This is part 1/3 in my series on healthcare costs. The analysis is driven by my own needs as an entrepreneur to find affordable healthcare. Part 1 introduces the problem with health exchanges, part 2 addresses the issue of price transparency, and part 3 introduces a web app that estimates your annual healthcare costs.
Politicians like to believe that if you build a marketplace, then a market economy will manifest, delivering all its glorious benefits. What they don’t seem to acknowledge is that for markets to work they need to be well-functioning, which means that the market must satisfy (most) of the conditions of pure competition [1, 2]. If these conditions are not satisfied, then it becomes significantly less likely that the invisible hand of Adam Smith will manifest, nor will prices reach fair value. Some of the (ideal) conditions that must be met are:
- Infinite buyers and sellers
- No barriers of entry and exit
- Perfect information
- Zero transaction costs
- Homogeneous products
- No externalities
In practice, perfect competition cannot be attained given idealized conditions, yet there are reasonable approximations. The foreign exchange markets are generally considered to be the closest approximation of perfect competition. However, in health exchanges none of the above conditions, even in their approximate form, are satisfied. If a market is not well-functioning, then you cannot expect prices to be fair. Hence the claim that bringing health insurance onto a marketplace will increase competition is only half-true. In the sense that there will be more sellers, competition has increased, yet this does not imply that prices will reach equilibrium. Let’s see why.
Infinite buyers and sellers
The first thing to notice is that there are many buyers and few sellers. This is because it is difficult to create an insurance company. Not only do you need a lot of capital, but you have to create a network of providers that will accept your insurance. When there are few sellers in a market, collusion and price fixing can occur. This happens surprisingly often in industries like airlines [3, 4], semiconductors , and even perfume . When looking at the premiums of healthcare plans in the same metal level, it is surprising how close the prices are.
No barriers of entry and exit
The difficulty of creating an insurance company is clearly a high barrier to entry for sellers. The consequence is that a seller has the opportunity to unilaterally control prices since competition is limited. In financial terms, this is known as cornering the market. While not necessarily illegal, it can obviously cause price distortions, not to mention lead to antitrust cases. Another consequence is that poor-performing providers can stay in business due to the lack of competition. This means there is a disincentive to improve since revenue can be generated at a lower cost (due to lower spending on providing quality services).
What about buyers? In theory, anyone can enter a market to buy an insurance product with ease. Technology glitches notwithstanding, this is largely a non-issue for buyers, except in the area of transaction costs, which is discussed below.
By perfect information, all participants (both buyers and sellers) are supposed to have full knowledge of the price, utility, quality, etc. of the products [7, 8]. It is very difficult to know the total cost of healthcare based on the premium, deductible, and the out-of-pocket limit alone. So despite there being transparent price in terms of the components of a plan, there is no price transparency when it comes to all the factors driving the total cost of the plan. This is like buying a car based on the price of the tires. In order to know the true cost of your health insurance not only do you have to factor in the premium, the deductible, the copay and/or coinsurance, medication, etc., you also need to estimate the quantity and cost of medical services required per annum. For the average individual this exercise by itself is quite challenging. The only people who really have a good sense of the total cost of healthcare are the health insurance companies themselves. This observation alone shows that information is asymmetric in the market since the sellers have a clear advantage of information over the buyers. The unfair playing field in health insurance is no less egregious than insider trading in finance.
An externality is any cost or benefit unintentionally incurred by a third party based on a given activity . For healthcare this takes the form of the cost of service for medical providers. Depending on whether your doctor is in-network or out-of-network in a given plan affects the price that they will charge you. The same is true if you are uninsured . Hence, for the same service and same doctor, the cost of service can vary dramatically. The fact that these prices are opaque means that it is difficult for the cost of medical services to find equilibrium. With health insurance being derived from the cost of services, how can insurance prices possibly be transparent? This is analogous to buying an option on an equity without knowing the value of the underlying stock (startups, anyone?).
In another sense, health insurance can be seen to rely on a different externality: the composition of participants affects everyone’s rates. This is codified in the desire to get as many young, healthy people on the exchange so they can subsidize the cost of the elderly and the sick . Hence, for the same insurance plan, your cost of insurance could go up (down) if other people became sicker (healthier).
Zero transaction costs
What happens when you want to switch plans? Any money spent towards the deductible is lost. Similarly most plans don’t prorate the deductible based on when you sign up. So there is a significant transaction cost to switching, implying that there is a disincentive to switch, which reduces the effects of competition. Compare this to auto insurance or home insurance where it is easy to switch at any time and any premium paid is refunded at a prorated amount.
When all products are the same, the product itself becomes fungible. It doesn’t matter which specific product you receive since they are identical. While an individual insurance plan is the same (think same plan, different policy number), they are not fungible across plans since plan details are different. This is similar to how cars are sold in broad categories like luxury, sedan, SUV. To know whether or not you’re getting a good deal requires a lot of research and also knowing the total cost of ownership of the car. One aspect of car buying is that people are generally not rational because there is a large emotional component to automobile purchases. This is not necessarily a bad thing and partially justifies a heterogenous market (since people value the emotion differently). In terms of health insurance, it is unlikely that anyone is going to get excited and have an emotional attachment to a platinum plan.
While it may not be necessary for health exchanges to meet all the conditions of a well-functioning market, it is important to understand the implications of not meeting the conditions. Certain externalities and barriers to entry are probably desirable, but other conditions, such as access to information, need to be improved. Only then can prices begin to reflect the true cost of healthcare and resources allocated efficiently. What is needed is a method to distill the total cost of healthcare down to a single number. This number should represent the best estimate of the cost of healthcare for an individual or family based on each of the plans available. Then it will finally be possible to reliably compare plans.
In part 2, I show how to estimate the annual cost of healthcare based on numerous plans available on the NY Health Exchange. While the examples are specific, the lessons are broadly applicable to anyone looking at health insurance.
 Perfect competition. Wikipedia. Visited 14 February, 2014.
 Perfect competition. The Economist. Visited 14 February, 2014.
 Swiss commission fines airlines for price-fixing. swissinfo.ch. Visited 14 February, 2014.
 British Airways fined £58.5m for fuel price-fixing. Visited 14 February, 2014.
 Semiconductor Execs Indicted for DRAM Price Fixing. PC World. Visited 14 February, 2014.
 Perfume giants fined 40 mn euros for price fixing. Fashion Mag. Visited 14 February, 2014.
 Information. Econlib. Visited 14 February, 2014.
 Imperfect Information. EconPort. Visited 14 February, 2014.
 Externality. Wikipedia. Visited 15 February, 2014.
 How to Get Health Care While Uninsured. The Billfold. Visited 14 February, 2014.
 Obamacare enrollment push for the young enters 11th hour. Reuters. Visited 15 February, 2014.