Free market healthcare and 2nd best economists

The conservative line of policy analysis as to why healthcare in America is so expensive is simple. People are too insulated from the actual cost of delivering goods and services so they massively overconsume.  Making people pay for 80% or 90% of their acturial value of care with a catastrophic insurance policy to take care of outliers would make people much more price sensitive and cause healthcare expenditures (in the short term at least) to crater as people decide that their broken leg can be treated better with whiskey and duct tape rather than a series of pins and screws inserted along the fracture zone.  There is the minor problem of a dramatic drop in herd immunity as people will massively underutilize vaccinations and other long term preventative care, but those moochers will die quickly as the market intended. 

Dani Rodrik in 2007 had an awesome post defining the two major tribes of economic policy analysis. 

I think the best way to understand the source of these disagreements is to recognize that there are two genres of economists. I call them “first-best economists” and “second-best economists.” Here is my guide to them.

You can tell what kind of an economist someone is by the nature of the response s/he offers when confronted with a policy issue. The gut instinct of the members of the first group is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up)….

Those in the second group are inclined to see all kinds of complications, which make the textbook answers inappropriate. In their world, the economy is full of market imperfections (going well beyond environmental spillovers), distribution and efficiency cannot be neatly separated, people do not always behave rationally and they over-discount the future, some otherwise undesirable policy interventions can generate positive outcomes, and general-equilibrium complications render partial-equilibrium reasoning suspect….Since they have given up on the textbook model, members of this group have an almost-infinite variety of “models” to choose from as they think of public-policy issues.

The first group’s instinct is always to apply the first-best reasoning to the case, ignoring market imperfections in related markets, while the second group almost always presumes some market imperfections in the system. I am over-simplifying a bit, but not a whole lot.

I worship at the book of Herb Simon, I genuflect in the direction of behavioral economists, and I say five “Our Agglomorations per historical coincidence” every night.

I will agree with first best economists that there are some serious market imperfections and distortions in the healthcare market, but I have amazingly strong doubts concerning the power of “liberated” consumers to spend their own dollars in controlling healthcare costs without seeing a significant spike in mortality.  Let’s go below the fold to talk about an area where free market reforms could lead to improved outcomes and lower expenditures.

Provider pricing is amazingly non-transparent, byzantine and convoluted.  In a well functioning market, similar procedures at the same facility should be pricing very close to each other.  In a well functioning market, similar procedures at different facilities should (quality and risk adjusted) have price clustering.  That is not the case. 

When I had my vasectomy, the total contracted rate for that procedure had six different options.  The options were dependent not on any unexpected complications or choices of anethesia, but on what fee schedule I was on.  If I was on Medicaid, the contracted rate would have been roughly half of the rate I actually paid.  Medicare would be different, Exchange narrow would be different, Exchange broad would be different, and out of network would have been different.  The pricing variation increases if I went to a different facility such as a community hospital or an outpatient surgical center. 

Uwe Reinhardt has a good explainer in the New York Times about the original Medicare payment system and the incentives for price inflation it set up:

Medicare was required to reimburse each individual hospital (and other inpatient facilities) retrospectively for all the money that individual facility reported having spent on treating Medicare patients. These pro rata costs included operating costs, annual depreciation of the capital investments in the facility, interest of debt incurred to finance that capacity and, for investor-owned hospitals, a guaranteed rate of return to equity capital invested in the hospital….

organized medicine struck a deal under which each physician (and certain other professionals) was to be paid his or her “customary, prevailing and reasonable (C.P.R.)” fee for each service…..

 

These systems beg for ever increasing costs for the same service to be performed.  There is another major cost driver in Medicare pricing.  Medicare pays academic medical centers a training bonus on all fees  to cover the slowdown implied in training new docs and other professionals.  There have been modifications since 1965 but the basic structure has been set up for several generations.  This would not be a problem except that almost all commercial price schedules are derived from Medicare pricing.

Setting consumers against a non-transparent pricing structure where the pricing had almost no reflection to the average or marginal cost of a procedure is a situation that is destined to fail if we want to keep people healthy, alive and non-bankrupt.  The power imbalances are too strong. 

However, de-bundling Medicare payments into a variety of separate payments would be a step that most first and second best economists would agree would be an improvement in the market for healthcare.  Major academic medical centers would receive a training subsidy that is explicitly separate from their care payments.  All facilities would receive a separate capital reinvestment payment that could be calculated on some average rate of reinvestment to minimize the incentive to overinvest in capital instead of bundling capital investment costs into every single procedure code’s billable amount. 

