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Asymmetric Information and Health Insurance - YouTube
Channel: Marginal Revolution University
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- [Professor Tyler Cowen]
In the previous video,
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we introduced the ideas
of asymmetric information,
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and adverse selection
and we applied those ideas
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to the used car market.
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Let's take those same
basic concepts,
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and build a basic model
of health insurance.
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Suppose that potential
health insurance consumers
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come in a range of states of health.
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For instance,
the least healthy people
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might cost about $30,000 a year.
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That's these folks here.
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The most healthy might cost
nothing in healthcare.
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That's these folks over here.
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Now consumers know this information,
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but by assumption, insurers don't.
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>From the insurer point of view,
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everyone is of the same
average health.
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Here again, we have
asymmetric information.
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That is consumers of healthcare
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have more information about
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their health status
than insurers do.
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In this scenario, insurers have to
price the coverage
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based on the average cost
among all consumers,
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namely, $15,000.
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But if the insurance costs $15,000,
then a portion of the market,
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the relatively healthy people,
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they will choose not
to buy insurance as
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the cost of that insurance
is greater to them
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than the expected benefit.
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So only part of this market
will buy insurance.
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The average cost of those
who actually will buy
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is then not $15,000 but $22,500.
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In that case,
the insurance company,
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if it tries to price at $15,000,
loses money.
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If the insurance company instead
raises the price to $22,500,
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well, the same dynamic
is actually going to kick in again.
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That is relatively healthy people
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won't find it worth
paying that price.
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The sicker people still will buy,
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and that will raise
the expected costs
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to the insurer,
and thus the price even further.
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This dynamic continues
until the individual insurance firm
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finds there is no price
at which it can attract
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a set of customers with
healthcare costs
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lower than the price of insurance.
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This is the same death spiral
we saw before with used cars
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and it leads to a market failure.
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As we saw in the used car market,
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there are several reasons
why reality may differ
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from the simple model.
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First, the model we laid out would
predict that the healthy people,
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those who exercise,
eat their veggies,
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and buckle their seatbelts would
not buy insurance,
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while the model is predicting that
the smokers, the mountain climbers,
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and the motorcycle riders would
buy insurance.
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Is this true? Mostly no.
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The people who buy health insurance
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actually turn out to be
the healthier people as well.
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Why is that?
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Well, those who try to avoid risk
by eating well
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also try to avoid risk
by buying health insurance.
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Our initial assumption that
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everyone calculates
costs and benefits
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in exactly the same way
is too simple.
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Once you account for the fact that
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people have differential
tolerances for risk,
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you can end up having
the healthier people be
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those who choose to buy
the health insurance.
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This is called
“propitious selection”
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where the people who buy
the health insurance are healthier,
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not sicker than average.
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This can keep costs low,
and prevent the death spiral.
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Another possible response
to the adverse selection problem
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in health insurance
might seem familiar.
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If you recall,
we saw that services such as
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CARFAX and Certified Inspections
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can alleviate
the asymmetric information problem
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when buying a used car.
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These services allow
the buyer of the car
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to have similar information
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to that possessed
by the seller of the car.
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The result of this information
is that better cars
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can sell for more,
and lemons can sell for less.
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Is there an analogous approach
for people in health insurance?
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Well, yes.
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The health of people
can be inspected
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just as cars are inspected.
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So while consumers initially
may have more information
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about their health than what
the insurance companies have,
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a checkup will allow
the insurance firms
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to get a better idea of
the consumer's expected
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healthcare costs.
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And that allows
the insurance companies
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to charge healthy consumers less
and sicker consumers more.
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In the used car market,
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that seemed like
a pretty good solution.
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After all, better cars
should sell for more,
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and lemons should sell for less.
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In the health insurance market,
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that solution might work,
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but some people feel it is
doubly unfair.
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Not only are the sick sick,
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but now they also have
to pay more
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for their health insurance.
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Another problem
with inspection is that
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it might reveal
too much information,
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thereby rendering health insurance
no longer viable.
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For instance, let's say there's
a very good diagnostic test,
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and it determines that
a patient A has cancer
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and then B we know that cancer
will cost $1 million to treat.
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Well, to insure against that cancer,
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the price of the policy
has to be about $1 million,
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but that's no longer insurance.
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That's just presenting the patient
with the bill.
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Insurance is protecting against
unexpected states of affairs,
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and it's a kind of risk pooling,
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a kind of protecting yourself
against the high bill.
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But if you're getting the high bill
no matter what when you're sick,
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well, then we've lost
those benefits of insurance.
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Another solution to
the adverse selection problem
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when used extensively
in the United States
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is group health insurance
through employers.
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Most people in America
don't purchase insurance directly.
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Instead, their employer
purchases it for them
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as part of a group plan.
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The benefit of the system is that
the insurance company
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doesn't have to worry about
adverse selection so much
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The employer doesn't know much
more about its employees' health
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than does the insurance firm.
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Furthermore, the employer is
going to be buying
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health insurance for the employees
regardless of their health.
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So for these reasons,
the adverse selection problem is
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much weaker with
group health insurance.
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Group health insurance, however,
does cause other problems.
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If you lose your job,
you can lose your health insurance.
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And what we do about retirees?
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In the United States,
various laws have made
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health insurance more affordable,
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and furthermore retirees are insured
by the government
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under Medicare.
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So, there are some solutions,
albeit imperfect ones as usual.
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The most recent approach
to the adverse selection problem
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was implemented
in the Affordable Care Act,
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otherwise known as Obamacare.
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Under the Affordable Care Act,
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everyone is supposed to buy
health insurance.
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If you don't,
you will be fined by law.
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The idea here is to force
all the healthy people into the pool
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of those who buy insurance
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that will moderate the cost
of health insurance,
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and we will avoid the death spiral.
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As you can see, although
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the adverse selection model
is pretty simple,
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it has lots of applications
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to some pretty complex
real-world problems.
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Next up we'll tackle moral
hazard. See you then.
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♪ [music] ♪
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- [Announcer] If you want
to test yourself,
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click “Practice Questions."
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Or, if you're ready to move on,
just click “Next Video.”
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