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By JohnGaltII
June 21, 2004

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I have been involved with multiple discussions on the economics of health care on multiple boards in the last couple of weeks. As a result, I have attempted to gather my thoughts in one place. This is my attempt, with substantial background included:


The first principle that needs to be understood is the concept of elasticity. This is a measure of how much a change in price will effect a change in demand. It is affected by a wide variety of things, which can be generally stated as the aggregate of each person's assessment of the item's relative value and the cost that he is willing to bear in order to obtain that value.

In the case of health care, the value of the service provided is generally proportionate to the seriousness of the malady. While no one would pay $1000 to have a cold treated, that price would be considered a bargain for the successful treatment of cancer. The underlying value is the sustaining of the patient's life, the reduction of morbidity, or the easing of discomfort.

Supply, Demand, Profit and Shortages

The purpose of any economic system, whether government directed or the free market, is to allocate available resources. In the free market, this is done using price. As the aggregate demand increases, the price goes up, producing an incentive for others to enter the market. The entry of new participants increases the aggregate supply dropping to price back down to its equilibrium point where supply and demand at that price are equal. The reason that new participants enter a market is in expectation of making a greater profit than if they pursued another course.

Government interference does a number of things. If the government interference is in the form of regulations and compliance costs, this will reduce the supply. People will not continue to produce a product or provide a service where their income does not provide a sufficient return on their investment of time or capital. This reduction in the supply results in higher prices, which reduces the demand creating a new equilibrium point.

Note that there is no external action required to be sure that the demand at the current price is met. There cannot be any shortages in a free market by definition. The profit motive encourages others to move into a field if the price is higher than a product could effectively be produced. This produces an efficient mechanism for allocation of all resources - raw materials, capital, and individual efforts. In short, profit is the price tag of efficiency.

Enter the government. If the government passes laws to reduce prices, the inevitable result will be a reduction in profits. Many people will no longer find it profitable to continue in the field and move to something that is more profitable. This will reduce the supply. But at the same time, since the price is lower, the demand will increase. So you have a gap between the aggregate supply and the aggregate demand; the result is a shortage. In the old Soviet Union this was commonplace; but it is also common in the U.S. where the government has interfered.

Once the government has intervened in the free market and created a shortage, there are two options. The government solution of rationing, and the adaption of the free market to the regulation. A perfect example of both was in the 1940's when the government instituted wage and price controls during World War II. This created an increased demand for workers and for products, while there was a shortage of both. The government solution was applied to things such as gasoline. There was a shortage of gasoline, and the price was controlled, resulting in rationing. In many places, gasoline ration coupons were used in trades; almost as a secondary currency. The effect on manufacturing was mixed - A substantial portion of the manufacturing base was converted to making war supplies (e.g. tanks, guns, artillery, munitions, etc.) limiting the availability of the goods previously produced. The market was allowed to respond with higher prices due to a decreased supply. Unlike manufacturing where there was central coordination of what would be manufactured, the allocation of the labor pool was left up to the free market exclusive of controls on wages. This created a huge loophole; while wages could not go up, fringe benefits could be increased. A major fringe benefit that was added was health insurance. By competing on fringe benefits, women who would otherwise stay at home were encouraged to enter the job market, and they responded, giving us "Rosie the Riveter". More on this later.

Far reaching effects

But interference by the government in the free market can have even more far reaching effects. Take, for example, rent controls. When rent controls are imposed, they have multiple effects. While they hold down prices, this ends up producing a gap between supply and demand. Note that before rent controls are applied (absent other government interference) the problem is not a lack of housing at the current price, but a lack of some arbitrarily defined "affordable housing". Housing is priced as it is because of supply and demand. The return on investment (which is directly related to the profit margin) is, on average, about the same as expected return from other areas where one's time and capital could be invested. If the profit margins were higher, more people would build housing increasing the supply and reducing the demand. If the profit margins were lower, people would move to other areas where they can generate a greater return on investment, decreasing supply and increasing profit margins.

