I saw Sicko on Sunday night. No doubt, Michael Moore makes a fun movie. Clearly the US health insurance system is broken. It is, in all honesty, an embarrassment – a fact Moore ruthlessly exploits to great effect. That said, I nonetheless left the theater vaguely unsatisfied. I think it is because there is virtually no analysis of why the US healthcare system is broken, beyond of course the old stand by of “corporations are evil.”

As the film repeatedly demonstrates, health insurance firms often behave appallingly. But it isn’t because they are staffed entirely by evil people. This is a structural problem. For some reason, these firms are incented to literally turn their clients into their enemies (which is never a sound business strategy).

The best explanation I’ve seen comes from 5 pages in The Undercover Economist (an excellent book) where the author – Tim Harford – talks about the problems created in markets where there are asymmetries in knowledge. It is so good, I’ve reprinted (in an edited and very condensed form) the relevant bits:

“Economists have known for a while that when one participant in a transaction has inside information, markets may not work. It makes intuitive sense. But it wasn’t until an economist named George Akerlof published a revolutionary paper in 1970 that economists realized quite how profound the problem might be.

Using the used car market as an example, Akerlof showed that even if the market is highly competitive, it simply cannot work if sellers know the quality of their cars and buyers do not. For example, let’s say that half the used cars on sale are “peaches,” and half are “lemons.” The peaches are worth more to prospective buyers than to sellers – otherwise the buyers wouldn’t be buyers – say, $5,000 to prospective buyers and $4000 to sellers. The lemons are worthless pieces of junk. Sellers know if the car they’re selling is a lemon or peach. Buyers have to guess.

A buyer who doesn’t mind taking a fair gamble might think that anything between $2000 and $2500 would be a reasonable price for a car that has a 50/50 chance of being a peach. The seller of course don’t have to gamble: they know for certain whether their car is a peach or lemon. The problem is that sellers with lemons would snatch up a $2500 offer while sellers with peaches would find it insulting. Wander around offering $2500 for a car and you’ll discover that only lemons are for sale at that price. Of course, if you offered $4001 you would also see the peaches on the market – but the lemons won’t go away, and $4001 is not an attractive price for a car that only has a 50% chance of running properly.

This isn’t just about a trivial problem around the fringes of the market. In this scenario there is no market. Sellers won’t sell a peach for less than $4000, but buyers won’t offer that much for a car that has a 50% chance of being a lemon. With buyers only offering $2500 the sellers won’t sell their peaches, so in the end the only cars that get traded are worthless lemons, which get passed around for next nothing. Less extreme assumptions about the problem lead to less extreme breakdowns of the market, but the conclusions are similar.

Now let’s look at health insurance in this lens:

Let’s say that people who are likely prone to sickness are “lemons”; people who are likely to stay healthy are “peaches.” If, I suspect myself to be a lemon, I’d be advised to buy all the medical insurance I can. If, on the other hand, you feel fine and all your ancestors lived to be a hundred, then you may only buy medical insurance if it is cheap. After all, you hardly expect to need it.

Thanks to Akerlof’s proof that markets whose players have asymmetrical information are doomed, we can see how the insurance market may disappear. You, whose body is a succulent peach, will not find a typical insurance package a good deal; while I, whose body is a bitter lemon, will embrace a typical insurance package with open arms. The result is that the insurance company only sells insurance to people who are confident they will use it. As a result, the insurer loses clients who are unlikely to make claims and acquires the clients who are likely to make costly claims. As a result the insurer has to cut back on benefits and raise premiums. People of middling health now find the insurance is too expensive and cancel it, eliminating even more marginal “peaches” from the insurance pool and forcing insurance coming to raise premiums even higher to stay in business. More and more people cancel their policies, and in the end only the most sickly of the lemons will buy insurance at a price that will be nearly impossible to afford.”

Admittedly, this hardly covers all the problems facing the US healthcare system, but it does give an assessment of why the market for health insurance creates firms who behave so poorly (and yes, criminally). It is, in my mind, the best explanation for why a single insurer system (like what we have here in Canada) can work more effectively. However, this a single insurer system also creates problematic incentives, but more on that later in the week… (is anyone left reading a post this long?)