Association for Public Policy Analysis & Management

Background: This paper estimates the magnitude of switching costs in the Medicare Advantage program. Switching costs are interesting for a number of reasons. First, if prior choice of plan stands in for strong preferences for unobserved plan characteristics, then prior choice is an important omitted variable that may have created bias in previous estimates of own- and cross-price elasticities of health plan choice. Second, if switching costs are high, this may create incentives for plans to act in non-competitive ways, depending on market structure. We will also identify individual factors that increase or decrease switching costs, such as age, health and income.

Theory: Consumers are generally assumed to pick plans that provide the combination of benefits and premiums that maximize their individual utility. However, the plan choice literature has generally omitted prior choices from choice models. In contrast, the influence of prior choices on current choices has received extensive attention in other literatures, such as marketing. Often referred to as habit persistence or inertia, there is a substantial economics literature on the role of state dependence, i.e., that choices this period are a function of choices in prior periods. State dependence has been subdivided into two further categories. Spurious state dependence refers to autocorrelation in the consumer’s utility function error terms over time. Thus some consumers may serially select certain plans because of unobserved preferences. This then reflects utility maximization – consumers consistently pick a particular plan because they like that plan the best. In contrast, with structural state dependence, past purchases directly influence the consumer’s choice probabilities for different brands creating “stickiness” in choices that may lead consumers to be in sub-optimal plans. Sources of structural state dependence include (1) loyalty (a change in preferences due to past purchases, also referred to as psychological switching costs); (2) search costs, which cause consumers not to consider products they have not recently purchased; and (3) learning.

Data: The analysis is based on five years (2007-2011) of the Medicare Current Beneficiary Survey, a nationally representative longitudinal dataset. The MCBS data were combined with data from the Centers for Medicare and Medicaid Services on Medicare Advantage Part C plan benefits and premiums. Individual choices are modeled as a function of individual characteristics, plan characteristics and prior year plan choices.

Results: We found relatively high rates of switching between plans within insurer (20%), although less switching between insurers. Prior year plan choices were highly significant at both the contract and plan level. Premium was negative and significant. Loyalty (contract and plan), premium and plan structure were found to be heterogeneous in preferences. We found a statistically significant willingness to pay for a lower prescription drug deductible and lower copays. Switching costs were higher for sicker individuals. Beneficiaries will switch plans if an alternative is perceived as $430 a month better than the current choice and switch contracts if the alternative is perceived as $970 better than the current plan/contract, on average. We provide evidence that the state dependence is structural rather than spurious.