Sympathy for the Insurance Companies

When assessing the effects of market concentration on competition, antitrust authorities look not just at how many competitors there are in a market, but also how they compete.  In one standard model, called Cournot competition, producers set levels of output, and prices adjust in relation to supply.  In another model, called Bertrand competition, producers set prices, and produce quantities sufficient to meet demand at the prices they set.  In pure Cournot competition, prices vary substantially based on the number of competitors in the market.  In a Cournot duopoly (a market with two competitors setting output), the producers will between them extract half of a monopoly profit.  But pure Bertrand competition pushes prices down toward marginal costs no matter how many competitors there are.

While the differences between Cournot and Bertrand competition are fundamental concepts of antitrust economics, they seem to have been lost in the race to pin responsibility for rising premiums on concentration in the insurance industry.  While the details of competition among insurers is complex and does not strictly follow any simple model, at a basic level they appear to engage in Bertrand competition for the business of insureds, i.e., they set premiums, and write as many policies as corresponding demand requires.  In this case, we should expect them to compete prices down toward their costs regardless of market concentration.  And we in fact see that insurers’ profit margins are relatively modest despite a longstanding trend of consolidation in the industry.

Providers, on the other hand, seem to engage (again, at a basic level) in Cournot competition.  They produce a given amount of capacity — building hospital beds, hiring physicians — and then negotiate with insurers over the price to use it.  If this is correct, then concentration in the provider market should have a significant impact on the prices that providers can charge insurers, and that insurers ultimately pass on to insureds.  By the same token, concentration in the insurer market should allow insurers to pay lower prices to providers because they are also engaging in Cournot competition on the buy side — they have a certain amount of demand that is set by the needs of their insureds, and they bargain with providers over the price of fulfilling it.  But because insurers are engaged in Bertrand competition on the sell side, they will tend to pass these savings on to their insureds notwithstanding their market concentration.

In this simple model at least, the ideal situation for insureds is to have a concentrated insurance market that approaches Bertrand duopoly on the sell side and Cournot duopsony (two buyers who set demand and take prices) on the buy side, with a competitive market for providers.  Of course, there are complexities — such as product differentiation, switching costs, and homing asymmetries — that can both attenuate and amplify the effect of this basic market structure for consumers, and I hope to address some of them in later posts.  But other things being equal, the implication is clear: concentration in the insurance industry does not necessarily harm and may well benefit consumers, while concentration among providers is a prescription for higher costs.

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