Thaler’s Unsound Argument About the Public Insurance Option

Thom Lambert —  19 August 2009

University of Chicago economist (and behavioralist doyen) Richard Thaler thinks “the question of whether a ‘public option’ should be part of the health care solution” is just “one big distraction.” In Sunday’s New York Times, Thaler argues that the debate over the public option is a “red herring” if, as President Obama insists, the public plan will have to break even and won’t be granted “the power to impose special deals with suppliers like hospitals and drug companies.” If those two conditions are satisfied, Thaler contends, the public plan is unlikely to have much success and certainly won’t drive out private insurers.

In setting forth his case, Thaler takes a page from the President’s own playbook, drawing a comparison to the U.S. Postal service and its private sector competitors:

[L]et’s assume that the public option does have to break even and can’t make any special deals. What should we expect to happen? Here is a thought experiment: Can you think of a domain where a government-run business competes successfully with private-sector companies? In a town hall meeting last week, President Obama mentioned one such example: the market for overnight shipments. This market now has two main private suppliers, FedEx and UPS, and one public one, the United States Postal Service. When you have to send something overnight, which one do you use? Most shippers choose one of the private companies.

It’s certainly a puzzling analogy for the President to draw. If we needn’t worry about the public option driving out private insurers because, well, it’s likely to suck as bad as the post office, then why create it in the first place? Thaler, though, isn’t trying to defend the public option. Instead, he’s just saying that it’s unlikely to do any harm if the plan really has to break even and won’t have the power to coerce special deals from providers.

The problem is that those are remarkably big ifs. In fact, they’re simply incredible. With respect to the first assumption, does anybody believe that Congress would let the public plan fail? If you do, you might want to read up on Fannie Mae and Freddie Mac, those other government-created enterprises that Congress insisted would have to stand on their own. Or you could look at the Postal Service itself. As Thaler concedes, “When [the Postal Service] periodically starts running deficits (as it is now) and proposes cost-saving measures like eliminating Saturday delivery or closing tiny post offices, Congress often intervenes [i.e., subsidizes] under pressure from predictable interest groups like bulk mailers, the 600,000 postal employees, and the users of those tiny offices.” Congress simply isn’t going to let the Post Office — or Fannie Mae, or Freddie Mac, or any public health insurance plan — fail. It will always step in and save the public plan from what are bound to be termed “extraordinary circumstances.” And because of this, the public option will have a huge advantage over private insurance plans, which really do have to stand on their own.

What’s more, the fact that all sensible people know that Congress will never let the public plan fail will give the plan a notable advantage over its private competitors in raising capital from private sources. Again, look no further than Fannie and Freddie for evidence of this phenomenon. Those entities have long had a capital-raising advantage, given that Wall Street knew they’d never be allowed to fail.

These explicit and implicit government subsidies promise to give the public option cost advantages that will permit it to charge lower premiums and steal the lion’s share of the health insurance market. Thus, the Lewin Group predicts that 70 percent of the 172 million privately insured Americans would convert to the public plan.

Given that outcome, Thaler’s second assumption — that the public option won’t be empowered to cut special deals — is similarly unfounded. Even if the legislation doesn’t give the public plan express power to negotiate special deals, such deals are inevitable. Once the bulk of Americans convert to the public plan, that plan will have serious bargaining advantages that stem from its monopsonist status. Monopsony power is simply the flip-side of monopoly power. Whereas a monopolist (a dominant seller) has the power to drive prices above cost (by withholding its output), a monopsonist (a dominant buyer) has the power to drive prices beneath sellers’ costs (by withholding its purchases).

While an exercise of such power might benefit some consumers, at least in the short term, the long-term effects would be quite negative. Forced to price below their costs, health care providers would quickly begin to cut all expenses unrelated to the immediate provision of services. Most notably, they would cut research and development expenditures, leading to reduced health care innovation. Because the United States is the dominant source of the profits that fund health care R&D worldwide, this would be disastrous.

As John Calfee recently explained in the Wall Street Journal:

The U.S. is unique because it alone is the source of half of world-wide profits that provide the payoff for the complex, lengthy, and expensive process of developing new treatments. When other nations construct their health-care systems, they ignore the impact of their pricing policies on R&D incentives. As the dominant R&D funding wellhead, we do not have that option.

Competitive markets have generated the prices and the profits necessary to induce a steady flow of medical innovation in this country. A public plan option would tend to dismantle that system. The people in charge will not know how to set reimbursement levels to motivate reasonable R&D efforts, and there is no reason to expect them to try. In public plans, the tried-and-true method is to push the prices of suppliers down until something gives — too few doctors willing to take on Medicare patients, for example — and then to ease up. That is a destructive approach to medical technology R&D.

Who knows what drugs will not be developed if reimbursement levels for a new multiple-sclerosis treatment are too measly? In virtually every advanced economy but our own, pricing authorities simply make sure prices are high enough so that existing drugs continue to be made available. We can expect a public plan here to do the same. The inevitable result is to drastically under-incentivize R&D.

In the end, Professor Thaler’s clever argument that the public option isn’t a big deal is based on incredible assumptions. To use the language of logical reasoning, the argument may be valid (in that the conclusion flows from the premises), but it’s unsound (in that the premises are wrong). The public option is a huge deal that should be an absolute deal-breaker.

Thom Lambert


I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

2 responses to Thaler’s Unsound Argument About the Public Insurance Option



    Can you explain why you believe that R&D levels will settle at a suboptimal equilibrium? It seems odd to claim that a monopsonist public health plan would drive R&D to suboptimal levels when the individual participants of the public health plan are the very people likely to benefit from optimal R&D funding.


    “If we needn’t worry about the public option driving out private insurers because, well, it’s likely to suck as bad as the post office, then why create it in the first place?”

    You’re assuming the Postal Service’s primary purpose is to compete with FedEx and UPS; that’s not the case. The Postal Service foremost exists to give all citizens access to mail services, especially those who may live in locations that the private market for mail delivery might not want to serve– say, rural North Dakota.

    A public health insurance plan would (or at least should) serve the same goal: provide a service to citizens that the private market prefers to ignore. Millions of people want insurance but simply can’t get it– because of pre-existing conditions, for example. Theoretically, these people could devote all their economic effort to paying exorbitant rates for insurance, but I’d argue that the state has a compelling interest in assuring citizens don’t pour all their economic resources into buying health insurance; it undercuts prosperity.

    More simply: I don’t believe healthcare is a right, no– but we’re at a point where it makes more economic sense to treat it like a right anyway.

    And by the way, the Postal Service will come to your house, pick up a piece of mail, and send it anywhere else in the country generally within three business days, all for 42 cents. Try getting UPS or FedEx to take two extra days time in exchange for charging that low rate. It doesn’t suck.