Free Market Assumptions in Healthcare

I’ve encountered an unexpected concept when debating and discussing healthcare solutions in the United States.

Healthcare in the United States contains both public and private actors, but it’s most important characteristic for a libertarian critique is its lack of price signals. Healthcare is not purchased in an open market. Patients select healthcare providers based on reputation and what their insurance covers, but most patients do not choose their insurance provider. That is usually done by their employer or the government (in the case of Medicare and Medicaid). Conversely, healthcare providers do not charge patients, they charge insurers where prices can differ by provider and by procedure. EconTalk recently had Christy Ford Chapin on to discuss the history of American healthcare and I would highly recommend the episode.

The libertarian position (and mine) is that healthcare could be improved with prices. There are many ways to do that, you do not necessarily need patients to pay those prices, but you need them involved in the decision making process. Otherwise, there is no downsloping demand curve, and therefore there is no incentive to improve efficiency in the market. Thus, we see higher prices over time instead of the usual results of technological innovation: higher diversity of choices, higher quality goods, and lower prices.

This post is not a defense of whatever Republican healthcare bill is now being floated to replace or repeal Obamacare. This is only an argument that having known prices and price transparency would allow for demand and supply curves in the health care market. Such a characteristic could be part of a host of possible healthcare policy landscapes, and I’m only saying that a landscape that has prices is likely better than one that does not. Today, and for most of the history of healthcare in America, the healthcare industry has not been governed by an openly priced market.

Such a libertarian critique is separate from the argument that a “free-market” system with prices would hurt the poor. This is a valid critique that could be addressed with direct cash grants or other form of government subsidy that avoids having healthcare prices set by the government (refundable tax credits, health savings accounts, etc).

The remarkable argument I’ve heard is that if we allowed healthcare to be purchased in a market with prices, it would fail because you “can’t have” a free market in healthcare. It’s hard to nail down exactly what these people imagine would happen, but it seems that they believe prices themselves would not obey the laws of demand and supply. I will now list some arguments I have heard, some of them several times, and why they are incorrect. Certainly these arguments are poor and perhaps I am wasting time with them, but apparently they are common enough that I have run into them several times and therefore must be addressed.

“Healthcare Demand is Inelastic”

This is by far the most common point I’ve heard. It’s not usually stated in economic terms, but more like “if you are in need of emergency medical care, you’ll pay any amount, and this breaks normal market assumptions”.  However, I’ve also heard it stated that evidence of competitive markets working in elective procedures (Lasik or plastic surgery) does not apply to regular medicine because of demand inelasticity.

Firstly, the assumption that demand for medicine as a good is totally inelastic (i.e. quantity would not respond at all to price) is obviously wrong. That would imply there are no unnecessary procedures done ever.  Yet we all are aware that because doctors are often paid per procedure, they are often incentivized to conduct tests because there is very little downside (i.e. it costs neither the patient nor the doctor anything to run the extra test). If there is no elasticity, then there is no room for reducing the amount of procedures done by doctors. I doubt that.

Nonetheless, let’s grant the assumption, or at least let’s say that demand elasticity is very low.  That means at higher prices, you’re likely to consume a similar amount of medicine. That sounds more reasonable; if you’re sick, it’s not your choice.

Ok well…so what? We can have competitive markets with marginal revenue very close to marginal cost even if demand elasticity is low. Gasoline is a classic example of an inelastic good, yet the gasoline market is highly competitive. Prices work without issue here. Again, we’re not saying that poor people would be really happy with prices, we’re just saying that prices would exist if patients could purchase healthcare in a market.

Another related point is that if you have a medical emergency, you’re not really in a position to negotiate prices. This, however, is not just due to demand inelasticity, but also monopoly pricing.  If you’re injured, you can’t just go to a different hospital, so the ER you arrive at is pretty much the only place you can go. This is a fairly good argument for government intervention in the ER. However, insurance is also a pretty good solution; if you won’t be able to make a choice in the moment, you buy insurance so that when the moment comes, you are already prepared. There is no economic reason that medical emergency insurance could not be purchased in a free market. Additionally, medical emergencies are a small part of the medical industry. The vast majority of medical procedures are not emergencies, and so for most situations, monopoly pricing is not an issue.

“Knowledge is imperfectly distributed in medicine”

Again, the fact that market actors have imperfect knowledge does not mean a market cannot exist. It may mean there are market failures, but government interventions are subject to government failures which may or may not outweigh the benefits of trying to fix the market failure. Moreover, this proves way too much, as it implies that you can’t have any market with imperfect knowledge, yet all markets suffer from this, and plenty are functioning just fine. In fact, I’d argue that prices are the single best way to spread knowledge.

Imperfect knowledge is usually fixed through regulation, like accreditation or inspections. You don’t have the knowledge to know that your airplane doesn’t have mechanical problems. Nonetheless, you are quite capable of comparing the prices of different airplane tickets, and you’ll likely respond to market forces when purchasing a ticket. Certainly imperfect knowledge is an argument for regulation, and I’m sure I’d disagree with plenty of people on how much regulation is necessary, but there is no world in which it then makes sense to argue that imperfect knowledge precludes a functioning price system.

