More on Health Care

There seems to be a misconception that there is a viable purely market driven option for the provision of health care. There isn’t. The never was. Surprisingly there isn’t too much argument about this in the world of economics. The ability of a ‘free market’ to provide a satisfactory health care system was totally debunked a very long time ago by Kenneth Arrow, who is one of the post-war era’s most respected economists, and the co-author of something called the Arrow-Debreu model of general equilibrium that forms the backbone of modern textbook economics. He is hardly a left wing ideologue. His paper on health care insurance provides the definitive technical counter-argument to anyone suggesting that a market left to its own devices will allocate health care resources in a socially acceptable manner. It can’t because of some now well established and well studied aspects of market functioning.

The basic argument resolves itself down to the problem of uncertainty. A consumer of health care services cannot be presumed to know when those services will be required. Nor can they be presumed to be able to meet the cost of those services at the moment they are consumed since our experience shows that the cost will be very significant with respect to average wages. As a result the provision of health care becomes a problem of insurance. For the vast majority of the population the costs and uncertainties associated with them can only be managed in the context of an insurance like scheme.

But this immediately undermines some of the central theoretical concepts of a free market and introduces other, well known, problems that markets cannot cope with.

One example of such a problem is the selection process that is naturally associated with insurance. Markets operate on the assumption that business firms will maximize their profits. For an insurance company to meet this goal it must eliminate, as far as it can, known risks from the pool of consumers it is insuring. It does this by establishing all sorts of selection criteria: it tries to weed out anyone who is definitely going to make a claim. This is absolutely acceptable and expected in a free market. Anyone with a ‘prior’ condition; anyone with a family history of an inheritable condition; anyone with a high risk lifestyle; and anyone who even hints of being sure to make a claim must be eliminated from the insurance pool for the company to maximize its profits. In short: a ‘free market’ will avoid providing care to the sick.

That’s why the average insurance application form enquires about the things that it does. The application form is an indicator of what the real interest of an insurance company is: not paying money to claimants.

The normal insurance company rarely investigates the veracity of the information it receives on those application forms until it is forced to confront a claim. Again this is simply prudent free market practice. Only when the prospect of having to make a payment – which represents a loss to the insurance company – is it truly economical to check whether the claimant was telling the truth at the time of application. Good solid free market practice then dictates that the insurance company does everything it can to delay or avoid making a payment. In other words the dynamics of insurance is to avoid payments. Particularly if those payments were predictable. The whole theory of insurance is that it provides coverage for unpredictable things. Where predictability enters the equation, as in life insurance – we all die sometime – then the premiums are established to generate certain profit given actuarial experience. Since illness does not conform to actuarial experience ex ante – it does ex post – health care insurers go to great lengths to limit their losses by reducing the likelihood or having to make payments. So they offer insurance only to those who need it least.

Let me clarify that a bit.

Illness is an ‘uncertainty’. We use the word ‘risk’ too loosely. There is a huge difference between a ‘risk’ and an ‘uncertainty’.

Something that is ‘uncertain’ is unknown. It cannot be analyzed. We have no way of putting proper analytical boundaries around the problem so it remains a matter of conjecture or guesswork.

In contrast a ‘risk’ is something that we have information about – analytically we are able to assign probabilities to outcomes because we are aware of the likelihood of those outcomes, both in terms of their nature and frequency.

So there is great ‘uncertainty’ attaching to the question of someone having a form of cancer – we simply don’t know who will get it. But once we know who has cancer, we can talk of the ‘risks’ associated with survival and cure etc. The uncertainty is resolved into a risk.

Health insurance wants to pay only for uncertainties. They want to eliminate risks.

Hence the selection process to weed out ‘known risks’ like existing conditions etc.

There is no way within a free market to prevent this behavior. It is both expected and acceptable. It is what a free market should do.

But as you can easily see it is exactly the opposite of what we expect from health insurance from a social perspective. From a social perspective we want the sick to be covered, not just the healthy!

Not only this but it opens the system up to ‘gaming’ by consumers, which is the converse of an insurance company’s priority. People who ‘know’ they are healthy – the young adult population for instance – will avoid getting insurance which means the remaining pool of insured consumers is skewed towards the unhealthy. This skew produces a higher-than-need-be claim rate which, in turn drives the cost of coverage up for those in the pool.

So: a free market will inevitably run into difficulties. More to the point: within a free market there is no known way to avoid these difficulties.

Which is why there is no free market.

Since all societies want at least some of the sick to be covered they have devised alternatives to a free market: they ration via other means or they limit the freedom of the insurance companies to pursue maximum profits. Similarly the natural tendency towards gaming means that a free market will tend to produce an expensive solution.

So a purely privately and unrestricted insurance style system will, inevitably, be both more incomplete in coverage and more expensive, than a restricted or publicly funded one.

That this eludes those who still advocate private insurance is baffling since Arrow wrote about it in 1963.

However given the hegemony of ‘free market’ thinking over the past few decades I suppose it isn’t surprising to find that most people are not aware of the well known limitations on the ‘power’ of a market to solve all problems. The truth is that these limitations have been known for a long time within economics, but our ability to recall them was swamped by the ideologically driven wave of thought during the Reagan/Bush era. The fact is that markets do not always self correct – we have just learned that in the banking crisis – and that do not solve all problems more efficiently than other forms of rationing – this is the lesson of health care.

A free market system would most likely produce results that even the most ardent advocate of free markets would abhor. They simply haven’t though through the mechanics of a market system unfettered by regulatory limits. So to be pragmatic we need to limit the market in order to help it function acceptably by:

1. Preventing gaming: all people should be forced to carry insurance. This will deepen the cash flow of the pool of insured and will drive down costs.
2. Prevent socially unacceptable selection by insurance companies. This will widen coverage and increase costs.

Both of these steps are part of Obama’s reform project. Which is why it makes sense.