Why is health care so complicated? An information economics prof navigates the current confusion

03/23/2017 05:36 pm ET Updated May 17, 2017

Health care policy is complicated. Even in the absence of partisan debates, it’s complicated. Resolving the current congressional debates over health care policy will not be easy, and indeed, it may remain impossible because of differences in moral preferences. But at least we can share an understanding of the facts behind the complexity.

· Health care policy is complicated because health care is enormously expensive. It is one of the largest and one of the fastest growing segments of the American economy. With the aging of the American population and with advances in medical sciences, size and growth are likely to continue.

· It is complicated because we differ enormously in what it costs to serve us, which makes individual insurance complicated.

· It is even more complicated because it is now possible to estimate in advance what it costs to serve each of us. This makes buying insurance less like buying a lottery ticket based on the odds, and more a matter of placing a bet, using the odds, when one or both of you know the outcome in advance. One of you is the sucker. One or both of you will know who the sucker is in advance.

· Finally, it is almost impossible to resolve the complications in designing a public policy for health care insurance because as a society, as a collection of political parties, and as a collection of individuals, we cannot agree on what would be fair. That is, we cannot even agree on what we are trying to do.

I can’t resolve moral debates about fairness or of conscience here. I cannot offer guidance on what is right or on what you should want. But I can provide a brief tutorial so that we can at least agree on what is possible. Republicans and democrats, conservatives, liberals and libertarians can at least agree on the inevitable outcome of different policies. They can master a basic understanding of the economics. And then they can disagree on objectives and fairness, without disagreeing on what is possible.

The first thing we need to agree on is rational self-interest. If you try to charge me much more for a used car than I know it is worth, I won’t buy it. If you offer me much less than I know my car is worth then I won’t sell it to you. The same thing applies to everything from financial products like annuities and insurance to almost everything we buy or sell.

The next thing we need to understand is information asymmetry and market collapse. If sellers knew the quality of their cars and buyers did not, buyers would only know that they had offered too much after they were stuck owning a car they should not have bought. The used car market would collapse.

In the used car market the problem of market collapse problem is solved with perfect information, or at least by reducing the information advantage of the sellers. Extended warranties for the good cars help buyers develop trust in the seller; if the car if defective, the seller is going to have to pay a great deal to restore it. Likewise, offering the buyer 30-day return privileges if serious defects emerge helps the sellers of the good cars. With perfect information, lemons have to be priced like lemons. Why can’t we do that with health insurance? Because, if we price lemons as lemons, then a lot of will be charged more than we can afford for our insurance.

Indeed, we cannot turn to free markets for much help. The market, when it functioned as markets are supposed to function, gave us the problems that RomneyCare was meant to solve. The young and healthy opted out of the insurance market, and then attempted to crawl back in when they got sick or injured. Allowing the market to exclude those with expensive pre-existing conditions left these formerly healthy individuals without insurance coverage.

So how do we solve the problems of informed selection, when healthy individuals delay buying insurance and less healthy applicants all buy insurance? Mostly, that could be solved by the Individual mandate and the abolition of insurance companies’ excluding coverage for pre-existing conditions. The healthy among us pay a small amount now for the coverage they don’t need yet but may need later.

But why isn’t that enough? Why are there so many other rules in the Affordable Care Act (ACA)? Why is health care policy so complicated? Because we differ too much. We can’t charge healthy 20-somethings and 30-somethings enough to cover the costs of 70-somethings and 80-somethings. Many states like Arizona and Florida have huge populations with the pre-existing condition known as old age. Insurance is just going to be too expensive for the elderly, unless there are a lot of younger citizens being overcharged to subsidize the market for them. So, if we really want universal access we have no choice. We need add two more conditions, a maximum difference between the prices charged to the youngest cohorts and the prices charged the oldest cohorts plus expensive government subsidies to cover the higher costs of providing insurance to the elderly.

Why do we need all four pieces if we want to provide universal coverage? Note the critical if here. We only need these four if we want to provide universal coverage.

1. Without the individual mandate, rational self-interest suggests that the youngest and healthiest segments of the population will opt out of the voluntary insurance market because it is priced higher than their perceived medical costs. They will then be a burden on the rest of us when, as inevitably happens, some have accidents or develop expensive medical conditions. Low risk isn’t the same as no risk.

