Code Red: Two Economists Examine the U.S. Healthcare System

February 10, 2014

The Real Health Reform Debate Starts Here (Warning: You Still Have to Pay for Lunch)

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 9:12 am

For the past five years our political leaders have pretended to be engaged in a great debate about the U.S. healthcare system. The President offered his vision for health reform. The Republicans offered a far less ambitious alternative and otherwise attempted to block any reform. Both sides claimed that their proposals would solve the problems of access and cost containment while the other side’s approach would accomplish nothing or worse. Neither side suggested that there could be any possible downsides to their promises of rainbows and ponies for every American.

While neither of us are naïve enough to suggest that politicians should present the flaws of their plans during a legislative debate, we’ve had several years where a responsible Administration would have been clearer about the inherent tradeoffs of their ambitious health care reform. At the same time, Republicans should have opposed the ACA on its merits instead offering knee jerk ideology and platitudes. This fervent and fact based opposition would have exposed many of the “problems” that are now emerging for the ACA – allowing a more fulsome discussion of these issues before the implementation of the legislation.

As we teach our first year MBAs here at Kellogg, no matter how much you hope it will be different every major policy decision facing businesses and governments involves trade-offs, and the best decisions come when you carefully evaluate the benefits and costs of these choices. Absent a serious debate about health insurance, neither the American people nor their elected officials seem to have fully considered the actual benefits and costs of the ACA. As these costs now emerge, the public appears to be shocked at what they are finding. We thought it would be useful to try and clear the air and rise above the purely partisan rhetoric about the trade-offs dominating the recent news. In our next blog, we will discuss other tradeoffs that are equally important, but have received less attention to date.

Tradeoff #1: Eliminating the employer-based insurance system versus encouraging labor supply.

This tradeoff received front page treatment last week after the Congressional Budget Office predicted that 2.3 million people would leave the labor force as a result of the ACA. Many people, including those who frankly should have known better, appeared surprised by this estimate. But economic theory tells us that this reduction in labor supply was inevitable, because an important feature of an employer-based system is that it encourages individuals to work. One reason for this, is it is often difficult (if not impossible) to obtain insurance in the individual market (a problem resolved by the ACA). Garthwaite and his co-authors have recently published a peer reviewed empirical study documenting this effect have just published a peer reviewed empirical study confirming this theory. Beyond access to insurance, the ACA’s need-based subsidies effectively drive up marginal tax rates, and drive down labor supply, for low wage earners.

Reaction to this CBO report has served as a Rorschach test of a person’s opinion of the ACA. Ardent ACA supporters such as the President’s chief economic advisor, Jason Furman, make a classic economic “revealed preference” argument that that we should respect the choices of those who opt out of the labor market. This rests on the fact that a primary benefit of the ACA is creating a non-employer option for health insurance and therefore many Americans who were working just to receive a fair price on benefits could now re-optimize without this inefficiency.

On the other hand, many opponents of the ACA have touted the CBO as a job killer. This may be a true about the law overall, but is certainly not what the CBO report says. More reasoned opponents have stated that it is disingenuous of the administration to suggest that this reduction in labor supply is a pure benefit. The CBO is clear to point out that the reduction in labor supply is also the result of negative incentives from the phase-out of means tested subsidies. This is true and also shouldn’t be surprising. Like other mean-tested transfer programs, the phase out of the ACA subsidies over time creates a disincentive for labor supply. At a minimum the ACA creates a large health insurance notch in an individual’s budget set at 400 percent of the poverty line. At this income level subsidies disappear entirely and, depending on a person’s age and location, earning a few dollars more could cost thousands of dollars in lost subsidies. This creates an artificial disincentive to supply labor and is something that everyone, including the economists at the White House, should be worried about.

Given declining trends in labor force participation, any policy that decreases labor supply should cause some concern. That being said, this is not something that is unique to the ACA. It is difficult to imagine how we can sever the link between employment and insurance through any type of insurance reform without providing tax subsidized coverage through exchanges and thereby reducing labor supply. Republicans and Democrats could have, should have, debated this issue. All Americans should have had an opportunity to weigh in. Instead, we are handed the Obama approach and told to like it.

Tradeoff #2: Lower premiums and overall health spending versus freedom of choice.

When the media weren’t concentrating on the labor supply effects of the ACA, this week also brought more stories about newly insured individuals from the exchanges realizing that their inexpensive plans had a relatively small number of providers. This is a feature of their plans – not some defect. As we have earlier blogged, most individuals could have opted for plans with broader networks, either through exchanges or the preexisting individual insurance market place, but chose instead for the low cost alternative. Perhaps some of these patients should think back to their excitement about finding a low cost plan on the exchange. This was not a gift from insurance companies, but instead is a direct result of narrow networks.

