Looking for competition in all the wrong places

Competition could work to improve quality and lower costs in health care, if the right mix of policies were part of health care reform. That increased competition would lower health care costs and increase accessibility seems widely accepted (at least publically) -- even among those on the left.  But the leading reform proposals do not address the barriers to competition in health care, and would accelerate cost growth, even if a "public option" isn't adopted.

America's health care market has a distinctive quality: over time, technology advances are associated with higher costs. This is unlike most markets. (Consider computers, high definition TVs, and digital cameras.)  And the difference is not caused by something special about health care technology. 

In fact, in the right market circumstances, health care technologies can advance while costs decline. The quality of some types of cosmetic surgery, such as breast augmentation, has increased while its cost actually has decreased:


Cost growth for medical procedures

2003 through 2007

Procedure

Annual growth

Breast augmentation

-1.1%

Liposuction

2.3%

Cosmetic eyelid surgery

3.2%

Abdominoplasty

3.1%

Breast reduction

0.5%

Cosmetic procedures average

1.6%

Health care average

5.5%

Source: http://www.surgery.org/




Since 2003, the cost of each of the five most popular cosmetic surgeries has increased at about the rate of inflation, whereas health-care costs have climbed at over twice that rate.  What makes health care different? 

The knee-jerk response is to say we need health care to survive and, thus, will pay anything for it.  Yet Americans obviously have limits on what they are willing to pay for health care, or health care costs would consume far more than 16% of GDP.  And if necessity alone explains increasing costs, then we should see the same pattern for food and clothing, but we don't.  

The difference between the food and health care markets can be explained by differences in the level of competition, but it is not a problem that can be solved by adding a government-owned health insurance provider to the hundreds of existing providers as many on the left are suggesting.  Rather the solution is embodied in one of the most useful (and widely cited) quotes from Milton Friedman: "Nobody spends somebody else's money as carefully as he spends his own."

For 60 years, the government has been encouraging consumers to buy health care using as much of other peoples' money as possible.  Since most Americans aren't paying for what they consume, they continuously demand more and better services with little consideration of the additional costs.  And since, in the U.S., the supply of health care isn't rationed -- as it is in other countries with universal health care -- the market has been unrestrained to provide incredible technology with little regard for cost.

Thus, unlike for food, clothing, and cosmetic surgery, health-care suppliers don't compete to provide better value -- more for less -- but, instead, only better products. This tendency is clearly seen when you compare the growth of costs in the different health-care sectors to the amount of the percentage of the costs consumers pay out-of-pocket (see chart).  The more consumers pay out-of-pocket, the slower costs grow.  Consumers pay nearly nothing out-of-pocket for hospital care, and the cost in that sector have increased by over 7% per year. On the other hand, consumers pay nearly 84% out-of-pocket for durable medical supplies, and costs in that sector have increased by less than 2.5% a year, or around the rate of inflation.

chart


On average, Americans pay about 20% of their health care costs out-of-pocket.  This is too low: Americans are paying for nearly all their health care costs using insurance, which is not the purpose of insurance. We buy insurance to protect ourselves from rare, devastating events.  Our fear of these events allows insurance providers to sell insurance at a cost that exceeds the expected payout by about 18%

That's fine, but bad tax policy is encouraging Americans to buy too much coverage: both employer contributions and employees' expenditures on health care insurance are tax deductable, which causes the real price of insurance to be negative.  For example, if the value of an insurance policy -- the consumer's expected health care expenses during the year -- is $100, the insurance company will sell the policy for around $118.  But since the premium is tax deductable, the consumer -- assuming a 25% tax rate -- pays only $89 for $100 worth of coverage.  At the same time, out-of-pocket health-care expenses are not tax deductable. This makes it rational to buy policies with very low deductibles, since the tax advantage makes it cheaper to use insurance -- rather than money -- to pay for, for example, a $200 visit to the doctor.

Since health-care consumers are not using their own money, they are not sensitive to price.  Doctors use patients' insensitivity to cost as an additional form of malpractice insurance: doctors prescribe precautionary services (an MRI, X-ray, a longer hospital stay...) that they wouldn't otherwise prescribe if they had no chance of being sued and consumers cared about cost. 

The 60 million uninsured and partially uninsured Americans may actually be one of the system's most important sources of competition. Some of them shop around on the basis of cost. For example, it is estimated that by 2012 Americans will spend $160 billion abroad on less expensive hospital services.  You can be sure that American hospitals are competing to keep some of that money.  Insuring those 60 million uninsured would greatly weaken their incentive to shop-around and hospitals' incentive to control cost growth.

This is not to say, we shouldn't create an environment where everyone has access to health care.  But implementing any policy that increases the number of those insured but does not address the source of rising costs will only lead to more rapid cost increases, since fewer people will care about cost.  And the system cannot take even the current growth rate for much longer.

In their book Healthy, Wealthy and Wise, Glenn Hubbard and John Cogan propose a simple solution: make all health care expenditures, including out-of-pocket costs, tax deductible. This would not only make health care more affordable, but it would also increase consumers' incentives to buy policies with higher deductibles. In turn, the higher deductibles would cause consumers to be more conscious about costs. The authors estimate that this change -- along with some other modest policy changes like tax credits for the poor -- would reduce costs by 9% and increase the number of insured by 20 million.

Regarding the current debate in Congress, it would be appropriate if policy makers followed the same principle as doctors: first, do no harm. Rather than starting the reform process with major, risky structural changes to the current system, we should first implement less intrusive -- but effective -- policy changes that address the real barrier to competition -- the "it's not my money" effect.

