Krugman and Edwards on Health Insurance

Paul Krugman discusses John Edwards’ plan for health insurance:

[M]arketing and underwriting — … screening out high-risk clients — are responsible for two-thirds of insurance companies’ overhead. With insurers selling to government-run Health Markets, not directly to individuals, most of these expenses should go away, making insurance considerably cheaper.

To understand insurance, one must understand the economics of uncertainty. We first assume that firms are profit-maximizers. Second, we assume that individuals are wiling to purchase insurance to eliminate uncertainty. Additionally, since most individuals are risk averse, the are willing to pay a premium that is above what is actuarily fair to eliminate uncertainty.

A health insurance firm sets prices based on the probability of occurence. Thus, individuals who present a substantially large risk will also not be offered insurance because the risk is too high. Under Edwards plan, the government would be responsible for the high-risk individuals.

The problem that I have with this is three-fold.

First, Krugman and Edwards believe that adverse selection is the problem with the health insurance system. In other words, they believe that the inability of the sick to get insurance is the sole problem. However, expenditures relative to GDP have been rising faster in the United States than every other industrialized country. This comes as a result of moral hazard and what Arnold Kling calls “premium medicine”, not adverse selection.

The second and more specific problem that I have with the suggested policy is that it overemphasizes overhead costs. Single-payer advocates often trumpet the efficiency of government processing relative to the private market. While this appears to be true on the surface, it ignores the deadweight loss incurred when the government taxes individuals to pay for subsidization (Edwards intends to tax the “rich”).

Finally, if the insurers are selling the policies to the government, there is little incentive for the companies to control costs. This could very well lead to higher premiums, which is a step in the wrong direction.

HT: Tyler Cowen, Mark Thoma