Health insurance market failures (and what can be done about them)

In his textbook, Economics of the Public Sector, Joe Stiglitz categorizes market failures in general and those that exist in health care in particular. The following — focussed on health insurance, as opposed to health care — is based on his list, with a lot of my own thoughts added. Anyone know of good papers that discuss health insurance (or health care) market failures and how they might be addressed? (I will cover health care market failures in another post.)

For the record, and for readers who don’t know, a market failure is any feature of the market that reduces allocative efficiency. (Jargon alert! Read the next sentence.) That is, it causes resources to be expended in a way that doesn’t maximize overall benefit to society. In principle, government intervention can increase that benefit (economic welfare) in such cases. In practice and in some cases, it’s debatable.

Failure of competition. Health insurance markets are famously concentrated. There are lots of proposed solutions to this: antitrust enforcement, competition across state lines, deregulation at various levels, including elimination of minimum benefits standards, and so on. It’s important to recognize that these are government roles, all establishing the nature and scope of the market.

However, there is one fundamental reason why competition can never be perfect in health insurance. The products, insurance policies, are not identical. They’re not commodities. As such, they don’t really compete with one another as equal goods. Roughly speaking you can think of each policy as a unique product with its own degree of monopoly power. This is a source of market power that cannot be purged from a market-based insurance system, no matter what government does or does not do.

Incomplete markets. An incomplete market is one in which consumers would be willing to pay more than the cost of a good or service but it is not provided. Insurance markets are clearly incomplete. Today, there are millions of people who are denied participation in the market (due to medical underwriting) who might be willing to pay a fair premium. Given the low level of competition in insurance markets, it is very likely that products that would be profitable are not offered (because they’re less profitable than what is offered). Until 2006, the market for prescription drug insurance for Medicare beneficiaries was glaringly incomplete. Until 1966, the market for hospital and physician services insurance for the elderly was also obviously incomplete.

Government responses in all these cases (banning medical underwriting, encouraging exchanges, offering Medicare and Medicare Part D) are designed to address the incompleteness of health insurance markets.

Information asymmetries. An information asymmetry exists when one participant in a market transaction knows more than another in ways that pertain to cost or price. Such asymmetries abound in health insurance. Individuals have private knowledge about expected utilization that insurers lack, leading to adverse selection. Individuals also may know more about their personal value of the insured services than do insurers, leading to moral hazard. Providers know more than insurers about cost and quality, leading to inefficient levels of reimbursement.

Private entities are likely just as capable of limiting moral hazard (e.g., by cost sharing or care management) and discovering cost and quality information (e.g., combating fraud) as government. Private entities can also address the degree of selection into their products, but not without exacerbating the problem of incomplete markets (e.g., not offering services that attract high risk enrollees or attempting to shed high risks).

However, the entire selection problem can be solved by government, in principle, as proposed by Mark Pauly. In brief, Pauly recommends risk-adjusted government transfers that fully compensate for insurer experience rating. That is, throw community rating out the window and have government redistribute income in such a way that every consumer faces the same marginal cost for an insurance product. (Such “vouchers” or “subsidies” could, and should, also be income adjusted.) The key here is that government can address the selection problem more completely than the private sector.

Are there more market failures in health insurance I missed? Did I leave out any private or public solutions? Likely “yes” to both. Let me know in the comments. And please suggest further reading.

I cover health care (not insurance) market failures in another post.

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