Jul 7 JDN 2460499

The concept of adverse selection is normally associated with finance and insurance, and they certainly do have a lot of important applications there. But finance and insurance are complicated (possibly intentionally?) and a lot of people are intimidated by them, and it turns out there’s a much simpler example of this phenomenon, which most people should find familiar:

All-you-can-eat meals.

At most restaurants, you buy a specific amount of food: One cheeseburger, one large order of fries. But at some, you have another option: You can buy an indeterminate amount of food, as much as you are able to eat at one sitting.

Now think about this from the restaurant’s perspective: How do you price an all-you-can-eat meal and turn a profit? Your cost obviously depends on how much food you need to prepare, but you don’t know exactly how much each customer is going to eat.

Fortunately, you don’t need to! You only need to know how much people will eat on average. As long as the average customer’s meal is worth less than what they paid for it, you will continue to make a profit, even though some customers end up eating more than what they paid for.

Insurance works the same way: Some people will cash in on their insurance, costing the company money; but most will not, providing the company with revenue. In fact, you could think of an all-you-can-eat-meal as a form of food insurance.

So, all you need to do is figure out how much an average person eats in one meal, and price based on that, right?

Wrong. Here’s the problem: The people who eat at your restaurant aren’t a random sample of people. They are specifically the kind of people who eat at all-you-can-eat restaurants.

Someone who eats very little probably won’t want to go to your restaurant very much, because they’ll have to pay a high price for very little food. But someone with a big appetite will go to your restaurant frequently, because they get to eat a large amount of food for that same price.

This means that, on average, your customers will end up eating more than what an average restaurant customer eats. You’ll have to raise the price accordingly—which will make the effect even stronger.

This can end in one of two ways: Either an equilibrium is reached where the price is pretty high and most of the customers have big appetites, or no equilibrium is reached, and the restaurant either goes bankrupt or gets rid of its all-you-can-eat policy.

But there’s basically no way to get the outcome that seems the best, which is a low price and a wide variety of people attending the restaurant. Those who eat very little just won’t show up.

That’s adverse selection. Because there’s no way to charge people who eat more a higher price (other than, you know, not being all-you-can-eat), people will self-select by choosing whether or not to attend, and the people who show up at your restaurant will be the ones with big appetites.

The same thing happens with insurance. Say we’re trying to price health insurance; we don’t just need to know the average medical expenses of our population, even if we know a lot of specific demographic information. People who are very healthy may choose not to buy insurance, leaving us with only the less-healthy people buying our insurance—which will force us to raise the price of our insurance.

Once again, you’re not getting a random sample; you’re getting a sample of the kind of people who buy health insurance.

Obamacare was specifically designed to prevent this, by imposing a small fine on people who choose not to buy health insurance. The goal was to get more healthy people buying insurance, in order to bring the cost down. It worked, at least for awhile—but now that individual mandate has been nullified, so adverse selection will once again rear its ugly head. Had our policymakers better understood this concept, they might not have removed the individual mandate.

Another option might occur to you, analogous to the restaurant: What if we just didn’t offer insurance, and made people pay for all their own healthcare? This would be like the restaurant ending its all-you-can-eat policy and charging for each new serving. Most restaurants do that, so maybe it’s the better option in general?

There are two problems here, one ethical, one economic.

The ethical problem is that people don’t deserve to be sick or injured. They didn’t choose those things. So it isn’t fair to let them suffer or bear all the costs of getting better. As a society, we should share in those costs. We should help people in need. (If you don’t already believe this, I don’t know how to convince you of it. But hopefully most people do already believe this.)

The economic problem is that some healthcare is rarely needed, but very expensive. That’s exactly the sort of situation where insurance makes sense, to spread the cost around. If everyone had to pay for their own care with no insurance at all, then most people who get severe illnesses simply wouldn’t be able to afford it. They’d go massively into debt, go bankrupt—people already do, even with insurance!—and still not even get much of the care they need. It wouldn’t matter that we have good treatments for a lot of cancers now; they are all very expensive, so most people with cancer would be unable to pay for them, and they’d just die anyway.

In fact, the net effect of such a policy would probably be to make us all poorer, because a lot of illness and disability would go untreated, making our workforce less productive. Even if you are very healthy and never need health insurance, it may still be in your own self-interest to support a policy of widespread health insurance, so that sick people get treated and can go back to work.

A world without all-you-can-eat restaurants wouldn’t be so bad. But a world without health insurance would be one in which millions of people suffer needlessly because they can’t afford healthcare.