a long overdue checkup

Everyone seems to agree that the health care system requires reform, although many differ in both the method and merits of that reform. Michigan is being touted as a “model for health care reform," focusing on information sharing and preventative health--two things they claim have reduced costs and improved health care. These two things are undoubtedly important and should be pursued, but do they amount to a panacea for our failing system? I think not. Rather, the search should begin with a thorough audit of the incentives that the current system creates for doctors, insurance companies, and individuals. It is understood within economics that “people respond to incentives” and the health care system is no exception.

Massachusetts is on board. They have the lowest uninsured rate in the country—2.6 percent compared to 15 percent nationally. But their system is failing due to the high cost of near universal coverage. The solution, as they see it, is to radically change the way that doctors and hospitals are paid. According to their system, Doctors would receive a flat fee for each patient on their rolls rather than a system that pays more for doing more.

Being paid more for doing more, that sounds better than the alternative doesn't it? And won’t a flat fee convince hospitals or doctors to drop their most expensive patients or not recommend pricey but potentially life saving treatments? On the surface, the answer to both of these questions is yes, but a more thorough examination could shed some light.

If doctor’s salaries are dependent on the number of visits, lab tests, and procedures they recommend, then it follows that they might over prescribe these things, especially if they don’t perceive it as harmful. Doctors say that our increasingly litigious society has made it financially dangerous to pass up any treatment that has a chance for success. On the other hand, we certainly don’t want doctors to under-prescribe. The problem, aside from the inordinate threat of law suits, is developing a system of incentives that induces doctors to prescribe only when it is beneficial to the patient.

What would be an efficient level of treatment? One way to tackle the problem is to imagine a simplified system. Imagine you are both the patient and the doctor, forced to balance the personal costs of treatments against the personal benefits of those treatments. We would expect that when the benefits outweigh the costs, the treatment is good and should be undertaken. In the real world, this is not the case. Patients do not directly perceive the full cost of treatments, and are not typically knowledgeable enough about medical issues to decide what is best for them without the help of a medical professional. So, if patients "see" the full costs of treatment and doctors only advised treatment they themselves would undergo, we would be much closer to an efficient level of treatment.

The most important thing to a patient undergoing treatment is, "will it work?" Will the treatment be successful? In that case, a good starting point would be to tie doctors profits to how successful their treatments are. Though in my view this should be only one component of their pay. A “pay-for-performance system” alone conjures thoughts of the used car lot, or in my case, the constant prying of a Guitar Center employee (I worked there for a short time). Nonetheless, there are obvious benefits to this approach. Namely, if altruism fails, doctors still care about the outcome of their patients. This approach, along with the one endorsed by Massachusetts to pay doctors based on their number of patients, seems ideal, at least given the current structure of the industry. Of course, a more thorough analysis could yield additional perverse incentives that were not part of the original system. My point is that this kind of analysis should be at the forefront of the argument. It should be a guiding light for policy makers, or better yet the economists that advise them.

The great thing about this type of exercise is that it doesn't require a PhD in Economics, or any other expertise for that matter. Anyone can do it, and perhaps more people should. As far as health care goes, I don't have any real answers (just in case you thought otherwise). But I can say with certainty that if the reforms that are put in place don't cater to the incentives they create, then we are administering the equivalent of a placebo for a truly sick patient.

mor on health

Health Bill Hacks Wildly at True Problem, and Misses

While Senate is out to play for recess, the rest of the country waits on their brilliant solutions to surface in the fall. Obama wants health care reform that reduces costs, covers more Americans, and makes doctors accountable to their patients. Sounds like a great plan.

I only find one problem with it: there is no plan.

A few bipartisan congressional committees have been arguing over different ideas for the past few weeks. A couple of proposals have been knocked around, and it looks as though we are in store for some sort of public health insurance plan designed to compete with those evil private companies that drive up prices to exploit the American public. (My brutality is entirely sarcastic.)

Basic, Adam Smith-style, economics show us why a publicly provided insurance plan will not achieve these goals without dire sacrifices. However, taken out of context, it can also show us why they think it will work.