James Eaves is an economist and Professor of Finance in Université Laval's business School. His personal blog is practicalpolicy.com. He welcomes your comments at james.eaves@fsa.ulaval.ca.
Competition could work to improve quality and lower costs in health care, if the right mix of policies were part of health care reform. That increased competition would lower health care costs and increase accessibility seems widely accepted (at least publically) -- even among those on the left.  But the leading reform proposals do not address the barriers to competition in health care, and would accelerate cost growth, even if a "public option" isn't adopted.

America's health care market has a distinctive quality: over time, technology advances are associated with higher costs. This is unlike most markets. (Consider computers, high definition TVs, and digital cameras.)  And the difference is not caused by something special about health care technology. 

In fact, in the right market circumstances, health care technologies can advance while costs decline. The quality of some types of cosmetic surgery, such as breast augmentation, has increased while its cost actually has decreased:


Cost growth for medical procedures

2003 through 2007

Procedure

Annual growth

Breast augmentation

-1.1%

Liposuction

2.3%

Cosmetic eyelid surgery

3.2%

Abdominoplasty

3.1%

Breast reduction

0.5%

Cosmetic procedures average

1.6%

Health care average

5.5%

Source: http://www.surgery.org/




Since 2003, the cost of each of the five most popular cosmetic surgeries has increased at about the rate of inflation, whereas health-care costs have climbed at over twice that rate.  What makes health care different? 

The knee-jerk response is to say we need health care to survive and, thus, will pay anything for it.  Yet Americans obviously have limits on what they are willing to pay for health care, or health care costs would consume far more than 16% of GDP.  And if necessity alone explains increasing costs, then we should see the same pattern for food and clothing, but we don't.  

The difference between the food and health care markets can be explained by differences in the level of competition, but it is not a problem that can be solved by adding a government-owned health insurance provider to the hundreds of existing providers as many on the left are suggesting.  Rather the solution is embodied in one of the most useful (and widely cited) quotes from Milton Friedman: "Nobody spends somebody else's money as carefully as he spends his own."

For 60 years, the government has been encouraging consumers to buy health care using as much of other peoples' money as possible.  Since most Americans aren't paying for what they consume, they continuously demand more and better services with little consideration of the additional costs.  And since, in the U.S., the supply of health care isn't rationed -- as it is in other countries with universal health care -- the market has been unrestrained to provide incredible technology with little regard for cost.

Thus, unlike for food, clothing, and cosmetic surgery, health-care suppliers don't compete to provide better value -- more for less -- but, instead, only better products. This tendency is clearly seen when you compare the growth of costs in the different health-care sectors to the amount of the percentage of the costs consumers pay out-of-pocket (see chart).  The more consumers pay out-of-pocket, the slower costs grow.  Consumers pay nearly nothing out-of-pocket for hospital care, and the cost in that sector have increased by over 7% per year. On the other hand, consumers pay nearly 84% out-of-pocket for durable medical supplies, and costs in that sector have increased by less than 2.5% a year, or around the rate of inflation.

chart


On average, Americans pay about 20% of their health care costs out-of-pocket.  This is too low: Americans are paying for nearly all their health care costs using insurance, which is not the purpose of insurance. We buy insurance to protect ourselves from rare, devastating events.  Our fear of these events allows insurance providers to sell insurance at a cost that exceeds the expected payout by about 18%

That's fine, but bad tax policy is encouraging Americans to buy too much coverage: both employer contributions and employees' expenditures on health care insurance are tax deductable, which causes the real price of insurance to be negative.  For example, if the value of an insurance policy -- the consumer's expected health care expenses during the year -- is $100, the insurance company will sell the policy for around $118.  But since the premium is tax deductable, the consumer -- assuming a 25% tax rate -- pays only $89 for $100 worth of coverage.  At the same time, out-of-pocket health-care expenses are not tax deductable. This makes it rational to buy policies with very low deductibles, since the tax advantage makes it cheaper to use insurance -- rather than money -- to pay for, for example, a $200 visit to the doctor.

Since health-care consumers are not using their own money, they are not sensitive to price.  Doctors use patients' insensitivity to cost as an additional form of malpractice insurance: doctors prescribe precautionary services (an MRI, X-ray, a longer hospital stay...) that they wouldn't otherwise prescribe if they had no chance of being sued and consumers cared about cost. 

The 60 million uninsured and partially uninsured Americans may actually be one of the system's most important sources of competition. Some of them shop around on the basis of cost. For example, it is estimated that by 2012 Americans will spend $160 billion abroad on less expensive hospital services.  You can be sure that American hospitals are competing to keep some of that money.  Insuring those 60 million uninsured would greatly weaken their incentive to shop-around and hospitals' incentive to control cost growth.

This is not to say, we shouldn't create an environment where everyone has access to health care.  But implementing any policy that increases the number of those insured but does not address the source of rising costs will only lead to more rapid cost increases, since fewer people will care about cost.  And the system cannot take even the current growth rate for much longer.

In their book Healthy, Wealthy and Wise, Glenn Hubbard and John Cogan propose a simple solution: make all health care expenditures, including out-of-pocket costs, tax deductible. This would not only make health care more affordable, but it would also increase consumers' incentives to buy policies with higher deductibles. In turn, the higher deductibles would cause consumers to be more conscious about costs. The authors estimate that this change -- along with some other modest policy changes like tax credits for the poor -- would reduce costs by 9% and increase the number of insured by 20 million.

Regarding the current debate in Congress, it would be appropriate if policy makers followed the same principle as doctors: first, do no harm. Rather than starting the reform process with major, risky structural changes to the current system, we should first implement less intrusive -- but effective -- policy changes that address the real barrier to competition -- the "it's not my money" effect.

James Eaves is an economist and Professor of Finance in Université Laval's business School. His personal blog is practicalpolicy.com. He welcomes your comments at james.eaves@fsa.ulaval.ca.