“People are irrational”

First, people don’t have to be economically rational, nor do markets have to be free from regulation in order to create accurate economic modeling. To make the claim that economic analysis can’t be done with healthcare because the market is not perfectly competitive, or actors are not perfectly rational, again proves too much; economic analysis would be “fatally flawed” in all markets. The only question that needs to be asked is whether it’s possible patients might call two different places for a quote on a chest CT or an MRI. If some of them would do this, there would be competitive pricing, even if most don’t know what an MRI actually does.

“Healthcare is too expensive for a market to function”

This point sort of ignores the thesis that we are arguing, as all I’m trying to say is that prices can exist in the healthcare market. However, this is related and while it’s a bad argument, I want to address it briefly.  Healthcare is pretty expensive, although I suspect that it would be cheaper if market prices were used. The obvious answer to me would be to imagine if the government gave a large amount of money to an individual to pay for their healthcare for a year. That would fix the endowment issue where the poor are excluded from the market. In this hypothetical, my thesis suggests that there would be a variety of options for healthcare spending, such as paying out of pocket, buying a high deductible insurance plan, subscribing to a doctor network, etc. All of these would be examples of functioning markets in healthcare. Additionally, if recipients were allowed to roll over funding into the next year, they’d be incentivized to find good deals this year.

My thesis is not that the government should stay out of healthcare, but that interventions that keep prices in place are preferred.

“Morally, patients should not have to pay for healthcare”

Again, this isn’t really an argument against my thesis, but I have heard it. It’s a bad argument, so I’ll address it briefly.

If we take a consequentialist utilitarian moral standpoint, there is no a priori humanitarian reason why patients should not pay for part of their healthcare. In other words, if patients paying for part of their healthcare creates benefits for all of society, including almost all patients and future patients, then the moral thing to do (from a utilitarian perspective) is to have patients pay for some of their healthcare.

So would there be benefits if patients paid for healthcare? Well, first you have to establish that prices can exists. We’ve done that for the theoretical, but how about the empirical?

Empirical Data

The first point is that in the area closest to healthcare where there are transparent prices, elective procedures, we see functioning markets with costs going down over time.  Highlights include:

1. For the top ten most popular cosmetic procedures last year, none of them has increased in price since 1998 more than the 45.4% increase in consumer price inflation (the price for the hyaluronic acid procedure wasn’t available for 1998), meaning the real price of all of those procedures have fallen over the last 18 years.

2. For three of the top five favorite non-surgical procedures in 2015 (botox, laser hair removal and chemical peel), the nominal prices have actually fallen since 1998 by large double-digit percentage declines of -25.2%, -43.8% and -23.5%. That is, those prices have fallen in price since 1998, even before making any adjustments for inflation.

3. Most importantly, none of the ten cosmetic procedures in the table above have increased in price by anywhere close to the 93% increase in medical care services since 1998. The 23.2% average price increase since 1998 for last year’s top five most popular surgical procedures, isn’t even close to half of the 93% increase in the cost of medical care services over the last 18 years.

However, there are some doctors who just take cash for normal, non-elective procedures. These would be procedures where there is “inelastic demand”. What happens to these doctors? Do they go bankrupt immediately? Is everyone confused and bewildered? Not really, it just works like any other market. They post their prices online, and people come and pay for their procedures directly, without insurance. The Oklahoma Surgery Center is one of the more well known health centers with this approach:

The Surgery Center would charge $19,000 for his whole-knee replacement, a discount of nearly 50% on what Villa expected to be charged at his local hospital. And that price would include everything from airfare to the organization’s only facility, in Oklahoma City, to medications and physical therapy.

And once that happened, lots of groups were incentivized to send their patients there, making other Oklahoma hospitals compete.

While no organization keeps track of how many cash-based medical centers have cropped up nationwide in recent years, Smith and Lantier say they’ve witnessed an explosion. In Oklahoma City alone there are roughly three dozen centers that are all or partly cash based, specializing in everything from radiology to oncology.

The RAND institute ran an RCT in the late 70s that found patients who cost shared saw a reduction in unnecessary procedures. Obviously it’s pretty old, but I’m doubtful human nature has changed that much from the late 70s; if people have an opportunity to save money, they will do so. Healthcare policy should utilize that.

More recently, in 2008, Oregon had a Medicaid experiment, where several people were given access to Medicaid based on a lottery. Thus, a study was conducted to determine what the affects were of having access to Medicaid. As you would expect, patients with Medicaid coverage were much more likely to utilize healthcare generally, and more likely to go to the ER. The price of medical care went down when this group was enrolled in Medicaid, and consumption of medical care went up. This supports the notion that healthcare has a downsloping demand curve…just like every other market that has ever existed.

