Medicare Vouchers Require Effective Central Planning

Peter Orszag’s column on the problems with the idea that Medicare can be made more cost effective by turning it into a voucher program reminds me of the general distinction between privatizing and contracting-out. To summarize my view of the distinction briefly, if the government owns a parking lot you privatize the lot by selling it to the highest bidder. A very different policy, often called “privatization” in the press, would be to merely contract-out the management of the parking lot to some parking management firm. Medicare is not something that you could privatize in the sense of selling it to someone, but the latest version of Paul Ryan and Mitt Romney’s thinking on the matter asserts that you could make the program much more cost-effective by contracting it out to private companies.

Now here’s Orszag on a problem that arises when we let private companies submit bids to cover Medicare payments:

To see why, imagine two beneficiaries. One has medical expenses amounting to $150 and the other, $50. The average cost is $100. Now imagine that a private plan bids $90 to cover beneficiaries, so it looks to be about 10 percent cheaper than traditional Medicare. That plan, however, while it is designed to be very attractive to the $50 beneficiary, isn’t appealing to the $150 one, so that person stays in traditional Medicare.

The result is that total costs rise from $200 ($150 for the expensive beneficiary plus $50 for the inexpensive one) to $240 ($150 for the expensive beneficiary plus $90 for the inexpensive one). So even though the plan “looks” like it saves money, it doesn’t. It overpays to cover the $50 beneficiary.

Now as it turns out, the government isn’t so naive as to let that happen. Instead the existing Medicare Advantage program tries to apply a risk-adjustment formula to the patients, and Ryan proposes doing the same in his greatly expanded version of Medicare contracting-out. But this doesn’t change the fact that the real profit-making opportunity here is to try to identify and exploit inevitable flaws in the risk-adjustment process. The winning strategy is to craft products that are appealing to customers the formula is willing to overpay for and unappealing to customers the formula would underpay for. Now that could be a small problem or a it could be a giant problem, all depending on how good the government is at setting the rates. Which is to say that for bringing private bidders into the process to work well, you need really effective central planning. And to the extent that you have effective central planning, it seems to me that it makes sense to take advantage of the economies of scale that come from a single-payer system.

Now ironically enough you can (and I think should) make the exact same critique of ObamaCare’s reliance on private insurance companies as a coverage mechanism for non-seniors. To the extent that this works it depends on central planners doing a good job, and to the extent that the central planners do a good job the private companies are acting as a basically unnecessary layer of extra costs and diminished purchasing power.