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In an Ezra Klein interview with CEA Chair Christina Romer, he asks:

“One of the things that struck me in the report is that the health-care discussion tends to be thought of in terms of insurance coverage. But this report located more of the key reforms specifically around providers and provider incentives. Want to say a word on that?”

And she replies:

“There are, as we document in the report, real market failures in the provision of insurance. We’ve been dealing with this for a long time. The problem of adverse selection is one of the main reasons we have Medicare. We were finding back in the 1950s that older people were having a really hard time getting insurance at an actuarially fair rate. And now, I have to confess, I’ve lost my train of thought. What was the question? [Laughs].”

I’m not laughing. In traditional insurance markets, adverse selection describes the process whereby LOWER RISK individuals opt out of insurance pools due to information asymmetries (i.e. they know more about their own risk than 3rd party insurers do). When individuals know more about their own risks than 3rd parties (let’s assume perfect lack of information on the 3rd party’s behalf), then insurers must charge premiums that reflect the average expected value of reimbursements over the life of the policy across all insured customers. Thus, if you know yourself to be lower risk (in the health care field, that means healthier) that kind of a premium is actually more costly than it would be to self-insure. So, acting rationally, you choose to forego formal insurance. That leaves the remaining insured pool a little more risky than before, which means insurers would have to charge higher premiums to cover their costs, which in turn encourages still healthy people, but less so than the first to opt-ou, to opt-out as well, leaving the remaining insured pool even less health and higher risk, requiring higher premiums, encouraging more people to opt out … and the whole entire insurance market “unravels.”

In other words, the invisible hand turns to thumbs in the presence of imperfect information as I describe above. The “problem” is that the less-risky population does without insurance, even though there is a price that they would pay and wish to have the insurance, and those folks that are insured are the riskiest – leaving a high-cost, low-coverage pool. Ms. Romer has my head spinning for two reasons.

  1. She claims that old-people being “left-out” of insurance markets is adverse selection. Call me silly, but I understood older people to be larger health risks than younger people. Therefore, if they were not getting insurance, it was not adverse selection that was causing it, but something else.
  2. She claims that older people could not get coverage at an actuarially fair rate. What that means is that they were being charged premiums that were larger than the expected value of their annual health expenses. Maybe she means that healthy old people could not get coverage?

I am as sure that the reason for Medicare is a market-failure problem as I am able to solve the Reimann riddle. Yep, it was market-failure. It had nothing to do with massive intergenerational wealth transfers to politically powerful voting blocs. And it’s super-encouraging to see a major White House economic advisor sitting down to read a book by Tom Daschle as the first one after being appointed to such a position. You know, an Air Force vet, former-Senator, paid-health care lobbyist and advocate for universal coverage with all that health care and economics training is exactly the person she should be reading. Maybe I should assign the darn thing to my economics students next year?

2 Responses to “Maybe I Need to Take More Economics Classes”

  1. jb says:

    She certainly botched that response, she appears to have no understanding of adverse selection. Good catch.

    By the way, it is my understanding that there are some libertarian types out there who express support for various mandatory health insurance plans. After all, what would we do about folks who choose not to purchase any health insurance, yet show up at the emergency room critically ill? Do we kick them back in the street? Does anyone know about these ideas? Who are the proponents?

  2. Michael says:

    You know, one bad part of this conversation is that health care is treated to be the same as health insurance. Another bad part is that typically when it comes to health care, in America you must either get the very best or none at all; we might be able to provide everyone in this country with 1980s level of technology. Unfortunately, that technology is outdated by newer technology which does save a lot more lives, but costs more.
    And let’s face it, only the government can provide insurance (Medicare) at a lower cost than what some companies can and then go around complaining that no one is providing low cost insurance! Thank goodness they are around to provide me my right shoe (see May 12th, 2009)!

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