When it comes to health care policy, two viable economic theories are battling it out across the left-right spectrum.
On the right, the explanation put forth to explain poor outcomes in health care is something called “moral hazard.” Moral hazard is the idea that shielding a party from the consequences of a behavior induces them to act differently than if they had not been shielded. The application to health insurance markets is simple: insured individuals have little incentive to reduce their health care costs, and, as a consequence, they overuse medical services, undergoing expensive and unnecessary procedures. The moral hazard explanation, when followed to its logical conclusion, results in health care policies like John McCain’s, which would have replaced the generous tax subsidy given to employers with a correspondingly generous tax credit to individuals.
McCain would have ended the current system of health care (in which a third party, employers, covers insurance costs) and replaced it with a direct insurance market where if an individual wanted the type of insurance that would cover all their unnecessary tests and procedures, they’d end up paying for it through higher premiums. The idea was that by more directly linking people to the health costs they incur, there would be more efficient rationing of health care, costs would go down, and more effective health care would be available for everybody.
On the left, the explanation put forth to explain poor outcomes in health care is something called “adverse selection.” Adverse selection is the idea that markets fail when there is unequal information between the two sides in a transaction. The application to health insurance markets is that insurance buyers know more about their own health and habits than insurance sellers. To illustrate: suppose that there is a pathogen, called Disease X, sweeping the country. It is fatal within four weeks of the first symptoms being detected, but is easily and forever cured with a pill that costs $10,000. The population has varying degrees of vulnerability to Disease X such that the probability of contracting it is 10% at the 1st decile, 20% and the 2nd decile, 30% at the 3rd decile, and so on. An insurance company looking to insure individuals against Disease X takes a look at the population and finds that the mean chance of contracting the disease is 50%, and so makes an offer: for $5,000, anybody can buy insurance against Disease X—in other words, if you buy insurance and contract the disease, the insurance company will pay for the pill that cures you. Individuals know their personal risk of contracting Disease X, but the insurance company does not have this information.
If everyone were to buy the insurance being offered, the insurance company would break even and all would be well. Unfortunately, with adverse selection, this doesn’t happen. Only the people with a greater than 50% chance of contracting Disease X end up buying the insurance, and the insurance company finds that on average it pays out $7,500 per customer instead of the predicted $5,000. If the insurance company had offered the insurance at $7,500 per person, their average payout would have been $8,750, and so on. With no profitable way to provide insurance, the market is unstable and results in millions of uninsured.
The left draws a conclusion that is almost entirely opposite that of the right. Direct markets for insurance don’t work — we need setups like employer-provided insurance if there is to be any stable market. Employer-provided coverage, nearly the sole vehicle for health insurance in the U.S, works because it avoids the problem of adverse selection — it is very rare for people to choose their employer based solely on the health benefits. In a given company, people of different ages and different levels of health sign up for the same program, so insurance premiums can be determined by population averages without the worry that the group buying the insurance will be different from the group that the statistics came from.
The policy prescription from the left, well represented by proposals from both John Edwards and Mitt Romney (though Romney would later disavow his own system in the Republican primaries), is insurance mandates. Making everyone buy insurance prevents people from adversely selecting to not buy insurance.
A side note: on the far, far left, kooks like Michael Moore trot out the old canard that big nasty companies and profit motives are to blame for the ills of the health care system. A good heuristic for sifting through policy debates is to ignore anyone who blames an outcome on profit motives. People who rail against profit motives are easy to spot: smelling bad, shouting, and waving cardboard signs suggests a profession other than “serious economist.”
During the campaign, President Obama campaigned on a middle ground that simply doesn’t exist. Although the problems facing health care are likely a mix of both moral hazard and adverse selection, Obama’s health care plan solves neither. Instead, he seems to view the task as if health policy were no more than an advanced form of welfare, a duty borne by the rich to fund the care and medication of the poor. But health care policy is more than a wealth transfer program — it’s a positive-sum game that should fix the fundamental problems threatening health insurance markets.
There are two simple reasons why President Obama should lean towards insurance mandates.
First, insurance mandates solve the problem of adverse selection without precluding a solution to moral hazard. The managed care debates of the past few decades, with the alphabet soup arguments between HMOs versus PPOs versus etc., are a monument to the variety of options available in dealing with moral hazard and reining in costs. Insurance mandates, combined with something like prospective reimbursement, could reduce adverse selection while curbing unnecessary procedures at the same time. In contrast, a McCain-type plan would do little to prevent adverse selection, and in fact seems predicated on the assumption that adverse selection doesn’t occur.
Secondly, insurance mandates and other Democratic proposals will reduce administrative costs. A significant slice of insurance premiums go to cover actuarial costs. The billions of dollars spent in underwriting and paperwork represent a real loss to society — avoiding them would be a happy side-effect of a mandate system.
Shifting to the left on health care will be doubly painful for Obama: not only will he be reneging on his commitment to bipartisanship, he’ll also be forced to eat the words he said on the campaign, when he ridiculed Edwards and Clinton for their support of mandates. But no one ever said that doing what is right would be easy, and it certainly would be a shame if health care policy was made to suffer because a president couldn’t admit his own party was right.