The Republican Health Care Plan

With a new round of health care negotiations about to start, it seems likely that Republicans will try to put forward their version of reform.  The basic idea of the Republican plan is that it allows insurers to sell across state lines, increasing competition and lowering costs in the process.  The typical response to this from liberals is that adopting this plan would essentially deregulate the insurance industry, where companies would cluster in the states with the most lax regulatory standards.  Indeed, some states may lower their standards to entice companies to relocate to their state.  That being said, I think it’s important to point out that, even beyond the issue of regulation, that there is little reason to believe that the Republican health care plan would actually lower costs.

Here is the basic logic behind the idea that increased competition will lower premiums.  It starts with the premise that most states are only large enough to support a few major insurance providers, basically making them monopolies (the markets would actually be oligopolies, but assuming that they are monopolies doesn’t change the underlying analysis).  Below is the basic graph of a monopolistic market structure, where q gives the quantity of insurance (how many people are covered, how generous their coverage is, etc) and p gives the price of premiums.  D gives the market demand for insurance, while S is the firm’s supply curve and MR is marginal revenue.  As shown in the diagram, a monopolist has price setting power.  In other words, the monopolist gets to choose the market price, and can charge prices in excess of marginal cost.

The monopolist chooses to produce the output such that marginal revenue equals marginal cost (which is also the supply curve), but then is able to price off of the demand curve.  This leads to lower output and higher prices than you would seen in a perfectly competitive market.  By increasing the number of insurance companies able to compete in a given region, the firm’s monopoly power is diminished, and it no longer gets to set prices above marginal cost.  Thus, more coverage will be offered and it will be offered at a lower price.

So this is the basic argument for the Republican plan, but what’s wrong with this story?  Well, at the end of the day, people do not demand a piece of paper that says they have insurance, rather, they demand the access to health care that insurance provides.  Insurance companies must bargain with hospitals and doctors’ offices to ensure that their clients can use the coverage they buy in many places.  However, in this market there is only one buyer (the insurance company), and there are many sellers (the hospitals and doctors’ offices).  In this market, the insurance company has monopsony power.  Below is a graph of this market structure, where q gives the quantity of medical care given to people covered by the insurance company (or rather the number of hospitals where its coverage is accepted) and p gives the price for the insurer of the medical care.

Once again, the insurance company has significant price setting capabilities, only this time as the buyer.  They choose the output where marginal cost intersects the demand curve (which is also marginal revenue) but then price off of the supply curve, leading to lower prices and outputs than you would expect to see in a perfectly competitive market with many buyers.  The next graph illustrates this and shows the effects of increased competition on the market.

As you can see, the insurance company must now pay more at all levels of output.  This increases their cost at all levels of output, and going back to the original market between the insurance company and people seeking coverage, it acts as a negative supply shock.

The end result on prices and the amount of coverage offered is ambiguous, and depends on your beliefs about how much insurance companies mark-up prices above costs and what kind of bargains they are able to get on medical care.  At least some evidence suggests that the mark ups on premiums are not actually all that large.  If losing their monopsony power causes costs to increase by more than this mark-up, then the Republican plan could actually raise premiums.

Also, even though prices may not decrease, the legislation would still increase competition in these markets, and firms would have to lower costs in any way possible.  The firms with the lowest costs are likely to be those based in states with the most lax regulation, those who cherry-pick the healthiest and lowest cost people, and those who engage in unethical behavior like rescission.

Update: Of course, the biggest issue here is that even if these reforms were to lower the level of costs, there’s no reason to expect them to slow the growth of costs.  Any serious reform must keep health care costs from growing so quickly.

Update II: Matt Yglesias makes a related point.


1 comment so far

  1. […] Posted March 4, 2010 Filed under: Meusebach, economics | A couple of weeks ago I authored a post here explaining why increased competition in insurance markets was unlikely to bring down premiums.  […]

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