 This would not equalize prices for Medicare across a market.  There would still be pricing differentials, but the procedure level pricing would be flattened a bit and slightly more transparent.  It would be a step to cleaning up the dysfunctional health care market, but it is not the only required step.

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37 replies
  1. 1
    Cervantes says:

    Herb Simon fan, eh? That makes sense.

    He was a great guy.

  2. 2
    Aimai says:

    Makes me think about terry pratchets Tiffany Aching character who has not first sight and not second sight but third sight.

  3. 3
    maximiliano furtive, formerly known as dr. bloor says:

    Unbundling might help overall costs, although it seems to me the capital and training funding will be sitting ducks when it comes to future budgeting.

    More to the point from the consumer’s point of view, this is all very interesting but the ultimate question is, “what’s my out-of-pocket expense for this?” As long as Hospital X’s and Hospital Y’s charges for a vasectomy both exceed Mr. Jones’s deductible, there’s no real incentive for him to comparison shop the way you did.

  4. 4
    Elizabelle says:

    Another morning, another good post by bjdick Richard Mayhew.

  5. 5
    mattH says:

    Had no idea that institutional pricing methods had so distorted prices. Thanks for the post.

  6. 6
    Nylund says:

    I will agree with first best economists that there are some serious market imperfections and distortions in the healthcare market,

    Admittedly, I’ve only been awake for about 90 seconds, but this sentence doesn’t read properly to me. First-Best economists typically assume there aren’t any market failures, which is why taxes and regulations only create distortions that make outcomes worse. It’s Second-Best economists who think markets are imperfect and that the first-best solution is impossible. Thus, they sugest we go for the second-best options, which often require the sort of market interventions you wouldn’t otherwise suggest were the market perfect and the first-best outcome possible.

    In other words, first-best think there are NOT imperfections, so market intervention creates distortions. Second-best think there ARE market imperfections, thus interventions can improve the flawed market outcome.

    Granted, the “first-best” types mostly lost this argument. These days, they admit perfections, and admit that market intervention could, in theory, make things better. Still, they don’t recommend such interventions, for there is a new boogeyman, “unintended consequences.” You see, whatever you do to try to counteract the market imperfect will create an unknowable new set of problems, so you shouldn’t try to fix anything…or something like that.

  7. 7
    greennotGreen says:

    Separate, separate, separate.
    But thanks for the useful and informative post.

  8. 8

    Slightly related, but Apple CEO Tim Cook told a right wing think tank shareholder to go fuck themselves after they demanded he dump the company’s green initiatives.

    Said the global-warming-denialist National Center For Public Policy Research:

    We object to increased government control over company products and operations, and likewise mandatory environmental standards. This is something [Apple] should be actively fighting, not preparing surrender.

    Said Tim Cook:

    We do a lot of things for reasons besides profit motive. We want to leave the world better than we found it.

    Get out of the stock.

  9. 9
    Richard Mayhew says:

    @Nylund: My understanding of Rodrik’s taxonomy is that first best economists acknowledge market frictions, but those frictions are usually externally imposed distortions that can be alleviated by more Free Market!

  10. 10
    Barry says:

    I would also add that the first-best right-wing economists have a long track record of being 100% full of sh*t, and of advocating schemes which were thought up by people trying to rip the rest of us off.

  11. 11
    Richard Mayhew says:

    @greennotGreen: updated — this is what I get for posting before coffee.

  12. 12
    Richard Mayhew says:

    @Barry: there are some first best economists that are not conservative or reactionary. There is a strong correlation between assumptions and political outlook, but not 100% correlation

  13. 13
    Richard Mayhew says:

    @maximiliano furtive, formerly known as dr. bloor: I’ll modify that statement a bit — as long as Hospital X and Y procedure costs exceed the deductible for Mr. Jones and Mr. Jones does not have co-insurance, he is indifferent.

    At that point, tiering and steering begins to make sense.

  14. 14
    PurpleGirl says:

    You have extreme pain in your leg. X-rays do not show what could be causing the pain. The doctor orders an MRI. The radiologists report comes back with a number of conditions. The lay person cannot pick and choose what to do as they do not have the education to tell the differences, pros and cons of any one or two treatments. The lay person, in pain and unable to walk, depends on the doctor to say, we’ll should do X. X costs $12,000 total. Another procedure may be less but not appropriate for that person or as effective as surgery.

    I think this is the fallacy of the market. Information is equally held or understood.

  15. 15
    Violet says:

    Many people go to doctors when they are sick or in pain. They may also have waited to go, hoping they’d get better. Sick or in pain people are not in the best place to make judicious health care decisions. It’s not like your non-urgent vasectomy that you could have had this year or next year and outside of some minor birth control inconveniences, it wouldn’t make a huge difference to you.

