Why are Health Care Costs So Hard to Control?

Actually, it’s not all that hard. Name a routine test or procedure and I can probably show you somewhere in the world where you can obtain it for a very reasonable price, provided by doctors who are U.S. board-certified, or have received training in the U.S. or Europe, and are meeting the highest quality standards.

Here’s the hitch. In order to find low-cost, high-quality medicine, you have to go to places where (a) the third-party payers are absent and (b) normal market forces have not been systematically suppressed. (The only exceptions to this rule are few and far between and appear to be distributed randomly.)

Now before reading further, I would invite you to stop and ponder how remarkable the previous paragraph is. It runs completely counter to everything we have been told by the leading health policy analysts for the last three decades!

  Conventional view: Markets don’t work in health care and the only way to keep costs down and quality up is for third-party payers to tell doctors how to practice medicine.
    Reality: Low-cost, high quality medicine requires the presence of markets and the absence of conventional third-party payment.

Inquiring minds will immediately ask two questions: (1) Why have so many people been so completely wrong for so long a time? and (2) What is it about the nature of markets and third-party payment that makes my observation true?

I’ll save the first question for a later day (although feel free to e-mail me any theories you have — especially any psychologizing you have to offer) and proceed to the second.

All insurance involves a pooling of risk. Since people are naturally risk averse, this pooling is potentially valuable. Once resources are pooled, however, people have incentives to change their behavior and do things they would not otherwise have done. People with life insurance may kill themselves, or allow themselves to be killed, in order to leave a substantial sum to a surviving wife or children. (Fans of “Damages” will know what I mean.) People with fire insurance may be less careful about avoiding fires — particularly if they would like to redo their home anyway.

In health care, people with insurance obtain tests and procedures and even undergo hospital surgeries they would not have opted for had they been spending their own money. Economists call this type of behavior “moral hazard,” although there should be some sort of penalty imposed on the person who came up with that term.

How perverse are these incentives? Very perverse.

On the average, every time a patient in the United States spends a dollar on health care, only 12 cents comes out of his own pocket. On paper, therefore, we have an incentive to consume health care until its value to us is worth only 12 cents on the dollar. But the reality is even worse than that. All too often, where patients have the most discretion they often face no copayment at all; and where they have the least discretion, their copayments are irrelevant. (More on this in a future Alert.)

Bad as these incentives are, the perverse incentives are even worse on the supply side of the market. Almost nowhere in the health care system are providers competing for patients based on price. And since they are not competing on price, they have no interest in reducing the cost of care.

To make matters worse, the structure of health insurance almost guarantees wasteful spending. In particular:

  1. There is almost no similarity between conventional health insurance and the type of insurance a rational person would want. As explained here, rational insurance assigns responsibility for decision-making to the person in the best position to make those decisions and wherever possible decision makers bear the cost and reap the benefits of the choices they make.
  2. Historically, the model for conventional insurance was not designed for the purpose of controlling costs; it was designed to ensure that providers got their bills paid. For most of the post-World War II period, commercial insurers paid claims the same way Blue Cross did. Even Medicare paid bills the way Blue Cross did. But the traditional Blue Cross approach was not the product of competition in a free market. Blue Cross was created by hospitals and Blue Shield was created by doctors.
  3. The conventional insurance market is not the result of competition in the free market; it is instead the result of suppressing normal market forces. Special interest legislation allowed the Blues to so dominate the market, that providers could refuse to accept insurance that paid in any other way. Today, we are still living with that legacy.

Bottom line: Successful cost control does not require more laws, more regulations, more bureaucracy and more nondoctors telling doctors how to practice medicine. To the contrary, it requires liberating the marketplace. Not only does the market work in medicine, where it’s allowed to emerge, it’s proving to work quite well.

Comments (32)

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  1. Devon Herrick says:

    Corrective eye surgery and cosmetic surgery are both examples of how a competitive market in medicine could work. The average prices for cosmetic procedures have risen more slowly than inflation, while other medical services have risen at rates three times that of inflation.

  2. Virginia says:

    There’s probably an interesting study to be done regarding cognitive dissonance among those involved in health care regulation. Despite years of effort, health care markets are still dominated by the laws of economics. And that reality stands in harsh contrast to the idea that “if we can just regulate a little more or a little better, we can make health care affordable for everyone.”

