Reputation and rescission (5 Aug 2009)

Economist Bryan Caplan, a health-care reform skeptic, argued that health insurers' concern for their reputation would prevent them from abusive practices like rescission, when coverage is revoked once patents need expensive care. Insurers are so concerned about reputation, he argues, that German insurers defied the Nazis and demanded the right to pay damages to Jews after Kristellnacht. Paul Krugman's skepticism about the almighty power of reputation prompted Caplan to wish for a chart that would expose companies' rescission rates (funny that didn't turn up so easily) and later to elaborate on the wonderful powers of reputation in a competitive free market.

When we wanted a new house built, we gave 10% of the purchase price to the builder upfront. The builder gave us a contract almost devoid of legal remedies - practically everything was at the builder's "sole and absolute discretion." A few months later, we moved into our house. 99% of the details were exactly right, and they fixed the rest for free. Why would the builder treat us so well? Altruism? Ha. Legal remedies? Ha. Even repeat business is a stretch. What are the odds we'll ever ask them to build a second house for us? The only answer that makes sense is reputation.

Caplan sneers at altruism, but is altruism so different from the professionalism we expect from doctors when we assume they are not keeping us sick to bleed more money out of us in office visits and so on? Altruism, human decency, professional dignity all matter in many of our exchanges, even though it is hard to find a place for them in a formula-driven rationalistic economic analysis of how capitalism functions. In fact (as the film The Corporation depicts) the firm may function to disperse that altruism and mitigate motives other than profit. Responsibility is spread throughout the corporation so no one has to feel particularly guilty about its cutthroat doings -- as when sick patients have their coverage yanked from underneath them. Individuals within the firm can focus on their responsibilities to the hierarchy rather than to customers or society without feeling like unreasonable monsters. (Proprietors of small businesses have to face more of the brunt of the moral consequences of their practices, which makes it harder for them to fend of behemoths like Wal-Mart.) Damage to a brand's reputation can be combated by the same forces that might publicize it, and a corporation is usually going to have more resources for this than those it has wronged.

Arnold Kling, Caplan's co-blogger at EconLog, raises another problem with the reputation idea as it pertains to health care. "Reputation matters when exit matters. That is, if people will switch suppliers based on word of mouth, then reputation will be important." But under the current system we don't do that. And most people don't have a problem with their insurers until they need to actually use the coverage, at which point it will be too late to switch.

UPDATE: Tyler Cowen makes another good point.

Reputation affects market practices, but possibly reputation is part of the problem. It's relative reputation which matters. The operative reputational incentive is not always: provide a better product to get more customers. Sometimes the reputational incentive is: customers tolerate bad treatment, because established reputations suggest they will receive equally bad treatment elsewhere.

This seems to imply the cycle of relative reputation can push all competitors downward.