A Libertarian Perspective on Economic and Social Policy

Lecture 14

Medical Care and Health Insurance

©2007 Jeffrey A. Miron

Introduction

• Governments intervene substantially in the markets for health care and health insurance.

• There is broad support for intervention but wide-spread unhappiness with the current system:– Persistent complaints about “affordability,” prescription drug

coverage, the uninsured, and more.– And one existing intervention, Medicare, is one of the “ticking

time bombs” that threatens to wreak havoc on budget deficits in coming decades.

• Thus, in recent years, there has been a constant demand for change in the U.S. system, with some advocating even more government involvement and others advocating more “market” mechanisms to control costs or the like.

Introduction, continued

• This lecture discusses the possibility that medical care, and more specifically medical insurance are, perhaps, somewhat different than many other goods:– In particular, asymmetric information is potentially an

important feature of insurance markets.– If this is accurate, the presumption that markets do

things fairly well, left to their own devices, might not be as compelling in this case as it in most instances.

Introduction, continued

• Nevertheless, the lecture also argues that even if adverse selection is a major problem, attempts to “fix” medical insurance markets can easily make things worse rather than better:– In particular, insurance creates moral hazard

problems that can have severe consequences for efficiency and equity.

– Thus, it is not obvious any plausible intervention improves matters overall.

• Plus, the magnitude of adverse selection does not appear to be dramatic in practice.

Introduction, continued

• Moreover, there are many interventions in health care markets for which there is far less justification than for government provision of insurance:– So these should be eliminated regardless of how one

comes down on the insurance issue.

• Thus, the analysis concludes that reduced government intervention in health care can substantially increase both efficiency and equity.

• The ideal level of intervention might not be zero:– But it is much smaller than what occurs now.

Outline

• Government-Provided Health Insurance

• Tax Subsidy for Employer-Provided Health Insurance

• The Food and Drug Administration

• Licensure of Physicians

• Miscellaneous

Government-Provided Health Insurance: Medicaid and Medicare

• Medicaid and Medicare fund health care for the poor and elderly, respectively.

• These are enormous programs:– In 2003, $233.2 billion for Medicaid, with about 52

million persons covered.– In 2005, $336.4 billion for Medicare, with about 42.5

million persons covered.• The two are funded differently:

– Medicaid provides grants to states, which administer varying programs within some guidelines;

– Medicare is totally federal; it has a dedicated tax that goes into a trust fund (similarly to Social Security).

Medicare and Medicaid

• There are two main arguments for these programs.

• One is the possibility of adverse selection in insurance markets:– This potentially applies to both Medicaid and

Medicare.

• Another is the desire to redistribute income:– This applies far more for Medicaid.

• Leave aside the income distribution issue for now and focus on the adverse selection issue.

Adverse Selection and Insurance

• A fundamental feature of medical care is that demand is likely to vary substantially over time for a given person and across persons at a given point in time.

• The fluctuation over time for a given person does not by itself imply a demand for insurance:– Instead, it implies a demand for borrowing, assuming the

magnitude but not the timing of the expenditure is known.

• The variation across persons, however, does imply a demand for insurance:– Each person does not know what his/her individual health costs

will be; many would be willing to pay some amount to reduce the uncertainty about the amount paid out over their lifetime.

Adverse Selection, continued

• Private markets can and do provide insurance, of course:– So why is a government intervention necessary?

• The standard answer given by economists is the possibility of adverse selection:– People vary in their degree of health risk– People know their own health risk, but insurers cannot

observe this risk for each individual.

• Under these conditions, private insurance might not arise:– Only the unhealthy demand insurance.

Is Adverse Selection Really a Problem?

• This lecture takes that possibility as given.• But the evidence is far less clear.• To begin, it could be that healthy people are also very

risk averse; so they purchase health insurance despite its “excessive” price.

• Plus, for a huge range of health issues, existing technology allows an insurer to determine health risk pretty well.– So, the information is not necessarily asymmetric.

