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Freitag '14: A big (expletive) deal

Discussion of the Affordable Care Act, also known as Obamacare, draws strong opinions in favor and against. For college students, the law may seem like an unintelligible mess. But what does it really mean for the average twenty-something?

Republicans will tell you Obamacare is a financial strain on business, making it harder for recent college graduates to find jobs. But Democrats will respond that the law allows you to stay on your parents’ plan until age 26, providing additional coverage to millions of young adults.

Economics doesn’t have all the answers — especially when it comes to health care. But economics does try to ask the right questions. Why is the current health care market failing, and what does the Affordable Care Act plan to change?

The United States’ free-market approach to private insurance simply hasn’t worked. Not only has the country lagged behind in most qualitative measures — we are 37th in the world, according to the World Health Organization — but we also spend more per person than any other country.

In theory, markets produce goods and services at efficient prices and quantities. But failures in the health care market have led to the underprovision and overpricing of services, or as economists call it, a Pareto inefficient result.  Private competitive markets are unable to provide health services efficiently due to issues like adverse selection, moral hazard and ethical concerns. The role of the government should be to correct for and remedy these market failures, in order to achieve a more socially optimal result.

The market failures of adverse selection and moral hazard are created by the informational asymmetry that exists between the purchaser and provider of health care. Adverse selection occurs when buyers of insurance have more information about their own risk and behavior than insurance companies. The insurer is unable to price premiums at an actuarially fair rate because those who are sick are more likely to buy insurance than those who are not. This can result in insurance companies having more costs in claims than revenue generated in premiums.

If insurance companies respond by raising their rates, healthy people will drop out of the market while sicker people remain. This cycle may eventually lead to a rate so high that no one will buy insurance — a death spiral. But the more likely result is that insurance companies will offer one very expensive, comprehensive plan and one cheap, bare-bones plan. This is known as a separating equilibrium, which will reveal buyer information to insurance companies, leading to higher uninsurance rates.

Moral hazard is defined as a behavioral distortion away from the social optimum. In health care, moral hazard means that insured patients — who are shielded from the costs of services — are more likely to ask for treatment. Similarly, doctors are more likely to order tests and prescribe medicine to the insured. This results in wasteful, sometimes ineffective care. Insurance companies try to reduce moral hazard by monitoring their patients’ and physicians’ activities, but breaches in contracts are often impossible to determine and difficult to prevent.

The ethical concerns associated with health care and the role the government should play in delivering health services is highly controversial. The altruist model is based on the idea that government should provide and protect god-given rights, including health care for all. Many examples of socialized health care abroad have proven largely successful at delivering higher standards of quality at much lower costs — the National Health Service in the United Kingdom, for one. Controversy over these systems is largely philosophical and not economic.

The individual mandate, which was established by the Affordable Care Act, penalizes all individuals who do not have health insurance. By mandating that all individuals join the health insurance pool, the government aims to reduce adverse selection. By preventing healthy people from dropping out of the health care market, insurance companies can offer a more actuarially fair rate, ensuring that the supply of those insured is large and includes enough people with lower expected expenditures. The idea is to make the market sufficiently heterogeneous.

To some people, this is nothing more than a redistribution of wealth from those who are healthy to those who are sick. But can health be determined by choice, or is health something we are born with? Economics doesn’t claim to answer this question.

One way to reduce some of the problems associated with moral hazard is to design payment mechanisms that reward providers for delivering only high quality, necessary care. The difficulty is designing policy that acknowledges that what may be high-value care for one individual may not be for another. The Affordable Care Act aims to improve quality measures by funding new research and releasing ratings data on procedures and physicians. The law also includes new programs that incentivize high-value care, including bundled payments — single payments per episode to providers, designed to encourage coordinated care and eliminate wasteful treatment.

In its entirety, the Affordable Care Act is a confusing 2,700-page document whose legacy is still uncertain. Regardless of your opinion and despite the imperfections of the law, the Affordable Care Act will expand coverage to millions of Americans, many of whom are in their early 20s. For college students, this should come as relief.

There are over 50 million uninsured Americans, with young adults leading the way. Whether the Affordable Care Act is a step in the right or wrong direction depends on your beliefs. But in a bipartisan, gridlocked Congress, where no steps at all has become the norm, Obamacare is a noble attempt at reform. It truly is, in the words of Vice President Joe Biden, a “big (expletive) deal.”


Scott Freitag ’14 specializes in current economic issues. He can be reached at


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