Health Insurance and Health Costs

Tyler asks Why is private health insurance such a disaster? in particular he wants to know, Why does private health insurance perform so badly in holding down costs?

There are actually two issues. Tyler mostly questions the traditional arguments that insurance increases costs. I won’t deal with all of his arguments (today!) but consider the following:

The tax-free nature of employer-supplied insurance benefits encourages wantonness. (TC: Why? You can subsidize the purchase of apples, that doesn’t mean apples will be produced inefficiently or at “excess cost” for that level of apple output.)

True, but the phrase “for that level of output” contains a whole bag of tricks because subsidies will change the output level both in quantity and quality terms. Assume that there are two drugs, a cheap one at $10 and an expensive one at $20. You think the expensive drug is worth $5 more than the cheap one. With no subsidy you buy the cheap drug. With a 75% subsidy the cheap drug is $2.50 and the expensive one is $5 and the difference is now only $2.50 – you now buy the expensive drug. Thus there is no necessary production inefficiency but costs double.

So it is true that 3rd party payment will increase total costs. I think some of the other arguments that Tyler questions are also correct but these arguments do have another problem – one Tyler does not mention. To the extent that third party payment is not increasing, the increase in demand will cause a one-time increase in the level of prices/expenditures. What we see in the United States and worldwide, however, is a sustained increase in relative prices and expenditures and for that you need some factor that is also sustained – that factor is technological advancement. In real terms technological advancement lowers prices but when you combine that with an elastic demand for medical care nominal prices and expenditures increase. (When Christian Barnard performed the first open-heart surgery in 1967 he reduced the real cost of treating heart disease but increased expenditures on open-heart surgery).

In other words, health insurance companies don’t hold down costs because their customers don’t want them to. In this sense, I don’t think private health insurance is a disaster. The problem, if there is one, is in ourselves.