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Home > Social Issues
Market Failures: Health Insurance & TABOR
by Bob Powell, 6/23/07
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This is a 6/21/07 presentation on "The Health Insurance death spiral and TABOR." It explains the origin of the "free market" failures that lead to the effects we observe [see also Health Care Dynamics].

This presentation (pdf, 304KB) addresses two examples of how "free market" ("lawless market") failures are behind virtually every major social problem we face [see also Invisible Hand Drops Ball & Economics 101]. That's because these problems are a result of conditions that are dynamically complex (see What is Systems Thinking?). As John Sterman writes, "... imperfections create feedbacks that sometimes overwhelm the negative loops normally balancing supply and demand, leading to inefficiency or even to complete failure of the market."

The idea that there can be "market failures" is anathema to libertarians and economic conservatives who believe the "free market" is infallible. Any problem is caused by interference and "burdensome regulation;" the market just isn't "free enough."

From:  A World of Ideas -- A Dictionary of Important Theories, Concepts, Beliefs, and Thinkers by Chris Rohmann, 1999

Edmund Burke also embraced the LAISSEZ-FAIRE economics of Adam Smith, maintaining that "the laws of commerce ... are the laws of nature, and consequently the laws of God."

John Sterman expresses an enlightened view in All models are wrong: reflections on becoming a systems scientist by John D. Sterman, Jay Wright Forrester Prize Lecture, 2002 System Dynamics Review, Volume 18, Number 4, Winter 2002.

A student once commented that Business Dynamics and the homework assignments in my course were too difficult, writing "Too many 'why' questions." Reading this I knew I had failed that student. It's by asking those 'why' questions that we come to understand that we are all embedded in systems, some natural, like the global climate, and some of our own making, like our schools, businesses, communities, and economies. It's by asking those 'why' questions that we gain insight into how we are both shaped by and shape the world, where we can act most effectively, where we can make a difference -- and [gain] what we are striving for.
When human beings evolved, the challenge was survival in a world dominated by systems we could barely influence but that determined how we lived and died. Today the challenges we face are the result of systems we have created. The hurricane or earthquake do not pose the greatest danger. It is the unanticipated "side effects" of our own actions, side effects created by our inability to understand and act in consonance with our long-term goals and deepest aspirations.
What prevents us from overcoming policy resistance is not a lack of resources, technical knowledge, or a genuine commitment to change. What thwarts us is our lack of a meaningful systems thinking capability. That capability requires, but is much more than, the ability to understand complexity, to understand stocks and flows, feedback, and time delays. It requires, but is much more than, the use of formal models and simulations. It requires an unswerving commitment to the highest standards, the rigorous application of the scientific method, and the inquiry skills we need to expose our hidden assumptions and biases. It requires that we listen with respect and empathy to others. It requires the curiosity to keep asking those "why" questions. It requires the humility we need to learn and the courage we need to lead, though all our maps are wrong. That is the real purpose of system dynamics: To create the future we truly desire -- not just in the here and now, but globally and for the long term. Not just for us, but for our children. Not just for our children, but for all the children.
It's demanding work. ...

Unfortunately, Burke, other conservatives, and libertarians see laissez-faire "free market" economics as "the laws of God." The infallible "free market" always produces the best possible results. Hence, "deregulation" of markets is always to be preferred -- unless, of course, the regulation is for the purpose of protecting capital, as opposed to protecting labor or the environment.

It's quite certain that Burke would have, and economic conservatives today do, consider systems thinking and system dynamics to be one of those "abstract theories" produced by "an act of folly" and "puny reason" inadequate to the task (see The Conservative Mind).

The view that "reason" is inadequate for designing social systems is reflected in libertarian view that any attempt to design social systems is resorting to impossible "command and control." But it's no more "command and control" than the techniques of gardening and farming ... setting the conditions (feedbacks, policies and actions -- structures) to produce a desired outcome (future).

A riddle: "How many libertarians does it take to change a light bulb?"

The answer: "None, they just sit in the dark and wait for the invisible hand to do if for them."

Bill Hawkins of the United States Business and Industry Council noted that "... as the 'invisible hand' turns off the lights in one factory after another in America, the intellectually dishonest [libertarian] has the temerity to deny that it is dark at all."


See the presentation. TABOR is a result, not a cause, of the way we ineffectively deal with growth. For more see The Growth Trap and the Growth Facts of Life.


