Maybe the Democrats have let the power go to their heads …

Filed Under (Other Topics) by Nolan Miller on Apr 16, 2010

As I tell my students, “I believe in markets, but I also believe in market failures.”  When the basic assumptions of perfect competition hold, markets do a great job at allocating resources efficiently.  The right goods are produced, and they find their way from the firms that produce them at the lowest cost to the consumers who place the highest value on them.  A well functioning market is a thing of beauty.

However, when the basic competitive assumptions do not hold, markets can work very poorly.  Without getting too long winded, it is reasonable to argue that industries such as health insurance and banking do not satisfy the competitive assumptions, and this provides a justification for government intervention.  For example, in health care the problems of adverse selection (the people who most strongly desire health insurance are the ones most likely to buy it) and moral hazard (when people don’t pay out-of-pocket for a service, they tend to use too much of it) are significant and serious reasons why unregulated markets may not be efficient, and introducing regulations to address these problems is the (economically) strongest argument in favor of reform.

Of course, the second part of what I tell my students is that “I believe in governments, but I also believe in government failure.”  Markets are complicated and difficult to actively manage in even the best circumstances.  Throw in the fact that governments themselves are filled with political and bureaucratic concerns that may prevent ideal regulations from being enacted, and it is easy to see why the cure is often worse than the disease.

Which brings me to my main point: government intervention should be motivated by the need to address a serious problem with markets and mindful of the fact that government has the potential to make things worse as well as better.

So, what could a group of six Democratic Senators possibly be thinking in introducing legislation aimed at preventing airlines from charging for carry-on baggage?  Where is the market failure here?  What is the great inefficiency that this legislation is supposed to address?

As Senator Schumer (D – NY) said “When you charge for a carry-on bag, it’s a slap for anyone who flies.”  Maybe.  But, people who choose low-cost airlines are saying that they prefer to be slapped rather than pay a few bucks more for a ticket.  If they don’t want to fly Spirit (the pioneer in charging for carry-ons), they can choose another airline, or another means of travel.  If people are wiling to choose Spirit despite the inconvenience of leaving their carry-on bag at home or paying to check it, then Spirit has actually done a good thing.  People just want low ticket prices.  Period.  And, Spirit is giving it to them.  That is a triumph of markets, not a failure.  Southwest in the U.S. and Ryanair in the UK/Europe have been very successful following a no-frills/low-price strategy.  The only thing preventing Spirit’s new pricing will do is prevent them from giving people what they really want: the lowest-cost seat on a plane.

On the other hand, if people choose alternate carriers, Spirit will quickly come to see the errors of its ways and remove the bag charges.  Or, if there really are benefits to the airline due to “lower[ing] some passengers’ costs, speed[ing] up boarding and lines at security checkpoints and reduce[ing] delays,” then Spirit could lower its prices even further in order to make up for the additional cost of paying for a carry-on.  Again, markets at work.

In my mind, to the extent that there is a problem here, it is that people do not know about and/or correctly anticipate the charges for things like checked bags, carry-on bags, etc.  So, if Senator Schumer and his colleagues want to do something to help here, they could think about regulation aimed at transparency in pricing.  For example, when you go to buy a ticket you could be told that “this airline charges $X for a checked bag, $Y for a carry-on, $Z for food, etc.”  This way, we could be confident that everybody was given the chance to learn about the airline’s pricing scheme.  As long as everybody knows that by choosing Spirit they save $17 on their ticket but will have to pay $45 if they choose to put a bag in the overhead bin, then we should trust market forces to bring about the right trade-off between the price of a seat for yourself and the price of a spot for your bag.

An Expected Surprise: The Doubling of the PBGC’s Deficit

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Nov 17, 2009

Last Friday, the Pension Benefit Guaranty Corporation (PBGC) announced that its deficit had doubled over the past year.  The PBGC is the government agency that insures defined benefit (DB) pension plans in the U.S.  While this doubling of the deficit was widely reported in the press, the only thing surprising about this announcement was that anyone was surprised by it.


Since the PBGC was created through the passage of ERISA in 1974, the basic design of the program has been fundamentally flawed.  As I have discussed in several papers, the PBGC fails to price this insurance properly, fails to provide adequate incentives for funding, and fails to provide adequate information to market participants.  As a result, DB plan sponsors have the incentive – and the legal right – to fund their pensions in a manner that imposes large future obligations on U.S. taxpayers.  (And as for the PBGC experts out there who will quickly point out that the PBGC is not funded by taxpayer dollars, I ask you only one question – given our experience of the past 15 months in which the U.S. government has not only bailed out government sponsored enterprises such as Fannie and Freddie, but also private sector companies such as G.M., do you really think Congress will let millions of pensioners lose their benefits when the PBGC runs out of money?)