2. We need a ban forbidding insurance companies from excluding coverage based on pre-existing conditions. We need a similar ban forbidding insurance companies from excluding coverage based on their use of information about genetic conditions and other markers of expected “future-existing” conditions.

The insurance companies’ revenues from the individual mandate subsidize the insurances companies’ costs associated with pre-existing conditions and expected future-existing conditions. Thus (1) and (2) go together. You need them both. You can’t have one without the other. And without both you won’t have universal access to affordable insurance.

3. Without some rules on age-based pricing and some caps on the differences between prices for different age groups, we still won’t have universal access to insurance. So we need caps on what can be charged the oldest applicants.

4. But these caps threaten the viability of the insurance markets. Insurance companies cannot collect enough from their elderly applicants to pay for the costs of serving them. So, we need to provide subsidies to insurance companies if we are going to cap what they can charge the elderly. And if these caps are tight, then these subsidies are going to be expensive.

The subsidies from the young and healthy are not going to be enough to subsidize insurance companies when the caps on charges to the elderly are set too low. And if these caps are not set low then many of the elderly will not be able to afford their insurance. So once again, the pair of (3) and (4) go together. When I go to an all-you-can eat steak and fries restaurant today I can eat only one steak; as an undergraduate I might have eaten three. A friend who played professional football might once have eaten eight. Still, we are looking at differences in cost to serve of no more than eight to one. And how many professional football players show up at any restaurant on any day? So, the restaurant can safely ignore the difference in our appetites for steak. In the case of medical care, the ratio of the costs to serve a 20-something vs an 80-something is closer to 10-to-1. That doesn’t seem too different from the ratio of costs to serve in an all-you-can eat restaurant, until you realize how few professional football players there are among us, and how many 70-somethings and 80-somethings there are in the American population. Insurance companies need to be protected from bankruptcy if we try to limit what they can charge older applicants. And these subsidies are expensive and represent the largest costs associated with the current Affordable Care Act.

Why won’t dropping all the rules of the ACA solve the problem? Why won’t the free market solve all our problems? Because the free market was the cause of the problems that the ACA was attempting to address. In a free market, the young and healthy will opt out, as they did in Massachusetts. In a free market, insurance companies will not be able to over-charge anyone and thus they will not be able to under-charge anyone. They will need to deny coverage to individuals with expensive pre-existing conditions and those extremely likely to develop such conditions in the future. And the costs for the elderly will rise significantly. The free market does not provide an easy solution.

Why won’t competition help bring premiums down? Let’s look at Arizona, which has been singled out as the worse failure of the ACA. Insurance isn’t expensive in Arizona because the market isn’t working or because there is no competition. Insurance is expensive in Arizona because the market is working, and because the cap on premiums for the elderly is too tight. As a result, no one wants to sell insurance there. We can loosen the cap on premiums to the elderly, and competition will increase again, but premiums are going to go up, not down. Once again, there is no easy free market solution.

So, what should Congress do? That’s not a question for economics. The answer depends on your moral beliefs and your sense of fairness. Should young and healthy individuals be allowed to take risks? If you believe that, then scrap the individual mandate. Should those who choose to be uninsured then pay for their mistakes later by paying much higher premiums for pre-existing conditions? If you believe that, then allow insurance companies to price policies based on pre-existing conditions. Do you believe that the elderly need access to affordable insurance? If you believe that then you are stuck with caps on the prices of policies for the elderly and stuck with expensive government subsidies. Do you believe that the truly poor are entitled to medical insurance? Then you are stuck with the expensive expansion of Medicaid.

Economics cannot tell you what you should believe about who can or cannot not have access to medical care, or at what price.

There are two things I can say with certainty.

1. Regardless of whether you believe we are all entitled to affordable health insurance or not, we are all entitled to competent representation in Congress. Liberal or Conservative, Democrat or Republican, Socialist or Libertarian, we are all entitled to Representatives who know what their constituents want and need, who understand what is and is not possible, and who work to get their constituents the best possible coverage consistent with their wants and needs.

2. We are all capable of understanding the costs and benefits associated with our beliefs, and the kinds of legislation needed to make those beliefs possible for society. It just takes some time to figure out.

Today’s delay bought all of us the time to figure out what we want and what it will cost us.

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