It's Adverse. But Is It Selection?

I'm afraid we're all just going to have to adjust to the fact that it's going to be All Healthcare, All the Time until the August recess.

So:  onto adverse selection.

Adverse selection is the idea that information asymmetries in markets can lead to sub-optimal outcomes.  Say 30% of all used cars are lemons that will cost you a fortune to repair.  A new car is worth $10,000 while a good used car is worth $5,000, but a lemon is only worth $1,000, because of the repairs.

The problem is, you can't tell which cars are lemons.  So you won't be willing to pay $5,000.  You might be willing to pay more like $3,500, which compensates you for the risk.  But the owners of the good cars will not wish to sell them at such a steep discount.  The owners of the crap cars, however, will leap at the chance to unload them for such a great price.  The percentage of lemons in the market goes up to 50%.  You demand a bigger discount to compensate you for the higher risk; now you'll only pay $2,500.  More owners of high-quality used cars decide to keep them rather than buy a new one.  The percentage of lemons rises to 70% . . .

You can see where this is going.  And, presumably, how it might apply to insurance markets:  you end up with a pool of very sick people who cost a lot to cover.  This (along with a lavish schedule of mandatory benefits) is arguably why health insurance in New York State costs so much.

Adverse selection is a favorite explanation of why markets for health care can't work, and health care therefore needs to be provided by the government.  Often, the proponents of this theory add a wrinkle:  insurance companies spend huge amounts of money on trying to keep from treating people.

Alex Tabarrok points out a hole in this theory:

If insurance companies do avoid covering people who are "likely to need care," this suggests that the uninsured are unhealthy.  But 60% of the uninsured are in excellent health (Table 10) (In fact, overall the uninsured are only slightly less healthy than the insured).

Henry Farrell voices the objection that immediately occurred to me.

But the statement '[Insurance companies] try to avoid covering people who are actually likely to need care' very obviously does not imply the statement 'All uninsured people are being refused coverage because they have expensive conditions.' The logical connection between the two implied by the 'contra Paul' bit is not, to put it mildly, clear to me. As a result, I am not sure what Alex's actual point is. Is he suggesting that the incentive problems that Paul identifies are in some sense unimportant?

But on reflection, I think Henry and I were wrong.  I was very surprised to follow through to the table Alex Tabarrok links (from the Kaiser foundation, hardly a right-wing advocacy group) and find out that the percentage of the uninsured* who are in "fair" or "poor" health really isn't much larger than the percentage of the insured in those categories:  10.3% of the uninsured, versus 8.4% of the insured. 

That is surprising because we would expect the uninsured to be sicker than the general population, even if the insurance companies were doing nothing to weed out the sick.  Being uninsured is correlated with other things that are strongly correlated with poor health:  being born in another (poorer) country; being too sick to work full time; little education; low SES. 

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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