  3. Dennis Lehew says:

    And it’s the same with bariatric surgery. With so many health plans excluding coverage for weight control, the marketplace has responded accordingly. Providers are agressively competing for private pay patients. And it seems patients who do opt to pay for their own surgery do a better job of following the doctor’s orders post-op. I’ve not seen any scientific studies but I’d bet the outcome is much better long-term than when insurance paid for the procedures and patients had less skin in the game.

  4. Earl Grinols says:

    The psychological reason for the fallacious widespread belief that “Markets don’t work in health care” is summed up in the remark that Ted Kennedy used at his brother Robert’s funeral: “Some men see things as they are and say, Why? I dream things that never were and say, Why not?”

    Most people merely repeat what they hear others say. For years, the observations of Galileo were simply dismissed by the experts because to change required original thinking and disagreed with their dogma. Original thinking would reveal that health care responds to market forces just like other knowledge-intensive services and products and that there are plenty of examples to show that they do.

  5. Don Levit says:

    A good example of trying, unsuccessfully, to incorporate market forces into health care, is to increase the demand.
    One increases demand by providing subsidies for products or services that are deemed too expensive in more “normal” times.
    Thus, we have the subsidies for people making up tp $88,000 per year!
    These subsidies are tied to a certain percent of GDP.
    If medical care conrinues to increase faster than GDP, the subsidies will not continue to increase faster than GDP in a few years (when the certain percentage of GDP is exceeded).
    I guess, then, and finally then, we will see a more appropriate demand function.
    Don Levit

  6. Elizabeth A. Reid, MD says:

    Here’s a little psychologizing about point #1. As long as we hide costs in the accounting books of insurance companies, we can fritter away one political season after another pretending the “healthcare problem” is just about access to medical care. We can avoid the tough questions about the goals of health care. Do we want to tie up the bulk of our resources the last 6 months of life, or can we acknowledge that intense intervention at the end of life adds a great deal of distress without much gain? How much do we waste and how much anxiety do we cause with extra tests and rules aimed solely at keeping the lawyers at bay? As we now begin to watch upcoming generations for the first time fail to exceed or even meet the life expectancy of their elders, can we admit that the high tech medical road we’ve chosen may be the wrong one? That real prevention is better than treatment? That real prevention requires education, patience, consistency and self-discipline more than obsessive searching for disease already present? That the research needed to tease out the ultimate causes of devastating diseases shouldn’t have to produce a saleable product until the answers are clear? It is so much easier to bury one’s head in the insurance morass than to lead the way in this kind of discussion – not to mention so much easier to get elected.

  7. Jennie Fiedler says:

    Yay, Dr. Reid! Prevention, education and precious, precious knowledge makes so much more sense. In a society that pushes indulgence and immediate gratification, education, patience and self-discipline are the real antidotes. It is not realistic to believe that if you break yourself like humpty-dumpty that someone can just put you back together again and restore you to complete health with no effort required on your part. Are we not the sickest we’ve ever been as a nation in this modern era? What is that telling us? Thank you doctor for your valuable insight.

  8. Bart Ingles says:

    I think the answer to the last comments is that insurance practices are discouraging may of the innovations mentioned.

    But mention “market forces” and someone always tosses out the mindless cliché about heart attack patients shopping for emergency care.

  9. Tom H. says:

    Great post. Most conventional health policy types don’t understand this at all.

  10. Jimbino says:

    Here in Brazil, I walked four blocks to see a doctor at the local “free” clinic. He saw 26 patients in 4 hours, spending 2 minutes with me to prescribe an antibiotic for a skin infection.

    Though I pay the socialist taxes to support this system that is mostly, let’s face it, for young clueless breeders, I did get my 28 pills without having to pay some $100 for what I already knew I needed and then pay through the nose at Walgreens for a prescription drug.

    I can get a 3-pill course of Mebendazole over the counter here, which would cost me over $100 in Obama’s USSA, what with doctor’s visits and the prescription mandate.

    Amerikans need to learn to cancel insurance and cross the border for cheap and effective treatment– at least until Walmart and Target clinics offer $10 2-minute doctor visits and $4 drugs (the latter they now do!!)

