Econ 101 of Healthcare Costs and Doctor Pay

An unimaginative title, but I’m going to make this a quick, to-the-point post; this is partly because I am expanding on a point that has already been made, and partly because I have a ton of work to finish up before the Pakistan-New Zealand clash at 5 am tomorrow.

Ezra Klein is probably the best source for the ongoing healthcare reform process; specifically, on costs, see these two posts. For the sake of convenience, I’ve reproduced a couple of shocking charts below (courtesy the International Federation of Health Plans via Klein):

Source: IFHP

Source: IFHP

I won’t bother summarizing Klein’s points, since the posts are fairly short by themselves. However, I did find this little “gem” on the internet that is worth quoting:

But all folks like Klein ever seem to want to talk about is “price”. This may comes as a surprise to some, but price is determined by cost and competition. It’s not an arbitrary number. In fact, competition keeps both cost and price (and thus profit) at a reasonable level. That’s how a market works, even one as distorted by government intrusion as our health care system.

Um, no. While the Econ 101 “competition drives price down towards the marginal cost level” theory is normally applicable, the folks over at Planet Money do a great job of showing just why we need to move to a more sophisticated analysis when it comes to doctor pay and costs of medical services. They interview Joe Califano, who notes that as part of the disastrous fee-for-service system instituted under President Johnson, the administration actually passed legislation to increase the number of doctors (both primary-care and specialists) in the system; the rationale seems to have been that more doctors ==> more competition ==> lowers prices. Sound familiar? Unfortunately, by 1975, aggregate healthcare costs had ballooned up to $133 billion ($33 billion more than LBJ had forecast) and have been rising ever since. Competition didn’t really do much there.

In the aforementioned podcast, the podcasters (is that a legitimate word?) explain the difference by pointing to a number of different factors. For now, focus on the key presence of an intermediary in the market for healthcare services: insurance providers. Thus, the market mechanism whereby customers would stop purchasing services from overly expensive providers has to mediate through the insurance providers. Now, teasing out the layers in the excellent Planet Money analysis further, there are two things to note here: first, additional intermediaries generally result in higher costs as a general rule of thumb (somebody needs to pay said intermediaries). Fair enough- if it needs to be done, it needs to be done.

Second, how do the insurance providers determine the prices that they should be paying? A fee-for-service system seems reasonable, but it cannot follow the model adopted by LBJ’s administration whereby no negotiation was stipulated and doctors essentially asked for whatever they felt like. The problem with this unregulated fee-for-service system is that while equilibrium will inevitably be reached through a self-regulating market mechanism, it will most likely end up at a higher equilibrium level than is socially optimal. Simply put, if all doctors dictate higher prices than they deserve, an equilibrium will eventually be reached that prevents doctors from demanding even more than this higher level, yet keeps prices at an inefficient level nonetheless.

So, we need a negotiated fee-for-service system, which raises the question: how do we determine these prices? Obviously, given historic trends in the healthcare market, resorting to the “competition keeps prices at a reasonable level” defense is plain wrong (as explicated above). Planet Money interviews Harvard Professor William Hsiao, who was one of the pioneers in determining the relative value of services provided by doctors, by interviewing doctors and asking them a whole host of questions. Naturally, as the healthcare industry caught wind of this, they realized that intervention was needed lest a truly competitive price for their services be arrived at. Hsiao talks about the manner in which consultants and lobby groups galore flexed their muscles, from manipulating his survey respondents’ answers to actually commissioning similar studies of their own. Sound familiar? Again, it should: institutional capture by interest groups is one of the biggest problems plaguing the American system today. One can examine the various reasons why- information asymmetries, political clout exercised by interest groups, private and therefore profit-oriented insurance companies- but ultimately, even Hsiao’s method for determining “fair” prices was destined to fail as well. The proof is right in front of us, as the charts above indicate. In addition, there is the issue of exorbitant drug prices (also covered in the package of charts provided by the IFHP and available here), but I promised to keep this post brief.

Returning to the aforementioned, ignorant critique of Klein, the authors observe:

Additionally, there is the quality of care – what does a $30 doctor’s visit buy in Canada or the UK in comparison with a $72 Medicare visit in the US? We really have no idea. So how then is such a comparison relevant to anything? I can buy a KIA or I can buy a BMW. Few would argue they have the same cost and certainly not the same value. The quality is entirely different. Yet they’re both cars. The chart assumes all care is equal. But we know that isn’t true.

No analysis of qualitative differences in care across countries is provided to back up their claim. Furthermore, even if there are differences in care, they may often be marginal: is a normal delivery in Canada so inferior to one in the US that it justifies a minimum 379% difference in price? As far as I know, the babies are delivered in a remarkably similar manner across the Western world and whatever differences do exist, are negligible for the purposes of this discussion. Even granting that there may be certain services that are superior in the US (a moot point at best), it seems far-fetched to attribute said superiority across the board to every service. Yet, that is the only alternative for those that would justify the prices based on an efficient, competitive markets basis. Try telling the majority of Americans that they receive a quality of healthcare that is significantly superior to the rest of the world and they would scoff…and rightly so. These are imperfect markets with skewed, highly imperfect results.

Finally, in the interests of doing this dismantling job properly, the authors also note:

There’s also another 800 pound gorilla in the room. Actually the gorilla is the bar on the graph disguised as a $72 fee from Medicare. How do you think the difference between those paltry fees and the real cost of the visit are recovered? Look left, young man, look left. That big bar of private insurance subsidizes Medicare by absorbing the cost shifting which goes on from Medicare payments which don’t cover cost. Without the ability to do that fewer and fewer doctors would accept or treat Medicare patients. In fact, why do you think they limit them now? That reality, of course, isn’t reflected at all in the chart.

Right, so if Medicare is only able to keep costs below the real costs of services by virtue of a coexisting, sacrificing private insurance, how does one explain the significantly lower costs in other countries? The “differences in care” argument is laughable and should not be entertained further. Where is the private insurance sector subsidizing healthcare in the UK? I expect the argument here would be that the government keeps prices artificially low, well below the true marginal cost of service provision. If that were so, wouldn’t we witness an exodus of people from healthcare professions, with increasingly fewer people applying to become doctors? As far as I know, other developed countries are not facing a dearth of doctors. On the contrary, skewed prices in the US have changed incentives, resulting in a gravitation of doctors towards specialization- we are headed towards a scary deficit of primary care physicians. Given that Hsiao’s study found their services to have amongst the highest relative values, I find this particularly poignant.

There is a lot of economics underpinning the healthcare debate, some of it complicated, but a lot of it startlingly simple. The least we can do is get the simple parts right.