Today’s post is on the healthcare industry. Whether it’s described as a bubble or ponzi scheme, there’s no doubt that we’re experiencing one of the most damaging – and misunderstood – economic events in our country’s history. (By way of comparison to the higher education bubble: The estimated amount of waste in the healthcare market – in just 1 year – would pay off every student loan in the country.)
I’m focusing on two areas: 1) The fundamental economics of the healthcare market, as effectively providing healthcare – both how and how much – is inherently an economic question. Even if, as some argue, healthcare is a fundamental right – and hence a moral issue – that does not mean a right to an unlimited supply, provided without regard to cost or benefit; and 2) The relationship between healthcare usage and health outcomes.
The Economics of the Healthcare Market
As a starting point, we can envision that a well-functioning healthcare market has patients with health issues who get the best treatments possible given their personal cost-benefit tradeoffs. We see this relationship below.
Any of us who have participated in the healthcare market know that it doesn’t work as other consumer-driven markets. In part this is because most patients – price-sensitive consumers – neither buy their own insurance nor pay the bills directly. Employers and the government, the largest “customers,” are more concerned with simplicity and expanding coverage than price or efficiencies.
The presence of price-insensitive customers doesn’t fully explain the skyrocketing prices in the healthcare market, however. After all, other industries with similar customer segments – professionals with expense accounts in the airline and rental car markets, for example – haven’t exhibited similar price behavior, despite someone else often “picking up the tab.”
No, there’s something that sets the healthcare market apart – its economic structure as a cartel. In a cartel, suppliers act to make output and price decisions. As we see to the right, suppliers typically restrict supply and increase price relative to a competitive market. Consumer pain is their gain, which we see highlighted in orange.
However, as an economic model cartels have a weakness: reduced demand. As prices rise, some consumers “opt-out” of the market, while others never enter. This price-demand dynamic serves to limit the size of inefficient market structures like cartels, and, in the long run, often results in their obsolescence.
But healthcare spending continues to skyrocket, increasing from $40B to $2,000B in just two generations. Why hasn’t the limiting factor – reduced demand – worked in this case? The answer, as we’ll see below, has to do with the nature of demand in the healthcare market.
Why Prices (Will) Always Rise in the Healthcare Market
I have two daughters and a disturbingly profligate lemon tree. Suppose my daughters open a lemonade stand and sell 5 cups a day for $1 each. One day, in a burst of magnanimity, I decide to buy a glass for everyone in our neighborhood. In an attempt to control how much I spend, I make my daughters an offer: I’ll pay a 50% markup on their costs, which I estimate to be just a dime per cup.
Of course, my daughters’ motivation changes the minute they agree to this deal. They’re no longer focused on trying to sell as much lemonade as possible; my offer ensures they won’t need to worry about customers. Instead they want to increase their costs as high as possible – a new Lemonada 5000 mixer, celebrity sponsors, cruelty-free lemons – because their profits grow as their costs increase.
The Affordable Care Act (ACA) mandates that insurance companies “pay out” up to 85% of their premiums (casinos face similar regulations). While this is claimed as a win for patients (or gamblers), our lemonade example shows it’s the opposite. Premiums are based on insurance companies’ costs, and providers – pharmaceuticals, hospitals, device makers, physicians – recognize that insurance companies want higher costs, because they’ll simply pass those on through higher premiums. Everybody wins!
Perversely, in an attempt to limit how much we spend by linking it to costs – but allowing the industry to determine its own “costs” – we’ve provided the perfect environment for costs – and hence, prices – to inexorably increase. Unlike with healthcare, at least with casinos we get a voice in deciding whether – and how much – we lose.
How the Medical Profession Increases Demand
The tension between the spirit of medicine and the spirit of commerce is ancient. In The Republic, Socrates asks, “Is the physician a healer of the sick or a maker of money?” The answer, of course, depends on incentives.
When our daughter wasn’t gaining weight, our pediatrician referred us to a specialist. Before our first appointment,we researched online, decided to try a different baby formula, and voila – immediate weight gain. Did that dissuade the specialist from ordering numerous tests, scheduling repeat visits, and in general acting as if the outcome we wanted – weight gain – hadn’t already taken place? No, his office kept at it until we stopped returning their calls.
Medicare studies show that in areas with surplus supply (doctors & hospital beds), spend per patient is up to three times higher than in areas with tighter supply. Another study showed that doctors who own MRI and CT scanners are four times as likely to order a scan as a doctor who doesn’t. While in consumer-driven markets, excess supply leads to consolidation and price competition, in the healthcare market, demand and prices increase.
Our approach to healthcare has made it in the doctor’s financial interest to over-supply medical care. Here’s how a recent Citigroup research report summarized it: “The more patients that go to a physician’s office, the more disease gets diagnosed, the more specialist referrals are made, and ultimately the more hospital visits and profit is generated.” The Hippocratic ideal, with its focus on the patient, seems downright stodgy – and certainly less profitable.