Again, the tradeoffs have been known for decades. Economists have long argued that selective contracting, and the creation of provider networks by insurers, is a powerful tool for reducing provider pricing, encouraging provider efficiency, and reducing overall health spending. Dranove has even written two books about this! Apparently the message of these books has not been fully understood by the general public or even policymakers. Selective contracting is ineffective unless insurers can credibly threaten high cost providers with exclusion from networks. Insurers first narrowed their networks in the 1990s, and health spending in the private sector moderated for the first time in decades. After the managed care backlash of the late 1990s, insurers felt compelled to offer broad networks. Unable to credibly threaten to exclude providers (especially those providers with market power), insurers could no longer extract deep discounts. Through most of the 2000s, right up until the Great Recession, health spending soared.

Once again, many insurers are offering narrow networks, and health spending seems to be trending down. Providers who have been excluded from networks are complaining and they have the ears of many politicians. There are proposals in state legislatures to compel insurers to expand their networks to include all providers willing to participate. And President Obama has floated the idea of mandating that insurers include certain designated safety net providers.

The tradeoffs here are a bit more obvious than for labor supply: If we want greater access we will have to pay for it. In most states, exchanges offer a choice of narrow and broad network plans, so patients can make their own choices. In those areas where plans don’t currently offer broad networks, if there is sufficient patient demand for these products at premium levels that are profitable, then at least one insurance company will create and offer such plans. And if no broad network plans can survive the cauldron of competition, this tells us how patients have evaluated this tradeoff.

Instead of allowing market forces to craft the types of plans that emerge, legislators are threatening to force insurers to broaden their networks. Describe as “any willing provider” legislation, these regulations are pitched as an attempt to improve access and support safety net providers. In reality, they are the camel’s nose under the tent that will destroy the potential benefits of narrow networks. If we want broad networks, we will vote with our dollars in the exchange marketplace. And we can support safety net hospitals through direct taxation and subsidies, rather than through the backdoor via insurance regulations. Unfortunately, our elected representatives seem inclined to decide on these tradeoffs for us. And as is so often the case, concentrated interest groups (namely, affected providers) are likely to sway the political debate, so that Americans are denied chance to make their own choices.

Forcing insurance companies to broaden their networks will undoubtedly increase premiums for many plans in the exchanges. Is it worth the higher cost to have broader access? Should Americans be allowed to make this choice, or are market forces too unreliable? We know how our elected officials feel about these issues, but what do the voters think? Who knows?

We are not suggesting that individuals should have a voice on technical policy decisions. But these are not obscurities we are talking about. These are fundamental questions about our healthcare system that transcend party lines. Should employers provide insurance? Should we insist on freedom of choice? It is not clear where most Americans stand on these questions and their inherent tradeoffs, because no one thought to ask. Instead, Democrats have pretended that the ACA was a magical world where we can have our cake and eat it too, while Republicans have seen their own sort of magic in market forces. Most Americans have figured out that the real world of health care is messier, with difficult tradeoffs.

Is it too much for our elected officials to treat voters with a bit of respect, stop playing partisan games with the health economy, and start talking about real issues? Sadly, we think the answer is yes.

Our elected officials have not asked voters where they stand on these issues. So we are asking. Given the inherent tradeoffs, should government do what it can to sustain employer-sponsored health insurance? Should government mandate broad access to medical providers? Tell us what you think.


  1. “Given the inherent tradeoffs, should government do what it can to sustain employer-sponsored health insurance? Should government mandate broad access to medical providers? Tell us what you think.”

    Government already plays a significant role in our health care system as it provides Medicare and Medicaid reimbursement to those covered from taxes collected. To that end, it should adapt broad policies that result in reducing health care costs and encouraging individual participation in their health care choices. If sustaining employer-sponsored health insurance and mandating broad access to medical providers results in lower health care costs and more individual participation in their health care decision, then YES to your questions. But I have my doubts.

    Comment by Ken Templin — February 10, 2014 @ 11:56 am

  2. Great points…both of these


    Bob Strickland
    Senior Vice President, Performance Excellence
    Executive Assistant: Debbie Sage, 303-383-2786


    Comment by Strickland, Bob — February 10, 2014 @ 4:26 pm

  3. 1. Given our longstanding levels of unemployment and underemployment, I am baffled that a reduction in the labor supply should not be an economic blessing. Whether in a fast food restaurant or a college, having lots of underpaid help does not make us more prosperous.

    2. Other nations solve the network problem rather easily with fixed national fee schedules. The ‘market power’ of expensive institutions is destroyed.
    I realize we cannot achieve that overnight, but it is possible.

    bob hertz

    Comment by Bob Hertz — February 26, 2014 @ 6:37 am

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