When Price Does Not Clear the Market

And other non-Neoclassical tales


Finance and Development has a profile of one of my teachers, Nobel Laureate George Akerlof, written by Prakash Loungani. Akerlof’s views are critical to recall in these times when some individuals think supply and demand are sufficient to answer all policy issues. Akerlof’s research highlighted the role of information asymmetries that prevent prices for setting quantity demanded equal to quantity supplied. From the article

While unemployment is the topic that has motivated him the most, it is his 1970 article showing how markets might break down in the presence of asymmetric (or unequal) information that won him the Nobel Prize. Indeed, if you play a game of word association with an economics PhD and say “Akerlof,” chances are the response will be “lemons.” This is because the example Akerlof gave was of used car markets, where sellers have better knowledge of whether their car is a good one or a “lemon.” The buyers’ best guess is that the car is of average quality, so they will only be willing to pay the price of a car of average quality. This means, however, that owners of good cars will not place their cars in the used car market. But that in turn lowers the average quality of cars on the market, causing buyers to revise downward their expectations of quality. Now even owners of moderately good cars are unable to sell, and so the market spirals toward collapse.


Akerlof says that the problem dates back to one that has confronted horse traders over the ages: “If he wants to sell that horse, do I really want to buy it?” But problems of asymmetric information are present in most markets, particularly in financial markets. “This [recent financial] crisis gave us glaring examples,” says Akerlof. “Ordinary people thought they were buying homes, not the complex derivatives that they later realized they had ended up buying.”


Akerlof says he chose the example of used cars to make his paper “more palatable” to U.S. readers. But his interest in the subject had been triggered when, during his stay in India in 1967–68, he noticed people’s difficulty obtaining credit. He kept this example in the paper, along with sections on how the “lemons principle” could also explain why the elderly had trouble obtaining insurance and why minorities had difficulty obtaining employment. All this proved too exotic for much of the academic market of the time; the paper was turned down by three leading journals before it was finally published in the Quarterly Journal of Economics.


Today, the questions Akerlof tackled in the “lemons” paper are a staple of the academic diet. And Akerlof himself continues to push the frontiers on the study of such questions, most recently in Identity Economics, coauthored with Rachel Kranton, then at the University of Maryland. Akerlof’s son, Robby, carries on the tradition. A graduate of Yale—where Shiller was one of his professors—and Harvard, he is studying questions such as why corruption and the tolerance of it vary across corporations; what managers can do to increase the legitimacy of their authority (paying efficiency wages turns out to be one option); what accounts for an oppositional culture where minorities disparage the majority and are disparaged in turn; and what fuels protracted feuds between two parties.

The insight that informational asymmetries abound in today’s economy leads me to suspect that merely removing impediments to the activities of firms will not lead to Pareto optimal solutions [edited 8:41am]. Free markets are not necessarily competitive markets, even if one rules out externalities, and market imperfections (oligopoly, monopolistic competition). And yet, some people are proposing competition as the solution to health care and financial markets, both arguably pervaded by information asymmetries.


Aklerof and Romer analyzed deregulation’s impact (and subsequent “looting”) in the runup to the S&L crisis, as I discussed in this post. It is a story that has great relevance for the most recent crisis, as Jeff Frieden and I document in our forthcoming book, Lost Decades (Norton, September).

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38 thoughts on “When Price Does Not Clear the Market

  1. dcomerf

    “The insight that informational asymmetries abound in today’s economy leads me to suspect that merely removing impediments to the activities of firms will lead to Pareto optimal solutions.”
    I think you’ve missed a “not”…