• Indeed, insurers are probably better at estimating health risk than individuals.– The asymmetry could go the “other” direction.

Is Adverse Selection Really a Problem?

• In fact, with modern technology, the key “problem” is that information is “too accurate.”

• Consider a genetic disease like Huntington’s Chorea.

• This a single gene disease. A simple test determines for sure whether you have the disease, so asymmetry of information is not the issue.

• Insurers could simply set different prices for people with and without the gene. This might be considered unfair. But it is not an issue for market efficiency.

“Solving” the Adverse Selection Problem

• To eliminate adverse selection, the obvious approach is to force everyone into the same “pool” of insured persons:– Require everyone to “purchase” insurance;– Require everyone to pay the “fair” premium;

• Thus, there is no selection problem, and the program balances financially.

• The natural agent to do this is government, since only the government can force participation.

“Solving” the Adverse Selection Problem, continued

• In contrast to many situations, then, economic theory provides a reasonable argument as to why government intervention might improve the allocation of resources by providing health insurance and forcing everyone to participate:– This intervention pools risk to the maximum

extent possible, which benefits everyone.– And it does something the market cannot

easily do on its own.

The Problem with Government Health Insurance: Moral Hazard

• In practice, however, there is a problem.• Insurance creates a moral hazard:

– When people know they do not pay the full price of something, they buy more of it.

– Similarly, when people are insured against risk, they engage in riskier behavior.

• This problem arises in many settings, and it affects both private and government insurance.

The Implication of Moral Hazard in Health Insurance

• The manifestation of this moral hazard in the health care market has two sides:– Patients do not pay the full price of health care, so

they demand more of it than they otherwise would.– Doctors know that patients do not pay the full price,

so they know patients have inelastic demands. It is in doctors’ interests to recommend lots of health care, both because it might help their patients and because this generates income for the doctors.

– In addition, if doctors worry about getting sued, they have an incentive to practice defensive medicine.

Implications of Moral Hazard, continued

• The increased demand means higher prices for medical care.

• In addition, technological progress is continually introducing better but more expensive techniques, treatments, medicines, and the like.

• This provides a second reason why, especially when people have insurance, expenditure continually increases.

• Thus, expenditure on health care is likely to be higher than it would be in an “optimal” allocation.– The decision makers do not pay the full cost, so they

consume too much health care.

Implications of Moral Hazard, continued

• If the effect of government-provided health insurance is only to increase expenditure on health care somewhat, many people might accept this as a cost worth paying in exchange for eliminating the adverse selection problem.

• The implications go beyond simply increased expenditure on health care, however.

Implications of Moral Hazard, continued

• Under government insurance programs, the government sets prices at which it will reimburse health care expenditures.

• As expenditure rises, this creates pressure to cut this expenditure.– The government responds by the setting prices at

which it reimburses doctors at below-market levels.• This causes rationing and other distortions.• It also encourages fraud, creative billing, and

other non-productive behavior in the health care system.

Implications of Moral Hazard, continued

• The problem just outlined – that solving adverse selection by providing insurance exacerbates moral hazard – is inescapable.

• It cannot be eliminated by universal coverage, single payer, or any other system:– It’s a fact of life due to the nature of

insurance.

Why Is Government Insurance Different from Private Insurance?

• In one fundamental way, it is not:– The moral hazard problem is present with both

government and private insurance.

• But, private insurance attempts to moderate the problem in various ways:– Co-pays– Deductibles– Coverage limitations

• Some government programs exclude these, which makes the problem even worse.

Other Negatives of Government Provision of Health Insurance

• Beyond this fundamental issue, government provision of medical insurance has other costs:– It politicizes issues like abortion.– It causes a DWL from taxation, which is far from trivial

given the magnitudes involved.– It partially crowds out private insurance.

• In particular, it appears that some private insurance would arise, despite adverse selection, except that demand is low due to (low-priced) government insurance.– This means there is less scope for innovation to solve

the adverse selection problem.

