for risk aversion may align with preferences for more health care services, mitigating or even offsetting adverse selection. In addition to the theoretical existence of advantageous selection, they document its empirical existence in insurance for automobiles, long-term care, reverse mortgages, and health care. (13)

Doctors also know more than insurers about the health care they provide, which presents another difficulty for insurers. This difficulty relates to the potential for deception--in reporting billing codes, pursuing higher-quality but socially inefficient care, using self-referrals and being involved in conflicts of interest, and practicing "defensive medicine." (14)

Concerns about all of this imply that health insurance would ideally be available but quite limited in scope. (15) Two contexts for insurance seem by far the most attractive: (1) costly but rare outcomes and (2) inexpensive and regular but beneficial preventative treatments. In the first case, consumers of health care in "catastrophic" cases will be less responsive to price and less able to exploit their information advantage (at least within the contract). (16) In the second...