Community rating has an economic rationale

I had a bit of a Twitter flurry this morning, with some back-and-forth with Avik Roy. One of the things that came up in the exchange that I agreed with turns out to be incorrect. So, let me correct the record.

In the tweet, Avik is talking about the age-based pricing regulations of the ACA that constrain exchange-based premiums for older consumers to be no more than three times those of younger consumers. This modified community rating scheme is one of the aspects of the law that he and Douglas Holtz-Eakin would like to see removed. They prefer unconstrained pricing. Well, if there’s no moral or economic reason for community rating, I agree it should go, though the replacement demands considerable income redistribution, which I find politically unlikely. Nevertheless, this is the barest of hints at an idea advocated by Mark Pauly long ago. (See, for example, his eBook.)

Coincidentally, not long after the Twitter exchange I turned to a developing working paper by Keith Ericson and Amanda Starc. (It exists as an NBER working paper and a more recent, ungated PDF.) Turns out, they offer an economic reason for age-based pricing regulations. So, Avik and I were wrong.

[C]onsumer welfare is higher with the [age-based] pricing regulation in place than it would be in the absence of regulation; the positive compensating variation for the older consumers is larger in magnitude that the negative compensating variation for younger consumers, who must be paid to be made whole. […]

With the ACA’s maximum allowable price ratio and minimum loss ratios, consumer surplus is increased relative to unconstrained age pricing.

The reasoning is pretty intuitive. In an imperfectly competitive health insurance market, insurers can exercise market power and charge markups over the competitive price. The degree of markup is related to consumers’ price sensitivity. In the insurance market, older consumers are less price sensitive than younger ones. That is, older consumers are willing to pay more for the same product. Consequently, in the absence of age-based pricing regulation, markups would be higher for older consumers relative to younger ones. (Note, this is true apart from health status differences. Older consumers have other reasons to be less price sensitive. They may be more risk averse, for example.)

What age-based pricing regulations do is cap the markups that could be charged to older consumers by yoking prices to those faced by younger consumers. This decrease in price for older consumers increases their consumer surplus (the value they obtain from the product less the price they pay for it). Of course, younger consumers experience an increase in price, decreasing their consumer surplus.

The crucial finding is that the decrease in consumer surplus of younger consumers is more than offset by the increase in surplus for older ones. So, though it is true that younger consumers are getting a bad deal (until they grow older), consumer welfare is increased overall. That’s not a bad policy outcome.

One need not like this economic rationale. Perhaps one could cook up a model different from Erikson and Starc’s that produces a different result. But, one can no longer say that there is no economic rationale for age-based pricing regulations. Modified community rating is justifiable on those grounds. I’m not touching the moral issues.

P.S.: I expect this and other issues to arise at the Health Insurance Exchange Conference at Penn’s Leonard Davis Institute, April 11-12. I’ll be there and will have more to say about it another day.

@afrakt

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