The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Health Care

             Why? Your insurance will cover it.
                                       ...dentist upon hearing that your author would seek a second opinion regarding
                                                                  the need for recommended oral surgery

Health care accounts for a large and growing proportion of all spending and production in the United States.  We currently spend close to 18 cents of every dollar on health-related items, up from only 5 percent in 1960.  Why such an increase?

First, we keep getting older.  Life expectancy is up and the percent of Americans who are 75 years or older is increasing rapidly.  That’s good news for those who need more birthday candles than a typical cake can accommodate, but it comes at a cost.  The older we get, the poorer our health becomes.  That means more aches and pains, more disease, more trips to the doctor, more medications, and more days in the hospital.  As the population ages, medical expenses rise.

But the primary cause of higher medical costs is technological change.  In fact, it's why we keep getting older.   In the not too distant past we spent almost nothing on cancer or heart disease or kidney disease or even infections.  We spent nothing because we had no treatments to offer.  Physicians could do little more than verify illness and wait for patients to die.  CAT scans, MRIs, kidney transplants, chemotherapy, hip replacements, heart bypasses – common procedures in modern hospitals – were unknown even fifty years ago.  In a world in which we could neither diagnose nor treat most medical ailments, health care was cheap. 

            Mounting medical costs now have forced countries to confront a critical question:  who should pay?  Should we treat medical care like potato chips and allow individual consumers and producers make free choices about what and how much to buy and sell?  Should we allow market supply and demand to allocate medical resources?

            Health care systems differ significantly across countries, but all can be categorized loosely as either government-run or privately-run.  Most developed countries view basic health care as a “right” of all citizens and provide universal access to all citizens through a taxpayer-financed government-run system.  For example, Canadians visit government clinics or government hospitals that are staffed by government-paid physicians, nurses, technicians and pharmacists.  The services provided are “free” to the patient.  All costs are covered by government (tax-payer) funds.

            The U.S. has chosen a very different route. We rely more on free-market supply and demand.  Private health-care professionals and organizations offer services and compete for patient business.  Individual consumers visit the health-care providers of their choice and pay for whatever services are provided.  Some consumers pay out of their own pockets, but most of us have medical insurance that covers major expenses.  Medical insurance often is part of the package paid by our employers. 

            Even though government does not provide medical care directly in the U.S. (with the exceptions of medical care to military personnel and some veterans), it impacts the system nonetheless.  All health care professionals, hospitals and medical schools must meet government licensing standards.  All drugs must pass Federal Food and Drug Administration (FDA) testing for safety and efficacy.  And, the federal government provides heavily subsidized health insurance for elderly citizens through Medicare and covers medical costs for eligible low-income families through Medicaid.

Although countries vary widely in the way medical care is provided, they share one important characteristic: discontent.  Citizens throughout the world are increasingly frustrated with their respective health care systems.  U.S. health economists share that frustration.   The U.S. system falls far short of attaining the economic goals of efficiency and fairness. During the recent, often heated, health care debates many citizens loudly announced that "the U.S. has the best health-care system in the world." Sadly, we do not.  And loud protestations will not make it so.  We lead the world in medical spending; no other country spends as large a percent of income on health.  Although richer countries naturally spend more than poorer ones on health care, America's costs per person are almost 40% higher we would expect based on our income alone.²  Despite this disproportionate spending, we lag behind many other countries in life expectancy and health outcomes. The U.S. simply does not get the "bang per buck" that other countries get from health care spending.  Although politicians love to proclaim that America has the best health care system in the world, the data clearly show that we do not.

Demand-side inefficiencies

            Many Americans demand inefficiently high levels of health care.  Remember, most of us have medical insurance that covers a large chunk of the costs.  The net cost to consumers is well below the true marginal cost of providing the care. 

            Check the graph below.  For allocative efficiency, we should produce care as long as the marginal benefit covers the marginal cost (Q₀).  However, suppose that our health insurance covers 80 percent of the expense.  Because this lowers the net MC to the patient, the rational consumer will want to purchase Q₁ units of care – considerably more than the efficient level.

Stop and listen.  Is your memory calling out moral hazard, moral hazard?  It should be.  It’s exactly the issue we discussed with saving lives. The more we insure against the effects of something, the more likely it is to occur.

