The defense of the public option coming from the administration, Paul Krugman, Mark Thoma and many others is that a public plan would have lower administrative costs and it would discipline the insurance industry. As stated, I find the argument weak. The argument, however, begins to make a certain kind of sense when you consider what else the major health insurance reform proposals would do.
The major proposals would require insurance companies to take all customers regardless of pre-existing conditions, offer guaranteed renewability and no dropping of coverage for the ill, impose no annual or lifetime caps, and offer coverage of preventative care with no-cost share, among other requirements. Finally, if insurance companies must take all customers regardless of pre-existing conditions it is obvious that sooner or later and probably sooner the government will require that everyone purchase health insurance.
In short, insurance reform will mean that everyone will be required to buy a product that will be tightly regulated and more homogeneous. Both of these factors will increase the market power of insurance firms. Since escape via non-purchase will no longer be a potential response to higher prices, mandatory purchase will reduce the elasticity of demand giving firms an incentive to increase prices. Moreover, in oligopolistic markets, a more homogeneous product can increase the ability of firms to collude.
I believe that health insurance reform will increase the market power of insurance firms and drive up prices. In this scenario, the public option at least has a raison d'etre, although whether it actually fulfills its purpose is an open question.
It's true that mandatory purchase doesn't necessarily lead to market power, auto insurance is quite competitive. Nevertheless, given the potential of insurance reform to increase the market power of insurance firms the search for some disciplining device like the public option is reasonable. Other useful reforms would be to have a single, national regulator of insurance – rather than the 50 we have now, allow an optional federal charter (as we do for banks) or (my preferred approach) move to a competitive federalist system for insurance similar to that for corporate charters.
Hat tip to Ray Lehmann for discussion.