Asymmetric Information and Health Insurance

In this video, we discuss asymmetric information, adverse selection, and propitious selection in relation to the market for health insurance. Health insurance consumers come in a range of health, but to insurance companies, everyone has the same average health. Consumer have more information about their health than do insurers. How does this affect the price of health insurance? Why would some consumers prefer to not buy health insurance at all? And how does this all relate to the Affordable Care Act? Let’s dive in.

Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics

Ask a question about the video: http://www.mruniversity.com/courses/principles-economics-microeconomics/lemons-problem-asymmetric-information-health-insurance#QandA

Next video: http://www.mruniversity.com/courses/principles-economics-microeconomics/moral-hazard-adverse-selection

1
00:00:13,958 --> 00:00:17,030
- [Professor Tyler Cowen] In the previous
video, we introduced the ideas of

2
00:00:17,030 --> 00:00:21,280
asymmetric information, and adverse
selection and we applied those ideas to

3
00:00:21,280 --> 00:00:26,960
the used car market. Let's take those same
basic concepts, and build a basic model of

4
00:00:26,960 --> 00:00:32,310
health insurance. Suppose that potential
health insurance consumers come in a range

5
00:00:32,310 --> 00:00:36,660
of states of health. For instance, the
least healthy people might cost about

6
00:00:36,660 --> 00:00:42,920
$30,000 a year. That's these folks here.
The most healthy might cost nothing in

7
00:00:42,920 --> 00:00:48,540
healthcare. That's these folks over here.
Now consumers know this information, but

8
00:00:48,540 --> 00:00:54,180
by assumption, insurers don't. From the
insurer point of view, everyone is of the

9
00:00:54,180 --> 00:01:00,600
same average health. Here again, we have
asymmetric information. That is consumers

10
00:01:00,600 --> 00:01:06,070
of healthcare have more information about
their health status than insurers do. In

11
00:01:06,070 --> 00:01:10,770
this scenario, insurers have to price the
coverage based on the average cost among

12
00:01:10,770 --> 00:01:18,420
all consumers, namely, $15,000. But if the
insurance costs $15,000, then a portion of

13
00:01:18,420 --> 00:01:23,460
the market, the relatively healthy people,
they will choose not to buy insurance as

14
00:01:23,460 --> 00:01:28,670
the cost of that insurance is greater to
them than the expected benefit. So only

15
00:01:28,670 --> 00:01:33,300
part of this market will buy insurance.
The average cost of those who actually

16
00:01:33,300 --> 00:01:41,920
will buy is then not $15,000 but $22,500.
In that case, the insurance company, if it

17
00:01:41,920 --> 00:01:48,580
tries to price at $15,000, loses money. If
the insurance company instead raises the

18
00:01:48,580 --> 00:01:54,917
price to $22,500, well, the same dynamic
is actually going to kick in again.

19
00:01:54,917 --> 00:01:58,876
That is relatively healthy people won't
find it worth paying that price.

20
00:01:58,900 --> 00:02:03,470
The sicker people still will buy, and that
will raise the expected costs to the

21
00:02:03,470 --> 00:02:09,070
insurer, and thus the price even further.
This dynamic continues until the

22
00:02:09,070 --> 00:02:13,950
individual insurance firm finds there is
no price at which it can attract a set of

23
00:02:13,950 --> 00:02:19,670
customers with healthcare costs lower than
the price of insurance. This is the same

24
00:02:19,670 --> 00:02:26,140
death spiral we saw before with used cars
and it leads to a market failure. As we

25
00:02:26,140 --> 00:02:30,540
saw in the used car market, there are
several reasons why reality may differ

26
00:02:30,540 --> 00:02:35,350
from the simple model. First, the model we
laid out would predict that the healthy

27
00:02:35,350 --> 00:02:39,720
people, those who exercise, eat their
veggies, and buckle their seatbelts would

28
00:02:39,720 --> 00:02:44,760
not buy insurance, while the model is
predicting that the smokers, the mountain

29
00:02:44,760 --> 00:02:51,550
climbers, and the motorcycle riders would
buy insurance. Is this true? Mostly no.

30
00:02:51,550 --> 00:02:55,270
The people who buy health insurance
actually turn out to be the healthier

31
00:02:55,270 --> 00:03:01,650
people as well. Why is that? Well, those
who try to avoid risk by eating well also

32
00:03:01,650 --> 00:03:06,090
try to avoid risk by buying health
insurance. Our initial assumption that

33
00:03:06,090 --> 00:03:12,060
everyone calculates costs and benefits in
exactly the same way is too simple. Once

34
00:03:12,060 --> 00:03:16,430
you account for the fact that people have
differential tolerances for risk, you can

35
00:03:16,430 --> 00:03:20,200
end up having the healthier people be
those who choose to buy the health

36
00:03:20,200 --> 00:03:25,340
insurance. This is called propitious
selection where the people who buy the

37
00:03:25,340 --> 00:03:31,860
health insurance are healthier, not sicker
than average. This can keep costs low, and

38
00:03:31,860 --> 00:03:37,700
prevent the death spiral. Another possible
response to the adverse selection problem

39
00:03:37,700 --> 00:03:42,440
in health insurance might seem familiar.
If you recall, we saw that services such

40
00:03:42,440 --> 00:03:47,460
as CARFAX and Certified Inspections can
alleviate the asymmetric information

41
00:03:47,460 --> 00:03:52,750
problem when buying a used car. These
services allow the buyer of the car to

42
00:03:52,750 --> 00:03:56,750
have similar information to that possessed
by the seller of the car.