When the rent controls are instituted, a number of things happen. First, new construction slows. Why invest in a new building if you will not be able to generate the return on investment that you could if you invested elsewhere? Second, in an effort to sustain the profit margin, service is reduced. In an upscale building, the doorman may be let go, or private security eliminated. Alternatively, the amount of money spent on upkeep might be reduced. Eventually the service will drop to nothing, and the upkeep will be the minimum possible. This is all obvious expected results. But there are less obvious results, too. People who would otherwise move out of larger apartments stay because they cannot find comparable smaller ones at a lower cost. So a couple whose kids are on their own will continue to keep their 3-bedroom apartment. This aggravates the housing shortage even more. The end result of all the activities is that the resources (apartment space) is inefficiently used (couples living in a three or four bedroom apartment), the curtailing or complete absence of new construction, and the reduced quality of the housing that exist. The latter is especially troublesome because eventually the cost of maintaining the property on even a rudimentary level (e.g. providing heat) becomes greater than the receipts and the property is abandoned.

Subsidization & Regulation

There have been multiple attempts at partially regulating areas of the economy. They have been uniform failures. In the 80's Savings and Loans (remember them) were partially deregulated. The risk was deregulated, the insurance was not. So there was all sorts of incentives to speculate. Worse case, the FSLIC would bail you out. The result was obvious to anyone who cared to look. Paul Pilzer (a member of the Reagan's board of economic advisors) even warned about [it] prior to it happening. When Congress ignored him, he wrote a book, Other People's Money, which came out shortly before the S&L debacle and bailout. Similarly, California partially deregulated the electrical industry - and the result was the disaster of a couple of years ago.

While it is true that all industries are regulated to some extent, the primary problem comes from the regulation of one part of the equation, but not regulating a counterbalancing area. The risks that the S&L's could take were deregulated; but the cost to the S&L's for taking risks continued to be regulated, and by doing so, shifting the cost to others. The result is generally converting from a fully regulated industry to a highly [regulated] industry where risk is highly subsidized, leading to unnecessary risks. This meant that the S&L's could take increased risk, but would not have to bear the cost of the increased risk; they would receive the benefit if they were right, they would lose nothing if they were wrong - FSLIC would pick up the tab. This is not unlike flood insurance, where people are subsidized to live in areas prone to flooding.

Partial regulation can work to an extent, but self-regulation is always more effective. McDonald's makes sure that its restaurants are clean, not because the law requires it (though it does), but because they will not stay in business long if the customers keep getting food poisoning. This becomes abundantly clear when one looks at a case in Atlanta. There is a water park that several years ago was independent. One kid with diarrhea pooped in one of the pools, and the ultimate result was two or three cases of E. Coli meningitis and two or three deaths. The water park basically went out of business, but was bought out by Six Flags theme parks. Yet they were following all of the government regulations.

Partial regulation creates problems when it creates perverse incentives, as in the case of the S&L's, the California Electricity crisis, or flood insurance. These perverse incentives result in effective, if not direct subsidies and are caused by the government tends to relinquish authority while maintaining ultimate responsibility. While regulation in general is usually counter-productive (I can't think of an example where it is not, though I'm sure there is one or two examples out there), partial regulation, when resulting from partial deregulation, is almost always a problem because of the incentives created.

Health care is a perfect example; perverse incentives in health care abound, which will be discussed next.

Rosie's Effect on Health Care

The far reaching effects of government interference become apparent when we examine Rosie the Riveter's effect on modern health care. As discussed previously, the wage and price controls of World War II resulted in companies competing for labor via fringe benefits, one of the most popular ones being health benefits. Once the war was over, it is pretty hard to eliminate benefits from workers, just as it is difficult to cut their pay. As a result, health benefits became the norm. At that time, all that was provided was catastrophic care. This was generally reflected in a $250 deductible and a 20% co-payment on the next $5000, or some similar type plan. Since office visits were generally less than $10, and a night in the hospital less than $100, in any given year most people never received any benefit.

During the time where most people in a given year did not receive any real benefit from medical insurance there was a huge incentive to keep the price down. Since people would be paying out of pocket for just about anything that was done, the elasticity of care for minor problems was fairly high; a significant increase would substantially reduce visits and therefore profits. Major problems involving long hospitalizations, or other expenses were generally kept in check indirectly. Since the cost of one night in the hospital would often be paid out of pocket, there was a need to keep that price down; ditto for medical fees. Insurance companies would not pay more for single visit of ten nights in the hospital than it would be charged for ten visits of one night each.

