The tradeoff between equity and efficiency in health care financing

NBER Working Paper 22440
Demand Heterogeneity in Insurance Markets: Implications for Equity and Efficiency

By Michael Geruso
National Bureau of Economic Research, July 2016


In many markets insurers are barred from price discrimination on consumer characteristics like age, gender, and medical history. By themselves, such restrictions are known to exacerbate adverse selection problems. But the conventional wisdom — widely reflected in policy — is that with regulatory tools like premium subsidies, it is possible to address selection and induce efficient plan choices without price-discriminating. In this paper, I show why this conventional wisdom is wrong: As long as different sets of consumers (men and women, rich and poor, young and old) differ in their willingness-to-pay for insurance conditional on the losses they generate, then price discrimination across such groups is welfare-improving. The conventional wisdom is wrong because it implicitly assumes a one-to-one mapping from insurable risk to insurance valuation. I show that demand heterogeneity that breaks this one-to-one relationship is empirically relevant in a consumer health plan setting. Younger and older consumers and men and women reveal strikingly different demand for health insurance, conditional on their objective medical spending risk. This implies that these groups must face different prices in order to sort themselves efficiently across insurance contracts. The theoretical and empirical analysis highlights a previously unexplored, but fundamental, tradeoff between equity and efficiency that is unique to selection markets.



By Don McCanne, M.D.

Individuals vary in their preference for insurance and willingness to pay for it. Michael Geruso explains that insurance pricing that takes preference into consideration is welfare-improving and thus efficient. Yet efforts to improve equity by compensating for price discrimination result in a tradeoff between equity and efficiency. Do we care?

What the majority of us want is a health care system that is accessible to all and funded equitably based on ability to pay. Using the analogy of the tradeoff between equity and efficiency, a system funded by progressive taxes would be highly equitable but might be terribly inefficient because wealthier individuals might not have a preference to pay higher taxes.

The efficiency that we actually want to see is greater value in our health care purchasing through eliminating much of the administrative waste that occurs in our dysfunctional financing system. The economist’s construct of efficiency as representing a measure of individual preference should be a negligible consideration when we have the ability to create a health care financing system that is equitable - fair - for everyone regardless of ideological preference.