Naked Economics: Undressing the Dismal Science pdfdrive com

matter how much an insurance company charges for its policies. At any given
price—even $5,000 a month—the individuals who expect their medical costs to
be higher than the cost of the policy will be the most likely to sign up. Of course,
the insurance companies have some tricks of their own, such as refusing
coverage to individuals who are sick or likely to become sick in the future. This
is often viewed as some kind of cruel and unfair practice perpetrated on the
public by the insurance industry. On a superficial level, it does seem perverse
that sick people have the most trouble getting health insurance. But imagine if
insurance companies did not have that legal privilege. A (highly contrived)
conversation with your doctor might go something like this:
DOCTOR
: I’m afraid I have bad news. Four of your coronary arteries are fully
or partially blocked. I would recommend open-heart surgery as soon as
possible.
PATIENT
: Is it likely to be successful?
DOCTOR
: Yes, we have excellent outcomes.
PATIENT
: Is the operation expensive?
DOCTOR
: Of course it’s expensive. We’re talking about open-heart surgery.
PATIENT
: Then I should probably buy some health insurance first.
DOCTOR
: Yes, that would be a very good idea.
Insurance companies ask applicants questions about family history, health
habits, smoking, dangerous hobbies, and all kinds of other personal things.
When I applied for term life insurance, a representative from the company came
to my house and drew blood to make sure that I was not HIV-positive. He asked
whether my parents were alive, if I scuba dive, if I race cars. (Yes, yes, no.) I
peed in a cup; I got on a scale; I answered questions about tobacco and illicit
drug use—all of which seemed reasonable given that the company was making a
commitment to pay my wife a large sum of money should I die in the near
future.

---

Insurance companies have another subtle tool. They can design policies, or
“screening” mechanisms, that elicit information from their potential customers.
This insight, which is applicable to all kinds of other markets, earned Joseph
Stiglitz, an economist at Columbia University and a former chief economist of
the World Bank, a share of the 2001 Nobel Prize. How do firms screen
customers in the insurance business? They use a deductible. Customers who
consider themselves likely to stay healthy will sign up for policies that have a
high deductible. In exchange, they are offered cheaper premiums. Customers
who privately know that they are likely to have costly bills will avoid the
deductible and pay a higher premium as a result. (The same thing is true when
you are shopping for car insurance and you have a sneaking suspicion that your
sixteen-year-old son is an even worse driver than most sixteen-year-olds.) In
short, the deductible is a tool for teasing out private information; it forces
customers to sort themselves.
Any insurance-type situation ultimately raises one explosive question: How
much information is too much? I guarantee that this will become one of the most
nettlesome policy problems in coming years. Here is a simple exercise. Pluck
one hair from your head. (If you are totally bald, take a swab of saliva from your
cheek.) That sample contains your entire genetic code. In the right hands (or the
wrong hands), it can be used to determine if you are predisposed to heart disease,
certain kinds of cancer, depression, and—if the science continues at its current
blistering pace—all kinds of other diseases. With one strand of your hair, a
researcher (or insurance company) may soon be able to determine if you are at
risk for Alzheimer’s disease—twenty-five years before the onset of the disease.
This creates a dilemma. If genetic information is shared widely with insurance
companies, then it will become difficult, if not impossible, for those most prone
to illness to get any kind of coverage. In other words, the people who need
health insurance most will be the least likely to get it—not just the night before
surgery, but ever. Individuals with a family history of Huntington’s disease, a
hereditary degenerative brain disorder that causes premature death, are already
finding it hard or impossible to get life insurance. On the other hand, new laws
are forbidding insurance companies from gathering such information, leaving
them vulnerable to serious adverse selection. Individuals who know that they are
at high risk of getting sick in the future will be the ones who load up on generous
insurance policies.
An editorial in The Economist noted this looming quandary: “Governments
thus face a choice between banning the use of test results and destroying the