Over the next several years, the combination of inflation and advances in medicine created a situation where it was quite common for people to spend more than $250/year on medical care. (This was further aggravated by other government interferences discussed below.) If the expectation was that the deductible would be used up anyway, the patient would consider only the cost of the co-payment, which would tend to be 20% of the actual bill. This means that if the bill for an office visit was $30, the increased cost to the patient was only $6. The remainder of the tab would be picked up by his insurance company, who would pass it on to his employer. Since there was a cost to the patient, this wasn't a "free lunch", but it was a highly subsidized one. This lead to the elasticity changing; the drop in demand that would have previously resulted from a $10 increase in costs would now require a $50 increase in costs. This meant that doctors could increase their charges five fold, were it not for the restriction on charges being "usual, customary, and reasonable" (UCR). This restriction was generally interpreted as any amount up to 10% over the average charge. Once the average charge was determined, however, it would lead to doctors increasing their rates to 10% above that, pushing the UCR rate up rapidly.

Two other factors also were involved in the increasing cost of medical care. In 1964, in an effort to correct some of the problems which were created by prior government interference, the government passed the Medicare authorization bill and Medicaid followed soon thereafter. The result was that Medicare started setting de facto prices for many things. The Medicare prices were heavily weighted toward procedures rather than thinking. The market responds as one might expect: Since doctors had a financial incentive to perform procedures, they performed any procedure that could be justified. This increase in procedures being performed substantially increased health care costs, with minimal benefit to the patient. Furthermore, it was rare that the government would reevaluate their payments; generally just indexing them to inflation. This created some really unusual incentives, too.

One such example of perverse incentives occurred with the advent of flexible colonoscopies (numbers are approximates). When the units first became available, they cost close to $100,000 and the cost per use was in the hundreds. Medicare, as a result, agreed to pay $1000 for each procedure. They indexed it for inflation using the CPI, but did not take into account the reducing cost of the technology. In a few years, it was possible to buy a unit for less than the reimbursement from a single procedure. This created such an incentive that papers were published, which attempted to find any possible reason to do the procedure. Standards of care were developed calling for one procedure per year in those over 65 (e.g. in those on Medicare).

The other factor increasing the cost of medical care was the breakdown in our tort system. This resulted in a substantial increase in lawsuits, payments to get rid of nuisance suits, increasing malpractice insurance premiums, and ultimately increases in actual costs to the doctor, which are passed on to the patient. But what is missed is that the psychological toll causes otherwise better qualified individuals not to pursue a medical career and current doctors to leave the field. This reduces the quality of care marginally and increases the risk of real malpractice. Furthermore, it has the cost of doctors being unwilling to go into certain fields, such as obstetrics and trauma. The lack of the former can result in long drives to hospitals where there is care and subsequent harm to the baby (increasing infant mortality); the latter can result in the lack of available care for victims of serious accidents. In both fields, there are areas where it is a four or five hour drive to the nearest qualified specialist. Neither of these can be solved by further government intervention in health care; only by correcting the abuses in tort law (loser pays is probably the best solution).

However, with the continued increase in cost, in the late 1970's the government decided that it had a fix for the problem. It was going to start encouraging Health Maintenance Organizations (HMOs). The theory was that by emphasizing preventative care, costs would drop. This HMO model, however, calls for a large monthly payment and a very small co-pay, often $2 or $3, with each office visit. Now the subsidized lunch has become practically free. When previously a mother would go to the drug store and pick up a $5 bottle of Dimetapp for her child, she now runs to the doctor, pays $2, and has a prescription equivalent given to her, along with the added assurance that there was nothing seriously wrong. Ditto for adults. If it is inconvenient to get off work, just head down to the Emergency Room. It doesn't matter, after all, someone else is paying the bill. At this point, the elasticity is essentially 0. The patient is immune to the cost of health care.

At this point the connection between seeing a doctor and the cost of care has been totally separated for many. Even though co-payments have increased to $20 in many cases, there is little disincentive left to take up the doctor's time with nuisance complaints. Imagine As a result, the cost of medical care has grown rapidly. This is an inherent problem with third party payers - the one initiating the expense has no apparent incentive to hold it down. Medical insurance has mutated from a catastrophic care policy to virtually full coverage. Imagine if you had full coverage on your automobile; when you had the oil changed or a tune up done it was paid by your insurance company. Imagine the cost of your homeowners policy if it covered routine lawn care. Automobile and homeowners insurance is as low as it is specifically because they are both catastrophic coverage, as all insurance should be.

