Obama is considering a “public option” in healthcare reform. The idea is that everyone will have the right to sign up with a public non-profit entrant in the health insurance market. This is meant into create more competition in the marketplace and drive down premiums for private health plans. The case for the public option is more subtle than I initially thought.
Here is my argument:
(1) Suppose there is free entry into the healthcare market. Then prices are close to marginal cost for private healthcare organizations so the public option only increases welfare if it has a lower cost. This means in this case the public option has to be more cost effective than the private firms to make the case for entry. There is some lively debate about whether this is actually the case!
But one might say there are entry barriers as a new firm would have to set up a network of doctors, hospitals etc which will be costly and hence prohibit entry. So:
(2) Suppose there are entry barriers and existing firms are playing an oligopolistic equilibrium. This equilibrium might even include implicit collusion at prices well above cost. Even if firms make profits, there will have to ensure that a new entrant cannot enter and make profits. There are two subcases
(a) The costs of the potential entrant put an upper bound on profits that can be made by the incumbents. Then, the public option has to have lower costs than the potential entrant for it to make sense. This cost is higher than that of incumbents but still has to be lower than potential entrants – so there is still has to be some efficiency advantage to the public option.
(b) The costs of the potential entrant do not put an upper bound on the prices charged by incumbents. This is because incumbents are deterring entry by the threat of a price war should entry occur. So quite efficient potential entrants are staying out – they could make profits if entry leads to a non-price-war equilibrium but not otherwise. In this case, the public option can be more inefficient even than the potential entrant, price at its costs and act as an upper bound on the prices that can be charged by incumbents.
Is there any evidence we are in case 2b rather than 2a? Also, the public option effectively acts as a price ceiling on incumbents. A price ceiling can be implemented without the public option. Not sure which intervention is more politically feasible.
Cheap Talk 
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July 9, 2009 at 12:02 pm
Alex
I can see the logic in thinking 2b is the case when we’re talking about health insurance. I think a key factor for this market in particular is that people will tend to stick with what they have. If a business is choosing between keeping their current health insurance plan and switching to another plan and they are both the same price, they will stick with the current plan rather than go through the hassle of switching. This means that should there be a price war, not only will the entrant not make any profits, they will make nothing (or close to it) because everybody will stick with their current plan.
In theory this would make the time that the entrant could stay in the market (should they try) even shorter and thus the threat is more credible since the entrant would be forced out of the market very quickly and the incumbents could all raise their prices again in a very short time.
As far as the public option versus a price ceiling goes, the public option is probably more politically feasible. The insurance lobby will fight against either. Conservatives have both an ideological opposition to government run services and price ceilings so they will oppose both as well. Deficit hawks will probably be neutral to both options and are mostly concerned with how much money we spend (or don’t spend) subsidizing insurance for low income people.
The key difference is that liberals have an ideological preference for the public option over a price ceiling. They will get behind a public option with great enthusiasm and will probably be lukewarm to the price ceiling.
July 9, 2009 at 6:08 pm
jhe
I’m not sure you’re looking at price competition here. From what I can tell, the market is not one oligopoly, but 50 state-sized ones. There are also markets within that.
One market is driven by firms with a set of highly-valued employees with relatively high compensation. Even if there are less valued employees in the firm, the highly-valued ones will drive the choice of a health plan.
The second market is firms largely employing less valued, less well-compensated employees. Third is small business and individual buyers. The second and third are cost conscious.
Health insurers design plans around all three. My guess is that the first type of firm has an ‘up or out’ structure and tends to skew younger, the second type probably has higher health costs and is less likely to fight for individual employees. The small firms have little or no bargaining position.
Firms compete for the first type of firm and compete only for the lower cost firms of the third type and pull stunts like recision on the second type of firm. Entering a market, you’re going to get the leavings from the other firms. You’re not going to have the credibility or the local knowledge to close the firms of the first type. Really, it’s about the size of the table scraps, not the threat of price competition keeping firms out.
Community rating and an end to pre-existing condition screens might tend to make the existing oligopoly players even more skittish about taking on higher risk populations (e.g., older people and women of child-bearing age). That’s where the public option comes in. It picks up the people likely to have expensive procedures and justifies subsidies because it’s insuring the actually sick and can show comparable cost-per-procedure numbers. It’s the one that’s actually, you know, insurance as opposed to just claims processing.