The Process Produces the Equilibrium

David Leonhardt makes an interesting argument about why employers don't choose employee health insurance carefully.  The argument is interesting because it is wrong but in a subtle way.

The bottom line: The cost of insurance comes mostly out of employees' paychecks. If insurance costs more, employees are generally paid less. If insurance costs less, employees are paid more. The cost of insurance does not have a big effect on employers’ overall compensation costs.

That’s why no one should be surprised that employers don’t make for good consumers of insurance. And it’s why insurers are not operating in a very competitive marketplace.

The premise is correct, employee compensation comes out of wages.  The subtle mistake is to forget that this is only true in equilibrium.  Imagine that a single employer was able to buy for his employees equal quality health insurance at a lower price. Would wages at that firm rise?  No, an employer only has to pay workers what they could earn in another job.  If other firms aren't paying more then this firm need not raise wages even though its costs have fallen.  Thus an employer that reduced health insurance costs while keeping real compensation the same could pocket the savings as profit.  It's only when other firms follow suit–also in an attempt to cut costs and earn excess profits–that wages at all firms rise, eliminating the excess profit everywhere.

The process produces the equilibrium.  You can't have one without the other. 

If you are still uncertain, here's another way of making the same point.  Imagine that an employer provided his workers with better health insurance at the same cost. Employees would then flock to this employer pushing down wages and increasing that firm's profit.

So do employers fail to choose insurance carefully?  Given the costs of health insurance and the profits to be made by cutting costs (holding quality constant), I have my doubts.  Nevertheless, it could still be the case that giving employees more choices about which insurance firms to patronize could improve things on some margins as Leonhardt also argues in a related column today.  


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