The Bottom Line on Government Provision of Health Insurance

• It is might seem harder to take a strong stand against this intervention than against many others:– There is a basic problem that markets do not necessarily handle

perfectly; the programs do seem to reduce risk.• Nevertheless, intervention creates substantial problems.

– And there is not much evidence of beneficial effects on health.• For Medicare, my hunch is that appropriate balancing of

these concerns unquestionably argues for elimination.• For Medicaid, my hunch is that appropriate balancing still

argues for elimination:– But there might be a case for a well-designed system, meaning

one that emphasizes benefits for children, includes some co-pays and deductibles, and emphasizes preventive medicine such as vaccinations along with catastrophic care.

The Tax Subsidy for Health Insurance

• In the U.S., most health insurance for the working population comes in the form of an employer-provided fringe benefit:– Employees have the option of obtaining

health insurance through their employer.– Typically the employer “pays” a portion of the

premium and the employee pays the rest.

The Tax Subsidy for Health Insurance, continued

• Theory and evidence show, however, that employers lower the wages they pay by the employer premium, so employees pay the entire amount in the form of lower wages.

• Thus, the main effect is on the kind of compensation received, not on the level.

• This arrangement is odd: why do employers do things this way? Why not just pay wages?

• The answer is that the tax code creates an incentive to provide some compensation in the form of health insurance (and other fringes).– Aside: arose during WWII to avoid wage and price controls.

The Tax Subsidy for Health Insurance, continued

• Employers treat premiums paid on behalf of employees just like they treat wages paid to employees:– A dollar paid in wages, or a dollar paid in premiums, reduces

profits by a dollar and lowers the employer’s tax liability.• Employees, however, do not have to treat premiums

paid on their behalf as taxable income.• Thus, assuming employees want to spend some of their

income on health insurance, they end up with higher net-of-tax income if employers compensate them partially by paying health insurance premiums on their behalf rather than by compensating them entirely in wages.

• Existing estimates suggest this reduces the price of health insurance to employees by roughly 30%.

Implications of the Tax Subsidy

• As with the direct government provision of insurance, the tax subsidy to health insurance means that people buy “too much,” expanding demand for health care and increasing prices.

• What is the solution?– Treat employer payment of health premiums as

taxable income to the employee.• Then there is no subsidy to health insurance

from the tax code:– Employees and employers would both prefer just

using wages as compensation.• This is basic stuff and easy to fix, politics aside.

The Food and Drug Administration

• One critical government intervention in health care is the Food and Drug Administration.

• Under current law, manufacturers of all drugs and medical devices must demonstrate to the FDA’s satisfaction that these products are “safe and efficacious.”– This demonstration involves slow and costly clinical

trials of these products.• The argument for this regulation is that, without

it, manufacturers would sell drugs and devices that have not been adequately tested and that have limited efficacy and/or serious side effects.

FDA, continued

• The claim that, in the absence of regulation, some drugs would be ineffective or “inappropriately” dangerous, is hard to dispute:– This happens even with FDA regulation.

• But that is not the right question:– Any system makes mistakes, so the right question is whether the

private sector or the regulatory approach makes more mistakes, and at what cost.

• In particular, it is important to balance the benefits of avoiding bad drugs against the delay in adopting good drugs.

• And there is ample reason to think the FDA errs substantially in the direction of excessive caution.

FDA, continued

• Consider the drug approval process:– One can always conduct more trials, thereby reducing

risk.– But this has a cost, namely, the delay in using those

drugs that are “safe” and efficacious.

• Any sensible approach must weigh these two considerations:– Faster approval may allow more ineffective/unsafe

drugs onto the market.– Faster approval means that more effective/safe drugs

are available sooner.

FDA, continued

• One possible view is that the FDA understands all this and balances the costs and benefits of approval procedures optimally:– This is highly unlikely: if the FDA approves something

that turns out badly, heads roll.– If the FDA tests “too much” and induces delay, there

is a cost, but it is spread over lots of people: no hearings, no one at the FDA loses a job.

