Mitt Romney and Paul Ryan have proposed a plan to allow private firms to compete with Medicare to provide healthcare to retirees. Beginning in 2023, all retirees would get a payment from the federal government to choose either Medicare or a private plan.  The contribution would be set at the second lowest bid made by any approved plan.

Competition has brought us cheap high definition TVs, personal computers and other electronic goods but it won’t give us cheap healthcare.  The healthcare market is complex because some individuals are more likely to require healthcare than others.  The first point is that as firms target their plans to the healthy, competition is more likely to increase costs than lower them.  David Cutler and Peter Orzag have made this argument.  But there is a second point: the same factors that lead to higher healthcare costs also work against competition between Medicare and private plans.  Unlike producers of HDTVs, private plans will not cut prices to attract more consumers so competition will not reduce the price of Medicare.  A simple example exposes the logic of these two arguments.

Suppose there are two couples, Harry and Louise and Larry and Harriet.  Harry and Louise have a healthy lifestyle and won’t need much healthcare but Larry and Harriet are unhealthy and are likely to require costly treatments in the future.  Let’s say the Medicare price is $25,000/head as this gives Medicare “zero profits”.  Harry and Louise incur much lower costs than this and Larry and Harriet much higher.  Therefore, at the federal contribution, private plans make a profit if they insure Harry and Louise and a loss if they insure Larry and Harriet.  So, private providers will insure the former and reject the latter. Or their plans deliberately exclude medical treatments that Larry and Harriet might need to discourage them from joining.  The overall effect will be to increase healthcare costs. This is because Harry and Louise get premium support of $50,00 total that is greater than the healthcare costs they incur now so they impose higher costs on the federal government than they do currently.  Larry and Harriet will be excluded by the private plans and will get coverage from Medicare.  This will cost more than $50,000 total so there will be no cost savings from them either.  Total costs will be higher than $100,00 as surplus is being handed over to Harry and Louise and their insurance companies.

To deal with this cream-skimming, we might regulate the marketplace.  It might seem to make sense to require open enrollment to all private plans and stipulate that all plans at a minimum have the same benefits as the traditional Medicare plan.  Indeed, the Romney/Ryan plan includes these two regulations.  But this just creates a new problem.

Suppose the Medicare plan and all the private plans are being sold at the same price.  The private plans target marketing at healthy individuals like Harry and Louise and include benefits such as “free” gym membership that are more likely to appeal to them. Hence, they still cream-skim to some extent and achieve a better selection of participants than the traditional public option.  (This is actually the kind of thing that happens in the current Medicare Advantage system. Sarah Kliff has an article about it and Mark Duggan et al have an academic working paper studying Medicare Advantage in some detail.)  So total healthcare costs will again be higher than in the traditional Medicare system.

But there is an additional effect.  Traditional competitive analysis would predict that one private plan or another will undercut the other plans to get more sales and make more profits. This is the process that gives us cheap HDTVs. The hope is that similar price competition should reduce the costs of healthcare. Unfortunately, competition will not work in this way in the healthcare market because of adverse selection.

Going back to our story, if one plan is cheaper than the others priced at say $20,000, it will attract huge interest, both from healthy Harry and Louise but also from unhealthy Larry and Harriet.  After all, by law, it must offer the same minimum basket of benefits as all the other plans.  So everyone will want to choose the cheaper plan because they get same minimum benefits anyway.  Also by law, the plan must accept everyone who applies including Larry and Harriet.  So, while the cheapest plan will get lots of demand, it will attract unhealthy individuals whom the insurer would prefer to exclude – this is adverse selection.  Insurers get a better shot at excluding Larry and Harriet if they keep their price high and dump them on Medicare.  This means profits of private plans might actually be higher if the price is kept high and equal to the other plans and the business strategy focused on ensuring good selection rather than low prices.  An HDTV producer doesn’t face any strange incentives like this– for them a sale is a sale and there is no threat of future costs from bad selection.

So, adverse selection prevents the kind of competition that lowers prices.  The invisible hand of the market cannot reduce costs of provision by replacing the visible hand of the government.

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