The bad economics of switching health-care plans.

The search for better economic policy.
Sept. 7 2007 7:29 AM

Taking Our Medicine

The bad economics of switching health-care plans.

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But the real-world market for health insurance contracts falls far short of this theoretical ideal. The "law of one price" assumes that health insurers are all peddling a similar product, and that it's easy for customers to learn about and compare the various offerings available. But shopping for health insurance isn't like buying a stack of 2-by-4s—you make a few phone calls to find the lowest price. It's difficult and time-consuming to weigh the costs and benefits of insurance plans with different reimbursement rates for thousands of procedures, diverse physician networks, and differences in quality of patient care. In economists' terms, the insurance market has "search frictions." Since the search for alternative plans is expensive, companies get locked into a relationship with whoever happens to be their current provider.

What's a costly headache for insurance buyers is a profit-making opportunity for insurance sellers. Insurers know that it's hard for their customers to leave them, so they push up prices secure in the knowledge that employers will have trouble breaking free. So much for the law of one price—because of search frictions, big price differences across plans don't get whittled away by rivalry.

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The authors of the new study argue, somewhat counterintuitively, that it's precisely these price differences that lie behind the high rate of employer switching. An employer may not be able to evaluate all competing choices, but it'll look for ones that present particularly promising alternatives to its current plan. And every few years, it'll find one. For large companies that effectively run their own insurance programs with the assistance of an insurance provider, this doesn't happen very often. But the authors calculate that smaller companies that require full insurance coverage make a change on average every five years. In other words, while the law of one price doesn't work well as a result of high switching costs, those costs are not so high as to prevent switching altogether.

Now that we've diagnosed the problem, can we develop health-care policies that will encourage preventive medicine? We could move to a system of universal health coverage, like Canada, France, Italy, and every other rich country on earth. That would get rid of turnover altogether. But it would also require fundamental changes to a system that has resisted major reform until now. And so as an alternative, the authors of this study suggest ways to tinker with the current model to reduce the search frictions that are responsible for much of the turnover problem.

Employers are tempted into switching because of price disparities across plans. A partial solution would be to legislate away these differences by capping what insurance companies can charge. This should reduce price differences between plans, and the incentive for employers to shop around for cheaper options. But where should the government set the ceiling? If it's too low, the government could end up destroying insurance companies' incentives to stay in business at all.

Another option is to make available a simple, easily understood, and reasonably priced health insurance plan. The authors argue that this would simplify an employer's search for good insurance and as a result, reduce the amount of switching. They suggest that the federal government could create a plan that all employers could choose to offer their workers. The authors wager that while most employers wouldn't use the federal plan, it would create the competition needed to drive down prices of private insurance. This modest proposal for government intervention won't satisfy Michael Moore or others pushing for a complete overhaul of American health care. But it may help to make Americans healthier while we wait for more ambitious reforms that are promised every electoral cycle but so far never delivered.

Ray Fisman is a professor of economics at the Columbia Business School and co-author of The Org: The Underlying Logic of the Office. Follow him on Twitter.