Tuesday, August 28, 2012

Will Increased Competition in the Health Insurance Market Lower Health Care Costs?

One of the things economists, and indeed most people accept--often at face value--is that increased competition is always a good thing in the marketplace. Paul Ryan's plan for Medicare seems to capitalize on this idea as a means to reduce health care costs. To be sure, the great majority of the time, I think that competition maximizes consumer welfare by lowering costs and--as cliche as it may be to say it--spurring innovation. But what if there was a case where increased competition didn't necessarily do either of these things? The case I'm referring to, as I'm sure you've already surmised, is the market for health insurance.

Before I can explain my case to all of you, a quick economics lesson may be in order. A health insurance plan is a wildly different product than the oft-mentioned "widgets" of our microeconomics classes. A widget, we've been told, is a simple, uniform, manufactured good, the price of which tends to fall as more firms compete to produce it. By contrast, a health insurance plan exchanges the cost of a premium for an innumerable set of potential services. These services fall under two general categories: insurer services and hospital services.

The first of these, insurer services, would include things like risk-pooling, claims processing, marketing to customers, etc. For these services, larger insurers have a clear advantage in cost control--that is, they have to spend a smaller percentage of their cash-flow on these services. Think about it like this: an insurer who has 50,000 enrollees in its electronic database probably has to spend far less per-enrollee on administrative costs than an insurer with 5,000 customers. The logic behind this stems from the idea that something like an electronic health database has a large, fixed start-up cost, but adding each additional person to the database has a fairly small cost. 

Put another way, imagine a small insurer and a large insurer both have to purchase a computer to store client files on. The computer, roughly speaking, doesn't cost any more or any less for either of them, but the small insurer has 5,000 customers paying them and the large has 50,000. If the computer costs $1,000, then the large company has paid a significantly smaller share of its total income from premiums on its electronic records database. Sure, they may have to pay someone to input all of those names, but the additional cost for each new name is likely to be small. It is for reasons like this that smaller insurance companies have much higher administrative costs than larger ones do. In the parlance of economists, these are called economies of scale

We can see the real-world evidence of this, too. According to the Council for Affordable Health Insurance, smaller insurers use 35-45% of their premiums for marketing and administration, while larger insurers have administrative costs around 20%. Even lower still are the administrative costs of something like Medicare, which covers over 50 million people. That money spent on advertising and administration is, in other words, money not spent on paying for medical procedures.

The second part of the services rendered in a health insurance plan would be on the hospital side--paying doctors and hospitals for health care. As you may or may not know, doctors and hospitals often negotiate with insurers over payment rates and what procedures will or will not be covered. Now this is where health care costs come in: the costs of procedures depends heavily on how much market power--that is, how much leverage--a doctor, hospital, or insurer has in payment negotiations.

Let's say an insurance company's client base represents a large part of any given physician's cash-flow. Now, if the physician's revenue is at stake here, he or she will be more willing to put up with lower payment rates and restrictions set forth by the insurance company during contract negotiations. This is, as I said before, because the insurer's client base is so large that the doctor stands to lose much more if they don't do business with such a large insurer. After all, less money is still better than no money! On the flip side, if a physician or hospital group treat most of the people a certain geographical area, they will have more leverage in negotiations with insurers--they're effectively the only game in town. As such, they will be able to charge higher prices for their services to insurers, because insurers have no real alternatives. You'd better believe that the insurer's increased costs are passed on to consumers, too, sticking us all with higher premiums. Sadly enough, this has become something of the rule, rather than the exception, and studies have shown that hospital mergers and physician group consolidations have played a large role in raising the costs of health care. 

All of this brings me full circle back to my initial question: will increased competition in the health insurance market actually lower health care costs? Based on what I've read, no, it won't. At least, it won't if numerous, smaller insurers compete in a market for ever-consolidating hospitals and physician groups, which is what seems to be the trend right now. With a larger number of insurance companies in the market, each one would represent a smaller share of a hospital's or a physician's income stream, so, if anything, this may actually raise costs further, as physicians would be able to refuse to do business with certain insurers and use their increased market power to extract higher payment rates from others. 

In reality, what economic theory and research suggests would yield lower costs for you and I would be a market in which hospital and physician group concentration was lower (read: had less leverage and more competition) and health insurers were somewhat larger and fewer in number. In this way, insurers would couple their increased negotiating power with hospitals and their lower overhead costs to ultimately yield lower costs overall. 

So really, based on what evidence we have, increased competition between health insurers likely won't lead to any meaningful reduction in health care costs for Americans. To be sure, it is certainly fashionable to pay lip-service to the magic of the marketplace, but that magic won't be of much help to something like Paul Ryan's Medicare plan, or indeed any plan that uses insurer competition alone as a means to lower health care costs.

Sorry to burst everyone's collective bubble.