Health insurance search frictions, part 1

Not since my undergraduate study of physics have I thought so much about “friction” as I will today. This is the first of two posts on this topic. Come back at noon for the second.

Because products vary so much across many characteristics, health insurance is not easy to shop for. Comparing plans is an apples to oranges problem, or maybe it’s more like apples to aardvarks. The challenges of comparison create “search frictions,” inefficiencies in one’s ability to wisely choose, to be a savvy shopper. This motivates the recent development of (draft) standards for health plan labeling.

How much will the new health plan labels, required starting next March, help consumers in their search for plans? How much grease will they add to the otherwise highly frictional process? I don’t know. A place to start is an examination of those frictions. What are they and how much do they matter?

That’s the subject of Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance, a new paper in the American Economic Review by Randall Cebul, James Rebitzer, Lowell Taylor and Mark Votruba. Theirs is an examination of search frictions in the employer-sponsored insurance (ESI) market, particularly those experienced by fully insured (FI) firms, in contrast to the self insured (SI). FI firms buy insurance from an insurance company. SI firms take on the insurance risk, only contracting out the management of their plans to third parties. Search frictions should be larger in the FI market than in the SI one because FI firms are searching for more: insurance plus administration versus just administration.

Those frictions are manifest in premiums. Even controlling for all the reasons why premiums should vary–plan characteristics, variations in the cost of care, the different mix of health risk of enrollees in plans–premiums will still vary due to search frictions and more so for FI firms. Think of it this way, when representatives of firms can’t easily assess a plan’s characteristics and compare it to other plans (search frictions) they will make errors in assessing and choosing plans. They know less about a plan than an insurer does.

This information asymmetry is a source of market power, permitting plans to charge above competitive prices, though to differing degrees perhaps. In other words, rather than one competitive price at marginal cost–what one would expect in a perfectly competitive market–prices are above marginal cost and in some distribution. Note that market power due to search frictions increases with the number of plans, while market power due to insufficient competition decreases. Therefore, nothing like a perfect market can ever exist for health insurance. Sorry!

Notice that I have not yet said anything substantial about the paper by Cebul et al. That’s the subject of the second post at noon.

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