All this is a series of attempts to correct one stupid policy in the 1940's - controls on wages. Had the controls never been placed, the actual cost of hiring an employee would have been lower, and we would not have this mess we have now. Because of the previous government intervention, we have people receiving medical services for pennies on the dollar, with the balance picked up by third parties; people sticking with current jobs because of pre-existing conditions; and people overusing what are essentially free services creating huge, unnecessary expenses. The solution is to eliminate incentives to continue the current third party payer system, not to replace it with a government run third party payer. Adopt laws that favor individual policy ownership with protections and create a disincentive to be a third party payer, transferring the cost of insurance and medical care to the insured, rather than insulating him from it. The first part has been done though the formation of Health Savings Accounts (HSA) in the recent Medicare bill. The latter has yet to be even seriously discussed in Washington.

"But," you ask...

"Isn't Health Care to precious to be left to the marketplace?" The response is obvious. What is more important to sustaining life, food or health care? Without food you will die in a few weeks at best. Without health care, you may live for many years. Yet food is provided in such abundance through the free market that one of our major chronic health problems is obesity, too much food.

"Aren't government run programs better and more efficient?" This depends on how you answer the question. In Canada, there is a two-tiered system. Those who use the government run system and those like former Prime Minister Pierre Trudeau who came to the U.S. in order to get his heart surgery. There are those who spend months in bed waiting for surgeries such as hip replacements and bypasses who would get it within 24 hours in the U.S. The government, unable to allocate based on price, is forced to allocate via rationing. A graphic example of this is the case of a baby born in Toronto with a heart disorder called Transposition of the Great Arteries (TGA). If not treated immediately, it is a lethal defect, usually by one week old. If surgically corrected promptly, the children can lead long lives. The parents of this child were told that the child could get the surgery in three weeks - two weeks after he most likely would have been dead. The only reason the child survived is the parents contacted Children's Hospital of Philadelphia who agreed to do the surgery. Only after this hit the newspapers did the Toronto Hospital for Sick Children suddenly find they could squeeze the child in.

"If government run programs are not better, aren't they more humane to cover everyone?" This is a common falsehood. It is true that if two people are the same demographically and have the same illness, if one gets treatment, so will the other. However, there are treatments that are either not made available to everyone. Just ask anyone who needed dialysis in Britain and reached 65 prior to the legalization of a private health care system outside of the government run program. Wait... You can't. They are all dead. This is because in an effort to save money, there was no funding for dialysis for patients over 65. Anyone with kidney failure who could not move out of the country died shortly after turning 65. This is humane?

"But won't the cost savings to business make them more competitive?" Someone has to pay. And government enterprises are notorious for being inefficient. Just compare any government school system to private schools of the same quality. The private schools operate for much less. Someone will have to pay, and whether it comes out consumers through higher prices at the checkout line as it does now, or whether it comes through higher taxes taken out of your check giving you less to spend in the checkout line is irrelevant. The cost must be paid. And if you are a student of history, government, or economics, you know that the cost will be higher if it is first filtered through the government. Let's face it; it was the Air Force, not United Airlines that spent $400 for a toilet seat.


Government interference in the economy has never worked. It has not worked for housing, it has not worked for wages, it has not worked for manufacturing, it has not worked for commodities, and it has not worked for health care. There is no reason to think that it will work if only the government interference is increased.

What has worked consistently is the free market. Allocation of all things are given to those based on how much each person values it. When the government interferes, it automatically creates problems by providing services which are not as highly valued while eliminating services which are more highly valued. But this is the precise reason for the interference. Once these problems become apparent, the government, instead of backing off completely, increases its regulation leading to even more problems. This sort of approach gave us a recurring social security "crisis", gas lines in the 70's, the S&L debacle in the 80's, and ballooning health costs becoming widely apparent in the 90's. Albert Einstein once said that the definition of insanity is doing the same thing and expecting different results. Government controls of the market have never worked. Why should the health care market be any different?



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