Friday, July 31, 2009

Healthcare Profits Good? Think Again

Baseline Scenario is back with another great post on health care. James Kwaak talks about the significance of profits, and why we should be suspicious of them when they are industry-wide. Free-marketeers will find this excerpt interesting:

I agree that the pursuit of high profits is a good thing. That is what makes a free-market capitalist system work, and it’s what made me start a company eight years ago. But basic microeconomics says that high profits themselves are generally not a good thing.

In a competitive market, if one company is earning high profits, then other people will want to start new companies to compete with it. By entering the market, they increase competition, reducing profit margins for the original market leader; more companies and more competition also mean more innovation; both of these factors increase overall social welfare. In a true competitive market, one without barriers to entry or market power, companies should not earn any profits at all, because competition will drive price down to marginal cost. (Steve Goldman, one of my economics professors, once said that if you wake an economist up in the middle of the night and ask him or her, “what is price?,” he should answer, “marginal cost.”)

The real world is different, of course. Companies have to earn profits sufficient to cover their cost of capital. And if you invent a successful new product, you will earn excess profits for some period of time; but over time your competitors will catch up and those excess profits will go away (see the IBM personal computer, for example).

So if you see a company that has very high profits over a sustained period, there are two possibilities: either it is benefiting from a non-competitive market (e.g., it is a monopoly), or it is simply exceptional at innovating and staying ahead of the competition for years on end. If you see a whole industry that has sustained high profits, however, the latter explanation cannot hold, and you should immediately suspect a lack of competition.

In short, the thing that we should celebrate is not high profits, but competition. The pursuit of high profits is what motivates competition; but if a whole industry achieves high profits, then what you are seeing is not competition, but its opposite.

A market like this, that sustains high profits over the long run, is simply not competing on price. Insurance companies are not designing and patenting new drugs or procedures; they are essentially selling a commodity, and so the prices should converge to somewhere around marginal cost plus cost of capital.

And how could a market like this compete on price? Although they are essentially offering the same underlying service, in another sense, each company is operating as a monopoly in its own market.

How can this be? Because although they are putatively selling the same product (insurance) they are actually all selling different products (insurance which no one can understand). Because you cannot properly value the insurance, due to the complexity of the policy, the impossibility of properly assessing your own future financial risk regarding health care, and your inability to know if rescission will leave you with no health care at all, you really have no way of comparing the value of one policy to another. Which makes the idea of a competitive insurance industry a joke.

So what are they competing on, to the extent that there is any competition at all? They are competing on innovative ways to add complexity to their products in ways what will encourage people to make poor valuations, and consequently make poor policy choices that end up costing them money. They are competing on regulatory on political capture. But they are absolutely not competing on ways to offer a better product at a better price.

Welcome to the healthcare market. What's so great about it again?

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