Public Option Compromise: Size Matters
Robert Reich has an interesting post today on the Senate public option compromise. First he reminds readers that the compromise includes (1) an expansion of Medicare for certain individuals without employer coverage and 55-64 years of age and (2) for younger individuals a system of private plans modeled on that available for federal employees (details in this NY Times article). Then Reich writes that
we still end up with a system that’s based on private insurers that have no incentive whatsoever to control their costs or the costs of pharmaceutical companies and medical providers. If you think the federal employee benefit plan is an answer to this, think again. Its premiums increased nearly 9 percent this year. And if you think an expanded Medicare is the answer, you’re smoking medical marijuana. The Senate bill allows an independent commission to hold back Medicare costs only if Medicare spending is rising faster than total health spending. So if health spending is soaring because private insurers have no incentive to control it, we’re all out of luck. Medicare explodes as well.
I agree with all that. However, Reich then goes on to explain that private insurers can’t control costs because they’re too consolidated. This actually doesn’t make much sense. Insurers, while apparently great fun to beat up on, are not the big problem. Providers are.
Though it is true that insurers with higher market power can charge higher premiums, they also obtain lower prices from providers. The optimal balance of power that results in the lowest premiums is not one in which insurers are weakest. In fact, insurers need a certain level of market power just to offset that of providers.
As I’ve written before, the vast majority of money flowing through private insurers ends up in the hands of providers. If one wants to address the health care cost problem one should follow the money to hospitals and doctors–to the prices they charge and the volume of ineffective services they provide. It is by no means certain that increased competition among insurers leads to lower prices.
That’s not to say insurers can’t play an important role. They can. The solution to taming health care costs is to provide incentives that will encourage insurers to pay providers differently, to pay for efficiency and quality, not volume. It will take reasonably powerful insurers to impose such a system on providers. The first type of insurer likely to do so is the big public one, Medicare. That there is any hope of success in this is due to the power Medicare wields from its size, which will be even larger (albeit by only a little) under the new compromise (hence the provider backlash).
To the extent that private plans can follow Medicare’s lead will be determined in large part by their market power. Blindly weakening insurers may throw the baby out with the bathwater. Of course, we haven’t even begun to fill the tub.
Later: Ezra Klein expresses similar ideas in a must read post today.
Health Care Costs and Market-Theory: Provider Network Externality
Sick of reading posts about market theory and health care costs? If so, skip this one and read this alternative post from the archives. It has nothing to do with health care costs or market theory.
Meanwhile, I’m obsessed with what market theory can tell us about health care costs. It’s a good thing because it’s my job (or part of it). Anyway, let’s revisit my favorite graph, which you might recall from prior posts on this topic. It illustrates how I think insurer market concentration relates to premiums (or health care costs in general), holding health care provider concentration fixed (the curve shifts up (down) for higher (lower) provider concentration).
While this graph explains a lot, it doesn’t explain everything. In particular it abstracts away the role played by what the insurers actually provide for the premium charged. The curve is for the average standardized premium, which means all the variations in benefit packages offered by insurers are taken into account or controlled for, adjusting the premium accordingly.
Of course benefits matter for enrollment, which is the source of insurer market power. The greater number of enrollees, the greater the power of the insurer. Most benefits are of the form “such-and-such is covered for a copayment of thus-and-so.” But one benefit is of a different flavor than all the rest. That benefit is the provider network.
The provider network is the set of providers to which policyholders have access through the insurer. Go outside that network and you’re not covered; you have to pay for the service entirely out of pocket. Of course the establishment of the provider network of an insurer is relevant to the market power of providers and the insurer. The negotiation over rates–payments from the insurer to providers for their services–includes the possibility of exclusion from the network. For a sufficient rate of pay providers will want to be in the network to have access to the volume of patients the insurer can deliver. At the same time, the insurer is only willing to pay so much to a given provider: more for a dominant provider, less for a small player.
What distinguishes the provider network from other benefits is that it exerts a positive externality on policyholders. This type of inter-group network externality is the defining feature of a two-sided market. The greater the number of providers in an insurer’s network, the more a consumer will pay that insurer for access. All other things equal, consumers like access to more providers. They’ll pay a higher premium for such access.
This (two-sided) market-theoretic aspect of health care costs is not reflected in the figure above, nor is it reflected in most theoretical motivation or empirical specification of analysis of health care markets in the literature. This is not a surprise. The foundational work on this is brand new.
Has Additional Insurer Consolidation Increased Premiums?
Leemore Dafny, with colleagues Mark Duggan and Subramaniam Ramanarayanan, has produced yet another fascinating paper on consolidation in the health insurance industry (I mentioned another of her papers in this area in a prior post). Their latest, “Paying a Premium on Your Premium? Consolidation in the U.S. Health Insurance Industry” (NBER, October 2009) examines the effect of health insurer consolidation on premiums and health care workers’ employment and earnings.
Three of the authors’ main results are that due increases in insurer concentration: (1) Between 1998 and 2006 premiums increased 2.1 percent. (2) Between 1999 and 2002 physician earnings declined by 2 percent. And (3) over the same period health worker employment declined 2.4 percent. Let’s put these results in context.
Recall the figure I introduced in an earlier post and reproduced below. It illustrates my hypothesis about the effect of insurer concentration on premiums, for a fixed level of provider market power. In the region in which insurers have a high degree of concentration (around point “C”), I would expect additional concentration to lead to higher premiums. This is exactly what Dafny and colleagues found.
Moreover, the authors find that the additional market power held by insurers not only led to premium increases, it also led to a reduction of input prices (physician salaries) and employment (a signal of reduced demand). The first of these phenomena is consistent with monopolistic behavior while the latter two are consistent with that of a monopsonist.
