Health Care: Insurance is the Problem

The current debate regarding the future of our health care system in America is inherently flawed. Many of our politicians and the public at-large seem to be overlooking the biggest contributor to escalating health care costs, and as a result, the proposed solutions (from both sides of the aisle) utterly fail to address the source of the problem. Current attempts to reform health care focus on decreasing the cost of insurance* (or changing the source of insurance). But they fail to recognize that, in general, insurance is the problem! A system driven by insurance is a classic example of a Third-Party Payer System. If you're not familiar with the term third-party payer, let me explain:

A Third-Party Payer System exists any time a person paying for a product/service is different from the person who gets (or demands) it. Health insurance fits this definition nicely: After you purchase insurance, you can go to the doctor and pay some pre-arranged co-pay (or percentage of the cost of the office visit). The insurance company pays the remaining cost of the office visit. Thus, the insurance company is the third-party payer. Now why is this a problem? Well, consider the classic Supply/Demand curve from ECON 101. I've prepared a sample for you if you don't remember the beastie:


From the graph, we have this scenario: The insurance company covers your doctor's office visit for a $10 co-pay. At a cost of $10, you would demand 90 "units" of service. If you were paying the full amount for those "units" of service, you would have to pay the doctor $90. Yet, the doctor probably won't get $90. They'll probably accept some reduced compensation (because of a reduced rate negotiated by the insurance company), say $75 -- your $10 co-pay, plus $65 from the insurance company. Yet even at a rate of $75 in compensation, your doctor is only willing to provide 75 units of service -- not the 90 units you demand. Overall, the system is out of equilibrium (if it were at equilibrium, the quantity supplied would be equal to the quantity you demand, which would be 50 units, and you would pay $50 for it.) Because the system is out of equilibrium, and demand exceeds the supply, the price level increases in an effort to reach equilibrium.

Take this to its logical conclusion: because the price level for health care increases, the price level for health insurance is also rising. (The insurance company pays more money out in benefits, so they have to recoup those costs somewhere, typically in premiums.) Thus, we have an expensive cycle of increasing health care costs, and increasing health insurance costs.

Based on this evidence, I believe that Insurance is the biggest reason for the increase in health care costs. When people pay less than market-value for any service, they'll demand more of it, pushing the price up. (This is a principle that is widely accepted among economists.) Only by making the party who demands services also pay for those services (and giving them a means to do so) can we begin to apply downward pressure to the price level of health care (without compromising quality or rationing care). If we can do this, we will have a true market-based solution to the problem.

What do you think? Is my analysis correct, or is there another cause for high health-care costs? Is there another "elephant in the room"? Let me know your thoughts -- I'm interested in having a constructive discussion of the issue that can lead to solutions.

* Note that I am using the word "insurance" which would generally include all types of insurance policies. The astute observer would realize that my argument really only applies to health insurance policies with very low deductibles, or those whose first dollar of coverage begins with little or no out-of-pocket expenses. While I'm using the all-encompassing word, I mean to refer to the aforementioned insurance policies. For purposes of my argument, the term "insurance" does not include plans that have a high deductible (like catastrophic coverage).