Case of the Day: Why Is Health Care So Expensive?
Some background on health-care economics
There are two characteristics of health-care markets that attract a lot of political attention: access and cost. Although they are related in that expensive health care may become unaffordable and limit access, they are to some degree distinct issues. Many people believe that access to basic health care is (or should be) a fundamental right that all should have. Health-care systems vary greatly among developed countries, with widely varying outcomes for both access and cost. The cost outcomes of a health-care system result from the kind of resource-allocation decisions that we study in microeconomics, both made centrally by governments and made by individual suppliers and demanders responding to the incentives offered by markets. The access outcomes are more akin to questions of income distribution that can sometimes be separated from considerations of efficiency.
Americans spend more per person on health care than any other country in the world. The fact that our incomes are higher than most doesn't explain our higher expenditure: as a share of GDP (or national income), the United States spent 16.0% on health-care in 2007 compared with the next-highest percentage 11.0% in France and the considerably lower 10.1% in Canada and 8.4% in the United Kingdom. (Figures are from OECD Health Data, 2009.)
This is not, in itself, remarkable. Americans also spend more on personal computers and hamburgers (and less on public transportation and fine wines) than most European countries at comparable income levels. To some extent, these differences simply reflect differences in preferences between the typical American and European consumers. What makes the health-care spending gap noteworthy is that it is not clear than Americans are actually buying more or better health care, they are just paying more. U.S. health-care outcomes such as rates of mortality and morbidity are usually no better (and in some cases are worse) than those of countries that spend much less. If we are paying more and not getting any better services, perhaps there are economic inefficiencies in the U.S. health-care system that, if they could be eliminated, might allow us to spend that money in other utility-enhancing ways.
Health-care systems in all countries are complex interactions of government and private programs. In the United States, federal and state governments are major payers of health-care costs through the Medicare program for the elderly and Medicaid for low-income families, but the government plays a very small role in actually employing providers of care and operating hospitals. While government supports for health-care costs are important, most Americans pay for their own health care either directly or through private health insurance. In some countries, such as Canada and the United Kingdom, the government not only pays for but also operates the health-care system, with or without a parallel private system for those who voluntarily choose (and pay for) it.
One way in which health care differs from, say, Alban white truffles is that many people believe that access to excellent health-care services should be a birthright of all Americans, whereas no one seems to mind too much that some people cannot afford to buy truffles (or don't want to). This creates a problem: while our social conscience would like everyone to be able to get the very best medical services, heart surgeons of the very highest quality are rare and each such surgeon can only operate on a few patients per week. Like other resources, health-care resources are scarce and must be allocated efficiently if we are to satisfy as many of society's needs as possible with the available resources. This motivates economists' interest in the health-care system as a whole: are there ways to utilize our resources better to get more services at less cost?
A New York Times article by David Leonhardt ("A Lesson From Europe on Health Care," published October 18, 2006) argued that some, but not all of the difference in health-care costs between the U.S. and Europe can be explained by differences in administrative costs: the centralization of the European national systems makes billing and coordination simpler. But, he argues, "something beside administrative costs is at work here, and it involves a basic cultural difference. Americans seem to be less willing to take no for an answer and more willing to try almost anything, no matter how expensive or how slim the odds, to prolong life. (The United States is also a fatter, more diverse country with wider income disparity, which gives our medical system a harder task.)"
"There are enormous benefits to the American refusal to go gently into that good night. It has made us obsessed with medical advances and turned this country into the world’s research laboratory. If you followed this year’s  Nobel Prize announcements, you may have noticed that every scientific prize went to an American. Even hernia surgery, which has been around for 5,000 years, is now based in significant part on American methods, notes Raymond C. Read, a retired surgeon who has studied its history. Some of our spending, in short, goes to support medical care in other countries.
"But much of it is simply wasteful. Expensive procedures — like some Alzheimer’s treatments, some knee surgeries and many body scans — are often no more effective than basic ones, according to research. Yet doctors can keep on getting reimbursed for the expensive ones. 'Basically, anything that doesn’t kill patients is paid for by Medicare and insurance companies,' said Jonathan Skinner, a health care researcher at Dartmouth College.
"This, I think, is the main lesson that we could stand to learn from Europe and Canada. We Americans tend to treat any rejection of a health claim as some conspiracy by insurance companies, the government, doctors and the pharmaceutical industry. In other countries, people have arrived at a better understanding that health care necessarily involves economic triage — that $10,000 spent on quixotic care is $10,000 that can’t be spent more usefully."