  16. 16
  17. 17
    RSA says:

    I worship at the book of Herb Simon

    You are the man. I was lucky enough to have a brief public conversation with Simon when I was a grad student giving a talk at an AI symposium. It was a disagreement, but oh, well… :-)

  18. 18
    Viva BrisVegas says:

    The conservative line of policy analysis as to why healthcare in America is so expensive is simple. People are too insulated from the actual cost of delivering goods and services so they massively overconsume.

    It’s a pity that there aren’t any real world examples of how price pressures on health care services are really affected by government regulatory structures.

    If only there were places, countries even, where government control and regulation of health services has not only resulted in reduced health care costs compared with the US, but also better health care outcomes.

    But I can’t think of any.

  19. 19
    hoodie says:

    @Richard Mayhew:

    people are rational and forward-looking to the first order of approximation

    Anyone who believes this is is hard to take seriously. I’m sure there are exceptions, but the conservative economists that get the most play are kind of like failth-based aerospace engineers, you wouldn’t want to fly on any plane they designed.

  20. 20
    Yatsuno says:

    @Viva BrisVegas: Heh. Rub that salt in a bit deeper why dontcha.

    We’re getting there. ACA is the first step in the major divorce of healthcare from employment that needs to happen in this country. No nation gets there overnight, we’re just behind the curve a bit. Of course we’ve also had the answer staring us in the face since 1965…

  21. 21
    Dexter's new approach says:

    I agree with the points about the nature of healthcare consumption is not best understood in a well-functioning market view. A knee replacement might work out well (for some) in the market model, with time to research, learn options, (possibly) shop for estimates, and weigh cost-benefit. But not for most healthcare interactions.

    In any given year, half the country consumes little to no healthcare, while 5% consume half of all spending. So most spending is with people who are very sick, blowing through whatever HSAs and deductibles they might have had in the perfect world market. That means again that most of the speeding decisions still lie with doctors (he’s the expert, right?) and the insurance companies that are paying the bills.

  22. 22
    Dexter's new approach says:

    I agree with the points about the nature of healthcare consumption is not best understood in a well-functioning market view. A knee replacement might work out well (for some) in the market model, with time to research, learn options, (possibly) shop for estimates, and weigh cost-benefit. But not for most healthcare interactions.

    In any given year, half the country consumes little to no healthcare, while 5% consume half of all spending. So most spending is with people who are very sick, blowing through whatever HSAs and deductibles they might have had in the perfect world market. That means again that most of the speeding decisions still lie with doctors (he’s the expert, right?) and the insurance companies that are paying the bills.

  23. 23
    Villago Delenda Est says:

    One does not go shopping for health care like one shops for say a new hard drive or a car.

    It just does not work out that way.

    Sometimes “the market” is a really, really, really stupid paradigm to apply to a situation.

    Also, too, what Viva BrisVegas: said at 18. Just click the link.

  24. 24
    Tommy says:

    I have a question Richard. Lets just say those with health care might over-consume. What about a person like myself. I am blessed and rarely do I get sick. When I do get a cold or something, I don’t run to the doctor. I drink a lot of orange juice, lay in bed for a day, and just deal with it. In the past 25 years, most of which I had about the best health care money could buy, I’ve been to the doctor once. Yes once. ER once, but that was cause I got clipped by a car on my mountain bike and I didn’t really have much of a choice.

    Do any of these studies look at how somebody like me might off set a person that goes to the doctor at the drop of a hat? Just curious.

  25. 25
    Villago Delenda Est says:

    @hoodie:

    I’d add that anyone who seriously thinks this (“people are rational and forward-looking to the first order of approximation”) needs to be beaten with a clue-by-four repeatedly until they stop “thinking” this.

  26. 26
    Richard Mayhew says:

    @Tommy: A person like you is barely in the universe of people using healthcare, so you’re barely counted in the health expenditure research. An insurance company loves you and if they could, they would be sending you flowers every month.

  27. 27
    Richard Mayhew says:

    @Villago Delenda Est: Oh, I completely agree. It is a useful model to play with as long as everyone understands the assumptions (realistic and unrealistic) that are in being implicitly and explicitly being made. It is a nice, neat model for potential ideal agreement zone definitions, but it is not anything approximating the real world.

  28. 28
    Villago Delenda Est says:

    @Tommy:

    The assumption that is made is that there are a lot of hypochondriacs out there who just love to sit in doctor’s waiting rooms all day waiting for the doctor to minister to their needs. Apparently this drives all “conservative” thinking on health care. It’s similar to all the “those people” assumptions on food stamps and medicaid.

