Believe it or not, lemons and cherries are eminently pertinent to the discussion of healthcare provision. But before we take a juicy bite into the main argument, it is important to state that I am not responding to any proposed healthcare policies either here or across the pond. In this post I intend to show that the market alone (absent government intervention) cannot provide an adequate healthcare system. The popularity of anarcho-capitalism and minarchism is on the rise, and although I find myself leaning toward the latter, I would disagree with (a not insignificant subset of) people who identify as ideologues of one of these two views and who believe that healthcare should be left completely to the free market.
Lemons and cherries in the used car market
The broad problem I will describe is the problem of information asymmetry in the market. That is to say, the problem that occurs when one party involved in a transaction has access to information that the other party does not. In 1970, George Akerlof expounded the problem of information asymmetry in the used car market; a thesis for which he was awarded a Nobel prize. A great account of this problem can be found in Chapter 5 of Tim Hartford’s book ‘The undercover economist’, from which I came to learn most about the problem of information asymmetry.
As the buyer in a used car market, it is impossible for you to know whether the car being sold to you is in top condition (a ‘cherry’) or one that will break down after a few miles (a ‘lemon’). The seller has this information but the buyer does not. Suppose the buyer is willing to spend £6,000 on a cherry, if there were some way to guarantee the condition of the car in question. In other words, the buyer values the car more than they do the £6,000 in their bank account. If the seller is willing to sell the cherry at £6,000, the seller values the £6,000 more than they do the car. Lemons are worth nothing either to the buyer or the seller. A problem arises when the buyer cannot know for sure whether the car they are buying is a cherry or a lemon. The seller cannot prove to the buyer that the car being sold is a cherry and will obviously not tell the buyer if the car is a lemon. Given this inherent risk in buying a car from the used car market, the buyer is never willing to pay the full price of £6,000 for a car that has a reasonable chance of turning out to be a lemon. Any intelligent buyer will pay less than the price of a cherry (let’s say around £3,000) in order to cover for the risk that the car may turn out to be a lemon. As seller with a shiny cherry to sell, I will refuse to sell my tiptop car for such a low price. As a result, the incentive to sell cherries vanishes, since no buyers are willing to risk paying the full £6,000, and it only becomes profitable to sell lemons. Lemons begin to crowd the market. When intelligent buyers become aware of this, they are much less willing to gamble, and will offer even less for the car of unknown quality, giving used care salesmen even less incentive to sell cherries. Asymmetric information has resulted in a market vanishing into thin air even though there existed ample demand for used cars. Note that it is not the lack of information simpliciter that has caused the problem. It is asymmetric information that results in ‘the bad crowding out the good’. Suppose neither the buyer nor the seller had information about the quality of the car being sold. In such a scenario, the buyer would offer £3,000 to cover the risk of ending up with a lemon and the seller would happily take the £3,000 since the overselling of lemons will cover the cost of underselling cherries. Once one party has inside information that the other party in the transaction does not, the party lacking the information becomes more cautious. In economics, asymmetric information is an example of an ‘externality’; an unintended consequence of the market that lies outside of the transactions that occur.
Health insurance and adverse selection
So why does asymmetric information in the used car market mean that healthcare cannot be left entirely to the free market? Healthcare is expensive. Some lucky people exist whose interaction with the health service comprises the odd visit to the GP for a chest infection. Other less fortunate people require expensive procedures and regular treatment and monitoring. No one wants the headache of paying a sizeable lump sum when their car breaks down, or their home is burgled, or indeed if they require an expensive operation. The market’s solution to this problem is insurance. If 1 million people make regular, small payments to insure themselves from bad luck, and only 5,000 of them ever do run into bad luck (and therefore make expensive claims) the insurance company profits overall thanks to the majority of people who did not make claims, and those unlucky few are happy because their bad luck has not run them into bankruptcy. But the picture is not so rosy, because asymmetric information strikes yet again.
