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Problems with Health Insurance

The absence of universal health insurance in the United States covering all illness at an “affordable” premium is widely viewed as a problem to be solved. Actually, health insurance makes some people better off and others worse off. Poor people are among the most likely to be worse off under existing and proposed health insurance systems, particularly universal health insurance, than they would be without the schemes. The media, politicians, and advocates of universal health insurance or nationalized health care perpetuate some common misconceptions about health insurance, including that health insurance is necessarily good for everyone and that universal coverage of all illness is possible at reasonable cost. They omit the loss of social welfare resulting from health insurance's inherent distortion of relative prices, the resulting excessive demand for health care, the consequent intolerable costs of health care, and the inevitable attempts to limit the costs through price controls, limited coverage, and so on. The absence of universal health insurance covering all illness at an “affordable” premium is widely viewed as a problem to be solved. In solving this problem, a useful base of comparison for any proposed solution is that it is “pareto-optimal”—a condition that leaves no possibility, in principle, of reallocating production and consumption to make at least one person better off without making anyone worse off. Existing and proposed health insurance systems are not pareto-optimal. Probably, universal health insurance systems that are close to pareto-optimal do not exist even in principle. With respect to realistic health insurance and health care systems, it is rational for some people not to want health insurance. Health insurance is viewed by many as too expensive and as providing too little coverage. A fundamental problem of health insurance is that participants regard premiums as a fixed cost; hence, they perceive a marginal price for health care that is well below marginal cost (a common copayment is only 20 percent of what providers receive). The result is far higher demand for health care than would exist if its marginal price were its marginal cost. A low marginal price does not change the fact that health care must be paid for. Thus, health insurance premiums are not a fixed cost for society. Consequently, health care demand exceeds what it should be given its cost. This price distortion and its effect may be why many health insurance participants feel that their premiums are too high and their coverage inadequate. Perceptions that health insurance premiums are too high lead to pressure to reduce them. Because health care must be paid for, only limiting supply or imposing price controls on providers can reduce premiums. Thus, a gap develops between the amount of health care demanded and the amount supplied, which reduces social welfare. Limitations in health care supply include the provision of some kinds of care only to specific groups, no provision of some kinds of care, and the delay of care. The resulting failure to cover virtually all health problems results in suffering that is exploited by the media and politicians. The result may be mandated coverage, as with patients' rights legislation. If so, participants are forced to pay for health care that they would not otherwise demand. It will be consumed, however, because of its perceived low marginal price. The resulting reduced social welfare goes unnoticed because the (otherwise unwanted) health care is consumed. Price controls may take the form of maximum fees for providers. This approach leads to inadequate supply to meet demand, including delayed or inadequate treatment. Again, the result is needless suffering and a reduction in social welfare. We apply basic microeconomic and insurance concepts to health insurance. To illustrate the concepts, we use relatively simple examples that will, we hope, convince readers that (1) the issues are more complex than public debate suggests and (2) much of conventional wisdom about health insurance is wrong.