Robert Vivian is Professor of Finance & Insurance, School of Business Sciences, Wits University, and a member of the Free Market Foundation’s Rule of Law Board of Advisors.
The views expressed in the article are the author's and not necessarily shared by the members of the Foundation.
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This article was first published on Medsuitemedia.co.za in March 2022
South African Medical Schemes market as an example of government created market failure
Free competitive markets produce optimum outcomes
The South African medical schemes market is of considerable interest from an economist’s perspective for the two reasons suggested by Sir Lionel Robbins (1932) in his famous essay on economic science. He argued that economic science produces generalisations which firstly could act as a guide to the interpretation of economic reality and secondly provide a basis for political practice. Political practice it is suggested is the formulation of policy-based decisions, and thus the basis of legislation. Economic reality is what can be observed, and thus economic science should be able to provide an economic explanation of that reality.
The South African medical schemes market reflects, more than any other market, one of the realities of our age: government intervention into private markets. There is probably no market which is subject to more government intervention than the healthcare market, including the medical schemes market. Two similar questions about this reality spring to mind. Firstly, why should governments intervene in private markets? And then secondly why do governments intervene? Although on the face of it the two questions are very similar the answers to the questions are vastly different. Taking a cue from Sir Lionel, economic science should be able to provide answers to these questions, the first question is now answered; why should government intervene?
The point of departure to this explanation is free, competitive markets. Free markets do not imply no government intervention. Indeed, the truth is the very opposite. John Locke argued that governments are formed to protect life, liberty, property. To this the Americans added and the pursuit of happiness. So, there has always been government intervention prohibiting actions of individuals where those actions pose harm to other individuals. The law prohibits fraudulent actions, assault, murder and so on. Governments have prohibited fraud since the beginning of recorded history. Government intervention is justified to protect individuals from the harmful actions of other individuals.
Insofar as free competitive markets are concerned, after a very long struggle by the mid-1800s it was understood that free competitive markets produce optimum outcomes. So as far back as 1859 John Stuart Mill could proclaim:
“But it is now recognized, though not till after a long struggle that both the cheapness and the good quality of commodities are most effectually provided for by leaving the producers and sellers perfectly free, under the sole check of equal freedom to the buyers for supplying themselves elsewhere,”
This became the generally accepted position which existed long before 1947 when Paul Samuelson, the future Nobel Laureate, articulated that “… there has never been absent from the main body of economic literature the feeling that in some sense perfect competition represented an optimal position”.
The questions to be answered now can be more clearly stated in context; if free, competitive markets produce optimum outcomes why should the government intervene? There should be no need for intervention and in all probability the intervention will leave society worse off. An answer springs to mind from the question itself; government intervention is justified where the specific market is clearly not producing the optimum outcomes obtainable from the free, competitive market. Should a market produce suboptimal outcomes that market can be said to be subject to market failure, a notion made popular by Francis Bator (1958).
For example, in cases where monopolies exist it could be argued that the government should intervene to eliminate monopolies. Alfred Marshall, England’s most famous academic economist had argued free competitive markets provide goods at the lowest price giving to consumers what he termed a consumer’s surplus . Free competitive markets eliminate monopoly profits. Thus if monopolies exist then the optimum market does not.
Against the background of this view America introduced the first modern government intervention with the passing of the Sherman-Anti-Trust Act of 1890, ostensibly to combat monopolies. In addition, back in England, Marshall’s protégé and successor Pigou argued the economic system should produce to society the maximum total economic welfare. This was a vague concept. Pareto, an Italian engineer put some flesh on those bones by pointing out the actions of some may impose involuntary costs on others; or as is usually said by economists, impose externalities on others.
For example producers may impose pollution on society. Government intervention in the form or regulations requiring polluters to clean-up the pollution they create would be justified intervention; the ‘Pareto optimal standard’ became accepted. If a market imposes externalities government intervention could be justified to deal with the externality.
Application to Medical Schemes Act
With this background the questions of government intervention into the medical schemes market can be examined. Take the intervention imposed in terms of section 29 (n) of the Medical Schemes Act 131 of 1998 which requires the contribution to medical schemes to be based solely on “… income and the number of dependents, and … not … any other grounds …”.
In the free competitive market insurers determine the premium using easily, inexpensively determined, risk factors, as for example age. These factors have a direct bearing on the cost of claims. Thus for example taking age as a risk factor typically the average health care spending on persons over 65 is about 6 times that of the spending on children and three times of that on a person of working age. Age would be a costlessly determined risk factor, to be taken into consideration when setting the premium.
In medical schemes because of the intervention, high and low risk members are pooled. This market is not Pareto optimal since high risk members impose externalities on low-risk members. The medical schemes market is thus subject to extensive market failure. In this case the government intervention has created this market failure. More importantly government intervention was not introduced to eliminate market failure. Economically speaking this intervention is not justified.
Economists can offer a general explanation for government intervention. Governments are justified in intervening in markets to eliminate market failure. Having made that statement it can then be said that this is not the explanation for the intervention into the South African medical schemes market.
In fact, economists could go further and state government intervention into the South African medical market creates market failure. The medical schemes market, economically speaking, is a sub-optimum market. This then leads to the second question, why do government intervene? This question is answered knowing the government intervention has caused market failure.
This second question is more difficult to answer but we can be guided to an answer relying on the view of John Stuart Mill (1863) when he wrote that all actions are undertaken to achieve some end and the rules which govern those actions must take their whole character and colour from the end to which they are subservient. The answer to the second question come from answering two other questions, Firstly, what was the end, or purpose of the intervention, and secondly has that end in fact been achieved?