Frakt, Aaron, and Alito on Externalities and the Mandate

post by Paul Kelleher

In anticipation of yesterday's Supreme Court oral arguments on the Affordable Care Act's individual mandate, Austin Frakt wrote:

The purpose of the mandate is to address some of the externalities of health insurance coverage decisions made by individuals. (“Externalities” is handy economics jargon for any effects a decision—like buying or not buying health insurance—has on those not directly involved in the decision.) [...]

[W]ithout a mandate (but maintaining the provisions of the law that prohibit insurers from denying coverage or from charging higher premiums because of an individual’s medical history), it’s likelier that relatively sicker individuals will purchase coverage than relatively healthy individuals. [...]

This type of behavior causes premiums to be higher than they otherwise would be, because the pool of people being covered includes more individuals who are sicker and more expensive to cover than would be the case with a mandate. [...]

Frakt reiterated this point yesterday in response to several Justices wanting to know what could be the difference between mandating the purchase of health insurance and mandating the purchase of broccoli:

There is a very clear difference between mandating broccoli purchase and mandating health insurance. I doubt it could be turned into a limiting principle suitable for court, but I’ll offer it anyway. First, if the government mandated purchase of broccoli, average broccoli price would rise. That follows from supply and demand, and I hope it is intuitive.

However, if the government mandates purchase of health insurance, average price of health insurance falls.

I could be wrong, but Henry Aaron seems much less comfortable with this particular externality-argument. In his recap of yesterday's oral arguments on the mandate, he writes (my emphasis):

Several of the justices, notably Scalia and Alito, responded to the externalities argument by saying that every economic transaction creates similar externalities. "If I don't buy a Volt, I raise the price of Volts," said Scalia. Alito said much the same thing. So did Paul Clement's brief for the plaintiffs.

This response was and is bad economics. It is true that every commodity is produced along what economists call a "cost curve"—raising output may lower average or marginal unit costs by spreading overhead or achieving economies of scale, but it may also raise costs by forcing up the cost of inputs or incurring diseconomies of scale. None of this occasions concerns about fairness or free-loading or, to use the economist's term, "externalities." But the cost shifting that occurs when uninsured patients fail to pay their bills does; it causes one group—the insured—to have to pay part of the cost of services others use. 

Although Aaron almost surely agrees that a mandate will lower average insurance costs, he notes that it may also raise prices elsewhere in the economy. For example, a mandate may increase the wages that non-insurance firms will have to offer to compete with the wages offered by insurance companies. Strictly speaking, this also seems to be a kind of externality. I assume, however, that many economists would argue that every policy "imposes" price-related externalities of some sort or other, and that it is very hard to determine whether one policy's price-related externalities are worse than another's. I suspect this is why Aaron chose to focus exclusively on a specific externality that strikes many as specially unfair. This is what Aaron refers to as "the cost shifting that occurs when uninsured patients fail to pay their bills does; it causes one group—the insured—to have to pay part of the cost of services others use."

A potential problem with this defense of the mandate, however, is that the ACA does not eliminate forces that "cause one group to have to pay part of the cost of services others use." Consider:

Cost of uncompensated hospital care in 2009: $39.1 billion. [1]

Annual ACA revenues from new taxes/fees/penalties on the wealthy, the insured, & industry: $38.4 billion. [2]

Even if we assume that all uncompensated costs are currently shifted to the insured and that the ACA would eliminate this, the ACA appears to create virtually the same degree of cost-shifting by imposing new taxes, fees, and penalties on industry, the wealthy, and the already insured. Just like much of the cost-shifting that currently stems from uncompensated care, the ACA's new revenues are to be used to provide care to those who cannot afford it. At the very least, this suggests that the mandate cannot be defended simply by pointing to the existence of cost-shifting externalities. For the ACA replaces one form of cost-shifting externality with others. What is needed is a rationale for shifting costs to one group rather than another. 

In addition to the new revenues cited above, the ACA clearly hopes that the threat of the mandate's penalty will induce young, relatively healthy individuals into the insurance market, where they will be required to purchase insurance coverage they are unlikely to use, thereby providing premium dollars that can be devoted to the care of others. This is clearly what Justice Alito was getting at in comments that Aaron called "the most glaring instance of the failure to appreciate what an externality really is." Aaron seems to think that Alito was trying to make the point that the uninsured are not in fact shifting costs to the insured:

[Alito] at one point challenged the solicitor general by positing that the cost of all of the care currently used by those who are uninsured is less than would be the cost of the insurance they would be forced to carry. That being the case, Alito asked, how can one say that the uninsured are shifting costs to the insured? This query is painfully detached from an understanding of what an externality really is, how insurance works, or what the impact of insurance would be on service use.

