Posted on November 15, 2005

Health Economics 101


By Paul Krugman
The New York Times
November 14, 2005

Several readers have asked me a good question: we rely on free markets to deliver most goods and services, so why shouldn’t we do the same thing for health care? Some correspondents were belligerent, others honestly curious. Either way, they deserve an answer.

It comes down to three things: risk, selection and social justice.

First, about risk: in any given year, a small fraction of the population accounts for the bulk of medical expenses. 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 a severe case of the economic problem known as “adverse selection,” in which bad risks drive out good.

To understand adverse selection, imagine what would happen if there were only one health insurance company, and 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 to anyone who wanted it would lose money hand over fist. Healthy people, who don’t expect to face high medical bills, would go elsewhere, or go without insurance. Meanwhile, those 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 don’t offer a standard health insurance policy, available to anyone willing to buy it. Instead, they devote a lot of effort and money to screening applicants, selling insurance only to those considered unlikely to have high costs, while rejecting those with pre-existing conditions or other indicators of high future expenses.

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. That is, private 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 - the United States included - 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, however imperfectly. Some of those unable to get private health insurance are covered by Medicaid. Others receive “uncompensated” treatment, which ends up being paid for either by the government or by higher medical bills for the insured. So we have a huge private health care bureaucracy whose main purpose is, in effect, to pass the buck to taxpayers.

At this point some readers may object that I’m painting too dark a picture. After all, most Americans too young to receive Medicare do 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.

Private health insurance in America comes almost entirely in the form of employment-based coverage: insurance provided by corporations as part of their pay packages. The key to this coverage is the fact that compensation in the form of health benefits, as opposed to wages, 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. On the contrary, 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.

Q and A with Paul Krugman, from The New York

On Pride, Prejudice, Insurance Health Care Crisis in the U.S.
Nov. 8, 2005

Nell Farr, Elk Grove, Calif.: Your fine column contained this line: “. . . Americans too young to receive Medicare and insufficiently destitute to receive Medicaid . . .” This implies that those under 65 receive Medicaid if only they are poor enough. Many people believe this is true. It is not. Only if a person under 65 is on some Federal aid program such as AFDC or a disability program is he/she eligible for Medicaid. Others have an option of a free clinic, if available, or an E.R. for an emergency condition. However, E.R.’s only stabilize a person if further care or diagnostic work is indicated, such as a mammogram or even chemo for cancer, usually such a person is totally out of luck. They die.

Your columns are usually 100 percent factually correct, and I was disappointed to see this line that reinforces the mistaken belief of most Americans.

Paul Krugman: It’s a bit more complicated than that. As I understand it Medicaid covers many children even if the parents aren’t on AFDC, and in some cases covers parents too. But you’re right that an American can easily be ineligible for Medicaid no matter how desperate his or her financial straits. In fact, that’s a big part of the awfulness of how the government is responding to the aftermath of Katrina. But I didn’t have space to go into all of that. Remember, 700 words.

Michael Pistorio, Des Plaines, Ill.: While I completely agree that it is a travesty for Americans to be devoid of a national health care solution, I question the rationale of comparing the costs of an American system to that of a foreign system. My reasoning lies behind the simple fact that the U.S. has a population considerably larger than the most populated country that you mentioned, and with this said, I would think that the reason other countries have lower costs is due to the smaller number of prospective participants. Please help me understand.

Paul Krugman: All of these comparisons are per capita: spending per person. So population is taken into account. Or, if you prefer, add up total spending by Western European countries, which have about the same combined population as the United States; you’ll find that they spend only about 60 percent as much on health care, but that everyone is insured, life expectancy is higher, and infant mortality is lower.

Philip Lohman, Lakewood, Calif.: You missed making your best argument: the huge difference between levels of overhead in health systems. Somewhere around 30 percent of all expenditures on health care in the U.S. are for administration. This money buys hundreds of millions of pieces of paper and phone calls, plus the salaries of the legions of employees of insurance companies, H.M.O.’s, P.B.M.’s and all the others who are required to make the whole creaky, maddeningly complex mess function. What it doesn’t buy is a single office visit or prescription.

Similar administrative costs in other countries are around a third of this. Compared to private insurance, Medicare, perpetually described as a boondoggle by conservatives, is a model of efficiency. I was managememt consultant in healthcare for twenty years. Some days I couldn’t bring myself to believe the lunacy of the whole system.

Paul Krugman: I agree, but I’m puzzled that you think I missed your point. The column clearly identifies administrative costs as a key problem with the U.S. system.

Carol Bouville, Gaithersburg, Md.: Why is the obvious so hard for us Americans to accept? We used to not want any government-sponsored child care either because it was too socialistic. I suspect that has a lot to do with not getting government involved in universal health coverage. After all, our leaders are my age and came of age when anything that mimicked socialism was verboten. I lived in France for 18 years. Yes, it was cumbersome sometimes to get around in the health care system, but at least it was very cheap and available - and good, too. We never had to worry about losing our coverage or about not being able to pay for necessary treatment or meds. I argue that because of that peace of mind, we had a better quality of life than most Americans. Why don’t people demand access to health coverage and refuse to vote for anyone who doesn’t pledge to make the single-payer system a reality? What do we have to do to make that happen?

