Tuesday, March 11, 2014

The reason why free market healthcare would never work

A couple people on Twitter yesterday were whining about the ACA's individual mandate, and instead wished the government would make health insurance so cheap that people would all just buy because they couldn't resist its cheapness.

(I guess our free will is being taken away in this country--not by the government, but by cheap stuff.) Indeed, though, the cry to unleash market forces to lower healthcare costs has been widespread since the complicated ACA became law. Free market, inexpensive healthcare would of course be lovely, but, like many libertarian fantasies, it won’t work in the real world.

The reason for this is due to what economists call a market failure. Say we start with a system where private companies sell health insurance to individuals, and the rate people pay depends on their general health, as measured by several risk factors. Of course, young healthy individuals, who don’t have much need for most of what health insurance covers, won’t buy into the pool in large numbers. If we’re talking about a free market, the insurance companies also won’t have any incentive to sell insurance to sick individuals at reasonable prices, as those companies likely wouldn't make enough off of the premiums to justify the bills the sick would incur. Thus, in this free market world the young and the sick are quickly out of the insurance pool.

Now, say the insurance company sets prices according to the aforementioned risk factors, as makes sense. People get that a young, non-smoking in their thirties will likely file fewer insurance claims than a smoker in their fifties. BUT, and here’s the kicker, even within the lowest-expense insurance tier, there will be people above and below the average risk in that particular tier. Now, the fact that the insured has more information about their health than does the insurer (called asymmetric information) produces the market failure. This arises from the fact that those who are the healthiest within their tier, and most likely to subsidize others, will be less likely to buy insurance. Once the healthiest of a particular tier drop out of the pool, the health insurance company will have to raise rates on the (now) slightly unhealthier clientele, which again motivates the healthiest, who are getting the worst deal, to further drop insurance and the feedback loop continues. This market failure is called adverse selection, and it’s the reason a free market solution to health care would never work. This is what the ACA's individual mandate fixes.

Note: This is partially why there isn't a rich country, that I can find, that uses the free market to bring health insurance to its citizens. Did I miss one? Is there such a country? Also: here's my very brief primer on how the ACA works (and avoids adverse selection).

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