Sunday, August 23, 2009

Health Insurance Fallacies

The proponents of health care reform like to argue that opponents are spreading misinformation to push their views.

I need to point out the one fallacy that I consistently hear from reform proponents, and that has sunk in due to its relentless repetition. I have had colleagues fall into the trap and many students as well, even those who have had several econ courses.

The fallacy is illustrated well by this quote from an AP story written by Ricardo Alonso-Zaldivar:

Proponents of a government plan say it could restore a competitive balance and lead to lower costs. For one thing, it wouldn't have to turn a profit.

Wouldn't have to turn a profit!! There is almost no economic nonsense that upsets me more than this kind of thinking -- that when we buy something from a company, we are paying an unnecessary "profit". In this make-believe world, profit is a "cost" that has to be paid, but only if we are buying from a private company. If only that private company were substituted for by a nonprofit organization or a government agency, then we could get the same service but at lower total cost. Magic!

Maybe it is the language of "for-profit" and "not-for-profit" that leads to this mistaken conclusion.

If only it were so simple to avoid an unnecessary cost! If it were, every single company in the world would fully vertically integrate, making all of its inputs itself -- why buy anything from another company and pay them an unnecessary profit? (Of course, this flies in the face of another trend that upsets many, that of outsourcing.)

And closer to home, nobody would lease a car -- why pay a profit to the owner, a bank -- and nobody would ever rent a house -- why pay a profit to the landlord?

The correct lesson from the most important part of any economics course, that on the organization and performance of competitive markets, has tragically failed to sink in. In a competitive market, any excess profit will get competed away. The only profit is a normal -- that is, the minimum acceptable -- return on invested capital. For example, if an insurance business requires $1 billion of invested capital, then at a 10% normal return, the level of profit will be $100 million. You should think of that $100 million not as a profit, but as a cost -- the cost of having that $1 billion invested in the insurance business. If the insurance business yields a profit of $125 million, then more capital and resources will enter that business, driving the return back down to normal levels. That is, there would have been in this case $25 million of "economic profit" and competition will drive that away.

A not for profit firm, or a government agency, cannot avoid incurring this cost of a normal return on invested capital. There is absolutely no sensible argument that a not for profit would not need the same amount of invested capital (buildings, equipment, cash on hand to pay employees and claims, etc.). And with the same amount of invested capital comes the same cost associated with its deployment. (In fact, with the public option being discussed in health care, the US government would give the new public organization an infusion of capital to get started. Do we think that capital comes free?)

One simply cannot argue that a not-for-profit or government agency can produce at lower cost because they can avoid paying a profit. The only way to argue that a not-for-profit or government agency can do something for less cost than a private entity has to rely on an ability to actually run the business more efficiently (fat chance!) or truly avoid some real cost (I will give you one idea here -- WHO DOES NOT PAY TAXES!)

This argument does of course rely on competition driving the return on capital to normal levels so it does not apply to an industry with significant monopoly power (if a company faces a monopolistic supplier of an input, then vertical integration can make sense). I am in no way prepared to accept that the insurance business is now or would be in the future characterized by enough market power to prevent the inexorable forces of economic competition from driving expected profit to normal levels, the arguments of folks such as Alonso-Zaldivar notwithstanding. My next post is going to revisit the issue of self insurance, which will raise even more questions about excess insurance company profit and the claimed lack of competition.

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