Real unemployment is 12%, not the "official" 4 - 5%. Many categories of people who need jobs are just not counted in "official" unemployment. There's even an Orwellian category, "Not in labor force, Persons who currently want a job". Not only are they not considered as unemployed, they're not even considered to be "in the labor force." This doesn't count the underemployed.

National policy is to keep that 12% slack of more people than there are jobs to avoid a feared "wage-price inflationary spiral." The fear is that, if there's a "shortage" of labor, those who work for a wage will demand higher wages, this will cause higher prices and further demands for increased wages. Whenever, in the view of the Federal Reserve, unemployment falls "too far" or employment rises "too much" the Fed tightens the money supply and/or raises interest rates to "cool" the economy. This reduces demand and puts people out of work. The Federal Reserve only allows so many jobs to be created and promotes worker insecurity to hold down inflation. Don't believe it? See the citations from Federal Reserve meeting notes in the handout and at "Response to a Conservative". There is no 'free market' for labor.

The problem with this is that inflation is really set off by speculation or the rising price of commodities (e.g., oil). No matter, the Fed "manages the economy" to assure there are at least 10% more people who need jobs than there are jobs.

Regional growth doesn't "create jobs," it only rearranges them. People leave slow-growing areas to go to fast-growing areas (see the charts in the handout that prove it ... faster growth does not reduce unemployment). Because there aren't enough jobs, regions must compete for the jobs that are allowed. They compete with lower taxes and less regulation (more costs socialized onto the public). Years later, this leaves regions without enough tax dollars to pay for infrastructure.

Governments pass, or attempt to pass, the costs onto the public by increasing taxes. But the public rebels and passes laws like Gallagher and TABOR. Alas, the growth has already happened, so if you don't pay in taxes, you pay by getting stuck in traffic and hitting potholes. Bummer.

So-called "conservatives" and libertarians have been very successful in blaming the problem on "tax & spend liberals." To the contrary, the problem is libertarian "cost side socialism" that redistributes costs onto the public.

On Health Insurance

See the presentation or the comments and excerpts from Sterman below that were included in the presentation. Added is a model of idealized supply & demand feedbacks and Sterman's model in the Instructor's manual of "Adverse selection and the Medigap death spiral," which was not shown or discussed in the presentation).

For health insurance, the failure is primarily due to what's known as "adverse selection." Adverse selection occurs in situations for which there is "asymmetric information," e.g., you know more about the status of your health than do the insurance companies.

Over 46 million persons in the U.S. were without health insurance in 2005 and the number is increasing steadily. Over 11 percent of the children, over 8 million, were not covered. The U.S. "system" is failing.

Excerpts from Business Dynamics: Systems Thinking and Modeling for a Complex World, Irwin/McGraw-Hill,  2000 by John Sterman. Dr. Sterman is Jay W. Forrester Professor of Management and Director, MIT System Dynamics Group. pp. 174 - 175

5.5.1 Market Failure, Adverse Selection and the Death Spiral.

Many real world markets are imperfect due to the limitations of information, costs of entry and exit, and inflexibility of resources. These imperfections create feedbacks that sometimes overwhelm the negative loops normally balancing supply and demand, leading to inefficiency or even to complete failure of the market. One source of market failure is adverse selection.
Feedback Structure of Markets: The "invisible hand" feedbacks that determine the equilibrium price at which supply & demand are equal

[Note: The "negative loops" to which Sterman refers ... see figure at right ... are the "supply and demand" balancing feedbacks of Economics 101 that help create an effective and efficient economic system.

Loop B1: Greater Price, relative to the Price of Substitutes, decreases "relative value." Lower "relative value" decreases Demand and decreased Demand decreases Price.

Loop B2: Greater Price, after subtracting the Cost of Production, increases "profits." Increased profits increase Supply, which decreases Price.

The loops are "balancing" loops (negative feedback) because we began with increasing Price and came back to Price with it being decreased.

These are powerful feedback loops; they're just not the whole story.]

Adverse selection can arise when sellers and buyers in a market have different information. [He goes on to describe Akerlof's treatment of the used car market where sellers know more about the condition of a used car than do the sellers.]

Each person, behaving rationally, given the information available to them, causes an outcome undesirable for all. Akerlof's result was a breakthrough in economics. Not only did his model form the foundation for the important field of information economics, a field of immense importance in economics today, but he also demonstrated that the workings of free markets were not always benign, even without monopoly power or collusive agreements among producers. Adam Smith celebrated market forces for creating an invisible hand leading individuals to "promote and end which was no part of [their] intention," and end which "frequently promotes [the interests] of society." Akerlof showed that rational self-interest could lead individuals to promote, though unintentionally, an end harmful to the interests of society -- and themselves.