  2. Ricardo

    Menzie,
    Good post.
    As is so often the case Hazlitt’s lesson in Economics in One Lesson is the key, consider all economic events over the entire economic timeline. This is especially true when applied to governmental command systems.
    There is no question that there are informational asymmetries in business transactions, but informational asymmetries are compounded when decision making is shifted from thousands of market traders to a handfull of government bureaucrats with political agendas. Markets have mechanisms to correct the asymmetries where governments do not. Profits expose asymmetries and entrepreneurs, motivated by profits, step in and reduce asymmetries through arbitrage.
    Concerning informational asymmetries the same ignorance exists in goverment as in business, but because there is no market discipline in government there is much more waste and error, not to mention fraud.
    Rather than being a problem a problem with free markets, information asymmetry is a significant reason why free markets exist. Market traders always take advantage of asymmetries, but in so doing the asymmetry is revealed and other market traders step in to arbitrage the asymmetry reducing its effect.
    It is instructive that Akerlof chooses used car salesmen as his example because we all know the reputation of the used car salesman causing most to exercise extreme care when dealing with these traders. Often politicians are compared to used car salesmen, but in truth there is a significant difference. The politician has monopoly and coercive power where the used car salesman does not. The market can discipline the used car salesman but the politician can use the coercive power of the state to limit his exposure to market discipline.
    Informational asymmetries are strong justification for free markets over command economies because, while complete clearing is never possible, markets do clear significantly while command systems do not.

  3. AS

    Having worked in financial and administrative positions in the health care field, I have had some experience with quality measures of facilities and physicians. I posit that if we had a truly competitive health care market with genuine medical IRAs, web sites would spring-up staffed by retired hospital administrators, RNs and M.D.s. These sites would make and disseminate value judgments about facilities and physicians just as judgments are make about restaurants, automobiles and other consumer products and services.

  4. AWH

    i am a fan of Ackerloff
    one of the only modest majority of Nobel winners that deserve it.

  5. b turnbull

    That’s right, free markets are inherently inefficient. With presence of permanent asymmetric information!

    So let’s have Obama stuff write 1 million pages of regulations (based on affordable care act) to help us with this problem in medical industry.

  6. Dan Nile

    Information asymmetry that goes past a certain magnitude is called fraud. Therein lies a key role of government in free markets: to provide buyers assurance that fraudulent transactions will be reversed and the perpetrators sanctioned. The continuing government failure in this area is well-documented, and its impact on the failure of the economy to restart is not being very well highlighted except for certain individuals such as Stiglitz and Black.
    For example, nobody is investing in mortgage backed securities not because of past performance, but because there is still fraud being discovered such as notes failing to be conveyed from originators to investor trusts (the real issue in “Foreclosuregate”). The MBS trusts turn out to have no note assets, and foreclosures on their behalf are being invalidated by courts. As long as nobody is going to jail for that, investors with pulses won’t touch MBS. The only economic solution is a law enforcement one.

  7. Bill Dawers

    Re: “This [recent financial] crisis gave us glaring examples,” says Akerlof. “Ordinary people thought they were buying homes, not the complex derivatives that they later realized they had ended up buying.”
    It would also be interesting to see this discussion extend to more basic issues of the housing boom. Buyers and even mortgage servicers did adequate diligence in most cases to avoid “lemons” in terms of quality of structures, but they were not aware of the most important numbers related to the housing market as a whole: levels of inventory, planned new units, actual numbers of sales, etc. I write a business-y column here in Savannah and was repeatedly stunned during the boom when even realtors had not reviewed the most basic information available through the MLS. If the media or planners or regulators — someone, anyone — had provided the relevant data to potential buyers in a timely fashion, we might be in a much better spot right now.