It seems to me, however, that Alito was making a much different point. Here's what Alito said (pp. 33-4, pdf):

If you took the group of people who are subject to the mandate and you calculated the amount of health care services this whole group would consume and figured out the cost of an insurance policy to cover the services  that group would consume, the cost of that policy would be much, much less than the kind of policy that these people are now going to be required to purchase under the Affordable Care Act?  [...]

The point is -- no, you take into account that some people in that group are going to be hit by a bus, some people in that group are going to unexpectedly contract or be diagnosed with a disease that -- that is very expensive to treat. But if you take their costs and you calculate that, that's a lot less than the amount that they are going to be required to pay.  So that you can't just justify this on the basis of their trying to shift their costs off to other people, can you? 

Alito is arguing that, in complying with the mandate, many previously uninsured folks will be paying much more than they need to pay to cover the expected costs that would be shifted to the insured in the absence of the ACA. In other words, he's noting that the cost-shifting argument is not sufficient justification for the specific kind of mandate the ACA includes. This strikes me as correct, and it raises additional questions about whether the externality/cost-shift argument can do the work that some of its proponents ask of it.

[1] American Hosptial Association, pdf.

[2] Maggie Mahar. This figure reflects: increased Medicare taxes on the wealthy; new fees on industry; the "Cadillac tax" on expensive insurance policies; reduced tax exemptions for health savings accounts; reducing deductions for itemized medical expenses.

Comments

[Brendan]

I'd have to think more about the first part of your post, but I think your gloss on Alito's comment is right. Didn't he also press the SG for why it would be justifiable for people to pay for certain kinds of benefits (like making a single man pay for prenatal care) that they will never need to use? I suppose that within the terms that the court is deciding this issue, that is a plausible argument to make, even though it's not plausible on my own explicitly normative view of why everyone should pay for insurance (social solidarity etc.).

[Brad F]

Paul
You made a point I have been waiting to see for some time, mainly, most of the "unfunded" liability of care is not new money entering the system. Its money the government will collect and redistribute. My guess is, the new younger entrants into the market who previously were detached from the insurance marketplace will augment the pot of dollars by a few billion only. Not much juice for the squeeze.

Where I do see this effort paying off is setting the foundation for the day ESI and tax advantaged status of premiums goes down. Then, the potential for market collapse is great, and the nature of the discussion changes.

In your closing, I guess I would ask, if we envision a system where job lock is eliminated, and individuals are free to move from job to job, state to state, and over a lifetime, AND they keep their plan with whatever health burdens that befall them, what then is an "expected" cost of a plan (what is a risk ban, and how do you stratify risk?).

In another words, is an insurance product an all in proposition--understanding some stop-loss is necessary for outliers--and Alito's view is a misperception of optimal risk pooling for society over a lifetime. After all, virtually 100% of us will use HC before we die; if we agree we need insurance, than it is a decades long endeavor.

Brad

[Paul Kelleher]

Hi Brad,

You're right that *if* we assume that people will have portable coverage that "they keep...with whatever health burdens that befall them," then sure, health insurance will be "a decades long endeavor." But Alito's wants to know why society should be able to force individuals into that situation in the first place. To answer his question, we cannot assume that the forcing has already been done (and done legitimately).

Another way to put that is this: I'm not a fan of Paul Starr's alternative to the mandate, but it is an alternative, and it's an alternative that would permit health insurance to be something other than a decades long endeavor. If Paul Starr wants to allow this, surely it's reasonable for Alito to ask what the reasons for forbidding it are, and whether they are good reasons.

[Brad F]

Can we then deduce that when the "if" occurs, Alito would revisit his position? Or, in other words, his beliefs are not rooted Constitutionally, but with the shifting sands of what congress legislates?

Also, on Starr, both in print and in interviews, I have never heard him justify how catastrophic care will reconcile into his scheme. For those who opt out and prefer to nickel and dime their minor ailments, no harm, no foul. But ultimately, who pays for the big, unanticipated events--the events that comprise 90+% of what the lock out is attempting to prevent in the first place. It dont add up, and I question the tool as a deterrent if above is what we are looking to prevent.
Brad

(this is something of mine, very short, that embodies the same): http://www.healthcarefinancenews.com/blog/individual-mandate%E2%80%A6

Brad

[Paul Kelleher]

That's the thing about the supreme court: once a law or policy has been around for a long time, it's harder to touch. I'm not sure that's the best policy, there there you have it.

I assume Starr would have to support a Do Not Treat list, right?
http://economix.blogs.nytimes.com/2012/03/28/how-about-a-do-not-treat-list/

[Paul Kelleher]

Brendan,

Your comment aligns nicely with my general take on all this, as I note in my post today.

[compare health insurance]

The problem with the mandate is that it basically requires everyone to have insurance. This runs into problems the second you consider the fact that many can't afford to do so.