Given that the program’s finances have been underwater for years, and given that numerous academics, think-tanks, and government policy experts such as the GAO and the CBO have all pointed out that the PBGC is on an unsustainable course, the latest numbers simply confirm what we already intuitively know – the PBGC’s finances are deteriorating rapidly.


Here are the facts as of September 30, 2009:

-         The PBGC had only $68.7 billion in assets to cover an estimated $89.8 billion in liabilities.

-         The PBGC “acquired” responsibility for an additional 144 plans during the year.

-         27 large plans – with liabilities of over $1.6 billion are now listed as “probably losses” on the PBGC’s balance sheet

-         The PBGC notes that “potential exposure to future pension losses from financially weak companies” is approximately $168 billion.


I do, of course, realize that it is difficult to get people exercised about this issue.  Even $168 billion, let alone $22 billion, no longer seems like a big number coming in a year after trillions have been spent on stimulus plans and TARP-like programs.  Nor does it seem large relative to the tens of trillions in unfunded liabilities facing Social Security or Medicare.  But $168 billion is still real money – even in Washington. 


What needs to change?  One useful first step would be to give the PBGC the authority to charge market-based premiums for the insurance it provides.  It is true that this might hasten the decline of DB plans in some sectors.  But I would submit that if making firms pay the true cost of their pensions means that they no longer find it attractive to offer them, then perhaps the efficient outcome is for them to end the plans before they dig the fiscal hole any deeper.

Is the U.S. Health Insurance Industry Competitive?

Filed Under (Health Care) by Nolan Miller on Oct 29, 2009

This week Jeff wrote about competition in the health insurance industry, wondering if the health insurance industry, while not competitive, might be “competitive enough,” and whether, if it isn’t, whether the government will properly price the public option it hopes will increase competition.

I don’t disagree with any of Jeff’s points.  But, I thought it might be useful as a follow up to write about how competitive the health insurance industry is.  It just so happens that a new National Bureau of Economic Research Working Paper by Leemore Dafny, Mark Duggan, and Subramaniam Ramanarayanan entitled “Paying a Premium on Your Premium? Consolidation in the U.S. Health Insurance Industry” provides new evidence on exactly this point.

But, first, a bit of background.  Economists, and particularly the U.S. Department of Justice, measure concentration in a market by summing the squared market shares of all of the participants.  We call this number the HHI.  DOJ calls a market highly concentrated if the HHI is over 1800.  This would be the case if, for example, there were four firms in the market, each of which has a 25% market share (25*25 = 625, 4*625 = 2500).  In highly concentrated markets, the DOJ has “significant competitive concerns” about any merger that raises the HHI by more than 50 points.  The AMA’s 2007 study on “Competition in U.S. Health Insurance” found that between 96 and 100 percent of health insurance markets were highly concentrated, depending on the market definition.  In terms of market shares, between 64 and 76 percent of health insurance markets have at least one insurer with market share greater than 50 percent.  In around 10 percent of markets, a single insurer has over 90 percent of the market share.

The AMA data suggests that, by any measure, health insurance is dominated by a small number of players.  This does not, in itself, suggest that there is a lack of competition in health insurance.  After all, if there are just two insurers who compete in a cut-throat fashion, this will quickly drive prices to competitive levels.  Or, if there is a threat of entry into health insurance, then potential competition might discipline prices even though those firms do not actually enter the market.  But, the AMA numbers certainly raise suspicion.

The real question regarding concentration in health insurance is whether the high concentration levels in health insurance lead to higher premiums.  The Dafny-Duggan-Ramanarayanan paper looks at this question. They use the 1999 merger between Aetna and Prudential, two of the largest health insurers in the country, to investigate it.  They find that the Aetna-Prudential merger did increase premiums and they estimate that, overall, the wave of insurer consolidations that occurred between 1998 and 2006 increased premiums by about 2 percentage points on average.  In addition, they found that increases in concentration increased the bargaining power of insurance companies with respect to healthcare workers, resulting in lower employment, and lower earnings for physicians.

So, the evidence suggests that the health insurance industry is highly concentrated and that high concentration is probably leading to higher prices.  But, there are several things we still don’t know.  First, do those higher prices translate into abnormally high profits?  Maybe the reason why prices are high and there are not a lot of firms operating in any region is that additional firms cannot profitably enter the market.  In this case, the high levels of concentration and prices would be evidence of market forces working, rather than a sign that further regulation is needed.  Second, if the insurers are earning abnormally high profits, why don’t other firms come along and enter the market, driving down prices?  If the lack of entry is due to practices that are prohibited by current law, then greater enforcement might improve competition.  If, on the other hand, they are due to features of the competitive playing field such as the ability to risk-rate premiums, deny coverage based on pre-existing conditions, difficulties in switching insurers do to the connection between insurance and employment, etc., then addressing these issues (as is done to one extent or another in all of the reform bills currently under consideration) might greatly improve matters.

