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♪ [music] ♪

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- [Professor Tyler Cowen] [br]In the previous video,

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we introduced the ideas [br]of asymmetric information,

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and adverse selection [br]and we applied those ideas

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to the used car market.

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Let's take those same [br]basic concepts,

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and build a basic model [br]of health insurance.

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Suppose that potential [br]health insurance consumers

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come in a range of states of health.

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For instance, [br]the least healthy people

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might cost about $30,000 a year.

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That's these folks here.

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The most healthy might cost [br]nothing in healthcare.

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That's these folks over here.

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Now consumers know this information,

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but by assumption, insurers don't.

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From the insurer point of view,

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everyone is of the same [br]average health.

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Here again, we have [br]asymmetric information.

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That is consumers of healthcare

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have more information about

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their health status [br]than insurers do.

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In this scenario, insurers have to [br]price the coverage

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based on the average cost [br]among all consumers,

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namely, $15,000.

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But if the insurance costs $15,000,[br]then a portion of the market,

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the relatively healthy people,

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they will choose not [br]to buy insurance as

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the cost of that insurance [br]is greater to them

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than the expected benefit.

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So only part of this market [br]will buy insurance.

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The average cost of those [br]who actually will buy

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is then not $15,000 but $22,500.

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In that case, [br]the insurance company,

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if it tries to price at $15,000, [br]loses money.

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If the insurance company instead [br]raises the price to $22,500,

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well, the same dynamic[br]is actually going to kick in again.

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That is relatively healthy people

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won't find it worth [br]paying that price.

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The sicker people still will buy,

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and that will raise [br]the expected costs

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to the insurer, [br]and thus the price even further.

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This dynamic continues [br]until the individual insurance firm

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finds there is no price [br]at which it can attract

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a set of customers with [br]healthcare costs

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lower than the price of insurance.

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This is the same death spiral [br]we saw before with used cars

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and it leads to a market failure.

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As we saw in the used car market,

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there are several reasons [br]why reality may differ

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from the simple model.

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First, the model we laid out would [br]predict that the healthy people,

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those who exercise, [br]eat their veggies,

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and buckle their seatbelts would [br]not buy insurance,

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while the model is predicting that [br]the smokers, the mountain climbers,

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and the motorcycle riders would[br]buy insurance.

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Is this true? Mostly no.

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The people who buy health insurance

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actually turn out to be [br]the healthier people as well.

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Why is that?

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Well, those who try to avoid risk [br]by eating well

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also try to avoid risk [br]by buying health insurance.

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Our initial assumption that

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everyone calculates [br]costs and benefits

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in exactly the same way [br]is too simple.

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Once you account for the fact that

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people have differential [br]tolerances for risk,

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you can end up having [br]the healthier people be[br]

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those who choose to buy [br]the health insurance.

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This is called [br]“propitious selection”[br]

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where the people who buy [br]the health insurance are healthier,

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not sicker than average.

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This can keep costs low, [br]and prevent the death spiral.

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Another possible response [br]to the adverse selection problem

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in health insurance [br]might seem familiar.

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If you recall, [br]we saw that services such as

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CARFAX and Certified Inspections

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can alleviate [br]the asymmetric information problem

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when buying a used car.

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These services allow [br]the buyer of the car

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to have similar information

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to that possessed[br]by the seller of the car.

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The result of this information [br]is that better cars

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can sell for more, [br]and lemons can sell for less.

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Is there an analogous approach [br]for people in health insurance?

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Well, yes.

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The health of people [br]can be inspected

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just as cars are inspected.

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So while consumers initially [br]may have more information

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about their health than what [br]the insurance companies have,

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a checkup will allow [br]the insurance firms

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to get a better idea of [br]the consumer's expected

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healthcare costs.

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And that allows [br]the insurance companies

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to charge healthy consumers less [br]and sicker consumers more.

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In the used car market,

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that seemed like [br]a pretty good solution.

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After all, better cars [br]should sell for more,

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and lemons should sell for less.

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In the health insurance market,

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that solution might work,

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but some people feel it is [br]doubly unfair.

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Not only are the sick sick,

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but now they also have [br]to pay more

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for their health insurance.

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Another problem [br]with inspection is that

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it might reveal [br]too much information,

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thereby rendering health insurance[br]no longer viable.

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For instance, let's say there's [br]a very good diagnostic test,

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and it determines that [br]a patient A has cancer

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and then B we know that cancer[br]will cost $1 million to treat.

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Well, to insure against that cancer,

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the price of the policy [br]has to be about $1 million,

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but that's no longer insurance.

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That's just presenting the patient [br]with the bill.

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Insurance is protecting against [br]unexpected states of affairs,

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and it's a kind of risk pooling,

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a kind of protecting yourself[br]against the high bill.

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But if you're getting the high bill [br]no matter what when you're sick,

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well, then we've lost [br]those benefits of insurance.

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Another solution to [br]the adverse selection problem

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when used extensively [br]in the United States

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is group health insurance [br]through employers.

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Most people in America [br]don't purchase insurance directly.

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Instead, their employer [br]purchases it for them

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as part of a group plan.

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The benefit of the system is that [br]the insurance company

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doesn't have to worry about [br]adverse selection so much

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The employer doesn't know much[br]more about its employees' health

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than does the insurance firm.

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Furthermore, the employer is[br]going to be buying

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health insurance for the employees[br]regardless of their health.

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So for these reasons,[br]the adverse selection problem is

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much weaker with [br]group health insurance.

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Group health insurance, however, [br]does cause other problems.

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If you lose your job, [br]you can lose your health insurance.

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And what we do about retirees?

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In the United States, [br]various laws have made

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health insurance more affordable,

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and furthermore retirees are insured [br]by the government

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under Medicare.

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So, there are some solutions, [br]albeit imperfect ones as usual.

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The most recent approach [br]to the adverse selection problem

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was implemented [br]in the Affordable Care Act,

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otherwise known as Obamacare.

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Under the Affordable Care Act,

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everyone is supposed to buy[br]health insurance.

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If you don't, [br]you will be fined by law.

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The idea here is to force [br]all the healthy people into the pool

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of those who buy insurance

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that will moderate the cost [br]of health insurance,

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and we will avoid the death spiral.

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As you can see, although [br]

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the adverse selection model [br]is pretty simple,

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it has lots of applications

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to some pretty complex [br]real-world problems.

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Next up we'll tackle moral[br]hazard. See you then.

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