Finally, there was a study done in 2015 looking at the healthcare system and it’s lack of prices. It found that transaction prices, that is prices negotiated between hospitals and insurers, still accounts for much of the differences in private inpatient healthcare spending. It also found that even after controlling for several different variables, hospital monopoly power was responsible for higher prices. This seems to indicate to me that if we had significantly more price transparency in a functioning market, hospitals and patients would respond to those incentives, creating incentives for lower prices and better, more efficient care.

Conclusion

This isn’t revolutionary by any means, but there’s seems to be plenty of empirical and theoretical reasons that if we had transparent pricing systems in the healthcare industry, it would function similarly to prices everywhere else in the economy. Certainly the use of insurance complicates things, but the way we use medical insurance is a result of the unique way we created the medical payments system as detailed in the EconTalk episode mentioned at the top of the post. There is no technical reason we need to retain that system, and I think transitioning towards more procedures having known prices would be beneficial, whatever that system would be.

 


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Against Hillary: Healthcare

This is the third post in my series opposing Hillary Clinton’s candidacy. See the introduction in Part 1 here. Read my opposition to Trump here. Read why you should mathematically vote for a third party here.

Healthcare

Now we’re turning to a subject where there may be an unavoidable Fundamental Ideological Disagreement. Nonetheless, I think there may be some agreement that the current healthcare system has many problems.

In 2009, the Democrats had complete control of the presidency, the House, and even had a super-majority in the Senate. Their priority was healthcare reform: the American system was prohibitively expensive, spent too much money even when patients were covered, tied your healthcare to your job, denied coverage to people with preexisting conditions and others who could not pay, and did not properly align preventative care incentives. They took a fundamentally left-leaning, centralized, top-down approach to solving these problems. The Obama administration specifically stayed out of the legislative process allowing much of the law to be patched together through Congress. They solved some of the problems in the American health system (and those steps are to be commended), some they tried to solve, but didn’t, and some they ignored altogether. Ironically, for a piece of legislation often called the “Affordable Care Act”, one of the problems Obamacare largely didn’t touch was the lack of market forces and pricing pressures on healthcare, guaranteeing the price problem would worsen.

When it comes to allocating resources, incentivizing cost saving and innovation, and producing the best quality goods for the lowest possible prices, there is no better system than a competitive free market with unregulated prices. Sellers seek to provide the best product at the lowest cost so that buyers will want to purchase them.  I’d hesitate to even call it a system, since, apart from pricing systems and private property, everything is driven by individuals making decisions, according to their own priorities and needs. Markets do have problems, but the biggest one is that poor people won’t have the money to get the product (i.e. healthcare) they need. Unfortunately, instead of just fixing that problem by giving government healthcare subsidies to the poor, Obamacare tried to solve all the problems of the entire healthcare system through legislation. Obama had an unprecedented opportunity to encourage both market reforms and increased coverage for the poor, but instead opted for the (politically easier) increased regulation on a system already heavily strained by bad rules.

Instead of making it easier to purchase healthcare as an individual, Obamacare cemented the relationship between employment and healthcare. Instead of allowing consumers and doctors to figure out some prices with high deductible insurance plans, Obamacare mandated many more items be specifically covered by insurance plans, thus hiding their costs from patients. Instead of allowing insurance and consumers to follow their own incentives to promote preventive care, Obamacare mandates one-size fits all preventative care regulations which encode waste into the system. For more critiques of the system, check out this review in the Cato Journal.

The result is a system that solved the problem of coverage for the poor and people with preexisting conditions, but did not fundamentally solve the lack of market pricing and bad incentives. The mandates on insurance companies and hospitals (besides creating waste) increased the cost of providing care. The increased cost was supposed to be alleviated by subsidies and more young people entering the system, but the costs have been higher than expected and thus fewer people have signed up than had hoped. Perhaps more subsidies would get more people to sign up, but that doesn’t really solve the fundamental issues, just puts the burden of cost onto the taxpayer instead of healthy consumers. As a result of a lack of healthy young people in the system, insurance companies are raising premiums, despite downsloping demand curves (you drop prices to bring people in, not raise them). Clearly, the problems will only continue, and we’re stuck in a political situation where some parts of Obamacare are popular and now can’t be politically taken back, despite them being unsustainable.

Hillary Clinton wants to keep much of this situation intact. This is a terrible policy. We need real market reforms or this cost growth will continue. This isn’t even to suggest that an insurance mandate would be bad policy, or that the poor shouldn’t be able to get healthcare subsidies; but if there is no price competition, no ability for consumers to choose their healthcare provider, then there are no ramifications for patient or doctor’s actions that are inefficient or unnecessary. The costs are just socialized by the system and the problems never fixed. And it’s not like we are out of ideas for fixing the healthcare system: ending healthcare ties to your employer, allowing for more widespread use of HSAs, scaling, split benefits, and reforming scope of practice laws are just some of those. Over the last 15 years, American middle class wages haven’t improved much. Yet healthcare costs (and spending as a part of GDP) has gone way up. Perhaps if these costs were better controlled (and not paid by employers), more of the productivity gains would return to middle class incomes. But we’ll never find out when Hillary is president.


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Picture Credit: Gage Skidmore, licensed under CC BY-SA-2.0