Insurance Exchanges Won't Work

Jeff  Carter
Posted: Jun 30, 2012 12:01 AM

In the aftermath of the Obamacare ruling, the proponents of Obamacare are touting “Insurance Exchanges” as one of the cost drivers to save people money. As a person who was on the board of an exchange, and has traded markets for twenty five years, I think I know a little bit about exchanges-or at least enough to analyze the government run exchanges for health insurance.

There is a lot wrong with the Obamacare bill. But one of the unique parts of the bill was the creation of exchanges for health insurance. However, these aren’t exchanges like you might be imagining.

First, exchanges never guarantee to save you money. An exchange is an efficient marketplace where buyers and sellers can meet to create a transparent price that sends supply and demand signals to that marketplace. Exchanges have always been created to create that common place, with a standardized set of rules to conduct business by. Exchanges never create, or influence the price of the good that is being traded there.

Second, we know from basic Microeconomics 101 that if you subsidize or put a ceiling on a price, the market is less efficient. Those types of actions distort prices. For a real world example, check out the price of corn ($ZC_F) which is distorted to the upside because of the ethanol subsidy. Farmers now plant more grain than would otherwise be planted because of the subsidy. Price ceilings have a different effect in the market. Because a price cannot go above a certain level, if demand would naturally take it above that level the marketplace becomes very imbalanced. There won’t be enough goods to go around and they will become scarce. Certain people in the marketplace will begin to hoard the good if the demand is high enough and scarce enough.

Graphically, this is a subsidy

and this is a price ceiling

The other thing about exchanges is that they work really great when there is one centralized market. It is an aggregation of the most buyers and sellers and because you have more market participants, you get a more market driven price. One of the issues in the stock market today is the fragmentation that has taken place which gives less price transparency. This creates a lack of confidence in consumers, and less faith in the market.

In the Obamacare system, they aren’t creating one insurance market. They are creating fifty of them. Each state will have it’s own market. That fragmentation will create massive inefficiencies. Because each and every state will have to incorporate the subsidies and price ceilings called for by Obamacare, there is no way for any of the fifty markets to work efficiently. Supply and demand forces just won’t be able to adjust freely and quickly enough to create the price transparency necessary to make the market valuable. The outcome will be a side car black market which will probably have the truer price of the good. This is not unlike the black markets behind the Iron Curtain for foodstuffs.

Not only that, but the pool of market participants won’t be big or varied enough to guarantee the randomness that true markets depend on for supply/demand interactions. What is a state like South or North Dakota going to do with a small population? Even in states like California with large populations, so much of that population today is already on government programs that there won’t be enough participants to balance their effect on the market. When pools get imbalanced like that in health care markets, prices rise aggressively. When the price rises aggressively enough to bump into the ceiling, scarcity will surely ensue.

In addition, there is no way for risk to be laid off in single state markets. There won’t be any arbitrage available between states to keep prices in line like there are in many financial markets today. The existence of arbitrage, or the threat of arbitrage, helps keep markets very efficient in financial circles.

Just because people go on television and tout the “free market” doesn’t mean they actually know what they are talking about. Most of them don’t know how to set up a free market. As evidenced by the way the Obamacare Insurance Exchanges are currently envisioned, we already know that there are built in imbalances to the market that will make it run extremely inefficiently.

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