43
00:03:57,000 --> 00:04:01,920
The result of this information is that
better cars can sell for more, and lemons

44
00:04:01,920 --> 00:04:07,110
can sell for less. Is there an analogous
approach for people in health insurance?

45
00:04:07,110 --> 00:04:12,280
Well, yes. The health of people can be
inspected just as cars are inspected. So

46
00:04:12,280 --> 00:04:16,330
while consumers initially may have more
information about their health than what

47
00:04:16,330 --> 00:04:21,110
the insurance companies have, a checkup
will allow the insurance firms to get a

48
00:04:21,110 --> 00:04:26,010
better idea of the consumer's expected
healthcare costs. And that allows the

49
00:04:26,010 --> 00:04:31,090
insurance companies to charge healthy
consumers less and sicker consumers more.

50
00:04:31,090 --> 00:04:36,080
In the used car market, that seemed like a
pretty good solution. After all, better

51
00:04:36,080 --> 00:04:40,600
cars should sell for more, and lemons
should sell for less. In the health

52
00:04:40,600 --> 00:04:45,380
insurance market, that solution might
work, but some people feel it is doubly

53
00:04:45,380 --> 00:04:49,760
unfair. Not only are the sick sick, but
now they also have to pay more for their

54
00:04:49,760 --> 00:04:54,270
health insurance. Another problem with
inspection is that it might reveal too

55
00:04:54,270 --> 00:04:59,620
much information, thereby rendering health
insurance no longer viable. For instance,

56
00:04:59,620 --> 00:05:04,260
let's say there's a very good diagnostic
test, and it determines that a patient A

57
00:05:04,260 --> 00:05:09,950
has cancer and then B we know that cancer
will cost $1 million to treat. Well, to

58
00:05:09,950 --> 00:05:15,170
insure against that cancer, the price of
the policy has to be about $1 million, but

59
00:05:15,170 --> 00:05:19,110
that's no longer insurance. That's just
presenting the patient with the bill.

60
00:05:19,110 --> 00:05:24,150
Insurance is protecting against unexpected
states of affairs, and it's a kind of risk

61
00:05:24,150 --> 00:05:27,740
pooling, a kind of protecting yourself
against the high bill. But if you're

62
00:05:27,740 --> 00:05:31,668
getting the high bill no matter what when
you're sick, well, then we've lost those

63
00:05:31,668 --> 00:05:37,680
benefits of insurance. Another solution to
the adverse selection problem when used

64
00:05:37,680 --> 00:05:42,630
extensively in the United States is group
health insurance through employers. Most

65
00:05:42,630 --> 00:05:47,430
people in America don't purchase insurance
directly. Instead, their employer purchases

66
00:05:47,430 --> 00:05:52,590
it for them as part of a group plan. The
benefit of the system is that the

67
00:05:52,590 --> 00:05:57,080
insurance company doesn't have to worry
about adverse selection so much. The

68
00:05:57,080 --> 00:05:59,875
employer doesn't know much more
about its employees' health

69
00:05:59,875 --> 00:06:01,542
than does the insurance firm.

70
00:06:01,542 --> 00:06:04,209
Furthermore, the employer is
going to be buying

71
00:06:04,209 --> 00:06:07,542
health insurance for the employees
regardless of their health.

72
00:06:07,542 --> 00:06:11,420
So for these reasons,
the adverse selection problem is

73
00:06:11,420 --> 00:06:16,310
much weaker with group health insurance.
Group health insurance, however, does

74
00:06:16,310 --> 00:06:20,270
cause other problems. If you lose your
job, you can lose your health insurance.

75
00:06:20,270 --> 00:06:26,220
And what we do about retirees? In the
United States, various laws have made

76
00:06:26,220 --> 00:06:30,660
health insurance more affordable, and
furthermore retirees are insured by the

77
00:06:30,660 --> 00:06:36,240
government under Medicare. So, there are
some solutions, albeit imperfect ones as

78
00:06:36,240 --> 00:06:41,540
usual. The most recent approach to the
adverse selection problem was implemented

79
00:06:41,540 --> 00:06:47,200
in the Affordable Care Act, otherwise
known as Obamacare. Under the Affordable

80
00:06:47,200 --> 00:06:51,460
Care Act, everyone is supposed to buy
health insurance. If you don't, you will

81
00:06:51,460 --> 00:06:57,660
be fined by law. The idea here is to force
all the healthy people into the pool of

82
00:06:57,660 --> 00:07:02,300
those who buy insurance that will moderate
the cost of health insurance, and we will

83
00:07:02,300 --> 00:07:07,980
avoid the death spiral. As you can see,
although the adverse selection model is

84
00:07:07,980 --> 00:07:12,860
pretty simple, it has lots of applications
to some pretty complex real-world

85
00:07:12,860 --> 00:07:17,042
problems. Next up we'll tackle moral
hazard. See you then.

86
00:07:18,790 --> 00:07:21,167
- [Announcer] If you want to test yourself,
click Practice Questions.

87
00:07:22,375 --> 00:07:25,459
Or, if you're ready to move on,
just click Next Video.