    I don’t know who these people are, because frankly I dread doctor visits, and want to avoid doctors as much as I can. What I do know is a lot of “conservatives” are projecting on to everyone else, and the “conservatives” are the ones who should be closely monitored for overconsumptive behavior. Once we’ve confirmed this behavior, bring out the clue-by-fours for some remedial actions.

  29. 29
    Villago Delenda Est says:

    @Richard Mayhew:

    Yeah, but the problem is that these people (“conservatives”) don’t seem to understand the concept of “assumptions”, too.

    A great number of economists (particularly the ideologically driven of the “Chicago school”) insist that people are rational actors every time they open their wallets. Uh. Huh.

    Idiots.

  30. 30
    Tommy says:

    @Richard Mayhew: I figured that might be the case. Until five years ago when I started to work for myself I had amazing insurance. I mean the best of the best. At some level I was like darn, wish I could have used it. Now the ACA got me a much better plan then I had, but still nothing like I used to have.

    I got dental, but not vision. Kicking myself cause I just went in for an eye exam. It was only $77 which seemed fair. But my lens alone will cost $462 (not including frames). Best I can tell I have a slight problem, sitting in front of a computer for 12+ hours a day for almost three decades, well isn’t the best for your eyes and I need a “strange” set of glasses.

    What I am VERY happy about, as I push my mid-40s is that preventive care is covered. Getting to that time in my life where I need to head to a doctor just to ensure nothing is wrong, even if I feel fine.

    BTW: I would take some flowers from them.

  31. 31
    Tommy says:

    @Villago Delenda Est: I will admit the folks I know fall into two groups. People like myself or brother who are blessed with amazing health and never go to the doctor. Then I do know a fair number of people. and honestly I don’t know if they just get sick a lot or they are something close to hypochondriacs. They seem to be at the doctor like monthly. I don’t judge them in the least, cause I honestly am not in their bodies and I don’t know how they feel. But it always did seem a little strange to me.

    I also really don’t like doctors much. Back in the 70s as a kid my parents thought I was a little “off.” Flew me around to experts that wanted to drug me. My parents were like no way is that going to happen. Thank god they didn’t. I mean I might me somewhat OCD, but I’ve learned to live with it, and even use it to my advantage.

  32. 32
    Fair Economist says:

    The idea that consumers can “rationally” allocate health expenditures is preposterous. It takes about 6 years of over-full-time education to be even passably good at diagnosis and treatment. A classic example of how “efficient market” theories rely on assumptions (in this case free information) which are completely and utterly false in the real world.

  33. 33
    🎂 Martin says:

    Very simply, a free market is one where all participants can opt out. Some markets can never be free. Healthcare is one. You can refuse to take your kid with a broken leg to the doctor, but you’ll later be arrested and your child taken from you. You can discharge your 30 week preemie AMA, and when it dies later that day from hypoxia, you’ll be arrested. The free market must be regulated because instrumental to the law of supply and demand working is that demand can be controlled from the demand side. That is, you can leave the demand side of the equation. You can opt out of the market. And THAT is what keeps prices in check – not choosing a cheaper alternative. If you can’t leave, then supply and demand doesn’t work, and regulation is needed.

    Health care overall cannot ever be a free market. It serves no purpose to describe it as a free market. If you think it can be, you’re wrong. Period. And anything you say after that should be ridiculed not because you misunderstand healthcare, but because you have no idea how market forces actually work.

  34. 34
    Villago Delenda Est says:

    @🎂 Martin:

    But…but…”invisible hand”!

    Stupid motherfuckers have never cracked open The Wealth of Nations, let alone actually understood it.

  35. 35
    JustRuss says:

    @Villago Delenda Est:

    The assumption that is made is that there are a lot of hypochondriacs out there who just love to sit in doctor’s waiting rooms all day

    This. Yes, there are few hypochondriacs and neurotics who would be happy to spend every day at the doctor’s for the attention. Then there’s everybody else, who have lives to live and things to do and really don’t want to waste their time sitting in a waiting room unless something’s wrong,

  36. 36
    Chris T. says:

    In Republican Heath Care world, husband and wife are driving past the hospital and see a sign: “SALE! KIDNEY TRANSPLANTS 50% OFF IN APRIL!”

    “Oh, look, honey! Let’s go do that kidney transplant while it’s on sale!”

  37. 37
    muddy says:

    @Villago Delenda Est: They have this identical attitude toward guns as well. Good guy with a gun vs. bad guy with a gun, so clear. No mention about the vast majority of shootings that involved incompetent guy with a gun, or drunk guy with a gun, or plain dumbass guy with a gun.

    All or nothing, black or white, projection of their own issues onto others. It’s pretty child-like thinking.

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