  8. Milton Recht

    But markets do respond to information asymmetry to correct the problem. For example, certified pre-owned cars with extended warranties. Also, there is a distinction, often confused, between information asymmetry and information uncertainty. Relevant product characteristics, such as need for repair, wear and tear, longevity or mortality, etc. often follow a normal (Gaussian) distribution. Neither of the parties to the transaction may have the information that allows them to determine if the sought item’s characteristics are better or worse than average, will have a longer or shorter average life, wear and tear, etc. The average is the best guess because it is the expected value. It is not asymmetric information in all situations. It can be uncertainty about future events, i.e. market risk, which lowers prices or makes transactions in markets unavailable. Sometimes there can be asymmetric payouts, which affect markets.
    For example, look at the senior life insurance market. Many people who buy life insurance only pay premiums for a few years and then stop. The insured, who die in the first few years while payments are made, collect benefits. The insurance company cannot solely use life expectancy tables to price the insurance because people will stop paying too soon for the insurance company to average out the expense over all the insured. So, rates must rise to account for shortened premiums. In the senior market, due to the much higher mortality rate than the average population, rates will rise to such a high level that very few seniors will participate, companies will not be able to make a profit, and so companies do not broadly offer insurance to this market. It is a risk sharing over the senior population problem and not necessarily an information asymmetry problem.
    If Pareto optimal solutions are not available, the barrier may be high transaction costs and there are often means (sometimes creative) to lower transaction costs to allow for Pareto optimal solutions.
    Since government and regulations often increase transaction costs, government’s solution and protection can in of itself be the reason for market failures and the failure of a Pareto optimal solution.

  9. Buzzcut

    In these days of social media, I am surprised that a blogger, of all people, would bring up the fallacy of asymmetrical information to argue against markets.
    Just an example: we may need to get a new furnace/ ac unit. I was just researching geothermal systems, and a certain manufacturer in particular. What did I do?
    Surfed the internet forums! Now I know all the disgruntled customers and what their issues were. I know what people paid, and what their savings over time really are. I can get past the rosy marketing and overcome the asymmetrical information issue.
    I do it all the time. Anytime I am considering a purchase, or have an issue, I consult internet forums. All the answers are there.
    As for the issue that made Akerlof famous, I have one word: Carfax. Yet another example of markets “fixing” markets.

  10. Jeff

    I find it odd that you refer to Aklerof and Romer’s S&L paper in support of your presupposition that deregulation will cause tremendous harm to heath care and financial markets. As Mankiw notes in the commentary, “The paper shows that the savings and loan crisis was the result not of unregulated markets, but of over regulated ones (or,
    at least, poorly regulated ones)”.

  11. Steve

    It was the Government intervention into a 60+ year stable housing market, that caused the problem in the first place. Forcing private banks to lend to unqualified borrowers has blown up the undelying strength of the U.S. economy. Since they made the mess they should go to the back of the bus have a seat and shut up. The free market will clean this up, but I don’t want to hear no talking out of the Government. Just sit there and don’t say nothin!

  12. 2slugbaits

    b turnbull I realize that quantitative thinking isn’t a strong point of Tea Party conservatives, but the Obamacare legislation is roughly 2000 pages, not 1 million. I can understand some rounding error, but being off by a factor 500 is a little much even for a teabagger.
    Interesting that you forgot to mention that Obamacare also eliminated many thousands of pages of insurance company regulations designed to exclude from subscriptions anyone that might actually need insurance and then exclude payments to any subscribers that might actually have claims to submit.
    The information asymmetry in health insurance is a peculiar animal. Presumably the individual buying the insurance is supposed to have a better idea of his or her health than is the insurance company. So this asymmetry causes insurance companies to create all kinds of artificial exit ramps once they get wind of some health problem. That’s what all those internal regulations are about. This may surprise you, but insurance companies are not in the business of paying claims, they are in the business of collecting subscription fees and only paying out just enough claims to convince enough people that they have an 80% chance of being covered if they make a claim. What Obamacare did was eliminate a lot of those asymmetries and swept aside private insurance company regulations and bureaucrats. Obamacare also eliminates any informational asymmetric advantage that individuals may have over the health insurance industry by mandating coverage. So it undercuts the asymmetry in two ways; first by closing off the exit ramps for insurance companies when they learn something you don’t know; and second, by forcing all individuals to buy health insurance irrespective of their health status. So no one has an informational advantage over anyone else.