Why the Insurance Industry Plays Along
No aspect of the healthcare market is as poorly understood as insurance. We saw above how insurance companies encourage higher prices because of their cost-plus payment structure. But if raising prices by double digits every year isn’t generating enough profits – and there’s no more growth from adding new subscribers – how else can the insurance industry make money? By increasing coverage of course.
This basic economic fact – that insurers only make money if health spend increases – is consistently misunderstood. How else to explain the common belief that insurers have incentives to see customers take better care of themselves, as if us spending less money on healthcare wasn’t bad for insurers? Or that having more procedures covered as preventive medicine (no co-pay) isn’t simply an excuse for insurers to raise premiums for everyone? “Forcing” insurers to cover more stuff simply allows the premium base to rise.
Expanding coverage is always supported by the insurance industry because it dramatically increases the scope of what they can charge for. Ten states require coverage of hair prostheses, while thirteen states mandate coverage of in-vitro fertilization, and in four states your massages are covered by insurance. Most recently, seven states are considering mandating gym memberships as preventive medicine. Just imagine what that will do to the price of joining a gym in those states, when everyone gets “free” memberships. Take that, insurance industry!
The Real Economics of the Healthcare Market
With a better understanding of market mechanisms, we can make some adjustments to how the healthcare market actually operates, which we see below:
There’s no longer a limit on demand based on a patient and their health issues; we’re all “patients,” and cost is based on coverage (easy to expand) rather than illness.
From an economics perspective, we’d say that insurance companies and the medical profession are able to increase demand, resulting in a rightward shift in the demand curve. This permits even higher cartel profits, which we see to the right.
This is, from what I can tell, a unique feature of the healthcare market today. I could find no other example where a cartel was able to control both supply and demand. Any other cartel must trade off higher prices for lower quantities. By giving insurance companies the ability to set price and coverage, and doctors the ability to determine treatment independent of need, we’ve created a hybrid that can increase both quantity and price, representing an historically unique combination that voraciously consumes our national (and personal) wealth. In fact, the distortions created by hiding and distorting prices – and removing the distinction between patient and consumer – results in another feature unique to this cartel: Demand higher than it would be in a competitive market.
Doctors fighting hospitals fighting insurers isn’t a sign of competition – it’s just different cartels fighting over our money while blaming each other for the country’s medically-induced insolvency. Some point to greed on Wall Street as the problem. But it’s not greed that’s to blame, but an industry structure that ensures ever-higher levels of spend, divorced from patient outcomes. I for one would love Wall Street to find a way to profit from real competition in healthcare. As patients (and taxpayers) we’d all be much better off.
What Have We Gained From the Healthcare Industry?
As I was researching and writing this post, my perspective was that while there was undoubtedly waste in the healthcare industry, net-net we are better off with a flawed system than none at all. But is that really the case?
To find out, I did some digging on average healthcare spend and lifespans across countries and over time. We see that below:
It’s probably no surprise that the U.S. has the lowest lifespan and spends the most; that’s the point of this post, after all. However, look at the country to the far right: It’s the U.S. from 1993, where I’ve adjusted for lifespan factors that aren’t directly impacted by the healthcare industry. Things like safer cars, less smoking, healthier fitness and diet habits. With those adjustments, we’ve spent more than $20T over the past 20 years to add a year to our lifespans. (The U.S. is not inherently sicker, fatter, older, or more litigious than other countries – see here).
To put those numbers in perspective: Every person who has died over the past 20 years could have been provided two options: Add that extra year to their life, or have $475,000 to spend as (or on whom) they chose. Put another way: Every new parent today could be given two options: Receive a check for $930,000 (factoring in predicted healthcare spend per year over a baby’s lifespan) to spend on their child as they wish, or enroll the child in our healthcare industry. Is there any doubt which option most of us would choose?
In the 1970’s, the RAND corporation conducted a series of experiments, putting patients into one of five groups, with varying levels of insurance (from “no insurance” to “free and full insurance”). While there was a strong relationship between healthcare usage and insurance, there was virtually no relationship between healthcare usage and health outcomes. Essentially, more insurance meant higher usage (cost) without better health.
There’s a more recent piece of research around healthcare spending and health outcomes: The Oregon Health Insurance Experiment. Here, poor patients are assigned different levels of Medicaid coverage, and their usage and health outcomes are tracked. Similar to the RAND study, while there is a clear relationship between coverage, usage, and cost, there appears to be little relationship between healthcare usage and health outcomes. Bummer.
In ways similar to the higher education bubble, we are seeing massive “investments” in healthcare with little apparent benefit. Just as students are graduating with massive debt and fewer opportunities, so too are patients getting hammered with medical bills that are inflated and delivering very little health benefit. Unlike the higher education bubble, however, the healthcare bubble is large enough to destabilize the entire economy when it pops.