Tax policy aggravates the problem by encouraging us to buy more and better insurance than we normally would.  Most Americans receive health insurance as a "fringe benefit" of their job.  Under current law the value of this benefit is not taxed. If an employer pays a worker $100 in straight wages or salary, the $100 is subject to both Social Security and income taxes. Only part of that $100 will end up in the worker's pocket after tax.  But if the employer "pays" the worker by buying her $100 of medical insurance, the entire value goes to the worker. The $100 escapes taxation. Without that tax break, a worker in a 30% tax bracket who wants to buy medical insurance on her own would need $130 of pre-tax earnings to get the needed after-tax $100. In effect, the tax laws make health insurance less expensive for the workers. And, like everything else, when the effective price goes down, the quantity demand goes up  We buy more insurance.¹

While insured Americans probably seek inefficiently large amounts of care, those without insurance demand too little.  Unable to afford visits to the doctor, uninsured patients face two possible options. Some forego routine check-ups for preventative care and ignore medical difficulties hoping that they will disappear in time.  The strategy sometimes proves effective, but too often the uninsured end up with major medical problems that could have been cured far less expensively or even prevented altogether had they seen a physician earlier.  Other uninsured patients do seek medical care for minor ailments but, because they cannot pay private physicians, they flock to hospital emergency rooms that face various legal obligations to treat patients regardless of ability to pay.  Unfortunately, the earache that could have been treated for a few dollars in a doctor's office sucks up thousands of dollars of expensive ER resources and creates bottlenecks for those truly needing emergency assistance.  In both cases the costs can be excessive -- so excessive that providing them with insurance actually might be less expensive in the long run.

Supply-side inefficiencies

            Similar problems arise on the supply side of the market.  Health-care providers have traditionally supplied more than is efficient. 

            Imagine walking into a boutique and explaining to the sales clerk (working on commission) that you have been a bit blue and are thinking about some new clothes.  If you ask the clerk whether or not new clothes will boost your spirits, what response should you expect?  Is the sales person likely to say “no” and send you on your way?  Of course not.  Next imagine explaining that you will buy whatever clothes the clerk recommends.  Should you expect the clerk to point you toward the clearance rack?  Of course not.  The clerk has a financial incentive to sell you as large and as expensive a wardrobe as possible.  The more you spend; the more commission the clerk earns.

            Historically, the patient-doctor relationship was quite similar.  Patients seldom decided what and how much care to buy; their doctors made those decisions.  Patients would ask their doctors what they needed and would usually purchase whatever the doctor recommended.  With the traditional fee-for-service arrangements, just as with the sales clerk on commission, the more tests and visits and procedures the doctor would recommend, the more income the doctor would earn.  The incentive was to recommend or supply as much as possible without scant attention to relative costs and benefits.

            Could health care providers be so crass?  Would they actually prescribe medical care that cost more than it was worth just to pad their own wallets?  Some would not, but many would.   Such oversupply provided another benefit to physicians as well – protection against malpractice suits.  As long as they were provided with everything possible, unhappy patients had few legal grounds on which to sue for malpractice.  Besides, many doctors would reason, the extra expenses are being paid by insurance companies, not by the patients themselves. So, why worry?

 Controlling costs

            As expenses mounted over time, pressure to control costs mounted as well.  Trying to moderate cost increases in its Medicare and Medicaid programs, the federal government acted first.  It modified the traditional fee-for-services-provided system and began paying hospitals set amounts for treating a specific ailment.  For example, if the government decided that $18,000 should be enough to cover the costs of an appendectomy, it would agree to pay $18,000 for the procedure, regardless of what actual costs were incurred.  This radically altered incentives for hospitals.  If the hospital was to receive a flat $18,000, it had no incentive to hold on to patients any longer than absolutely necessary.  If the $18,000 was enough to cover three days in the hospital, administrators had no incentive to let a patient stay a fourth day.  Longer hospital stays now meant fewer profits rather than more profits for the institution.  In fact, pushing such patients out after two days would be even better.  Hospitals would still get the same $18,000 revenue, and would save the expense of caring for the patient the third day.

            Private insurers followed by pushing patients into managed care programs that monitored services more closely.  They directed patients to "network" providers with whom they negotiated discounted rates, forced patients to get second opinions for elective surgeries and limited access to specialist services.  Some also created health maintenance organizations (HMOs) that accepted a fixed annual fee from members in return for free health care from HMO physicians.  Because the HMO receives the same fee regardless of how many services you require, it has the incentive to keep you well and to supply as few services as necessary.  While physicians under the fee-for-services-rendered system have an incentive to supply as much as possible, HMOs have an incentive to provide as little as possible.

            To some extent the reforms have been successful.  The rate of cost increases did slow appreciably in the 1990's and billions of dollars were saved.  However, the fee-for-services-rendered system continues to dominate U.S. health care and the quantity of services provided to well-insured patients remains inefficiently high.  Unfortunately, schemes that reward health-care providers for keeping people healthy rather than treating their ailments meet heated resistance.

