Healthcare is No Free Market

“Our health care system is in need of major reform, but we need to go more in the direction of free enterprise and free market principles,” said Congressman Jimmy Duncan (R-TN). Tea party supporters, vocal opponents of what they call “ObamaCare”, echo the same sentiment: health care should be a free market. Democrats have taken the route of explaining why government solutions might be beneficial, but this skirts the underlying issue: healthcare is not a free market to begin with. The current system of medical care and more specifically insurance creates a system which violates a number of contingencies for the application of free-market principles.

If everyone could pay for their healthcare out of pocket, free-market principles would indeed apply. But the problem is really the double-edged nature of insurance—while it helps shield policyholders from unexpected cost, it also eliminates any incentive to use discretion in seeking medical care. Such perverse incentives along with imperfect information are problems which free-market theory assumes do not exist and is therefore unable to alleviate.

A key assumption of free-market theory is that perfect information exists; that is that all market participants have all the information they require to accurately value goods and services. When this is not available, the problem is described as one of imperfect information. More specifically in the case of healthcare, asymmetric information, meaning that insurance applicants often know far more about their health than the companies selling the policy, drives prices higher for everyone. There is an obvious incentive to hide potential pre-existing conditions—for most people the lower premium is well worth the remote legal risk. How does this affect honest applicants? Health insurers cannot know whether you are honest or not and to compensate for those who understate their health problems they must charge everyone the same rate. Whether you like it or not, you are paying for any gains made by those who withhold information on their applications.

When this sort of problem manifested itself in the used car market, George Akerlof introduced the concept of a “Lemon market” in 1970. The idea was that because used car buyers do not know whether a used car is good or a “lemon” (somehow defective), they will deem the quality of the car to be somewhere in between and expect to pay an average price. Good car sellers will not be able to find a buyer at a high enough price and will withdraw their car, leaving lemons to flood the market.

The same issue of lemon cars in the used market presents itself in healthcare

When it comes to healthcare, the “lemons” are those who have hidden information from insurers. The victims are the healthy individuals who, given the inflated cost of insuring themselves, will choose not to. While many still choose to buy insurance even when information asymmetry fixes prices higher than they should be, others will not be able to afford insurance at the incorrect price the market has established. Lemons in the car market were driven out by federal and state legislation which protects purchasers of used vehicles. Hidden information problems in healthcare could be solved one of two ways, the second not unlike the Lemon Law legislation. We could supplant the market; government provided healthcare sidesteps the issue of high-risk applicants concealing medical history because they have no incentive to do so. But asymmetric information issues can also be combated by creating centralized, government-administered heath records and by providing better assistance to those who would have high premiums and would be likely to fudge the truth when applying for insurance. Government can either play a big role by superseding insurers or a small one by aiding them. It cannot however, do nothing. Imperfect information represents a failure of markets to provide the best outcome not only for everyone, but for anyone at all, and government must intervene to correct failures of the free market.

Millions of insurance applicants in the U.S. are turned away for pre-existing conditions

Maybe the reason why so many people feel compelled to withhold information from insurers is the strict stance against pre-existing conditions insurance companies have taken. Under the current insurance system, it is logical that people with pre-existing health risks should have to pay higher premiums on their insurance. Those who represent a greater risk to the liability pool must, by the nature of insurance, contribute more to that pool. Whether this is morally right or even desirable is beside the point; left in private hands, insurers and policyholders will seek the best short-term outcome for themselves, and that will never involve accepting financial responsibility for others. But where the insurance industry fails to adhere to market logic is in its rejection of risky applicants. Regardless of how severe the risk they present might be, surely there is some price at which private insurers would be willing to cover these applicants? Insurance could remain mostly privately operated if insurers could ascribe some sort of price to risk, an additional 10% onto your premium for low risk pre-existing conditions like asthma, perhaps. Maybe private coverage could do better than the woefully deficient, overpriced high-risk pools offered by 35 U.S. states in insuring those who are likely to need it. But at least for now we’ll never know, as risky patients hang in limbo because the free market cannot determine a price on its own.

Frequency of CT and MRI scans has increased dramatically in the past decade

It’s not those who are costly to insure though that present the greatest challenge to the healthcare system. Insurance can often create perverse incentives, negatively affecting an insured individual’s behavior by reducing his responsibility for his actions. Take the use of magnetic resonance imaging (MRIs), for example. The number of MRIs per patient tripled from 1997 to 2006, according to a 2008 study published in Health Affairs. The study confirmed speculation that overuse of MRIs was unnecessarily driving up healthcare costs. The phenomenon holds true for a host of other examples. You are far more likely to see your doctor for a cold, a dermatologist for an innocuous rash, or a chiropractor for temporary muscle tightness when the cost of such actions is dramatically reduced by medical coverage. Although co-payments and deductibles help to check medical superfluities, they certainly do not eliminate them. Regardless of the real cost of a copayment, the feeling that the majority of the cost of a procedure will be covered by an insurer may make it seem like a great deal, even when it’s wholly unnecessary. Such perverse incentives may help individuals be minutely healthier, but they also create inefficiencies and inflate medical costs. Free market thought assumes that incentives, the driving force behind human decision making, will generate the most efficient outcome. But the moral hazard of health insurance incentives creates just the opposite. It allows us more medical coverage than we need at the expense of those who truly need that coverage, but cannot afford it.

Healthcare should not become a government enterprise, at least not immediately. Private ownership often is more efficient and productive than government management and sometimes its thriftiness can pay off. Advocates for the immediate government takeover of the entire healthcare system are as deluded as those who still claim it is a free market and should remain so. There is no sense to adopting dogmatic reform which forces the nation to admit that either fully private or fully public healthcare is the only feasible system. But healthcare has clearly expanded to a point where it no longer acts like a market in many respects and in those areas legislation or partial government management are required to correct market failures. The “free enterprise and free market principles” which Congressman Duncan supports in many cases simply do not exist. While free markets often produce efficient outcomes, markets can sometimes fail to accomplish what we want them to. In those cases, government is the solution to problems the market cannot solve.

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