Markets in Medicare: will the good deal last?

Keith M. Marzilli Ericson is an assistant professor of Markets, Public Policy & Law at Boston University’s School of Management. He is also a fellow at the Institute for Quantitative Social Science at Harvard University. The following article is based on his paper “Market Design when Firms Interact with Inertial Consumers: Evidence from Medicare Part D.”

“As Congress and the President debate Medicare’s future, the new prescription drug benefit in Medicare has been getting lots of attention. Known as Part D, the new benefit is different from the rest of Medicare because it allows seniors to choose their own prescription drug insurance plan from private companies in a regulated market.

“Part D has cost less then expected and seems a success story. Advocates of market-based Medicare reforms, such as Representative Paul Ryan, argue that Part D’s success was due to choice and competition. They assume that competition will continue to keep costs down. But the history of Part D should give them pause.

“One company, Humana, took the Part D market by storm. Humana recognized that while seniors would be very price sensitive when they initially picked their plans, they would be less willing to switch plans later on. And so Humana set extremely low prices in 2006, Part D’s first year: about $10 per month on average for the basic product. This was substantially below the market’s average of about $30. This strategy was a big success: Humana acquired a dominant position in the market. It then quickly increased its premiums. By 2010, the average premium for a Humana basic plan was over 200% higher than in 2006.

“The experience of Humana shows that what looks like cost-containment in the Part D market is partially due to insurance companies offering what amounts to introductory, or “teaser,” pricing. Things look good early on, when companies set prices low to attract customers. But these low prices are transitory. Companies will raise prices later, once they’ve acquired a base of customers who won’t switch away. We’ve all seen free trial offers for magazine subscriptions, but we don’t expect them to stay free forever. The pattern in Part D is more subtle, but it is still there. My research shows that while Humana is an extreme case, we see teaser pricing throughout the Part D market. Plans that have been around for five years cost about 10% more than newly introduced plans. (This analysis takes into account regulatory changes to Part D, changes in drug prices, and differences in the characteristics of plans.)

“Why don’t people just switch to cheaper plans when companies raise prices? Even though enrollees are allowed to switch plans each year, they are typically reluctant to do so. Switching is time consuming, and the decision process is grueling. When seniors were picking their initial plans, newspapers were filled with stories of confused seniors wading through their options. Who wants to go through that again? Plus enrollees have more to lose if they switch plans as time goes on – they’re learning more about how their plan works and choosing drugs that are covered by their plan, but not necessarily covered by alternative plans.

“We should expect to see teaser pricing in other markets as well, including the state-based health insurance exchanges planned by the recent federal health reform (PPACA). Though teaser pricing has been criticized as “bait and switch,” it is not the result of a few unscrupulous companies. Nor is it an anomaly of the Medicare Part D market. Companies are responding to the incentives they face. They simply have less to lose in later years if they raise prices, since their customers are less likely to switch. When markets are first set up and many people are making an active choice, we should expect to see lower than average costs. But price increases will soon follow.

“It’s true that Medicare Part D has cost less than predicted. But it’s too early to know whether these low costs are the beneficial result of competition, or a sophisticated marketing strategy in which companies offer seniors low prices now in exchange for high prices in the future. We’ve already seen price increases – in some cases, large ones. Competition and choice have benefits, but need to be judged on their long-term cost, not just today’s good deal.”

Contact Keith M. Marzilli Ericson,