Paul Krugman: Health Economics 101

It's nice to have Paul Krugman discuss a question that has been addressed repeatedly at this site, market failure in the provision of health and social insurance due to moral hazard and adverse selection:

Health Economics 101, by Paul Krugman, NY Times: ...[W]e rely on free markets to deliver most goods and services, so why shouldn't we do the same thing for health care? .... It comes down to three things: risk, selection and social justice. First, about risk: ... In 2002 a mere 5 percent of Americans incurred almost half of U.S. medical costs. If you find yourself one of the unlucky 5 percent, your medical expenses will be crushing, unless you're very wealthy - or you have good insurance. But good insurance is hard to come by, because private markets for health insurance suffer from ... the economic problem known as "adverse selection," in which bad risks drive out good. To understand adverse selection, imagine what would happen if ... everyone was required to buy the same insurance policy. In that case, the insurance company could charge a price reflecting the medical costs of the average American, plus a small extra charge for administrative expenses. But in the real insurance market, a company that offered such a policy ... would lose money hand over fist. Healthy people, who don't expect ... high medical bills, would go elsewhere, or go without insurance. ... [T]hose who bought the policy would be a self-selected group of people likely to have high medical costs. And if the company responded to this selection bias by charging a higher price for insurance, it would drive away even more healthy people.

That's why insurance companies ... devote a lot of effort and money to screening applicants... This screening process is the main reason private health insurers spend a much higher share of their revenue on administrative costs than do government insurance programs like Medicare, which doesn't try to screen anyone out. ... [P]rivate insurance companies spend large sums not on providing medical care, but on denying insurance to those who need it most. What happens to those denied coverage? Citizens of advanced countries ... don't believe that their fellow citizens should be denied essential health care because they can't afford it. And this belief in social justice gets translated into action... Some ... are covered by Medicaid. Others receive "uncompensated" treatment, ... paid for either by the government or by higher medical bills for the insured. ...

At this point some readers may object that I'm painting too dark a picture. After all, most Americans ... have private health insurance. So does the free market work better than I've suggested? No: to the extent that we do have a working system of private health insurance, it's the result of huge though hidden subsidies. ... [C]ompensation in the form of health benefits... isn't taxed. One recent study suggests that this tax subsidy may be as large as $190 billion per year. And even with this subsidy, employment-based coverage is in rapid decline.

I'm not an opponent of markets. ...  I've spent a lot of my career defending their virtues. But the fact is that the free market doesn't work for health insurance, and never did. All we ever had was a patchwork, semiprivate system supported by large government subsidies. That system is now failing.  And a rigid belief that markets are always superior to government programs - a belief that ignores basic economics as well as experience - stands in the way of rational thinking about what should replace it.

For similar comments on Social Security insurance, see  Social Security is about insurance, not savings, The Need for Social Insurance, and Optimizing Social Security through Poverty Insurance and Retirement Saving. And from Paul Krugman, see Passing the Buck.

Update: Tyler Cowen at Marginal Revolution notes:

Marginal Revolution: Paul Krugman, circa India: Here is yesterday's column on health care; I am not sure if the The Hindu will be carrying them all on-line.  Arnold Kling offers excellent commentary.  Thanks to Eswaran for the pointer.

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