Bryan Caplan  

How Arnold Underestimates Reputation

When Doesn't Reputation... Are Progressives Totalitarian?...
Arnold writes:
I think that reputation matters when exit matters. That is, if people will switch suppliers based on word of mouth, then reputation will be important.
This sounds eminently plausible, but it's misleading.  Imagine a world where we all choose our health insurance provider when we're twenty; then we're locked in for life.  If we take Arnold literally, reputation would be powerless in this world, because no one can exit.  But the mere fact that insurers have to get initial voluntary consent gives them a strong incentive to treat all of their locked-in customers well.  Otherwise, it's going to be hard to attract new customers.

I'm not saying that reputation in this "choose-once" regime would be as effective as it normally is.  But I'm still confident that it would work fairly well.  And in truth, many major markets - such as residential construction - are close to choose-once regimes.  Yes, if you don't like your house, you can move; but if the builder did a bad job, it will be reflected in price you're able to get.

What about Arnold's three specific doubts about reputational incentives in health insurance?

1. Most people get their health insurance from an employer. The individual cannot switch companies. The most the individual can do is voice complaints (about non-payment of claims for example) to their human resources department, and hope that the human resources people use the threat of exit to change the insurance company's behavior.

My reply: Yes, health insurance is bundled with jobs.  But markets bundle lots of products, and I see no evidence that this bundling undermines reputational incentives in the least.  Think about a typical restaurant.  It bundles many kinds of food, plus service, decor, cleanliness, and location.  But restaurants' concern for their reputations leads them to maintain quality on all of these dimensions.  Admittedly, it may be hard for any one customer to get exactly the combination of food, service, decor, cleanliness, and location he wants.   But if the restaurant can make a significant number of customers happier at a reasonable price, it will.

2. Turning to the individual health insurance market: In many states, such as Maryland where I live, there are not enough suppliers to have meaningful competition and opportunities for exit. The state regulations for "community rating," "must-carry" and mandated coverage have driven most companies away.

Lack of competition raises prices.  But why should it reduce cariers' desire to be known for high-quality service?  Even a profit-maximizing monopolist-by-law has to worry about the reputation of its products.  After all, the monopoly price for a well-regarded product is a lot higher than the monopoly price for junk.

3. The insurance industry does not have a solution for the pre-existing condition problem, so many people face lock-in. If John Cochrane's idea of health status insurance were implemented, that would address the problem of lock-in.

I agree that Cochrane's idea would be better than the status quo.  But again, if your firm has a reputation for mistreating locked-in customers, people aren't going to want to become your customers in the first place.

Can reputational incentives really be as robust as I say?  I know it's hard to believe.  But think about all of the firms you interact with that have the same problems that Arnold attributes to health insurers: Restaurants, grocery stores, apartment complexes, builders, car companies, employers, etc.  How often is it in their short-term interest to mistreat you?  How often are you in fact mistreated?  Aren't reputational incentives the only reasonable explanation?

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COMMENTS (10 to date)
Kevin Dick writes:

To point (1), when I was CEO of a startup, our choice of human resources company was greatly affected by the health insurance options they offered. Several of the initial employees said, "I must have access to [insurance company X]." So that was one of the top three factors in our decision about human resources company--which bundles many employment related services.

Joe Marier writes:

One big counterargument: AIRLINES.

Thomas DeMeo writes:

Your example to counter the bundling argument is unfair. Choosing another restaurant bundle might mean a tradeoff in things like driving distance, a few dollars in price, or a pleasant decor. These things matter to us, but are easily dealt with.

Choosing another healthcare bundle may mean a new job, exposing your family to the risks associated with pre-existing conditions, etc... The stakes are what matters, and the stakes in healthcare are very high.

The level of coercive pressure in the bundle is what matters.

david writes:
Imagine a world where we all choose our health insurance provider when we're twenty; then we're locked in for life. If we take Arnold literally, reputation would be powerless in this world, because no one can exit. But the mere fact that insurers have to get initial voluntary consent gives them a strong incentive to treat all of their locked-in customers well. Otherwise, it's going to be hard to attract new customers.

Not really. If you can imagine successive generations of consumers, you can imagine successive generations of insurance providers; the optimal strategy for shareholders is to diversify among multiple generations of providers, each of whom focus solely on extracting optimal surplus from their generation of locked-in customers. Reputation is presumably attached to firms, not to shareholders of said firms.

A firm that extracts the most possible surplus will have horrid reputation and zero future customers, but in every given short run it will generate more surplus than any firm that is nicer to its customers.

Jeff writes:

If a lack of competition allows a given firm to play things a bit loose with the price of the goods/services they offer, what makes you think they will not also play things a bit loose with the quality of those goods/services?

Do firms not primarily compete on the basis of price and quality?

Gary writes:

Joe Marier, are you most upset about the lowest fares in history, the greatest number of available flights in history, or the greatest number of locations served in history?

alex writes:

One problem with this argument is that everyone does get ripped off once in a while. I can think of really crappy restaurants, dishonest used car salesmen, locksmiths who overcharge people who are locked out, and so on.

Ripping off poorly informed consumers can be a viable business model.

cputter writes:


You've forgotten that within any one generation you have different insurance companies competing amongst one another, that actually cover several generations. You're attempting to argue that a 'generation' is some sort of fixed span of time, let's say every 10 years, within which all companies magically incorporate during the beginning then disappear at the end. That's just silly.

Joe writes:

What really matters is how your reputation affects your profits margins, and what that means for the industry as a whole.

If you have a good reputation, and you pay out all of the high cost claims that your insured pool presents, your profits will be lower than a competitor that does not, unless you charge higher prices. But at higher prices your insured pool would most likely decrease, increasing your fixed costs. Either way, you are less profitable, have a lower share price, and are a less attractive capital investment opportunity. If any one firm denies a small enough percentage of its highest claims to allow it to become more profitable, while the percentage of claims denied is so small the reputational damage is nil, all firms will start denying a small percentage of their highest claims.

From a competitive standpoint, the best strategy is to seem to have a good reputation. Pay most claims, but deny a small percentage the highest claims. The general perceptions is that you have a good reputation, i.e. you pay 98% of claims, and so do all of your competitors. Because this allows for profit maximization at little cost to reputation, every firm will follow suit.

joe writes:

I will have to tip my hat to Tyler Cowen..I just read his article after I posted this comment.

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