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Note on last econ discussion

The last econ discussion was about the role of health in economic development. Overall, the presentation was pretty informative and interesting, and the invited speaker, who is a UCI econ grad student, is very friendly and open to questions. There is one issue I want to clarify though.  At the end of the discussion, we talked about the economics of healthcare in general. I raised my hand and asked a question: “how is the healthcare market different from other markets?”. The speaker responded that the healthcare market is different because externalities (a form of market failure) are prevalent so government needs to intervene to correct this failure. When I asked for an example, the speaker brought up obesity. Her reasoning is as follows: since obese people are more likely to have life-threatening diseases (such as heart diseases, diabetes, cancer, etc.), their healthcare expenses are probably much higher than those of normal people over their life time. This in turn has a “spillover” effect on insurance premium: insurance companies must increase their fees on everyone else to cover the high cost of those obese people. The “externality” here is the monetary damage on the non-obese insurance buyers, who do not do anything to deserve the hike in their insurance premium. I then asked the speaker: “if that’s an ‘externality’, then we can see it in all other markets, not just healthcare. For example, when a large number of people suddenly love to eat rice, their purchase of rice will push the price of rice up, making the rest of us worse off since we will have to incur more cost than before to obtain the same amount of rice”. The speaker then said: “it’s not an externality, it’s just supply and demand”. To which I replied: “then the obesity example is also supply and demand. Obese people simply increase the demand for healthcare, thus increasing the insurance premium. I think the real problem with the healthcare market is information asymmetry, not externality”. The speaker then said: “information asymmetry is just a kind of externality”. The conversation ended there as we had limited time and other questions to cover.

Now, how do we make sense of the conversation above? Is “obesity” with its “spillover” effect on insurance premium an “externality”? Or is it something else? Technically, it is not wrong to argue that the effect is an “externality”. But how about my example of the rice market? Is it a kind of externality too? Well, it is. But these “externalities” do not have the implication that our speaker assumed (resource misallocation). Yes they are “externalities”, but are they “market failures”? The answer is probably not. There are two kinds of externality: pecuniary externality and technical (or real) externality. Both of our cases fall into the former category, which is pecuniary externality. A pecuniary externality is one that operates through prices, not real resources. A pecuniary externality is generally not considered a market failure as it has offsetting effects. In my rice example, the increase in price would disadvantage the rice buyers, but would advantage the rice sellers. The “negative externality” on the buyers are offset by the “positive externality” on the sellers. Similarly in the obesity case, the “negative externality” on the insurance buyers is offset by the “positive externality” on the insurance providers (through higher insurance premium). This is very different from a “real” externality case, where usually no such offsetting effect is present. The “real” externality (or technical externality) is the standard market failure we learn in econ classes: non-compensated, direct resource effects imposed on a third party. A barbecue at your house may emit harmful smoke to a neighbor next door. Your smoking cigarette may make me sick. These are externalities that cannot be offset (or easily offset) by the same price mechanism as in the aforementioned pecuniary externality cases.

So there is nothing wrong with the healthcare market? Not necessarily. According to standard economics, healthcare insurance suffers from a kind of market failure called “information asymmetry”. The basic idea is that when one party in an exchange has more information than the other, the market will be “mispriced”, resulting in loss of beneficial trades. In a typical health insurance model, the insured knows more about his/her own health than the insurer. Therefore, those with higher risks tend to buy more insurance while those with lower risks tend to buy less. The insurer, presumably not being able to differentiate the high risk people with the low risk ones, charges the same premium to all customers, based on the average risk of the whole group. The result is that those with higher than average risks will buy insurance and those with less than average risks will opt out. Consequently, the insurer cannot cover the healthcare costs because the premium only reflects the average risk while all of its customers have higher than average risks. This forces the insurer to increase the premium, which in turn drives more customers out of the market. The problem here is not merely that low-risk customers are made worse off, as the “externality” narrative suggests. The true problem here is that both parties (the insurer and the insured) are made worse off as fewer than potential trades are made. If the insurer knew the true risk of each customer (no information asymmetry), it would charge different premiums to different people. As a result, those with higher risks would not necessarily drive out those with lower risks as the two groups would pay different levels of premium. The information asymmetry model in health insurance is based on a debatable assumption: that insurers cannot differentiate risky customers from safe ones. Whether this assumption is true or not is up to empirical evidence to decide.

To those interested, here is a good overview of information asymmetry by Professor Bryan Caplan. If you are looking for a balanced view with fresh analysis and great insights into the healthcare market in the US, I recommend Crisis of Abundance by Arnold Kling. The book is a dispassionate study of what is wrong with healthcare in the US and what options and trade-offs we should consider when trying to solve the problem.

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