  13. Wisdom Seeker

    It’s hard to argue that we have competitive markets when corporate profits are at or near record highs (as a share of GDP), yet unemployment and underemployment are rampant.
    With relatively few exceptions, most corporations in most industries do not appear to be willing to compete on price in order to gain customers. If prices were lowered, more demand would need to be met, production would have to increase, more workers would need to be hired, and those workers would in turn start spending and lead to new growth. Profits might fall for the near-term, but the sustainability of the economy would no longer be in grave doubt.
    The same issue was identified during the Great Depression and publicized by folks like J.K. Galbraith.
    I think we need both information transparency and a bit of antitrust enforcement.
    This is another example of what Dan Nile points out — restoring the rule of law would go a long way towards repairing the economy.

  14. Steven Kopits

    In my experience (certainly in post communist Hungary), these problems tended to arise when the recipient of services was not the same as the payer for those services, to wit, state-provided healthcare, education, and rail transportation, for example. Provision of services tended to be schizophrenic, partly reflecting consumer needs and partly determined by payer institutional priorities and budget constraints.

  15. Bryce

    Some excellent posts by Ricardo, Milton Recht, & Steven Kopits. I’ve found the market for used cars to work reasonably well. & over the years, a number of innovations have improved it.
    Assymetric information, a fact of life, is no reason to have govt distort prices–as it is forever doing–thereby clouding the information available to market participants further.

  16. Mark A. Sadowski

    @2slugbaits,
    You wrote:
    “b turnbull I realize that quantitative thinking isn’t a strong point of Tea Party conservatives, but the Obamacare legislation is roughly 2000 pages, not 1 million.”
    Cut him (it) a break. He (it) meant to say “two gazillion.”
    @Steven Kopits,
    You wrote:
    “In my experience (certainly in post communist Hungary), these problems tended to arise when the recipient of services was not the same as the payer for those services, to wit, state-provided healthcare, education, and rail transportation, for example.”
    In my own experience, with few exceptions, consulting people who are from formerly communist countries on this matter is the worst thing one can do (speaking as I am myself one). They see only the benefits of free markets and they fail to see any free market failures at all. The truth lies somewhere in between.

  17. Joseph

    But markets do respond to information asymmetry to correct the problem. For example, certified pre-owned cars with extended warranties.
    Let’s say that I, as a used car salesman, know the condition of the car but you as a buyer do not. Because of this I can sell you a car and charge an insurance premium that certifies that I won’t screw you too badly. (Nice little car you got there — be a shame if anything happened to it.)
    That’s generally known as extortion. That’s not a market correction. It is validation of Akerlof’s point.

  18. Craig

    I realize that quantitative thinking isn’t a strong point of Tea Party conservatives, but the Obamacare legislation is roughly 2000 pages, not 1 million. I can understand some rounding error, but being off by a factor 500 is a little much even for a teabagger.

    The legislation might be only 2000 pages, but the regulations that are created to obey the legislation will be significantly larger than 2000 pages.

    If congress passes a law “All traffic lights shall have a 3-second yellow period,” the law is nine words in length. But the regulations that will be generated to obey that law will be much longer than nine words. Regulations that specify which agency will test the lights, how lights that cannot be set to the required interval will be taken out of service, etc. The Planet Money podcast had an episode about four lawyers who work for a federal agency. Their job was to convert one tiny section of Obamacare legislation into an entire binder full of regulations.

  19. ppcm

    Prices are asymmetrical to markets information and understanding,may these few examples raise the level of thoughts.
    The mandate of central banks are well known by now and so are the banks turmoils (causes and causation) not only in the USA but in Europe at large.
    Bloomberg
    “Heinrich Mussinghoff, bishop of Aachen, did two weeks ago in his address on the occasion of the awarding of the Charlemagne Prize to Jean-Claude Trichet.”
    The Banker awards ceremony and proud beneficiaries as granted by London is worth a meditation.
    Few months after being granted,the award of the best corporate governance in Russia,a famed well known group and shareholders were proved guilty and condemned for tax evasion.
    Sometimes markets information are not only symmetric but reliable,they are confusingly right and to be classified as exception to the rule:
    Few years before the great recession and its underground malpractices,a movie was granted the price of the best film of the year at the Berlin movie festival”False monayeurs”
    It is quiet likely that I have dealt with the (primary function} of the today s subject,when the core subject was the derivatives.