In the "Policy Analysis" section of the  Business Dynamics Instructor's Manual: 5.9 The Medigap Death Spiral (Section 5.5.1), p. 51:

Adverse selection is a problem of market failure: the positive feedbacks overwhelm the normal negative loops of the free market; the outcome is a drop in social welfare as well as corporate profit. Market failures can be addressed through government intervention, for example, the creation of a single-payer system or national health insurance. When the sick cannot be excluded by insurers and the healthy cannot opt out of participation, the adverse selection loops disappear. The solution to the problem is not solely an economic one but is fundamentally a social, even a moral one. Are we, as a society, willing to pay a bit more so that the all of us, including the oldest, poorest, and sickest, have access to good health care, or will health care remain a privilege available only to the young, affluent, and healthy?

Obviously a serious answer to these questions must go beyond the illustrative causal diagram presented here. The health care policy debate also elicits many strongly held beliefs and ideologies regarding the role of government, the efficiency of the market, the privacy rights of citizens, and so on. Good discussion can be generated by posing these questions in a class or group and requiring them to separate assertions about the causal structure of the system from assertions about how the system would behave. Having people draw out the feedback structures representing their views sometimes reveals that the behavior they claim does not follow from their understanding of how the system is structured.

Below is Sterman's causal loop model of "Adverse selection and the Medigap death spiral" and a discussion of the model from the Business Dynamics Instructor's Manual, pp. 48 - 49:

5.9 The Medigap Death Spiral (Section 5.5.1)              Chapter 5

Exhibit 5-19 shows the feedback structure for adverse selection in the Medigap insurance market. Medigap premiums are affected by the required premium and the intensity of competition among providers in the Medigap market. The required premium is determined by total Medigap costs (including the insurers' required profit margin) divided into the subscriber base. The more intense the competition in the market, the lower premiums will be relative to the required level. The intensity of competition depends on the number of Medigap underwriters in the market. The number of underwriters, in turn, responds (with a delay) to Medigap profits, which are the difference between revenue and total costs. Since revenue depends on the subscriber base, higher premiums, by boosting profits and attracting new competitors, tend to push premiums back down through the Competition loop B1. There is a substantial delay between a change in profits and the entry or exit of underwriters. 

Figure 5-19 Adverse selection and the Medigap death spiral

The remaining loops identified in the diagram are all self-reinforcing. Suppose Medigap premiums rise. Some subscribers find they can no longer afford it. Others find they can get their health care more cheaply in other ways. The subscriber base falls. The total costs of Medigap must now be raised further, forcing still more people out of the market (the Subscriber Base loop R1). Under normal circumstances this loop is offset by the Claim Volume loop B2: As the subscriber base drops, so does the cost of claims paid, lowering the required premium. However, if general, sales and administrative expenses don't also fall as subscribers and claim volume drop, required premiums can rise as these fixed costs are spread over fewer and fewer subscribers.

Adverse selection is the real driver of the Medigap death spiral. The subscribers opting out of Medigap when premiums rise are not representative of the average subscriber, but will instead be the youngest and healthiest -- those who will be offered the lowest rates by other insurers. As the fraction of the elderly population enrolled in Medigap falls, therefore, the average health of the remaining subscribers drops. The number of claims per subscriber and the average cost of each claim rise, boosting total costs and forcing premiums still higher (the Claim Frequency loop R2 and Claim Unit Cost loop R3).

Due to the delays in recognizing the cost increase and adjusting rates, or perhaps due to regulatory delays, premiums may not increase as fast as required. In this case actual profits will fall, eventually forcing some underwriters to exit the market, or, perhaps, into bankruptcy. As the number of insurers falls and competition drops, those remaining can raise premiums still higher, but this only forces even more of the comparatively healthy out of the market and boosts total costs even more (the Bankruptcy and Exit loop R4). In New England several major managed care organizations went bankrupt in 1999 alone, in part due to deficiencies in their accounting and information systems that prevented them from tracking claims costs and adjusting their rates.

Finally, as the subscriber base falls, underwriters lose any economies of scale and purchasing power with health care providers, boosting the cost per claim even higher and forming the positive Scale and Market Power loop R5. This loop does not involve adverse selection but speeds the death spiral once the adverse selection loops R2-3 begin to dominate the dynamics.


URL: http://www.exponentialimprovement.com/cms/healthinsurtabor.shtml

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