Posted by Nolan Miller on Mar 28, 2012
Filed Under (Health Care)
The argument over the fate of the Patient Protection and Affordable Care Act, a.k.a “Obamacare,” is taking place before the United States Supreme Court this week. Three questions are being considered. The first is a technical question regarding whether the challenge to the law can be heard now or if it has to wait until someone actually pays the penalty the law imposes. Perhaps this is an interesting legal matter, but there isn’t much economics there. The second question is whether the individual mandate, which requires most Americans to buy health insurance or face a penalty, is a constitutional exercise of Congress’s power to regulate interstate commerce or not. This is the key question, since, if the justices decide that Congress overstepped its powers in passing the law, the part of the law that results in nearly universal health insurance could be struck down. The third question is, if the individual mandate is struck down, how much of the rest of the law will go along with it.
As I said, the second question is the key, and SCOTUS heard arguments on this question yesterday. By all accounts, the administration bumbled it. Here’s an excerpt from the New York Times:
But several of the more conservative justices seemed unpersuaded that a ruling to uphold the law could be a limited one. Justice Alito said the market for burial services had features similar to the one for health care. Chief Justice Roberts asked why the government could not require people to buy cellphones to use to call emergency service providers.
Justice Scalia discussed the universal need to eat.
“Everybody has to buy food sooner or later, so you define the market as food,” he said. “Therefore, everybody is in the market. Therefore, you can make people buy broccoli.”
Justice Alito asked Mr. Verrilli to “express your limiting principle as succinctly as you possibly can.”
So, the justices wanted to know if they allow the individual mandate to stand, what won’t Congress be able to regulate. The administration’s response:
Instead of a brisk summary of why a ruling upholding law would not have intolerably broad consequences, Mr. Verrilli gave a convoluted answer. First of all, he said, Congress has the authority to enact a comprehensive response to a national economic crisis, and the mandate should be sustained as part of that response.
He added: “Congress can regulate the method of payment by imposing an insurance requirement in advance of the time in which the service is consumed when the class to which that requirement applies either is or virtually most certain to be in that market when the timing of one’s entry into that market and what you will need when you enter that market is uncertain and when you will get the care in that market, whether you can afford to pay for it or not and shift costs to other market participants.”
Here’s what they should have said. It is true that people need to buy burial services and food, but these markets differ from health care in that there is no threat of “adverse selection” as there is in health insurance, and adverse selection has the potential to make it impossible for individuals to purchase insurance at reasonable rates (i.e., the sick pay less than their expected cost of care and the rich pay more) unless that market is regulated.
Take the market for broccoli or burial services. As the justices point out, it is true that everybody needs food or burial, eventually. However, my ability to consume food or be buried does not depend in any crucial way on what others do. In economic terms, we say that there is no “market failure” here.
Now, take the market for health care services. Suppose there are two kinds of people. Healthy people have expected annual health care costs of $1000, while sick people have expected annual health care costs of $11,000. If there are equal numbers of healthy and sick people, then the average cost of caring for all people is (1000 + 11000)/2 = $6000. Next, assume that individuals know whether they are healthy or sick, but health insurers don’t know whether a person is healthy or sick, or, as is done in the new health care law, are prohibited from using this information to charge different prices to healthy and sick people.
Suppose the insurer charges a price of $6000. If everyone purchased this insurance, the insurer would break even. But, a person who expects to have only $1000 healthcare costs would not be willing to purchase this coverage, since by doing so they spend $6000 for something worth $1000. A person who expects to so spend $11,000 on health care would be willing to buy coverage. But, if the insurer expects that only sick people will buy the insurance, it will not be willing to sell it at a price of $6000, since by doing so it would lose $5000 on each policy.
In this example, the only sustainable outcome is where the insurer charges $11,000 and only the sick people buy insurance. But, at this price, the sick people are no better off than they would be without insurance, and the insurer earns zero profit. So, nobody benefits from this market. In cases like these, we say that adverse selection (the fact that those who value a product the most are likely to be the most costly to serve) has led to a market failure. In this case, the fact that the healthy are unwilling to purchase health insurance voluntarily makes it impossible for the sick to purchase it at a reasonable price. It is this interdependence that makes health care markets and broccoli markets fundamentally different.
This market failure could be addressed by mandating that everybody had to buy insurance, as is done in PPACA. In this case, the price of insurance would be $6000. Firms would just break even, sick people would benefit from insurance, and healthy people would be forced to subsidize the sick against their will.
Rather than focus on the distinction made above, the administration has argued that the key distinction between health care and other markets is that there is a degree of uncertainty about future use in health care markets that is not present in other markets. This case is empirically weak, and more importantly, not a market failure that requires government intervention. They have also argued that even those who choose not to purchase health insurance often consume health care, and in many cases these costs are passed onto others. This argument, however, would seem to fail the broccoli test: if not eating broccoli today means I’ll be less healthy and more likely to collect government benefits in the future, then, by extension, the government should be able to force me to eat broccoli. I don’t think the administration wants to be making this argument (at least not today, in front of the Supreme Court).
The example I discussed above illustrates how the PPACA provisions that prohibit charging higher prices to sick individuals and the individual mandate work together. The result is a situation where everyone is covered by private insurance. However, there is clear redistribution from the healthy to the sick. This may be desirable from a social perspective, and somewhere in the administration’s convoluted argument is the idea that the healthy are always at risk of becoming sick. Whether you favor PPACA on social grounds depends on your individual preference for redistribution and, even if you are in favor of increased redistribution, whether you think intervening in health insurance markets is the best way to do it. However, one thing that is indisputable is that health insurance markets are different from broccoli and burial markets. The administration’s failure to effectively show that there is a bright line between the market for health insurance and broccoli might result in PPACA being overturned.