Why we need an individual mandate for health insurance

(MoneyWatch)  COMMENTARY There's a similarity between used cars and health care. And once you understand the economics of used cars, you may look at health care in a new light.

Let's start with used cars. "The Market for Lemons" by George Akerlof is a famous paper in economics demonstrating how markets can break down when buyers and sellers are differentially informed. For example, suppose that there are 1,001 used cars worth from $0 to $1,000, i.e. one car is worth $0, one is worth $1, the next is worth $2, and so on up to a car valued at $1,000. Assume that the car owners can assess the value of the cars they are selling accurately, but buyers can't discern any difference in quality from examining the cars. That is, sellers are better informed than buyers about the car's quality.

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In such a market, a buyer would expect to receive a car of average quality, and the price would settle at $500 (the exact price doesn't matter, all that's required is that the market sets some price below $1,000). But at a price of $500, all the sellers with cars valued from $501 to $1,000 would withdraw their cars from the market since the price of $500 is less than their cars are worth.

At this point, the only cars left on the market are valued between $0 and $500, and with buyers once again expecting to receive a car of average quality, the price would fall to $250. At this price, all the people with cars valued from $251 to $500 would take their cars off the market, and the cars left on the market would now be valued between $0 and $250.

The process repeats itself, the price drops to $125, more cars drop out, and this continues until there is just one car on the market selling for $0. That is, the market for used cars breaks down.

The technical term for this is an "adverse selection" problem, and there are many ways to solve it. The buyer can hire a mechanic to determine the value of a car before the purchase; the sellers can offer insurance against the car breaking down; the sellers might have a desire to maintain a reputation for quality (dealers selling cars that fall apart shortly after purchase will lose their reputations and go out of business), and so forth.

What does this have to do with health care? The adverse selection problem is one of the reasons we need an individual mandate for health care insurance (i.e. a requirement that everyone must purchase insurance that is part of the proposed health care reform package).

To explain how the adverse selection problem arises in these markets, note that people purchasing health insurance generally have better information about their health status than the people selling the insurance. If insurance is offered in this market at somewhere near the average cost of care for the group, people will use the superior information they have about their own health status to determine if this is a good deal for them. All of the people expecting to pay less for health care than the price the companies are asking for the insurance will drop out of the market (the young and healthy for the most part; all that is actually needed is that some people are willing to take a chance and go without insurance). With the relatively healthy people dropping out of the insurance pool, the price of insurance must go up, and when it does, more people drop out, the price goes up again, and the result is just like in the used car example above: The market breaks down and nobody (or hardly anybody) can purchase insurance.

But since we do not want people ruined or unable to get care when they are struck with a costly health problem, we need health insurance, and that insurance must be distributed over a wide variety of people so that the average cost of care will be affordable. One way to ensure that the pool is broad-based is to require that anyone who might need health care -- i.e. everyone -- purchase health insurance. (For a further discussion of these issues, see here.) In the past, the broad-based pools needed to make insurance work were obtained through a large tax break to induce firms to provide insurance to their employees, combined with a requirement that if the insurance is offered, it must be available to all employees. But the steady erosion in the employer-based system is one of the motivations for reforming the health care system.

Without an individual mandate, the health insurance market is likely to break down due to the adverse selection problem, but such a mandate can place a considerable burden on some households. Thus, while the individual mandate is necessary to make these markets work, it is also necessary to provide subsides to lower and middle class households who wouldn't be able to purchase the insurance without such help.

[RobertBeyers]

I am a 73 year old Canadian. We have had compulsory health insurance for than 50 years now, and it works wonderfully. When it was first introduced, we who were young complained, but we were wrong. Over the years, besides my regular visits to the doctor for minor ailments at no cost out of my pocket, I have had a few trips to the hospital.
Broken leg and follow up care. No cost
Gall bladder removed. No cost
Serious eye injury. No cost
I have heart problems and require frequent special tests etc, no cost
I could go on but there is no need to, except to say , through the years I have raised a family with no medical costs.
Canadians have a longer life expectancy than Americans.
We live on average healthier lives than you.
At the end of my life I will have spent much, much less on health care than an American with a similar health history.
I pay only the dispensing fees for my medication.

I have heard American anti-healthcare people say such things as:
Canadians have to wait up to six weeks for hip or knee replacements. That is true, but how many Americans will not get those replacements no matter how long they wait, simply because they can't afford it. We do have longer waiting time in the ER but we don't need a credit card to get treated.
I don't say all of this to boast, but rather, to tell you that those nay sayers are wrong. Health care is a good deal for everyone. In response to one poster, we do get the same care and treatment as our politicians do. We not only have some of the best doctors, healthcare workers and hospitals in the world, we also have at no cost to us, access to the best hospitals in the U.S. if needed. Anyone who is not happy with the health care they receive are able to look elsewhere.
In the U.S. you seem to be saying:
Am I my brother's keeper?
Here in Canada we are saying:
I am my brother's keeper.
Cheers.

[olyboy]

This only makes sense if you are willing to re-establish the US as a dictatorship. Liberty means having the right to make the wrong decision. The democrats are saying that only they are making the right decisions and that everyone should be forced to follow their lead. That isn't liberty, and our constitution was written to prevent just such tyranny. If we are going to have some level of state sponsored healthcare, it's going to have to conform to our form of government, sorry Obama.

[jeffromac23]

I guess mine and most states are dictatorships than because they make me buy car insurance and give the crap that it protects other people because the same would apply for health insurance because it would protect me from paying higher premiums by paying for the uninsureds health care at the E.R and that includes the illegal aliens that use these E.R's.

[Galactus9]

This would just result in giving free health care to millions of illegal aliens. It would also attract more illegal aliens.

[ge556]

Did you make that up, or did Fox/Rush liars tell you that?

In fact, we already give free health care to illegal aliens in emergency rooms, just like we do for uninsured citizens. I don't think that will change. But they won't have health insurance, so how would they get additional coverage?

[owlgal]

Make Congress have to have the same healthcare they are willing to mandate for the rest of us and see how quickly things change.

[ge556]

The plan does allow for congress to keep their employer-provided health care, just like for everyone else who chooses to do so, or to choose another plan, like everyone else.

[magnumdr]

What America needs is to lower the pay we give to all of our elected people and cut their insurance benefits. Also when these people retire from politice they should have to collect SS like the rest of the people in the USA have to do, instead of getting full pay and benefits like they do now!

[ge556]

Actually, making it so that only rich people can afford to run for office is a very bad idea. We are already too far in that direction.

[gep1955]

Mark, you leave out a key point in your commentary, health care costs began and continue to escalate because the government (corrupt politicians) began to mandate rules and regulations on the industry to make it "better". Mandating all citizens send more money to Washington to "fix" anything has always resulted in financial disaster and billions in uncontrollable fraud. Government has no respect for the peoples taxes. If you doubt me, see our current levels of spending and debt.

[ge556]

Wow. I sure don't want health insurance that drops me when I get sick, or that excludes all kinds of coverage that I might not know I need. Regulations are very important.