---

industry, or allowing their use and creating an underclass of people who are
either uninsurable or cannot afford to insure themselves.” The Economist, which
is hardly a bastion of left-wing thought, suggested that the private health
insurance market may eventually find this problem intractable, leaving
government with a much larger role to play. The editorial concluded: “Indeed,
genetic testing may become the most potent argument for state-financed
universal health care.”
5
Any health care reform that seeks to make health insurance both more
accessible and more affordable, particularly for those who are sick or likely to
get sick, will have devastating adverse selection problems. Think about it: If I
promise that you can buy affordable insurance, regardless of whether or not you
are already sick, then the optimal time to buy that insurance is in the ambulance
on the way to the hospital. The only fix for this inherent problem is to combine
guaranteed access to affordable insurance with a requirement that everyone buy
insurance—healthy and sick, young and old—a so-called “personal mandate.”
The insurance companies will still lose money on the policies that they are
forced to sell to bad risks, but those losses can be offset by the profits earned
from healthy people who are forced to buy insurance. (Any country with a
national health care system effectively has a personal mandate; all citizens are
forced to pay taxes, and in return they get government-funded health care.)
This is the approach that Massachusetts took as part of a state plan to provide
universal access to health insurance. State residents who can afford health
insurance but don’t buy it are fined on their state tax return. Hillary Clinton
supported a personal mandate in the 2008 Democratic presidential primaries;
Barack Obama did not, though that arguably had more to do with distinguishing
himself from his toughest Democratic opponent than it did with his analysis of
adverse selection. Obviously, forcing healthy people to buy something that they
would otherwise not buy is a heavy-handed use of government; it’s also the only
way to pool risk (which is the purpose of insurance) when the distribution of risk
is not random.
When the Obama Administration passed the Affordable Care Act
(Obamacare), the most unpopular part of the legislation was the personal
mandate, which required that all Americans buy health insurance or face a fine.
The irony is that Democrats did not come up with the idea of mandatory health
insurance; conservatives did—decades earlier as a tool for protecting private
insurance markets from adverse selection. The ACA offers reasonably affordable
insurance coverage to all Americans, even those who are already sick or at a
high risk of becoming so. That is an admirable goal, but it invites abuse. As

---

noted earlier, if anyone can buy insurance at any time—sick or healthy—the
most sensible time to buy insurance is after getting a nasty diagnosis. Mandatory
health insurance is a way to ensure that there are enough healthy people paying
into the system to fund care for those who are sick. When Mitt Romney, a
Republican, passed health care reform in Massachusetts—long before
Obamacare—the plan included a personal mandate.
Here are the relevant economics: (1) We know who is sick; (2) increasingly
we know who will become sick; (3) sick people can be extremely expensive; and
(4) private insurance doesn’t work well under these circumstances. That’s all
straightforward. The tough part is philosophical/ideological: To what extent do
we want to share health care expenses anyway (if at all), and how should we do
it? Those were the fundamental questions when Bill Clinton sought to overhaul
health care in 1993, and again when the Obama administration took it up in
2009. The Trump Administration repealed the personal mandate component of
the ACA in 2017, leaving the rest of the legislation intact. It’s not clear what the
long-term impact will be on private health insurance.
This chapter started with the most egregious information-related problems—
cases in which missing information cripples markets and causes individuals to
behave in ways that have serious social implications. Economists are also
intrigued by more mundane examples of how markets react to missing
information. We spend our lives shopping for products and services whose
quality we cannot easily determine. (You had to pay for this book before you
were able to read it.) In the vast majority of cases, consumers and firms create
their own mechanisms to solve information problems. Indeed, therein lies the
genius of McDonald’s that inspired the title of this chapter. The “golden arches”
have as much to do with information as they do with hamburgers. Every
McDonald’s hamburger tastes the same, whether it is sold in Moscow, Mexico
City, or Cincinnati. That is not a mere curiosity; it is at the heart of the
company’s success. Suppose you are driving along Interstate 80 outside of
Omaha, having never been in the state of Nebraska, when you see a
McDonald’s. Immediately you know all kinds of things about the restaurant.
You know that it will be clean, safe, and inexpensive. You know that it will have
a working bathroom. You know that it will be open seven days a week. You may
even know how many pickles are on the double cheeseburger. You know all of