Jeff’s overall point is still one I agree with.  The government’s success in designing insurance schemes has been mixed at best.  If the government doesn’t know why our current system fails to be competitive (if, indeed, it does), then it is unclear how introducing a government plan, in and of itself, is going to fix things.  In the absence of a clear theory of what is wrong with the market and how a public option solves the problem (rather than vague statements about how it will lead to greater competition) I strongly suspect that we’re more likely to successfully improve health insurance and health care by adjusting the rules of the game and improving the government’s role as referee, rather than by introducing the government as a player.

How will the Government (Mis-) Price the “Public Option” for Health Care?

Filed Under (Health Care, U.S. Fiscal Policy, Uncategorized) by Jeffrey Brown on Oct 27, 2009

Senate Majority Leader Harry Reid came out in the past week in favor of a “public option” as part of a health care reform package, giving new life to an idea that many had previously pronounced as on life support in the Senate.  Given this, I thought I would use this week’s post to briefly explain one of the (many) reasons that a public option worries me, namely, the government’s horrible track record of pricing insurance according to basic economic principles.  


Prices play a central role in well-functioning economies because they direct resource allocation, create incentives, and generally serve as signals of value.  In the context of health insurance, advocates of the public option seem to believe that the government has the ability to price the insurance correctly, and that the private sector does not.  Indeed, the belief that the private sector is somehow pricing the insurance incorrectly – thus leading to what public option advocates believe are excessive profits – is part of what lies behind the unfortunate demonization of the insurance industry.  


My own view is that while the health insurance industry may not be the Adam Smith ideal of a perfectly competitive market, it is likely competitive enough – in most markets at least – that it is difficult to sustain abnormally large profits for long. 


But even if that is not the case, there is still an important question that is not being discussed enough.  Is the government capable of pricing insurance effectively?  


This is a complex question, including what we mean by “pricing effectively.”  But for now, I want to keep this discussion at the 30,000 foot level and simply take a look at some insurance markets where the government has intervened.  Earlier this year I organized a conference at the American Enterprise Institute for which I invited six teams of authors to write about government insurance programs.  Specifically, respected experts in each area wrote about the U.S. crop insurance program, the Pension Benefit Guaranty Corporation, the Federal Deposit Insurance Corporation, the U.S. government’s terrorism risk insurance program, the National Flood Insurance Program, and federal and state approaches to insuring natural catastrophes.  


As I wrote in the introductory chapter for the book: “If there is a single theme that comes through loud and clear in all six chapters in this book, it is that the government has a terrible track record at appropriately pricing risk. In the FDIC insurance program, Pennacchi shows, premiums have often been set too low, which leads an increasing proportion of the financial system to seek access to artificially cheap credit, and in turn worsens the stability of the financial system. Biggs and Brown show the lack of risk-adjustment in the PBGC program encourages firms to overinvest in risky assets and discourages them from fully funding their pensions. Russell and Jaffee note that the government does not even pretend to try to price terrorism insurance effectively—on an ex ante basis, it simply gives away the insurance free of charge. Kunreuther and Erwann-Kerjan note that the state of Florida’s catastrophe insurance program is severely underpriced, which can lead, among other things, to overdevelopment in risk-prone areas. Browne and Halek suggest that the flood insurance program has likely led to overdevelopment in flood zones. Goodwin and Smith discuss the land-use misallocation that arises from mispricing in the crop insurance programs.”


To be clear, I am not arguing that a public option will be exactly analogous to any of the above programs.  The analogy is imperfect for dozens of reasons.  What I am arguing is a more general point – namely, that I have yet to find a single government program in which the U.S. government has priced insurance in a manner that even closely approximates an efficient approach.  Put simply, when political considerations bump up against economic efficiency arguments, political considerations typically win.  As a result, even the most intelligently designed public option is unlikely to be intelligently designed once it passes through the Congressional sausage-making process.   


Does any of this matter?  Absolutely.  I don’t know exactly how a public option will be priced, but I am willing to bet it will get it wrong on at least one dimension.  And depending on the nature and degree of mis-pricing, a public option could have any number of bad effects, whether it be the partial (or in the extreme, even the complete) destruction of the private health insurance industry, the creation of an enormous unfunded liability for taxpayers, or even an increase in the level of health care costs in the U.S. as newly insured individuals decide to rationally consume more care.