  11. Don Levit says:

    John Goodman wrote: “But the traditional Blue Cross approach was not the product of competition in a free market.”
    You’re exactly correct, John.
    In fact, this is why the Blues lost their federal tax exempt status in 1986, with the enactment of 501(m).
    This IRS paper gives a great summary on page 1.
    “Congress determined that although the Blues and plans similar to them historically operated in a manner that furthered community benefit and social welfare, these plans had evolved to the point where many of the characteristics that distinguished them from the commercial insurance carriers were no longer apparent. Therefore, there was no longer any justification for the continuing exemption for service benefit plans if their primary purpsoe was providing medical insurance indistinguishable from that provided by commercial carriers. It was Congress’ look at the Blues’exemption that served as the impetus for the enactment of IRC 501(m).”
    For tax-exempt insurers to properly earn their tax-advantaged status, plans like you suggest should be offered.
    In addition, the innovation and creativity are virtually limitless, as long as the carriers are distinctive and solvent.
    Go to: http://www.irs.gov/pub/irs-tege/eotopicl92.pdf.
    Don Levit

  12. Vicki says:

    Excellent post. But where is our musical pairing? We become spoiled.

  13. ilovebenefits says:

    One potential answer to question #1. It is a socialist mentality trying to operate in a capitalist environment. http://www.hcbn1.com

  14. The Apoplectic Left says:

    “Actually, it’s not all that hard. Name a routine test or procedure and I can probably show you somewhere in the world where you can obtain it for a very reasonable price, provided by doctors who are U.S. board-certified, or have received training in the U.S. or Europe, and are meeting the highest quality standards.”


    I guess it’s *not* that hard, John, when you surmise what you could “probably” find “somewhere in the world” and then build an argument on the speculative assumption! Nice song, Dorothy.

    As a general observation, the right makes the comfortable (to their fantasy view of the world) mistake of thinking people would ever shop for health care the way they do for a new car. They don’t. Many people, like me, avoid the health care system at all costs and don’t deal with it until they absolutely must. By then, it’s too late for shopping around: You’re sick, you’re injured. You’re in no physical or mental position at that point to shop around or negotiate for a discount. The whole notion of people doing so where their imminent well being is concerned is beyond ludicrous.

  15. Linda Gorman says:

    MEPS shows that the majority of spending on health care is not conducted under life or death circumstances. At least half of all the money spent to treat things such as cancer, heart conditions, COPD, diabetes, hypertension, and hyperlipidemia is spent either on office-based visits or prescription drugs.

    People can and do shop for less expensive office visits and less expensive drugs just as they shop for advanced medicine when they have a serious problem.

    As for negotiating for a discount, people with high deductible policies and HSAs (not what John means by “coventional third party payment) already have an expert negotiating for them–that expert is their insurer.

  16. Bart Ingles says:

    What Linda said. Thanks to Apoplectic Left for confirming my prediction.

    To “avoid the health care system at all costs and don’t deal with it until they absolutely must” is itself a market decision. If the consequences of such irresponsible behavior were clear, and the availability and cost of more sensible alternatives were equally clear, then these individuals might make better choices well in advance of the emergency.

  17. Ronald Feldman MD says:

    Physicians like myself who started IPAs to contract for “a 10 percent discount” in exchange for large numbers of new patients began the downward spiral. The small discounts became cuts of well over 50 percent and when combined with regulation upon regulation have destroyed the morale of medical communities all over the country.

    I plan to help lead us out of this morass before I retire by ultimately refusing to contract with any health plans. Physicians are essential to health care and can manage all other aspects of the system to the benefit of the patients we serve.

    Physicians have been in denial a long time and having a disheartened medical community benefits no one.

  18. Tom P says:

    Getting the unit cost for a service is absolutely important. But more rational utilization is even more so. Sure, this means that people in higher deductibles are more likely to ask whether an MRI is necessary. But this also means getting higher utilizers of services to take control of their lives. For example, the compliance rates for patients with diabetes (i.e., doing what they know they should do to manage their condition) is under 50% for patients with rich, third-party paid coverage. Put same consumer in a higher-deductible plan that offers incentives for compliance (i.e., get $800 to offset medication costs) and the consumer takes better care of herself and has a higher quality of life. While the system saves money and can offer lower premiums.

    To go back to your examples of other forms of insurance, I would tweak your argument a bit. Third-party payment isn’t necessarily horrible; third-party payment without a feedback loop is. So if I’m a lousy driver, my car insurance rates skyrocket. If the costs were socialized, I’d have little incentive to care.