  20. Steven Kopits

    Let’s be clear, Mark, I said that divorcing service recipients from payers tends to lead to suboptimal outcomes. I didn’t call for an end to government, but I have called–and will continue to call–for incentives that align societal interests with those of individual politicians. (See below.)
    I am not from Hungary, but grew up in here in the US.
    As for Hungary, yes, I know pretty much how all the players there think, and I worked extensively for the government, much of it related to privatization or venture capital. I saw companies and cities die for lack of responsible government there–indeed, the whole country has imploded for lack of it. If you want to talk about the benefits of free markets, I am happy to discuss specific examples sector by sector: banks, steel, airlines, mines, porcelain, wine, healthcare, water/sewer, manufactured goods, government investment funds, telecomms, food, printing/packaging. I can give you examples from all those and more.

  21. Steven Kopits

    For just the second time in 25 years, the California Legislature has passed a budget on time. Why? Because they brought in a rule that the legislators would be docked a day’s pay for every day the budget was late.
    Incentives matter.

  22. CoRev

    Gotta watch Ole 2slugs, he desperately wants to be correct and control the discussion by lying, misreading and exaggerating. This is to what he responded: “So let’s have Obama stuff write 1 million pages of regulations (based on affordable care act) to help us with this problem in medical industry.”
    And, this is what 2slugs said: “b turnbull I realize that quantitative thinking isn’t a strong point of Tea Party conservatives, but the Obamacare legislation is roughly 2000 pages, not 1 million. I can understand some rounding error, but being off by a factor 500 is a little much even for a teabagger.”
    See how arrogant and wrong he was? Add MarkAS… with 2slugs on the arrogance factor.

  23. Ricardo

    Steven,
    Your post above all made me smile. Thanks for bringing reason to the discussion.

  24. Rich Berger

    C & R-
    Here is an example of how Obamacare legislation converts to regulations. The ratio over was 70 to 1. Extrapolating we get 140,000 pages of regulations, but that may be conservative. I have seen the IRS turn 20 words into 100 pages and they weren’t trying to commandeer 1/6 of the economy.

  25. 2slugbaits

    CoRev and Rich Berger I should have been clearer, I was referring to the implementing regulations. The law itself is 974 pages. The proposed regulations are available here.
    http://www.hhs.gov/ociio/regulations/index.html
    Rich Berger’s link is not to the actual regulations, but to an explanation of the regulations and descriptions of their intent. Most of the regulations are fairly small (less than 20 pages). And most all of those are strictly internal to HHS, such as defining which sub-cabinet office will oversee this or that provision. Those kinds of things don’t impact business at all. I think we’re a long way from a million pages unless you print it in GOP friendly giant fonts, ala the GOP budget plan.
    I don’t know if you’ve actually seen the bill itself, but way most of it is just wordsmithing instructions to change clause xxxx from “blah blah blah” to “bloh bloh bloh.”
    In any event, your opposition to what you believe is too much regulation doesn’t square with what the Tea Party types were whining about in 2009. Back then the complaint was that the rules weren’t adequately defined and too much was left to the discretion of HHS bureaucrats. It was business that was clamoring for more detailed regulations. So you guys are all over the ballpark on this. You can’t seem to remember from one day to the next what you were complaining about. I’ll give that a sheesh.
    2slugs on the arrogance factor
    Of course I am deeply crushed. My personal mission statement has always been “Missionary Work Among Savages” and now I feel unappreciated. And now you tell me that my all my attempts to remove the Tea Party scales from your eyes have all been in vain. Sigh.
    Getting back to Menzie’s topic, one of the effects of healthcare reform will be to replace private insurance company bureaucracies with their own rigged set of rules and regulations with greater discretion for impartial government regulators and boards. This removes one of the great informational asymmetries in healthcare. Prior to Obamacare insurance companies had a huge informational advantage because they made the rules as they went along…sort of like the Yu-Gi-Oh! cartoon character who made up his own card game rules with each episode.
    http://en.wikipedia.org/wiki/Yu-Gi-Oh!
    That power has been reduced. And insurance companies will have to fire company bureaucrats because they must now redirect a larger percentage of their revenue towards paying out claims.