Let’s begin with the latter, the logic behind the public plan: A public insurance policy or series of regional nonprofit cooperatives (the two primary health reform proposals) are designed to compete with private insurance providers. The lower prices of these subsidized entities will attract customers to switch from private providers and attract the uninsured to jump on board. The competition will pressure private providers to reduce prices to try and keep their customers. Such is the beauty of competition.

Now the problems with that logic: In a perfectly competitive world, prices are driven down to the actual costs of doing business. This is because firms undercut each other until profits are minimal. As a result, private insurers naturally have vast incentives to reduce costs and waste, as they are profit maximizing, competitive firms. If their prices were artificially high, competitors would have opportunity to charge less and take customers. This is a basic market system.

However, we do not live in the perfect world. Firms can get around this by conspiring with competitors to charge an agreed-upon, higher price. Even if this was legal, short-run incentives to cheat typically cause these cartels to fail (think OPEC). If the U.S. government thinks that collusion is taking place in the health care insurance industry they should look into anti-trust action, rather than jumping in the with their own firm(s) to stir the pot.

We need to examine the reasons why costs are so high in the private sector before thinking about hijacking the industry with a subsidized public entity. (Not to mention that the government does not have a very good track record with efficient operations: postal service, department of motor vehicles, social security, etc.)

Costs are high for a much less controversial reason: asymmetric information. Meaning, we know more about our health, and likelihood to use the policy, than does the insurance companies. So if you are extremely healthy, and will not cost the insurance company very much, you should not pay very much. And, conversely, if you are unhealthy (or paranoid), you should pay more for your constant doctor visits and prescriptions.

Unfortunately, insurance companies cannot clearly tell how healthy its customers are. To cover these risks they are forced to charge somewhere in the middle. Healthy people are charged more than they are eager to pay (some choose to opt out), while unhealthy people are charged too little. As you can imagine, operating costs in the insurance company are driven up because its customers are primarily unhealthy; prices follow accordingly. Soon enough, premiums and deductibles are so high that it is barely insurance at all, and you are better off paying out of pocket. If it were not for the terrifying risk of being caught sick without a method of payment, the market would crumble altogether.

Hence, the problem is not in private companies exploiting the public for vast profits. The problem is inherent in this type of insurance system. Generally, insurance is supposed to be something you never hope to use, like car insurance. And we purchase it for some peace of mind. Health insurance, on the other hand, has turned into a sort of ambiguous savings account. We all contribute as little as possible to the communal pot and draw down as much as possible.

A public insurance system does not address this problem of asymmetry, and would also be plagued with high operating costs. The only way to reduce the prices is to run at a loss (which government firms can do) relying on subsidies to stay afloat. Money to fund subsidies must come from somewhere—your pocket, pockets of the wealthy, your employer’s, your kid’s…who knows? Congress will figure that out in the fall.

Around 60% of Americans are provided healthcare benefits through their employers. Congress hopes to elect incentives (or mandates) to motivate more companies to provide this benefit. Providing healthcare imposes huge costs on firms, resulting higher prices for their customers, reduced wages for employees, and/or fewer employees altogether. To make the matter worse, firms – not the customers – are choosing the health insurance providers. And as our beautiful and prosperous market system has demonstrated for hundreds of years, the consumer always makes the most efficient choice in spending their money. Your employer has as much business in purchasing your healthcare than it does in purchasing your food and housing.

Democrats argue that the proposed reforms, although not ideal, are better than doing nothing. I would have to agree on some levels. However, better options are out there. Rather than making feeble attempts at optimizing a system that clearly doesn’t work, we should focus on real reform by changing the way Americans purchase healthcare.

an essential reform

On the world stage, U.S. health care is a topic of almost humorous discussion: an American attempt at free market ideals failed—miserably. As a citizen, it is merely depressing. In this immensely wealthy nation, 15% of the population goes without basic health coverage; private sector spending is enormous while government spending is disproportionately daunting. A brief Wikipedia skim will give you a sense of the problem: Health Care in the United States.

