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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September 17, 2012 at 11:13 am
Systemic Disorder
The object of a for-profit company in the healthcare industry is to make a profit, so we should not surprised that making a profit will become the ultimate object of the healthcare company. Maximizing returns for the shareholders is the legal requirement of a publicly traded healthcare company, the same as a company in any other business.
An interesting side of this debate is that government-run healthcare systems are more efficient than private healthcare companies: http://wp.me/p2cpPS-2d. An interesting study published in the Journal of the Canadian Medical Association found that the U.S. and Canadian Medicare systems had a far lower overhead than did HMOs. No surprise there, since Medicare doesn’t have to generate giant profits for Wall Street or giant bonuses for the executives.
September 17, 2012 at 11:16 am
Anonymous
where is jeff holidaying
September 17, 2012 at 11:34 am
foosion
Competition may help, but the real issue in healthcare versus HD TVs (or whatever) is that high profits lead to more supply in the case of TVs, but the supply of healthcare providers is artificially limited.
Doctors are insulated from competition by licensing restrictions and the limited supply of acceptable medical schools, pharma companies are insulated from competition by patent regulation, etc., etc.
If we didn’t have these limits on supply, then competition would do its usual job of reducing prices.
September 18, 2012 at 8:39 am
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September 18, 2012 at 3:31 pm
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September 18, 2012 at 4:47 pm
ezra abrams
the second paragraph is poorly written; the “simple example” sentance should be the lead for the paragraph
November 30, 2012 at 4:16 pm
Adam
I wouldn’t mind panyig my health care contributions with after tax dollars, and thus eliminating the government subsidization of my health care benefits. But taxing the entire thing as income is excessive. I think we should level the playing field, not sow it with land mines. My wife and I together pay about $ 160/month for awesome insurance, and we have a flexible reimbursement account that allows us to set aside $ 100/month pre-tax for expenses like co-pays and over the counter drugs. That means we wind up saving around 23% for the year as opposed to panyig with after tax dollars. People without employer based health insurance don’t have that option, making it a government subsidy. So get rid of that aspect, but if my entire plan were taxed as income I couldn’t afford it. And I know a lot of other people who couldn’t as well. That’s a cure worse than the problem.
September 18, 2012 at 4:50 pm
mulp
In what universe has lower prices for HDTV reduced the spending on HDTVs?
Lower HDTV prices has not lowered prices on tube TVs but tube TV spending has cratered and must be near zero.
Competition by HDTV suppliers who seem to be outside the US has destroyed the tube TV suppliers who largely originated in the US.
Perhaps Asian economists understand microeconomics, while US economists must undergo a mind wipe to remove microeconomic theory from their brains to be politically correct.
Competition in a free market will increase the total production and consumption of goods if the competitors are successful. They will be do so by doing everything possible to divert spending on consumption from one set of goods and services to their goods and services to increase the total spending in their market segment.
Further, economists argue that competition increases the total production and consumption and spending and costs because competition and free markets are not zero sum.
Why can’t economists get economics right in America any more? Conservative dogma rejecting reality??
September 19, 2012 at 12:17 am
Why Competition Will Not Reduce The Price Of Medicare « Cheap Talk « mawillits
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September 19, 2012 at 1:11 am
nylund
Here’s an imperfect analogy with HDTV’s that adds a future cost with bad selection issues. Imagine a law was passed saying that if your HDTV was stolen, the manufacturer has to replace it for free. It won’t take long before HDTV makers realize that theft is correlated with poor neighborhoods where residents don’t have money. Their incentive will be to raise the prices of their TV to discourage those most likely to have their TV stolen from buying their TV’s in the first place. Anyone who tries to undercut them will end up selling to the high-theft-risk market and eventually lose money. The TV manufacturers will compete on quality, not price, to get those high end buyers. In equilibrium, only high quality, high priced TV’s will be left. It’ll be great for those who can afford them, but bad for those who can’t, and it surely won’t lower prices.
You could further complete this analogy by adding a “minimum quality” standard to the TV’s (which would then remove the incentive to create really crappy, essentially disposable TV’s that the manufacturer may still be willing to sell to high-theft-risk buyers).
September 19, 2012 at 10:17 am
MDaly
great analogy actually.
September 19, 2012 at 4:42 am
Joe Jones
Let me paraphrase the article: Because government control over healthcare occurs at the federal, state and local level loosening the federal controls will not lower the price of medicare.
The article is too narrow – both in subject and in scope.
September 21, 2012 at 3:06 am
Competition Will Not Reduce The Price Of Medicare | FavStocks
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September 22, 2012 at 3:58 am
DavidN
Great post. Helps an non-American understand the economics behind US healthcare debate a lot better.