understanding insurance costs

Pretend you decide to spend a night out eating at Olive Garden. You arrive to find the restaurant filled with 49 other people, all who value and love Olive Garden’s food. But as soon as you sit down, the waiter informs you that tonight there is a special deal going on. All 50 people would not be served individual bills. Instead, all individuals would have their bills be added together and divided by 50 (the number of people). How would this effect individual spending habits?

Personally, I never order wine ($5) or soda ($2). Those are extra costs whose benefit does not outweigh the added cost to my paycheck. But in the scenario above, I would not be paying the $5. I would be paying one fiftieth of that cost (10 cents). While the extra consumption on my part would add $5 to the total consumption, personal costs would not be noticeable to my bank account. At this rate, I might as well order the fanciest wine that there is ($15 per glass, costing me 30 cents). The glass of wine might even be more expensive then the entire meal I wanted before the entering the restaurant!

If every person held the same logic, Olive Garden would make windfall profits that night. If everyone was only going to order a $15 meal before, but then upgraded to steak and fancy wine, every single person will now be ordering $30 or more. Before the cost sharing, only $750 ($15 x 50) would have been purchased. Afterwards, $1500 ($30 x 50) is purchased.

Naturally, this system drives up costs. While my individual decision to consume $15 more in food only costs me individually 30 cents, because everyone else is doing the same, my total bill reflects the shared amount. I may have entered Olive Garden believing I would only spend $15, but when I exit my bill would reflect the average amount ($30) no matter how much or little I consumed. The more people added into the equation, the more true this becomes.

Even if I was only in the mood for Soup and Salad ($6), the fact that everyone else is ordering expensive items means that I will never realized the benefits of skimping. I am better off ordering my heart’s desire, no matter the cost.

Of course, a business which ran like this would soon find themself out of business. When people can vote with their feet, they will choose not to subsidize other people’s behaviors (especially strangers). Instead they will patron a place which gives them the value they want.

In the insurance world, this is not a possibility. The insurance world works like the above scenario: everyone is incentivised to spend but no one is incentivised to skimp. The government has ensured that health insurance markets cannot work competitively. They have outlawed plans that only cover catastrophic events. They have outlawed plans that do not allow pre-existing conditions. They have outlawed cross-state competition. They have outlawed plans that discriminate. They have tied health insurance to having a job (should car insurance be employer provided as well?). In the insurance industry, the government has taken all possible steps to insure all insurance plans do not allow thrift to pay off. The only thing left for a healthy individual to do is to withdraw from the market, but of course that is now illegal too.

About christopher fisher

The blog is meant for educational/entertainment purposes. All material can be used and reproduced in any length for any purpose as long as I am cited as the source.
This entry was posted in Econ 101, Economics, Goverment, Human Nature, Price Controls. Bookmark the permalink.

One Response to understanding insurance costs

  1. Pingback: the great medical cost decline | reality is not optional

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