In brief, the findings suggest excessive insurer market power relative to providers. But how excessive is it? That is, is the market operating closer to point “C” or to point “B”? We don’t know, but a related piece of evidence is that over the time period of the study premiums increased 100%. So the measured effect of insurer concentration on premiums–a 2.1% increase–is quite small relative to the overall increase in premiums and the degree of increase in concentration in the insurance market (the fraction of the market deemed “highly concentrated” rose from 68% to 99% in the study period).
Whether the market was operating closer to point “B” or “C,” the slope of the curve in the region it was operating is modest. Despite the large increase in concentration, the vast majority, about 98%, of the observed increase in premiums was due to other factors, including additional provider concentration, medical technology, increased consumer demand, and so on. This suggests that additional insurer concentration is not an important factor relative to all others. Note that this is a result on the change (the additional) market concentration and says nothing about the level.
Can we therefore conclude that insurer concentration is not a substantial factor in premium inflation? That would be going a bit too far. After all, this study, like all studies, has limitations. It is beyond the scope of this post to go into them but there are several reasons why the results may not be generalizable to the entire health insurance market. Some of the reasons are provided in the paper itself, and a few others were raised when this paper was presented at the 2009 Annual Health Economics Conference hosted by the BU School of Public Health (at the time of this writing some conference papers are still online at the bottom of the web page).
So I am very enthusiastic about this paper but interpret the results with caution. This measured reaction is totally normal. All studies, even good ones such as this, have limitations. That’s why one should base conclusions on a body of work that looks at the same issue from multiple perspectives, using different data and methodology. Nevertheless, this is a good paper on an important problem using appropriate methodology. I encourage you to read the entire manuscript.
Health Care Costs: A Market-Theoretic View
Health reform, even with a public option, will be built largely on a private insurer infrastructure. That means hundreds of billions of dollars will be pumped through insurance companies on their way to payment to providers for health care services. Given this reality, we should all want as efficient a health insurance market as possible.
This appears to be the beginning of an argument for encouraging additional competition among health insurers. Greater competition is the source of greater market efficiency, isn’t it? The answer is, it depends on the market. The simple type of idealized market taught in Econ 101 does become more efficient (in an economic welfare sense) as competition increases. But other types of markets–in particular, so called two-sided markets, among others–do not always behave this way. And health care is one of them.
Let’s first consider the best-case scenario for the consequences of greater competition in the health insurance market. About 85% of insurers’ costs are medical. The remaining 15% is for administration, marketing, management, and profit (profit itself is about 6% at the time of this writing). With additional competitive pressure insurers would compete away some of that 15%. Perfect competition would reduce profit to zero and may force efficiencies elsewhere. So, perhaps the best competition could do would be to cut in half that 15% for administration, marketing, management, and profit.
Figure 1
Now a 7.5% reduction is not chump change. It represents a lot of money, tens of billions of dollars annually. But that’s only an optimistic best case. And it pales in comparison to the cost savings that are available on the provider side, the 85% of insurers’ costs. (Hat tip: Michael Chernew.)
If we really wish to understand what would happen if the insurance market is made more competitive we have to go one step further. There is a reason the health care market is not analyzed in Econ 101. It is much more complex than, say, the market for coffee. In fact, additional competition in the health insurance market could drive costs up. Here’s a a graphical depiction of what I have in mind.
Figure 2
The figure is drawn for a fixed level of provider market concentration. The horizontal axis is insurer market concentration, and the vertical axis is premium for a standardized plan. Relative to the fixed level of provider concentration, insurer concentration is high in the region of point “C,” and premiums are above the minimum possible level. Insurers are charging above the competitive premium level because they have excessive market power. In this region, higher premiums stem from higher insurer profits and/or lack of administrative efficiency (the red zone of Figure 1).
On the other hand, insurer concentration is low relative to that of providers in the region of point “A,” and premiums are again above the minimum because insurers can’t negotiate down to the lowest possible price with providers. Providers have too much power relative to insurers and are charging prices above the competitive minimum. Insurers pass those high prices onto consumers through higher premiums. In this case, higher premiums stem from higher medical costs (the green zone of Figure 1).
As provider power weakens the whole curve shifts downward, and as provider concentration increases the whole curve shifts upward.
If we’re now at point “C” (and this is by no means certain) it may be possible to achieve lower premiums by diluting the insurance market, weakening insurers with respect to providers. But if we go too far, we’ll shoot past the optimum “B” and be no better off. On the other hand, if we’re now at point “B” we should do nothing to upset the insurer-provider balance of power. And if we’re at point “A” then it is the provider market, not the insurance market, that has excess concentration.
As far as I know, nobody knows which of the many local health care markets are operating at “A”, “B”, or “C.” In fact, I have not yet seen any studies that can tell us what mix of insurer-provider market structure achieves the optimal point “B.”
It is worth noting that what is being considered in Washington as the long-term solution to health care costs has less to do with finding an optimal mix of insurer-provider power and more to do a change in the incentives of provider payment. The goal is to shift the entire curve in the figure above downward so that in every type of market–”A,” “B,” and “C”–health care costs and premiums come down. But a downward shift due to payment reform may be offset by a movement leftward along the curve. Such an offsetting effect could be brought about by antitrust action against insurers, weakening their market power with respect to providers. A similar offset could occur through additional integration of providers under a payment reform model (ACOs, CHTs). Both of these potential offsets are included in current legislation.
There is more to say about health care costs from a market theory point of view. I will be returning to this issue and referring to Figure 2 in the near future. The bottom line, however, is that the failure of policymakers to consider the insurer-provider balance of power may prove to be a costly oversight.
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