Krugman Watch: Pharmaceuticals

[Jim Devine <jdevine@xxxxxxxxxxxxxxx>]

>July 26, 2000 / New York TIMES

>RECKONINGS / By PAUL KRUGMAN

>Prescription for Failure

>In denouncing President Clinton's plan to extend Medicare coverage to
prescription drugs, and in touting their own counterproposal, Republicans
have rolled out the usual rhetoric. They excoriate the administration plan
as a bureaucratic, "one size fits all" solution. They claim that their plan
offers more choice.

>And for once their claims are absolutely right. The Republican plan does
offer more choice. Unfortunately, this is one of those cases in which more
choice is actually bad for everyone. In fact, by trying to give people more
choices the Republican plan would end up denying them any choice at all.<

This column is a very reasonable and readable application of the economic
theory of "adverse selection." In this case, the problem is that the
Republican (GOP) plan involves asking the insurance companies to cover
drugs. However, >Healthy retirees, who know that their bills won't be that
high, would be unwilling to buy insurance that costs enough to cover the
bills of the average senior -- which means that the insurance plan would
attract only those with above-average bills, meaning higher premiums,
driving still more healthy people away, and so on until nobody is left.<
Similarly, though PK does not make this point, if they are given any choice
in the matter, the insurance companies would only want to cover those old
folks who don't have very expensive drug bills (what's called
cream-skimming or cherry-picking). So most oldsters would be excluded -- or
would exclude themselves -- by the automatic processes of the market. In
sum, a program like Clinton's is needed.

As PK points out, >Insurance companies understand this logic very well --
and are therefore simply not interested in getting into the market in the
first place.< PK also criticizes the GOP for their quasi-religious (or
Hayekian) belief that markets solve all problems; he also sees the drug
companies as providing the financial backing for this plan, since they fear
price controls.

One phrase caught my eye: >bad risks drive out the good.< I'm sure that
someone has pointed this out before, but this suggests that adverse
selection is the basis of Gresham's famous law, i.e., that "bad money
drives out good."

This column was highly superior to that of Sunday, July 23.

Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine