An Unhealthy Market for Competition
Skip to content
Policy Strategy Economics Jul 5, 2011

An Unhealthy Market for Competition

Health insurance companies in the U.S., not consumers, control the market

Based on the research of

Leemore S. Dafny

A decade before Americans first heard the term “Obamacare,” health insurance premiums were steadily climbing and the insurance industry was busily consolidating, but few raised concerns about the potential relationship between the two trends.

Instead, there was widespread belief that the health insurance market was competitive and that market forces would protect U.S. workers from price gouging by insurers. One indicator of that faulty assumption was a rapid increase in the outsourcing of public insurance to the private sector. Another was a 2004 Federal Trade Commission/Department of Justice report saying that most experts at the time held fast to the “competitive” assumption. Fortunately, Kellogg economist Leemore Dafny was not one of them.

Instead, the associate professor of management and strategy had decided to get to the bottom of the competitiveness question herself, and one day happened to tune into a National Public Radio report that touched on the idea. That early 2000s radio segment described the very different fates, post–9/11, of aviation giants United Airlines and Boeing: Boeing was booming, taking in mega-contracts, while United Airlines faced bankruptcy in a new apocalyptic landscape where consumers suddenly had a fear of flying. “Listening to the NPR stories on these two companies, whose fortunes varied so much,” Dafny remembers, “made me think, ‘I bet that United is getting a great deal on its health insurance policies, and Boeing is not,’ owing to its profit surge.”

“This in turn led to the realization that health insurance is a prime setting for what economists call ‘perfect price discrimination,’ when a seller charges different prices to different buyers so as to extract the great possible profits from each transaction.”

Uncovering Evidence
Over the succeeding years, Dafny would prove her hypothesis of perfect price discrimination, especially in smaller insurance markets. As she wrote in the American Economic Review: “I find [that] firms with positive profit shocks subsequently face larger premium increases, even for the same health plans. Moreover, within a given firm, those sites located in concentrated insurance markets experience the greatest premium increases”—particularly where there are six or fewer carriers.

In short: The companies Dafny examined that were doing well were actually penalized for their profits in the form of higher premiums. So insurers, not customers, controlled the market.

That finding was fairly revelatory. “At the time I began the research there was very little concern, apart from expected opposition voiced by the American Medical Association, about the potential role of the health insurance industry in contributing to rising health-care costs,” Dafny says. “So the very basic question I wanted to ask was, ‘How well are these markets functioning? How can we diagnose whether health insurance is a fairly competitive industry or isn’t?’ ”

Other researchers had made efforts in the same direction but were stymied by incomplete and unreliable data. What helped Dafny test her theory was a treasure trove of data she luckily stumbled upon. “I was discussing my general research interests with a businessperson, a family friend,” she says. “He kept telling me, ‘You know what? We have some really terrific data; we’re a large benefits consultancy.’ ” Such offers are few and far between, Dafny knew; proprietary data is rarely made available to researchers. Yet here was a businessperson “interested in gaining a new perspective” and willing to facilitate a data-sharing agreement in order to contribute to academic research.

What a gift that database was, describing as it did the health insurance plans of large U.S. employers between 1998 and 2005. Included were 776 large, multi-site corporations spread across 139 different geographic markets and a range of industries, from financial institutions to manufacturers to consumer products companies. In total, these companies insured 4.8 million active workers and more than double that many people, adding in their dependents. “There are very few data sources that tell you anything about private insurance,” Dafny says, of the database’s value. “We have a lot of data on the public health programs, but these were contracts struck between private insurance companies and employers.”

Dafny documented a steep rise in the number of highly-concentrated insurance markets: In 1998 only 7 percent of employees in her sample were receiving their coverage in locations with six or fewer major, full-insurance carriers; by 2005, that percentage was up to 23 percent. As of 2009, the percentage was a staggering 41 percent. “This is becoming a more important phenomenon over time,” Dafny comments, “and the phenomenon that is most important in my view is not price discrimination per se but the fact that insurers have that ability to raise premiums.”

“It’s difficult with this analysis to estimate how uncompetitive things are, but it is a first step in my view at debunking the assumption that the industry was pretty competitive. I tried hard to find anybody besides the American Medical Association raising the possibility that the industry wasn’t very competitive and robust back when I embarked on this project, and I couldn’t find it.”

Dafny then matched the public companies in the database—some 77 percent of her sample—to a financial database that included various measures of profit margins. She included all categories of health plans offered by these employers, from health maintenance organizations to indemnity plans, but excluded self-insured plans as employers rather than insurers actually set the premiums for these plans.

What the economist found was that a company with an increase in profit margins subsequently faced higher insurance premiums (and vice versa), but only for plans offered in locations with a small number of insurance carriers. The effect was significant in areas with ten or fewer major carriers and particularly pronounced with six or fewer carriers. In the latter areas, a profit increase of 10 percent was associated with an increase in health insurance premiums of 1.2 percent.

Unexpected Answers
So why would employers tolerate price increases in the wake of a good profit year? Dafny went into the field to find out, interviewing insurance brokers. They told her that switching plans is a “tough sell” to employees, who are loath to deal with the myriad changes required when one’s health plan changes. Not only is the paperwork significant, but many patients have to change providers if their current providers are out of network in the new plan.

Workers do tolerate switches in bad times—“taking one for the team,” Dafny calls it—but are less tolerant in good times. Dafny then turned to the data, which corroborated this line of reasoning: Firms with increased profit margins were less likely to make changes in the set of health plans they made available the following year. Conversely, companies with decreased profit margins were more likely to make changes to their health plan offerings, in particular removing some plans to save money.

Dafny’s findings do not bode well for a future of affordable health insurance. “Although advocates of the private insurance system usually appeal to the virtues of competition,” Dafny wrote, “there is little empirical evidence to support the assumption of robust competition among insurance carriers.”

Today, legislators and regulators in Washington share her concern. Dafny describes “a lot of conversations” she has had with high-level administration officials and congressional committee members trying to get a handle on “whether these markets are sufficiently competitive to support the expansion of coverage”—health reform’s central aim—“through the private industry.”

The current level of competition is far from ideal, Dafny says she tells them. She also tells them that the solution is to come up with ways to facilitate new entry into the insurance industry. The key, Dafny notes, is to help these entrants access provider discounts so that their networks can be competitively priced.

That is a continuing dialogue. Meanwhile, implementation of the Patient Protection and Affordable Care Act that President Obama signed into law in March 2010 continues apace, and Dafny has embarked on further research into the effects of consolidation on premiums and the value to consumers of having greater choice in health plans. That treasure trove of data is still paying off.

Since health-care reform relies on the private insurance industry for fully half of the expected increase in the number of insured Americans, “It’s critically important,” Dafny says, “to look at the industry, assess where and when it functions well, and try to promote competition through well-designed regulatory reforms.” The question is how closely lawmakers are paying attention.

Editor’s note: Dafny’s paper “Are Health Insurance Markets Competitive?” was awarded the 2012 Stanley Reiter Best Paper Award, an honor bestowed by Kellogg School faculty upon a research paper judged to be the “best” of those published between 2008 and 2011.

Related reading on Kellogg Insight

Games Hospitals Play: How hospitals cope with competition

Tort Reform No Miracle Cure: Limiting liability has limited impact on healthcare costs

The Effects of Health On Wealth: Major illness leads to financial catastrophe for the uninsured

Congenital Defect: Systemic hospital cost inflation

Featured Faculty

Member of the Department of Strategy from 2002-2016

About the Writer
Joan Oleck is a freelance writer based in Brooklyn, New York.
About the Research

Dafny, Leemore S. 2010. “Are Health Insurance Markets Competitive?” American Economic Review. 100(4): 1399-1431.

Read the original

Most Popular This Week
  1. 3 Tips for Reinventing Your Career After a Layoff
    It’s crucial to reassess what you want to be doing instead of jumping at the first opportunity.
    woman standing confidently
  2. College Campuses Are Becoming More Diverse. But How Much Do Students from Different Backgrounds Actually Interact?
    Increasing diversity has been a key goal, “but far less attention is paid to what happens after we get people in the door.”
    College quad with students walking away from the center
  3. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  4. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  5. Podcast: Does Your Life Reflect What You Value?
    On this episode of The Insightful Leader, a former CEO explains how to organize your life around what really matters—instead of trying to do it all.
  6. 5 Ways to Improve Diversity Training, According to a New Study
    All too often, these programs are ineffective and short-lived. But they don’t have to be.
    diversity training session
  7. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  8. Your Team Doesn’t Need You to Be the Hero
    Too many leaders instinctively try to fix a crisis themselves. A U.S. Army colonel explains how to curb this tendency in yourself and allow your teams to flourish.
    person with red cape trying to put out fire while firefighters stand by.
  9. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  10. Podcast: China’s Economy Is in Flux. Here’s What American Businesses Need to Know.
    On this episode of The Insightful Leader: the end of “Zero Covid,” escalating geopolitical tensions, and China’s potentially irreplaceable role in the global supply chain.
  11. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  12. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  13. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  14. Why Well-Meaning NGOs Sometimes Do More Harm than Good
    Studies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
    To succeed, foreign aid and health programs need buy-in and coordination with local partners.
  15. How Much Do Campaign Ads Matter?
    Tone is key, according to new research, which found that a change in TV ad strategy could have altered the results of the 2000 presidential election.
    Political advertisements on television next to polling place
  16. How Experts Make Complex Decisions
    By studying 200 million chess moves, researchers shed light on what gives players an advantage—and what trips them up.
    two people playing chess
  17. Jeff Ubben Explains His “Anti-ESG ESG” Investment Strategy
    In a recent conversation with Kellogg’s Robert Korajczyk, the hedge-fund leader breaks down his unique approach to mission-driven investing.
    smokestacks, wind turbine, solar panel
  18. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
More in Policy