            Moreover, the savings have been partially offset by a drop in quality.  Patients who belong to HMOs or other managed care groups often assert that necessary care and access to specialists is withheld “to save money.”  Numerous patients have complained that they have been released from hospitals prematurely and have been forced to hire private-duty nurses and other professionals to care for them at home.  Since these home-care professionals often are not covered by insurance, cost savings for the insurers have often meant higher costs for the patients. 

            Is this drop in quality a bad thing?  Not necessarily. Like other products, higher quality is efficient only when its marginal benefit exceeds its marginal cost.  In daily life we willingly choose lower quality options when the dollar savings are large enough.  We choose cheap generic foods over higher quality brands to save money.  We choose cheap used cars over new luxury models to save money.  We choose cheap coach seats over first-class seats on airlines to save money.  If the cost savings are large enough, people rationally will choose lower quality medical care as well.  Nonetheless, cost containment measures in health care have not been free.  Some health care quality has been lost.

            New concerns about fairness also have come to the fore.  First,  people with serious medical conditions are finding it more difficult to get insurance.  Insuring healthy people is far more profitable than insuring sickly ones.  As cost pressures mount,  insurers increasingly react by denying coverage to anyone with "pre-existing conditions".  For those of us with histories of cancer or heart problems or diabetes, medical insurance can be impossible to find or else prohibitively expensive.  Moreover, knowing that their insurance premiums will skyrocket, firms often are unwilling to hire workers with poor medical histories.  As one pundit has written, "the business model of private insurance has become, in part, to collect premiums from healthy people and reject those likely to get sick -- or, if they start out healthy and then get sick, to find a way to cancel their coverage."

            Second, in the past, uninsured patients who were unable to pay for care often were treated as charity cases.  Hospitals covered the costs of this care by charging those with insurance a bit more.  In essence, patients with good insurance were indirectly subsidizing care for those who could not afford it.  However, as government programs and private insurance firms clamp down, hospitals increasingly are unable to raise the extra dollars to cover the costs of charity care.  It is not unusual for sick, uninsured patients to find themselves being pushed from hospital to hospital -- like the proverbial hot potato – seeking needed care. 

            Attempts to manage care also have added to the bureaucratic red tape health-care suppliers must endure.  Providers must complete additional forms to convince government and private insurers that all care supplied is medically necessary. And, since each insurer has its own unique regulations for what is covered under what circumstances, the administrative paperwork burden is enormous. 

            More importantly, the cost savings seem to have been short-lived.  The reforms did wring some fat out of the system, but medical costs are being driven primarily by technological change, not by fat.  As technology continues to enable us to diagnose what we previously could not diagnose and to treat what we previously could not treat, cost increases have reverted to their long run rise.  As one medical researcher put it, the “capacity of medicine to provide ever-advanced technology is endless.  No matter how much you spend, you can always spend more.” ³

Less government or more?

           Perhaps the most contentious element of competing reform proposals involves the role of the federal government.  Political liberals advocate moving more toward a system in which the government takes a more active part in financing care and ensures that that every citizen is covered.  They argue that such systems are inherently fairer than our current one and, also can control costs more effectively.  First, government power can effectively force pharmaceutical firms and other private providers to lower prices.  Indeed, patients in single-payer systems such as Canada's typically pay far less than do Americans for identical drugs and medical procedures.  Second, dealing with a single government system as opposed to a complex patchwork of private insurers can slash administrative costs by hundreds of billions of dollars annually.  For example, on a per-patient basis, the U.S. system employs 44% more administrative staff than does the Canadian system and, in addition, U.S. physicians spend more time on administrative issues than their Canadian counterparts.⁴ One estimate suggests that these administrative savings alone are enough to finance the cost of covering all currently uninsured patients in the country.⁵

            Political conservatives recoil in horror at such a government "takeover" of the private market system.  They contend that only competition among suppliers and insurers can create the quality of care Americans deserve.  Just as competition compels auto companies continually to strive to produce better vehicles at better prices, competition in medical care markets creates better and more efficient health care. Where, they ask, will firms find the incentives to develop better products and processes, if government controls suck potential profits out of the system?  Conservatives also warn that government-run plans will ration health care -- they will deny important services to contain costs. ⁶

           Both sides offer valid arguments.  However, it is worth noting that surveys suggest that Americans served by Medicare, a government-run single payer system, typically express more satisfaction with their health care than those with private insurance.  Indeed, amusingly enough. many elderly citizens at the politically charged town hall debates about proposed health care reforms in 2009 railed heatedly against government-run "socialized" medicine while, at the same time, warning legislators to keep their hands off their (the government-run) Medicare.  While far from perfect, many experts in the field conclude that Medicare seems to deliver care more cost-effectively than do private insurance systems.  By primarily relying on private rather than government-funded medical care U.S. residents save some dollars by having lower taxes, but might be paying even more dollars by having to cover higher medical bills out of their own pockets.