  26. Jeremy

    Both health insurance and health care provision have information asymmetries. However, none of them are asymmetries that go unsolved in other markets; nor does any of the recent US government intervention reduce these asymmetries.
    Let’s start with health insurance. The biggest information asymmetry is customer health status. Here the roles (and price direction) in the “used car salesman” example are reversed. Oddly one of the arguments in favor of ACA type regulation is that insurers got too good at leveling this information asymmetry. People with pre-existing conditions (“lemons”) were being priced out of the insurance market leaving healthy people with better prices (“good” cars were sold at prices that more closely matched their value). Similarly there was proposed legislation to restrict the use of genetic testing in determining health insurance eligibility, directly thwarting the markets attempt to level information asymmetry. Clearly there is a strong incentive for the market to overcome this information asymmetry and it is capable of doing so even in the current state of restricted price competition. Community Rating and Individual Mandate legislation locks in information asymmetry forcing the outcome that Dr. Akerlof points to. Insurance companies are forced to offer the price for an “average quality” customer, “lemons” receive a great deal at the expense of “good cars” and prices explode as the average quality declines.
    In health care provision the doctor obviously has much more knowledge than the customer in regards to quality / efficiency of procedures and medications. This asymmetry is much more similar to the “used car salesman” example cited. Again US government intervention merely exacerbates the problem. Medicaid (and front running proposals for reducing Medicare expenditures) forces the “average” price lower causing “good” doctors to withdraw their services from the market.
    As others have pointed out both instances of information asymmetry are being mitigated by the free market in practically every other industry where they crop up. Carfax, Consumer Reports, Yelp, Angie’s List, etc. all strive to close the various information asymmetry gaps in their respective industries. Government, in turn, provides generalized fraud protection that both deters and compensates for knowingly “lemon car salesman” behavior.
    Neither health insurance, nor health care provision are unique markets where the market failures require specialized consideration. The solution to used car markets is not Community Rating (setting every price equal to the average of all “blue book values”) and an Individual Mandate (you buy the first car the salesman offers you), nor is the solution to derivatives markets a single purchaser forcing lower prices through monopsony power (Single-Payer). The same proposals are just as ineffective for health insurance and health care provision.
    Market failures exist, but not to such a degree that a free market is incapable of decent allocation. Most proposed government health care intervention is even less optimal.

  27. 2slugbaits

    Jeremy
    I agree with your point that individuals do hold one informational advantage. Indeed, I made exactly that same point further up this thread. But your analysis went off the tracks here:
    Insurance companies are forced to offer the price for an “average quality” customer, “lemons” receive a great deal at the expense of “good cars” and prices explode as the average quality declines.
    What you forgot is that Obamacare handles this problem by mandating that healthy young people buy insurance as well. One of the central arguments for mandating the purchase of health insurance was that if you didn’t do that, then you would end up with exactly the problem you cited.
    You also went astray here:
    Again US government intervention merely exacerbates the problem. Medicaid (and front running proposals for reducing Medicare expenditures) forces the “average” price lower causing “good” doctors to withdraw their services from the market.
    This is actually an argument for heavily taxing gold plated health insurance programs. But your key mistake is that it is not the Democrats who are calling for the kinds of Medicare & Medicaid cuts that would cause this problem. That is the kind of thing that would happen under Rep. Paul Ryan’s plan, but that is not what the Obama plan recommends. The Obama plan tries to cut growing healthcare costs by refusing to pay for expensive and medically useless procedures. That produces a very different set of results than what you are suggesting.
    Finally, a lot of market failures are not really resolved, as you seem to be suggesting. Most are just tolerated because oftentimes the transaction costs of fixing the problem exceed the problem itself. But healthcare is different. Healthcare is not really something that can be tolerated. People really don’t have the option of deciding not to buy it, or to wait until it goes on sale. When you’re having a heart attack you don’t really have the luxury of consulting Angie’s List to shop around for the best deal. And unlike other businesses, health insurance companies are not looking for repeat customers. In fact, they hope they never have to see your face at all. Unlike most other businesses, insurance companies are in the business of denying a product, not in supplying it.

