Competition and Reducing the Cost of Health Insurance

http://economix.blogs.nytimes.com/2010/11/05/competitions-shortcomings-in-curtailing-health-care-costs/

We all may be getting tired of debating healthcare reform but the GOP has decided that repealing healthcare reform is its top priority. This link is to an article that looks at the relationship between increasing competition among insurers and its role in lowering insurer premiums. The Democratic plan attempts to increase competition by establishing exchanges that provide coverage in competition with existing insurers. The GOP plan would give individuals vouchers that could be used to purchase insurance and it would make it possible for more insurers to enter state markets.

The basic idea in both reforms is that selling insurance is like selling widgits. High prices in commodity markets attract more competition and prices fall as the number of insurers increase and compete with each other on price. This does not hold, however, if there are economies of scale in the insurance market. If one looks at the things that insurance companies do to operate their business, it seems likely that operating costs are subject to economies of scale. For example, an insurer with a larger number of customers would have lower marketing and administration costs per customer since the fixed cost of these operations would be divided by a larger number of clients. The big advantage of scale, however, is in negotiating the prices that insurers pay to healthcare providers. For example, hospitals in most large markets have joined together into partnerships that negotiate the prices that they charge to insurers. Small insurers are at a disadvantage to large insurers in the price negotiations. They typically pay higher prices for the same services provided by the hospitals that large insurers pay. Consequently, they would be unable to compete on price with larger insurers. Their operating costs would be higher and they would have to pay more for hospital services. Their premiums would have to be higher in order to stay in business.

Since there are considerable economies of scale in the insurance business, the attempt to lower insurance premiums by raising the number of market competitors will cause premiums to rise rather than decline. Medicare, for example has a very large number of customers and it has lower operating costs than most private insurers. It also has negotiating power with service providers. The best way to lower the cost of healthcare would have been to make Medicare available to everyone. Since this was not considered politically possible, we have to look elsewhere for cost reduction opportunities. Increasing the number of insurers in each market is bound to fail.