    We as humans are horrible at assessing long-term risk (present company excluded, I’m sure). By pulling forward the long-term risk/benefit to current carrots and sticks, we can help consumers do what they know they should be doing for their own financial and health benefit but don’t. All of this happens in an environment with a third-party payor — a catastrophic insurer – with an aligned incentive to keep the consumers costs down as well. Not, to be sure, a present-day big company insurer with a 35% annual churn rate and little incentive to think longer term. But a true individual catastrophic insurer.

  19. Stan Ingman says:

    John.. One response is fraud .. 20% or more.

    Home care fraud seems to be increaasing in Texas and beyond.

    Wheel chairs ..electric.. to patients who can use them.

    Criminal capitalism is one issue.

    What is your solution to this issue?

  20. Ralph Weber says:

    While the “health policy analysts”, have been imagining that these procedures are more costly, MediBid.com has been proving that they are in fact very affordable if you let doctors set their own prices in a competitive environment.
    Recently, we’ve had a couple of clients request knee replacement procedures. One got a bid for $12,000 in New Jersey, and another client got a bid for $7,000 in India.
    When you allow third party payers (government OR insurance) to fix prices, it will always cost more.
    MediBid allows doctors to set their own rate, and allows the client to shop not only across state lines, but across international boundaries.

  21. Don Levit says:

    I find your true catastrpophic insurer idea intriguing.
    We need to have an insurer who has “skin in the game,” for an extended period.
    Do you think a non-profit insurer could be one possible solution, one who operates differently from those commercially available?
    Do you or others have more ideas?
    Don Levit

  22. Linda Gorman says:

    With respect to “criminal capitalism,” would anyone care to comment on the evidence concerning the success of efforts to detect fraud by a) private insurers and those who pay for their own care versus b) the government?

  23. reking says:

    John, I have my own version of the answer to your first question: Any policy that is substantively right (to hold down health care costs) is politically wrong and any policy that is politically right is substantively wrong. Then you have Obamacare, that manages to be both politically wrong and substantively wrong. I enjoy reading your health alerts.

  24. Elizabeth A. Reid, MD says:

    Dr. Feldman has the courage to admit we were wrong. But I think it goes back a lot farther than IPAs. I remember eavesdropping on the grownups in the 1950s, after a large family reunion dinner, and hearing a distant relative rail about the doom facing physicians if they started accepting insurance as a mechanism of payment for services. He was a general surgeon with a practice based out of an office behind his home. He had one nurse and he billed his own patients. If we want to look for a starting point of the downward spiral we might look all the way back to the interposition of the third party in the contractual service between doctor and patient. Perhaps this relationship is the proper starting point for real reform.

  25. Rick Weber says:

    Here’s an interesting point made in a blog post I read recently. When you go to the store, the customer and the clerk both say “thank you,” because they are both better off.

    In the health care market today that can still be true (though the doctor’s producer surplus may be smaller than it otherwise would be if they are being paid Medicare rates). However, we don’t see people arguing with their doctors; the argument is in the political arena. Doctors and patients are better off for any given transaction, but taxpayers are a hell of a lot worse off for the amount they pay relative to what they get.

  26. The Apoplectic Left says:

    “MEPS shows that the majority of spending on health care is not conducted under life or death circumstances. At least half of all the money spent to treat things such as cancer, heart conditions, COPD, diabetes, hypertension, and hyperlipidemia is spent either on office-based visits or prescription drugs.”

    Those aren’t life or death conditions, Linda? That’s news to me! I said, when you are sick or injured, you are not in a good position to negotiate, and that’s undeniable, just as the schmoe whose car crapped out on him may no longer be able to shop far and wide for the best possible deal to replace it, for lack of time and transportation. Bottom line: When you have cancer, you want to be cured, and you don’t even consider being cured at the best possible price.

    But look, the rightwing argument for Goodman’s fend-for-yourself care is full of hogwash on many counts, to wit:

    People may have other factors than price in mind when shopping for what is, ultimately, the preservation of their life. The Wal-mart mentality is not applicable when one’s own life or quality of life is at stake.