  28. snjmom

    In comparing health care markets to used car salesmen there is a Ceteris Paribus problem in that a used car salesman will not refuse you a car because you really need one.

  29. Mark A. Sadowski

    Steve Kopits wrote:
    “I am not from Hungary, but grew up in here in the US.
    As for Hungary, yes, I know pretty much how all the players there think, and I worked extensively for the government, much of it related to privatization or venture capital. I saw companies and cities die for lack of responsible government there–indeed, the whole country has imploded for lack of it. If you want to talk about the benefits of free markets, I am happy to discuss specific examples sector by sector:…”
    In short you know little about Communism. You claim to know how the capital markets worked before the fall of the wall.
    Guess, what? Things worked pretty well without the meddling before the wall came down. You may have increased the efficiency but you did not save our rearends.
    In the final analysis, why was the US so afraid of the East?

  30. Anonymous

    2Slugs wrote:
    “Unlike most other businesses, insurance companies are in the business of denying a product, not in supplying it”.
    When I was active as either a financial or administrative executive of health provider organizations, my understanding was that health insurance companies paid-out 70+% of premiums. Sure seems that health insurers are doing a bad job of keeping premiums given the after tax profits of the largest six publicly traded health insurers. The median after tax profits of the largest six publicly traded health insurers was 4.8% for 2010 and is projected to be about 4.5% for 2011 per Value Line. In 2002 they had a paltry return of 2.9%.

  31. Jeremy

    2slugbaits;
    What you forgot is that Obamacare handles this problem by mandating that healthy young people buy insurance as well. One of the central arguments for mandating the purchase of health insurance was that if you didn’t do that, then you would end up with exactly the problem you cited.
    I did not forget. It reduces the “average quality” thus increases average price relative to the “competitive market” solution. Again the deeper point is that a market solution wouldn’t have the “race to the bottom” condition that Dr. Akerlof points to, since insurance companies are demonstratively very good at eliminating the information asymmetry.

    This is actually an argument for heavily taxing gold plated health insurance programs. But your key mistake is that it is not the Democrats who are calling for the kinds of Medicare & Medicaid cuts that would cause this problem. That is the kind of thing that would happen under Rep. Paul Ryan’s plan, but that is not what the Obama plan recommends. The Obama plan tries to cut growing healthcare costs by refusing to pay for expensive and medically useless procedures. That produces a very different set of results than what you are suggesting.
    Incorrect. “Gold plated” health insurance programs do not differ from the amount paid to doctors under “normal” health insurance, they only differ in the level of price insulation to the consumer. The Democrats are advocating the “doc fix”, finally getting around to following the restrictions on procedure payments by taking large cuts to those payment schedules now. Rep. Ryan’s plan would alter Medicare to give seniors money directly to pay for their healthcare as opposed to the government paying doctors. Rep. Ryan’s plan is attempting a move towards a market solution not a monopsony buyer solution as I outlined and Democrats are proposing. It’s amusing that you bring up the ACA solution of having a government body determine “expensive” and “useless” in a discussion on information asymmetry. I would point out that this approach introduces more information asymmetry (and/or principle-agent problems) when compared to a market approach, not less.