The economics of the U.S. health-care system
In the United States, decisions about the allocation of health-care resources—how much and what services to provide to whom—are made through the interaction in the health-care market of decisions made by individual consumers (both in their "well" role as buyers of health insurance and in their "sick" role as patients), health-care providers (doctors, clinics, and hospitals), private health-care insurers (by setting rules about what treatments will be covered and what providers may be chosen), and governments (both through general health-care policies and through specific programs like Medicare and Medicaid). As in other situations, economists view health-care resource allocation as efficient if decisions are made in such a way that the marginal benefit of services equals their marginal cost. You have seen that under ideal conditions, perfectly competitive markets can map the separate decisions of consumers and producers into efficient resource allocation. But the health-care market differs in important ways from the economic nirvana of perfect competition.
A large share of Americans pay for health care indirectly through private insurance plans. These plans are usually arranged as "group plans" contracted through employers and paid for either by the employers directly (as an employment benefit in addition to wages) or through deductions from the employees' paychecks. Individual health insurance policies of the kind typical in the car, home, and life insurance markets are the exception rather than the rule.
Health-insurance plans usually follow one of two major models: "fee-for-service" plans or health-maintenance organizations (HMOs). Some plans combine elements of both, but we'll consider fairly pure forms here.
Fee-for-service insurance plans allow the individual consumer to decide, within some limits, what care to obtain and from what provider to obtain it. Some plans require a physician referral for specialized services, but in most cases the patient has considerable discretion over health-care decisions. Most plans have a sizable "deductible" (the consumer pays the first $250 or $1000 of health-care expenses out of pocket in each year) and some "copayments" on expenses incurred after the deductible is satisfied (the consumer pays, say, 25% of the next $2000 of expenses). Consumers (and/or their employers) pay monthly premiums to cover the costs of the health insurance.
HMOs combine insurance with direct provision of health-care services. Consumers (and/or their employers) pay a monthly premium as in fee-for-service plans. However, unlike the fee-for-service case, she must usually obtain health services from the HMO itself. For most illness, she would initially visit an HMO clinic and be seen by an HMO-employed physician (or other professional). This physician acts as a "gatekeeper," deciding whether and how to treat the illness directly and/or what referrals are appropriate. Referrals are normally to specialists within the HMO organization, who then decide on further treatments. Services that are not specifically recommended and performed by HMO doctors are not usually covered by this insurance. Deductibles on HMO plans are usually low and often zero. Copayments are also usually lower than fee-for-service plans. The customer saves out-of-pocket costs, but gives up some choice over providers and treatment options.
The public health systems in Canada and the U.K. operate like a universal HMO, with funding from general tax revenue rather than insurance premiums. Costs are lower under these systems, but patients have less decision-making power and are often subject to long waits for non-emergency procedures. (A recent book comparing national systems for allocating health-care resources is Henry J. Aaron and William B. Schwartz, Can We Say No? The Challenge of Rationing Health Care, Brookings Institution Press, 2005.)
Proposals to reform health-care policy
The annual Economic Report of the President (ERP) is written by the president's Council of Economic Advisors and published early each year. In addition to a basic assessment of the condition of the overall economy, it contains chapters that cover specific parts of the economy on which the administration wants to focus policy attention.
Both the Bush Administration (in 2006) and the Obama Administration (in 2010) devoted a chapter of the ERP to proposed health-care policies. Chapter 4 of the 2006 ERP (full ERP link / local link to chapter) is called "Improving Incentives in Health Care Spending." It discusses some ideas that the Bush Administration economists proposed for health-care policy. Chapter 7 of the 2010 ERP (full ERP link / local link to chapter) is called “Reforming Health Care” and includes a discussion of the Senate and House versions of the reform bill that was eventually enacted in compromise form months after the 2010 ERP was published.
Each of these chapters is 20-35 pages in length, but they should be easy reading. Peruse the chapters to get an idea of how the Republican and Democratic administrations have approached health-care policy, focusing especially (but not exclusively) on the sections that deal with health-care markets and costs (pp. 88-97 of the 2006 report and 185-191 in the 2010 report) and on their policy proposals (100-105 in the 2006 report and 202-210 in the 2010 report).
Questions for analysis
1. Why is it that the current U.S. health-care market might lead to overuse of some health-care procedures and to misallocation of resources?
2. Many health economists viewed HMOs as having the potential to reduce wasteful health-care spending. Indeed, HMOs often charge lower premiums than fee-for-service plans. Why might HMOs be able to lower health-care costs? Are there any "negative side effects"?
3. Compare the policy approaches of the Bush and Obama Administrations on each of the following issues:
- Expanding access to basic health care
- Dealing with inefficiencies caused by moral hazard
- Dealing with inefficiencies caused by adverse selection
- High costs induced by malpractice insurance
- High costs induced by high drug prices
4. Overall, which set of proposals do you think is stronger on access issues and which set on cost-control issues?