    The shortage of physicians, especially general practitioners, in many parts of the country negates any incentive for them to negotiate. Hell, I’ve got fine insurance (thanks, Mitt!), but the main reason I don’t go for checkups is nobody in my area is accepting new patients. My so-called consumer choice is now, and would continue to be in a fend-for-yourself world John Goodman pines for, take what you can get.

    As an insured individual with every incentive, according to Goodman, to gorge myself cheap healthcare, I don’t. I went to a doctor once over the last decade, and I don’t expect to go to one again until I’m ailing. Maybe it’s because I’m a human being who operates in the real world, and not like a consumer “on paper” does in Goodman’s fantasy world. If I found a store where they were practically giving away ballerina’s tutus, I’d pass. What is wrong with me???? Cheap tutus! C’mon!!! Eh, John? Eh?

    It all comes around to this: Doctors may treat patients with economics in mind (in fact, I know they do), but patients want to be cured. If a seal bites off my hand, and I’m told it will take every cent in every account I have, plus my house, to have it sewn back on, sold. I’m not going to go snooping around on Medibid or Priceline or the like to see if I can do better. My incentives, at that point, are not economic in the least.

  27. Linda Gorman says:

    People who have the good fortune to be in good health are often dismissive of the abilities of those who are not.

  28. Ralph Weber says:

    Traditional Health care “coverage” does not work because it is an attempt to “cover” unsystematic risk. A scheme where the winners and losers are known in advance, is simply wealth redistribution, and through adverse selection, is constantly manipulated.

    The principles of insurance demand that risk be systematic, and diversified, and that does not describe healthcare “coverage”.

    Since maximum deductibles are decreasing in 4 years, and the price to pay for an “options to purchase” insurance is very low, it will make the risk even more systematic.

  29. Paul Hogan says:

    I greatly appreciate your insights. Part of this review reminds me of when I started Home Instead Senior Care. The only person who thought we would fail was a 25 year traditional home care pro who relied on Medicaid for payment. I’ll never forget her remark, “franchising is for fast food and retail. It will never work in health care.” Now we do 40 million hours of care each year in 14 countries and there are thousands of players in the industry. Thanks for all your great work.

  30. John Goodman says:

    The Apoplectic Left views my ideal health care system as “fend for yourself care,” which is a strange way of thinking about the problem.

    Under third-party care, the providers look to the third party for guidance on how to treat the patient, and the providers compete to satisfy the third party payers’ needs. The reason: The third party is the real customer. In a market based system, by contrast, the patient is the real customer and providers compete to satisfy the patient’s needs.

  31. Robert says:

    “But mention “market forces” and someone always tosses out the mindless cliché about heart attack patients shopping for emergency care.”

    What do you mean?

    “If a seal bites off my hand, and I’m told it will take every cent in every account I have, plus my house, to have it sewn back on, sold. I’m not going to go snooping around on Medibid or Priceline or the like to see if I can do better. My incentives, at that point, are not economic in the least.”

    This is interesting, are you sure your incentives are not economic, because it sure sounds like you just made a economic decision. Bascially it sounds like a cost-benefit calculation that the value of your hand is worth dramatically more than adjusting your life in order to keep your money, house, cars and whatever else.

    “When you have cancer, you want to be cured, and you don’t even consider being cured at the best possible price.”

    I disagree only because I think most people would and want to consider it, but in our current system that is not even an option becasue it is impossible to even get that type of information. This argument also has to assume that people go from diagnosis to treatment with in hours if not minutes, and all the people I know that have had cancer seem to have a few days if not weeks before treatments begin.

    If we had a more market based system this type of information would be readily available; one could probabaly watch “youtube” videos of physicians explaining the different procedure types, consumer reports would have reviews and rating systems of physicians and hospitals based on treatment. I can even imagine an Amazon type web-site where hospitals could market their cancer services with bundling and consumer rankings based on a star system or multiple star systems comparing staff, physicians, food, bed comfort, ect.

    This is not fending for oneself this is controlling and making decisions for oneself – As Dean Alfange stated
    “I do not choose to be a common man it is my right to be uncommon. I seek opportunity to develop whatever talents God gave me – not security. I do not wish to be a kept citizen, humbled and dulled by having the state to look after me. I want to take the calculated risk; to dream and to build, to fail and to succeed. I refuse to barter incentive for a dole. I prefer the challenges of life to the guaranteed existence; the thrill of fulfillment to the stale calm of utopia”

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