The United States has established a fairly privatized health care system in contrast to many other industrialized countries. In the U.K. basic health care is free for all residents (NHS). In the U.S. coverage is only provided for to the elderly and the disabled with Medicare and Medicaid, respectively, while spending much more per capita than Britain spends in their public and private sectors combined. In fact, U.S. government health care spending is the highest in the world. Why has the ever-efficient market system failed? There are a number of reasons we can choose from:

(1) The first, and primary, is a matter of imperfect information. When purchasing health insurance, the consumer knows more about their likelihood and frequency of coverage use than does the insurance company. This failure can be explained by George Akerlof’s work on adverse selection commonly explained in the market of used cars:

Lets say you want to sell your car. Your potential buyer has no idea if your car is the remarkable feat of engineering you say it is—or is it a pile of junk with a nice pain job? And worse yet, you have no way to prove it to them. Because of this risk, the buyer is only able to offer you a diminished amount below what the car is actually worth. Since you know the true value, you’re not going to part with it for anything less. In the end, you decide to keep your car because no one will pay you what it is worth. The market for your nice car doesn’t exist. The market for health insurance, however, is not as easily avoided. This is because the risk of being caught without is so great.

Having health insurance reduces the price of each visit to the doctor down to the co-pay, which is typically negligible in comparison to the actual cost of care. Because of this, people go to the doctor more often than they would if they paid out of pocket. Insurance companies pay the difference, further increasing the cost of insurance. Consumer's may also have a reduced incentive to keep themselves in the upmost health because they know that if they become ill, it's paid for. Economists refer to this behavior as moral hazard.

(2) The current system also slows the job market. Almost 60% of Americans are insured through group coverage with their employer. This causes workers to hesitate when leaving their job, reducing sensitivity to wage and other working conditions. Conversely, employers subsidize health care expenses, increasing their cost structure.

(3) Finally, incentives are out of place. It is in the employer’s best interest to choose a single company with a set of insurance policies that will work for the majority of their employees and cost the company the least. The insurance policy has every incentive to deny coverage or pay the absolute least for the health care provided. Doctors compete for contracts with insurance companies rather than for patients and their recommendations.

Although the universal health care systems enacted by many other industrialized nations (Canada, Britain, France) has proved to be substantially less costly while providing similar adequate coverage, major problems still exist. Wait times at government provided facilities are, on average, much longer than in the U.S. and incentives are still not appropriate.

How can we fix U.S. health care?

Tim Harford explores a simple and obvious (in retrospect) idea in The Undercover Economist. Rather than eliminating the market entirely (like many of our industrialized counterparts), simply alter it by focusing on deterring Akerlof’s dilemma of asymmetry and aligning incentives. When insurance companies or the government provides health care, these parties take over interest in making decisions for the patient, which is less efficient. The reformed system would allow a patient to pay for most of the costs and only leaving the most severe costs to government or insurance—however which we want to handle it (I prefer the latter). The self-interest provides an incentive to make the most efficient choice by researching practitioners and care methods.

The proposed system would require a compulsory savings account—this could be subsidized by a tax cut of around $1,500 (roughly the current tax allocation to health care). The savings is invested similarly to a retirement savings to grow over a lifetime. Because most health needs come about in later life, this savings account has time to grow. Leave it up to the individual to make their consumption decisions, as the free decision to consume best maximizes the individual’s utility.

To cover the unfathomable—loss-of-limb type—accident, catastrophe insurance will be available fairly cheap because of the reduction in inside information. Private companies would find it profitable to sell this type of insurance because their customers sincerely hope they will never have the opportunity to use it—much like home owners insurance, etc.

This system has proven successful over the past twenty years in Singapore. Comparing per capita costs and benefits in Singapore and the U.S. will give us a sense of the urgency to reform.

Source: UC Atlas of Global Inequality 2000

U.S. spending is outrageous, even if you argue that the discrepancies in death rates and life expectancies are a result of our nasty health habits. The figure is still seemingly disproportionate.

Why have we not reformed?