Neeta Moonka, MD, Demarest, N.J.: Thank you for this column. I am a physician who has been convinced of the need for a single-payer plan in this country since before I went to medical school in 1981. Please know the patchwork of employer based insurance, Medicare, Medicaid, not to mention the uninsured, takes its toll on doctors as well.

Bill Hess, Wasilla, Alaska: Your comments on nationalized insurance resonate with me. I am sitting here, feeling a notable amount of pain, thinking it would be good to go see a doctor and ask about it, but I dare not - I can’t afford to. Not because I don’t have insurance, but largely because I do. I am 55 years old and when I first got my insurance over a decade ago, it was a good deal. In the time since, my insurers have continually forced me to pay more for less, to drop my dental care altogether, to increase my deductible while still cutting back on my medical benefits. Yet the rate I pay has more than doubled to over $600 a month - that’s just for me. Fortunately, my wife and grown children receive care under the U.S. Indian Health Service.

I have a prostate problem for which I take three medications, all of which I must purchase myself along with any other medications I might find myself needing at any time. Last spring, my urologist ordered up a cat scan to double check a few things, which turned out okay. Two weeks later, I was struck by some intense abdominal pain. The physician who saw me felt it necessary to order up still another cat scan, which revealed nothing that wasn’t on the original, but did add several thousand to the medical bills I was already facing, bills denied by my insurance company.

So I have been trying to pay off this big debt and now I dare not go see a doctor again, as long as I am able to function and move around. I simply cannot afford to. An older brother recently had part of his colon removed due to cancer and another brother suffers a variety of often severe colon ailments. My father has had part of his colon removed as well. This puts me in the group of at-risk people who are advised to get a colonoscopy, but I checked into it and, even with my insurance, I would be facing a few more thousand in additional medical debt that would be uncovered by my insurance.

I know what happens when my insurance company receives one of my medical bills - they do not say, “Let’s see what we can do to help this guy and keep him healthy for as long as we can.” They say, “Let’s see if we can deny all of this, or as much as possible, and lets keep raising his rate dramatically every few months so that, hopefully, by the time he really needs care and we would have to put out some bucks we will already have forced him to drop our coverage.”

They may not actually vocalize it in those terms, but I sincerely believe both scenarios to be an accurate reflection of their policy.

Mark Sengel , Banglamung, Thailand: Thanks for your focus on health care. I am 50 and teach in Thailand. The hospitals here are excellent and tens if not hundreds of thousands of foreigners are coming here from all over the world to have root canals, colonoscopies, and back surgery. Meanwhile, everyone I know in America feels their choices are limited. They choose to stay in jobs they don’t like, they don’t start businesses, and they live in places they don’t really want to in order to get health care. Most have no idea how they are going to retire, estimating they need hundreds of thousand dollars just for health care if they are going to retire in their early 60’s. And these are people that are way ahead of the average American. What is the endgame?

Lynne Koester, Yuba City, Calif.: Would it be feasible to convert Medicare into a national health insurance system? I realize that its present per-patient cost is high because of the age of those who qualify for Medicare, but if the pool were enlarged by including most all Americans, wouldn’t the per-patient cost decrease? By eliminating the profits built into private health insurance companies, we could save even more money. Plus, when ill, many uninsured people presently use a hospital emergency room because they do not have medical insurance, but if they were covered by a national health insurance, they could be treated in a doctor’s office, which is less costly than a hospital.

Paul Krugman: Yes, indeed. One way to implement national health care would simply be to expand Medicare to everyone.

Of course, doing that would require additional funds, probably in the form of an increase in the payroll tax. And that would elicit howls from the right. But the apparent rise in tax rates would be an illusion: it would simply substitute an explicit tax for the implicit tax that companies and workers pay in the form of insurance premiums. Given international experience, I have no doubt that overall spending on health care would actually fall, and that job creation would actually rise, after the supposed tax increase.

It’s a simple solution, building on a program that we already know works. It would make the vast majority of Americans better off. And it’s considered a complete non-starter politically. Now why is that?

Notes on International Comparisons of Health Care
Nov. 7, 2005

Some readers may want to follow up on my Nov. 7 column on international comparisons of health care. Here are a few useful links.

Trends in employer-based insurance: The underlying data come from the Census. Here is a shorter, useful summary of the data.

International comparisons of health spending: The Factbook of the Organization for Economic Cooperation and Development, an international research organization supported by member governments, is available at It provides comparative data on many economic, environmental, and social trends. Data on health care spending per capita are measured using “purchasing power parities” - that is, they are adjusted for international differences in the cost of living.

Two things stand out. First, the United States is off the scale in terms of the amount we spend per person. Second, the U.S. system is unique in its reliance on private spending.

Quality of Health Care: “Taking the Pulse of Health Care Systems: Experiences of Patients With Health Problems in Six Countries,” is a new study published in Health Affairs. Check out Exhibits 6 and 7, in particular.

Taiwan: A very interesting study, also [in Health Affairs], is “Does Universal Health Insurance Make Health Care Unaffordable? Lessons from Taiwan.” Since it’s predictable that some of the usual suspects will attack my column by citing newspaper articles about runaway costs in Taiwan, it’s particularly interesting to read the paper’s discussion of how “political theater” - overstating the quite mild financial difficulties of the Taiwanese system - was used to sell a modest increase in premiums.