In the health insurance market, the buyers, not the sellers, have inside information that the insurers are not privy to. If you are a fit, healthy person in your prime, you are unlikely to make many high cost claims and are only willing to pay a small amount for health coverage. The insurance company likes cherries like you. However the individual with a family history of disease, or a long-standing chronic condition, or a high risk job, knows they may have to make some high cost claims and will be willing to pay a lot more for insurance. These are the lemons of the health insurance market. The insurance company does not know if the prospective client who has just walked through their door is a cherry or a lemon. They will be forced to push up the price of their insurance to cover the cost of lemons. But this happens at the expense of cherries who cannot prove they are cherries. With insurance prices higher than cherries are willing to pay, fewer cherries buy insurance. With fewer cherries buying health insurance, the insurance company in turn must make the cost of insurance even higher since the cherries are no longer there to cover the cost of the lemons. Those who are neither lemons nor cherries, who feel that there is a reasonable but not a high chance they may have to make expensive insurance claims are now also put off by the high price of insurance. As a result, the market is once again crowded by lemons. People who know they will make expensive claims buy the insurance while the cherries, who the insurance company wants to recruit, refuse to pay. The phenomenon whereby the price of insurance spirals as a result of asymmetric information is called adverse selection. In the end no one is happy. The cherries are not happy since they have been priced out of the health insurance market, the lemons are not happy since they are paying through the nose for insurance, and the insurance company is not happy since the lemons have crowded out the cherries. In reality, the health insurance market does not work quite like that. Even cherries often end up buying very expensive health insurance due to a fear of running into extremely bad luck and having to fork out for expensive procedures. Nevertheless, adverse selection still means that coverage is far from ideal and those who do buy insurance have to break the bank to do so.
Astute readers may well remain unconvinced that this is an insoluble problem. In the used car market, for example, sellers can signal their commitment to high quality cars by buying an expensive showroom. The showroom signals to the buyer that this is a seller who plans on sticking around and riding on their reputation. A salesman who knows they will quickly gain a reputation for selling lemons would not buy an expensive showroom. Similarly, mightn’t adverse selection be soluble privately? For example an insurance company could offer two types of packages; low premiums with high deductible (attractive to those who do not expect to make many claims) and high premiums with low deductible (attractive to those who expect to make regular, expensive claims). This ‘solution’ is still far from ideal. Those unlucky enough to be lemons are still forced to pay very high premiums to cover the cost of their claims and cherries who are unlucky enough to end up needing treatment end up paying a high deductible, which leaves both groups wondering if there was any point in having insurance at all.
Perhaps if we can bridge the information gap we can come to some kind of happy solution? Insurance companies can ask their clients to fill in lengthy questionnaires to find out how likely they are to make claims. Clients who smoke for example will have higher premiums than ones who do not smoke and exercise regularly. Perhaps in the future, insurance companies can sequence clients’ DNA and find out if people have genetic diseases or susceptibilities that would push their insurance up. In this scenario, both the client and the insurer have the same amount of information. The insurance company will then know lemons from cherries. But no problem has been solved here. If the insurance company can make a rough calculation regarding the cost of insuring a client with cystic fibrosis, they will raise the premium to take account of the cost of all the claims that the client will make. The aim for the insurance company is that no client should cost them money, however sickly they are. The obvious problem now is that lemons gain no benefit from buying insurance at all, since the cost of all their claims have been taken into account anyway. Insurance is only useful for unforeseeable events. If one can see the future, then there is no use for insurance. So, just like the used car market, the health insurance market would work best if neither party had any information. Cherries who don’t know they’re cherries would be happy to pay a middling price for insurance, and lemons who don’t know they’re lemons would pay the same price. Overall, the insurance company would happily take on all those clients since the cherries would pay for the lemons. Once it is known how much any one person will claim, there is little point in insuring for the ‘unexpected’.
Various clever solutions have been proposed for the problem of asymmetric information and I cannot comment on all of them here. The Singaporean approach to the problem involves a healthcare system reliant mostly on the free market along with small government intervention to iron out externalities. Whatever the solution, I have yet to come across a completely private solution to Akerlof’s problem that does not leave a bitter aftertaste.