    Finally, a lot of market failures are not really resolved, as you seem to be suggesting. Most are just tolerated because oftentimes the transaction costs of fixing the problem exceed the problem itself. But healthcare is different. Healthcare is not really something that can be tolerated. People really don’t have the option of deciding not to buy it, or to wait until it goes on sale. When you’re having a heart attack you don’t really have the luxury of consulting Angie’s List to shop around for the best deal. And unlike other businesses, health insurance companies are not looking for repeat customers. In fact, they hope they never have to see your face at all. Unlike most other businesses, insurance companies are in the business of denying a product, not in supplying it.
    I never suggested they were resolved. I said they are mitigated by the market itself more effectively than specialized government intervention. There is indeed a role for government in generalized protections (fraud, breach of contract, etc.), or disseminating information to counteract asymmetric information. Neither the urgency nor importance change the impact of asymmetric information in regards to healthcare. I really tire of the “can’t shop around when you’re having a heart attack” allegory. The shopping around happens well before the heart attack with all the benefits of a competitive market, you use Angie’s List to select your primary physician or your insurance network and when you are treated for your heart attack you benefit from your decisions. Furthermore when we talk about conditions driving up healthcare costs it’s not heart attacks or the like but chronic conditions like diabetes, hypertension, etc. The vast majority of which are a constant consideration not a sudden out of the blue occurrence. Health insurers would love repeat customers, in fact one of the reasons they are hesitant to invest in the customers “wellness” is because customers can leave each year. If insurers knew that customers would stay with them for a longer period the “wellness” investments would benefit both the insurer and the customer.
    None of the proposals for further government intervention in health insurance or healthcare markets (please remember they are distinct) reduce information asymmetry or any of the other market failures that apply. In a lot of cases they in fact make these market failures worse. Markets have failures, as do government interventions, very rarely are government interventions less disturbing to the market.

  32. AS

    2slugs says, “Unlike most other businesses, insurance companies are in the business of denying a product, not in supplying it.”
    According to the latest Value Line report for example, for United Health (UNH) the March 2011 quarter showed a medical cost ratio of 81.4%. In addition the 2010 median after tax profit margin for the six largest publicly traded health insurers was 4.8%. 2011 after tax median profit margins are estimated at about 4.5% for these six companies. 2002 showed a median of 2.9%. The managers seem to be failing at keeping the premiums.

  33. kms

    I see a ton of stuff in blogs and the media about the asymmetry of information market failure in healthcare. 2slug is the only one who bothers to mention that people who need healthcare are in no position whatsoever to negotiate or shop. The people who can shop (relatively healthy people looking for preventative care) cost next to nothing to provide for. The lemon problem is not the foremost issue in healthcare, the hold up problem is. Insurance companies know that sick people are in a terrible position to fight recission- many of them are too busy fighting cancer to battle with WellPoint. Providers know that people in hospitals and emergency rooms are in no position to refuse treatment AND that the taxpayer will pick up the bill if the sick person is uninsured. Talk about perverse incentives. The “consumers”, on the other hand, aren’t likely to go contract AIDS on purpose because they think Kaiser Permanente will pick up the bill. They just want to be well.
    I also hear a lot in the comments about free markets. You all should know- as smart as you all seem to be- that there are no free markets. It’s like you are arguing that we should expect permanent winter because that’s what we see in Narnia. Markets work in theory because of the assumptions we make about them, and if we want them to work in fact we must enforce those assumptions via regulation. Rule of law makes economics possible- otherwise we’d all just be highwaymen. In short, get used to regulation- we need it as protection against theft and fraud. “Honesty hath no fence against superior cunning.”

  34. 2slugbaits

    AS I never claimed that health insurance companies were well run or providing good value for their shareholders. Health insurance companies are oftentimes bloated and run by retired politicians. One of the Blue Cross/Blue Shield’s was run by an ex-governor, who upon retirement passed the job along to his successor in the state house when he retired.

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