You Cannot Control Health Care Costs by Pushing Down Prices

One of the very first things all students learn in their first economics course is the meaning of the word “cost.”

They come to economics thinking that the cost of something is the price you must pay. Sometimes the two are equal. Often, they are not.

In a field such as health care, cost and price are almost never the same. They are usually not even connected.

It follows logically that if you try to control one of these variables by controlling the other, you will fail. And fail miserably.

The social cost of any good or service is its opportunity cost. If the only two goods were guns and butter, the cost of one more gun would be the value we place on the amount of butter we must give up in order to produce it. The cost of one more unit of butter is the value we place on having fewer guns.

The same principle applies to health care. What is the cost of training and employing a new doctor? It is the value we place on not having one more engineer or one more accountant or one more PhD in computer science. Similarly, the cost of one more hospital bed or one more piece of diagnostic equipment is the value we place on the alternative uses of the resources needed to produce them.

This simple truth, which every freshman student learns on the very first or second day of class in Econ 101, has not been discovered by some very bright people. They include some of the top health economists, the editorial writers at the New York Times and the paper’s Nobel laureate economics writer Paul Krugman.

For example, in a lengthy editorial  the Times declared that there are only two ways to bring down health care costs: deny people care or negotiate better prices. This is wrong on many counts, but the second option is especially wrong. The most common argument for single payer health insurance is the idea that if government were the only buyer, it could lower health care costs by using its monopsony power to bargain for lower prices. This idea has appeared numerous times in Krugman’s editorials.

Why negotiate? Why not just freeze all medical fees by edict? Answer: when it comes to health care, people on the left are incredibly unimaginative.

That said, I don’t know of any government in the world that negotiates prices in health care. In our own country, Medicare and Medicaid do not negotiate anything. They dictate prices on a take-it-or-leave-it basis. Increasingly, doctors are opting out – refusing to take new patients, especially in Medicaid. But there are no negotiations.

The only negotiations I know of are in the private sector. Walmart, for example, has negotiated fees with centers of excellence for certain types of surgery. Physician-run Medicare Advantage plans negotiate – usually asking for a different bundle of services in return for a different type of fee.

In many markets the price you are charged is equal to the social cost of producing the item you buy. That is one of the things we expect to happen in competitive markets. In medicine, however, things are different.

In this country and in just about every other country in the world, the market in health care has been so systematically suppressed that none of us ever sees a real price for anything. Every price we face is a phony price. And that is why international comparisons of health care systems are so misleading

The way national income accounting is done, the green eyeshades tally up all the health care transactions at their phony prices and arrive at one big phony number. There is not much to be gained by an international comparison of phony numbers, however.

That’s why first-rate health economists turn instead to a comparison of real resources. (How many doctors? How many nurses? How many hospital beds?) On this score, the U.S. does not spend more than other countries. In fact, we are in the middle of the pack. See this recent study.

Mark Pauly is a health economist at Wharton who made all the points I am making here  more than 25 years ago in an article in Health Affairs. Plus, Pauly actually estimated the opportunity cost of medical labor (doctors, nurses and technicians) in the various OECD countries. By one estimate, the U.S. shows up near the middle of the pack. But by another very plausible set of assumptions, we are near the bottom.

Here is what confuses many people – on the right and the left. We do pay our doctors more. But those payments do not reflect the true opportunity cost of medical care. If we put a 30% surtax on physicians’ incomes in the U.S., there would probably be very little change in health care delivered – at least in the short run. In the long run, the profession might attract less able medical students and we might end up importing more foreign medical school graduates. So, there might be long-run effects on quality.

Now let’s turn to solutions.

If you believe that people on the supply side of the market are making too much money at the expense of patients and taxpayers, there is an easy solution to that problem and there is a dumb solution. The easy solution is to impose a surtax on the providers and rebate the funds to everyone else.

The dumb solution is to have government set 6 billion physician fees, which is what Medicare is doing on any given day. When government sets that many prices – or even a small fraction of that many – it’s going to get a great many of them wrong. Specialties which are relatively over-paid will attract doctors and develop surpluses. Specialties that are relatively underpaid will develop shortages.

Also, when individual prices are set by the political system, they will be determined by the ebb and flow of special interest pressures, rather than the  needs of patients.

And what is true of physician fees is also true of hospital fees and prices for drugs.

Prices drive behavior. Interfere with them artificially (and stupidly) and you will get perverse behavior.

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