Reform?

An ideal system would provide high-quality care to all in a cost-effective manner.  However, those goals often conflict.  Providing high-quality care to all increases costs, and attempts to control costs inevitably results in high-quality care being withheld from at least some patients. The controversial Patient Protection and Affordable Care Act (PPACA) passed in 2010 attempts to blend these disparate goals. 

First, it moves the United States toward universal coverage by requiring everyone (with a few exceptions) to purchase medical insurance and by providing government assistance to low-income families that might otherwise be unable to afford it.  It also stops private insurers from cancelling coverage for those who fall sick or denying coverage to those with pre-existing conditions, and allows dependent children to be covered under their parents' policies up to age 26.  It also sets minimum standards for what insurance plans must cover.

Second, it contains a variety of measures to contain costs.  For example, private individuals traditionally have been forced to pay much higher premiums for health insurance that those covered by group policies from employers with the power to negotiate better rates.  Under the PPACA, everyone will be able to benefit from "group" rates by buying policies through state-run insurance exchanges.  Perhaps more importantly the PPACA further shifts the U.S. away from the fee-for-services-rendered system and attempts to reward quality rather than quantity of care.  It expands the system of paying providers a fixed fee for treating a given ailment and punishes hospitals whose patients must be readmitted multiple times for the same problem.  It also creates a board of independent medical experts able to push providers into using those medical strategies found to be most cost-effective and funds a variety of innovative experiments to find still better approaches.  Finally, to discourage overly generous "cadillac" insurance plans that encourage patients to demand inordinate amounts of unnecessary care, the PPACA will subject such plans to tax.

Political conservatives rail against this additional government intrusion into the marketplace and argue that America cannot afford the extra expense the PPACA is sure to create.  Political liberals counter that the U.S. system will continue to be dominated by private insurers and private health-care providers.  They also note that the non-partisan Congressional Budget Office estimates that the PPACA actually will lower projected government budget deficits.

            Which side is correct?  Will costs rise or fall?  Do we need more government or less?  As things currently stand, we cannot afford to provide all of the medical care that patients demand.  Privately-run and government-run systems face the same pressures and, assuming that medical technology continues to create more life-saving procedures, these pressures will continue to increase.  In the long run we have only two choices.  Either we spend more, or else we deliberately withhold care from those who might potentially benefit from it.  Neither option sounds like much fun.  If we spend more; from where will the funding come? If we ration, how will we do it?  Will we allow a government agency to decide what and where care should be given?  Or, will we keep with the current system that rations on the ability-to-pay; that provides excessive care to the well-heeled and almost none to the uninsured?

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Notes: 

1.         The tax break only goes to those receiving insurance from their employers.  Self-employed workers and/or those working for firms that do not provide insurance are less fortunate.  They must buy their own insurance (without benefit of the tax break) or do without. 

2.         Reinhardt, Uwe E., "Why Does U.S. Health Care Cost So Much? (Part II: Indefensible Administrative Costs)", New York Times, November 21, 2008.

3.         Kristof, Nicholas D., "Health Care That Works", New York Times, September 3, 2009.

4.         Cutler, David M. and Dan P. Ly, "The (Paper)work of Medicine: Understanding International Medical Costs", Journal of Economic Perspectives, volume 25, number 2, Spring 2011, pp. 3-27.

5.         Reinhardt, op. cit.

5.         Some argue out of both sides of their mouth. When proponents of the recent health reform legislation boast of providing more care, critics blast it for running up extra costs. When proponents praise the cost-cutting measures of the legislation, critics blast it for cutting care.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Explain why Americans are spending an increasingly large percent of income on health care.

2.         Describe the major ways in which the government impacts the U.S. health care system.

3.         Explain why most Americans demand inefficiently large quantities of health care and illustrate with an appropriate graph.

4.         Explain why uninsured people actually might drive up medical costs in the long run.

5.         Explain why American health-care providers historically supplied inefficiently large quantities of care.

6.         Describe what government and private insurers have done to control medical costs and explain how they have changed incentives.

7.         Explain the impacts these cost containment measures have had on the quality of care, on the system of charity care for low-income uninsured patients, and on the long-run trend of medical costs.

8.         Discuss the arguments for and against more government control of the health care system.

9.         Discuss the major provisions of the PPACA and why its proponents feel it they will move us closer to a system that provides high-quality care to all in a cost-effective manner.

10.       Identify the two ultimate choices we face and the problems they present.

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