The impact of consumer inattention on insurer pricing in the Medicare Part D program

• Published date: 01 December 2017
• DOI: http://doi.org/10.1111/1756-2171.12207
• Author: Fiona Scott Morton,Kate Ho,Joseph Hogan
• Date: 01 December 2017

RAND Journal of Economics

Vol.48, No. 4, Winter 2017

pp. 877–905

The impact of consumer inattention on

insurer pricing in the Medicare Part D

program

Kate Ho∗

Joseph Hogan∗∗

and

Fiona Scott Morton∗∗∗

The Medicare Part D program relies on consumer choice to provide insurers with incentives to

offer low-priced, high-quality pharmaceutical insurance plans. We demonstrate that consumers

switch plans infrequently and search imperfectly. We estimate a model of consumer plan choice

with inattentive consumers and show that high observed premiums are consistent with insurers

profiting from consumer inertia. We estimate the reduction in steady state plan premiums if all

consumers were attentive. An average consumer could save $1050 over three years; government

savings in the same period could amount to $1.3 billion or 1% of the cost of subsidizing the

relevant enrollees.

1. Introduction and motivation

The addition of pharmaceutical benefits to Medicare in 2006 was the largest expansion to

the Medicare program since its inception. Not only is the program large, it is also innovative in

design. Traditional Medicare Parts A and B are organized as a single-payer system; enrollees see

the physician or hospital of their choice and Medicare pays a preset fee to that provider, leaving no

role for an insurer. In contrast, Part D benefits are provided by private insurance companies that

receive a subsidy from the government as well as payments from their enrollees. The legislation

creates competition among plans for the business of enrollees, which is intended to drive drug

prices and premiums to competitive levels. Each Medicare recipient can choose among the plans

offered in her area based on monthly premiums, deductibles, plan formularies, out-of-pocket

∗Columbia University and NBER; kh2214@columbia.edu.

∗∗Columbia University; jph2154@columbia.edu.

∗∗∗Yale University and NBER; fiona.scottmorton@yale.edu.

Wethank Mark Duggan, Liran Einav,Gautam Gowrisankaran, Ben Handel, Robin Lee, Bentley MacLeod, AvivNevo, Eric

Johnson, and participants at numerous seminars and conferences for helpful comments. We especially thank Francesco

Decarolis for sharing his data with us. All errors are our own.

C2017, The RAND Corporation. 877

878 / THE RAND JOURNAL OF ECONOMICS

costs (OOP costs or copayments) for drugs, and other factors, such as the brand of the insurer

and the quality of customer service.

The premise of the Part D program was that consumers’ ability to choose their preferred plan

would discipline insurers into providing lower prices and higher quality than would be achieved

through a government-run plan. Critically, these better outcomes require that consumers choose

effectively, so that demand shifts to plans that consumers prefer because they offer low prices or

high quality. If consumers choose plans randomly, a plan will have no incentive to lower its price

because this will not affect enrollment, and markups will be high. In contrast, if many consumers

choose to enroll in a plan that lowers its price, markups will fall as firms offer lower premiums to

consumers.

This article compares Part D plan pricing when some consumers are inattentive to the case

when all consumers are attentive. We demonstrate that, in reality, consumer choices are made

with substantial frictions. Consumers rarely switch between plans and do not consistently shop

for price and quality when they do switch. We provide evidence that, because of the absence

of strong disciplining pressures from consumers, insurers set prices above the level they would

choose if all consumers were attentive.Thus, plans extract high rents due to consumer inattention.

Not only would improved consumer search benefit consumers directly, it would also lead to plan

repricing that would save both consumers and the government significant sums. Our estimates

indicate that removing inattention and allowing prices to adjust while leaving other sources of

consumer preferences unchanged could reduce consumer expenditures by over$1000 per enrollee

over the three years 2007–2009. Under our assumptions, government program costs would fall by

$1.3 billion overthe same period due to plan repricing. We find that the insurer response—lowering

premiums—results in significant savings to both enrollees and taxpayers.

One concern when Part D began was that the prices the plans paid for drugs would rise be-

cause plans would lack the bargaining power of the government. Duggan and Scott Morton (2010)

demonstrate that this did not happen. Rather, prices for treatments bought by the uninsured elderly

fell by 20% when they joined Part D. Since the program’s inception, increases in pharmaceutical

prices have been restrained. This is due in part to aggressive use of generics by manyinsurers, but

also to insurers’ ability to bargain for rebates in exchange for favorable formulary placement and

therefore market share. According to Congressional Budget Office (CBO) estimates, drug costs

under the basic Part D benefit increased by only 1.8% per beneficiary from 2007–2010 net of

rebates. The remainder of plan expenditures—approximately 20% of total costs according to the

CBO—consists of administration, marketing, customer service, and like activities. The Personal

Consumption Expenditures (PCE) deflator for services during this same time period increased at

an average annual rate of 2.40%. Yet, despite these modest increases in the costs of providing a

Part D plan, premiums in our data were on average 62.8% higher in 2009 than they were in 2006,

the first year of the program, which corresponds to a 17.6% compound annual growth rate. The

CBO estimates indicate that plan profits and administrative expenses per beneficiary (combined)

grew at an average rage of 8.6% per year from 2007 to 2010.

These figures raise the question of why slow growth in the costs of drugs and plan admin-

istration were not passed back to consumers in the form of lower premiums. One possibility is

that Part D may be well designed to create competition among treatments that keeps the prices

of drugs low yet may not do so well at creating competition among plans in order to restrain the

prices consumers face. Because the program is 75% subsidized by the federal government, any

lack of effective competition wouldincrease government expenditures as well as consumer costs.

Our objective in this article is to investigate the extent to which consumer choice imperfections

in this market impede competition between plans.

Section 2 of the article describes the Medicare Part D program and discusses reasons for

search imperfections. In Sections 3 and 4, we review the literature related to consumer demand

with choice frictions, in Medicare Part D and elsewhere, and the dynamics of pricing in that

environment. In Section 5, we describe our data set, which provides detailed information on

the choices and claims of nonsubsidized enrollees in New Jersey. In Section 6, we observe that

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The RAND Corporation 2017.