• Thus, the bias in the regulatory approach is for excessive delay.

What is the Alternative to the FDA?

• The tort liability system allows people harmed by bad drugs (or other products) to sue manufacturers.

• Manufacturers weigh the risks of selling a product too quickly or not quickly enough:– They lose if they introduce things too quickly;– They also lose if they introduce things too cautiously.

• There is no guarantee each manufacturer gets it exactly right, but on average the balance is probably better.

• Plus, in the absence of an FDA, there would be private organizations certifying quality:– Competition would make these more efficient than the FDA, and

they would also balance costs and benefits.• Bottom Line: There is no convincing reason for the FDA;

getting rid of it would enhance efficiency substantially.

Licensing of Physicians

• One additional intervention in health care markets is government licensure of physicians.

• To practice medicine in the U.S., a physician must be licensed by a state licensing board.

• To become licensed, one must have graduated from an accredited medical school.– There are some minor exceptions, but these are not

quantitatively important.

Licensing of Physicians, continued

• The standard argument for licensing is that this protects patients from untrained or incompetent doctors.

• The argument is unconvincing, for several reasons.– First, as with drugs, the malpractice insurance / tort liability

system provides strong incentives for quality care.– Second, as with drugs, there would be more and better private

mechanisms certifying quality if such efforts were not being crowded out by government licensure.

– Indeed, even with licensure, HMOs provide much of this certification because they are large and have reputations to protect.

• Thus, the claims that the market cannot provide adequate monitoring of quality is weak.

Licensing of Physicians, continued

• In addition, whether or not licensing increases quality, it unquestionably reduces quantity:– This means higher prices for physician services for everyone.– The adverse impact is greater for lower income persons.

• There are lots of low or medium difficulty tasks that can be carried out competently by people with less skill and/or training than physicians (e.g., nurses, physicians assistants).

• So any improvement in quality from licensure must be balanced against the reduction in quantity.

• And the success of HMOs suggests that the ability of lower-priced personnel to substitute for MDs is large.

• Thus, there is not a good case for licensing physicians.

Should We Care That Expenditure on Health Care is Increasing?

• One reason many people offer for increased government intervention in health care and health insurance markets is the “rising” expenditure on health care.

• The first thing to note is that, if expenditure on health care is rising (as a fraction of GDP), it is not obvious this is a problem.– As societies get richer, there is no reason the composition of

spending should remain constant.– For some items (food, clothing, shelter) there might not be much

benefit from increased expenditure once one gets beyond a certain level.

– Or, increased expenditure might take the form of increased quality, not quantity (nicer food, clothing, housing).

Increased Expenditure on Health Care, continued

• In fact, it is likely that, over a relevant range, many persons want to spend a higher fraction of their income on health as income rises:– After all, better health increases enjoyment of

everything else.

• So, increasing health care expenditure, per se, is not the issue.

Is Health Care Getting More Expensive?

• No. In fact, it’s getting cheaper.• What is happening is that technology is constantly

progressing, so health care is improving in quality.– This often means higher prices, at least in the short run.

• But, the cost of any given drug, treatment, or procedure, is typically constant or falling.– We are just consuming a better and better bundle of goods over

time.• Thus, much of the whining about rising health care costs

is utterly misplaced; quality adjusted, there is no increase.

• To the extent costs are increasing “too fast,” this is mainly due to the interventions discussed above.

Miscellaneous

• Should we outlaw genetic testing? No.• Is malpractice insurance and/or the tort

liability system a major problem? No.• Holding government expenditure on health

care constant, should Medicare cover prescription drugs? Yes.

• Should all drugs be available without a prescription? Yes, except possibly anti-biotics.

Conclusions

• There are many existing interventions that should unquestionably be eliminated:– Medicare– Tax Subsidy– FDA– Licensure

• There is one current intervention that, perhaps, can be defended:– A scaled back version of Medicaid.

• Overall, government intervention in health insurance and health care markets does far more harm than good.

• And some of the alleged problems are not in fact problems in the first place.