Medical Economics and Medical Ethics

A lengthy op-ed in The New York Times the other day typifies the way quite a few doctors think. Written by Gilbert Welch (Dartmouth Institute), the article acknowledges that there are perverse economic incentives in the practice of medicine. But these incentives play second fiddle to a much bigger problem: the failure of providers to act ethically and the lack of moral outrage in the face of such lapses.

What are the ethical lapses Welch has in mind? They include:

  • Hospitals charging outrageously high prices that have nothing to do with real costs (“highway robbery”);
  • Hospitals acquiring doctors so that they can charge Medicare two to four times what the doctor was previously getting in private practice;
  • Over-testing (too many colonoscopies and echocardiograms); and
  • Too much expensive equipment of questionable value (a proton beam in every facility).

He goes on to ask, “At what point, does it become crime?” and answers:

The word “crime” is awfully strong. Many prefer to call all this a problem of perverse incentives: good people, working in a bad system.

We could make the system better…But the incentives will never be perfect. Ultimately, society needs individuals to be guided by ethical standards. And in medical care, those standards are getting pretty darn low.

Too many of us have passively accepted the situation as being beyond our control. Medical care in America could use a dose of moral outrage. It would be best for all if it was self-administered.

But why separate ethics and economics? That’s foolish.

Economists have long known and long established that if you want more of something, you subsidize it; if you want less of something you tax it. People respond to economic incentives. And this principle applies just as much to ethical behavior and even criminal behavior as it does to any other activity.

Did you know that the fraud rate for credit card transactions is much less than 1%? But the fraud rate for Medicare and Medicaid is estimated to be ten times higher than that. In principle it should be immeasurably easier to steal with someone else’s credit card that to steal from a government health care program. Think about how many times you hand a credit card to someone you don’t even know. Think about how many times it is out of your sight. Given the opportunities for abuse, it is remarkable how rarely credit card theft occurs.

Why is that? It’s because the credit card issuing businesses, in cooperation with each other, have set up systems to greatly reduce the expected gain from fraud and substantially increase the cost to the potential criminal. If we unleashed the marketplace (contract Medicare collections to VISA?) and allowed similar incentives to prevail in health care, about nine in ten dollars of Medicare fraud would go away.

Or, let’s think more broadly. Suppose we had a health care system in which the incentives were all correct. Imagine that every doctor, every patient and every hospital administrator faced financial incentives to make optimal decisions with respect to the difficult tradeoffs between money and medical care. There might still be unethical behavior. But it would be a tiny fraction of what Welch is complaining about in today’s system.

Some may be surprised to learn that Adam Smith was a moral philosopher as well as the father of economics. His book the Theory of Moral Sentiments is less well known than The Wealth of Nations, but is a nice complement to it. One of his enduring insights was that in competitive markets pursuit of self-interest on the part of producers and sellers is consistent with maximizing the welfare of the buyers.

Contrast Smith’s insight with what happened in the Soviet Union. Under communism, every price consumers and producers encountered was the wrong price. So everyone had perverse economic incentives to do the wrong things (over-consume, over-produce, etc.). From time to time the Soviet government would exhort people to ignore incentives and do what was good for society as a whole.

We know how well that worked. And it reminds me very much of Welch’s editorial.

Like the Soviet consumer, patients in our health care system pay nothing for basic services, or at least far below the social cost of those services. To see the magnitude of the perverse incentives on the provider side, consider the following from a Wall Street Journal editorial I wrote:

Medicare is potentially setting about 6 billion prices across the country at any one time…

Is there any chance that Medicare can set prices and approve transactions in a way that does not cause serious problems? Not likely.

What happens when Medicare gets it wrong? One result is that doctors face perverse incentives to provide care that is costlier and less appropriate than the care they should be providing. Another result is that the skill set of our nation’s doctors becomes misallocated, as medical students and practicing doctors respond to the fact that Medicare is over-paying for some skills and under-paying for others.

Like the Soviet experience, we are not going to get very far encouraging patients not to over-consume care and encouraging doctors and hospital administrators to ignore the financial incentives created by 6 billion incorrect prices. (BTW, my casual impression is that the vast majority of people ― both buyers and sellers ― in health care believe they are being taken advantage of by impersonal bureaucracies and feel no moral qualms about “getting theirs.”)

Are there heath care markets that come closer to the ideal? Yes. Cosmetic surgery, Lasik surgery, walk-in clinics, other retail medical outlets, online mail order drug houses, telephone and email consultation services, domestic medical tourism, international medical tourism ― in short, wherever patients are primarily spending their own money and third-party payers are relatively unimportant, economic incentives and medical ethics seem to be very much aligned. I have written about those markets elsewhere.

Can we transform the entire health care system into one that aligns ethics and economic incentives? Yes. That is the subject of my book, Priceless.

Comments (31)

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  1. Vicki says:

    John, where’s today’s song.

  2. Dewaine says:

    “…the article acknowledges that there are perverse economic incentives in the practice of medicine. But these incentives play second fiddle to a much bigger problem: the failure of providers to act ethically and the lack of moral outrage in the face of such lapses.”

    This is central to the debate in general. Incentives vs. greed, science vs. emotion… I don’t know where they expect to go with this argument. If failure to act ethically is the biggest barrier to prosperity, won’t we have to have a uniform ethics to abide by?

    • JD says:

      We already create a uniform ethic in a lot of ways: murder, theft, etc., but you do have a good point. An overreach here is awfully close to establishing a “national morality”.

  3. Devon Herrick says:

    I’ve heard thinking like this before. It posits: why don’t those greedy doctors and hospitals just be honest!!! It’s not that simple. They are being honest considering the incentives society has provided them. What keeps Walmart from price gouging are laws that prohibit collusion among retailers, laws that prevent predatory pricing, and an economic system that rewards Walmart for competing on price.

    Doctors and hospitals don’t compete on price because it would reduce their profit margins rather than enrich them. If we want our health care system to operate as if it were a competitive market, we need to change the incentives. The problem is how? HHS and public health advocates want to create pay for performance, ACOs and bundled prices (i.e. centrally-planned health economy). Free market economists want to put patient in control of more of their own dollars. There seems to be little common ground.

    • Jimmy says:

      What would patients in control of their own dollars look like?

      • Peter Ferrara says:

        Health Savings Accounts. Look them up and how well they have worked. There are materials on this website that explain.

    • Neil S says:

      No, no, no…the laws you mention are not what keep Walmart from price gouging (whatever that is). Competition among sellers, and the choices freely made by consumers are what keep Walmart’s prices low.

      Antitrust and predatory pricing laws almost never achieve their stated intents. See Dominick Armentano’s Antitrust and Monopoly.

  4. Dewaine says:

    “Hospitals charging outrageously high prices that have nothing to do with real costs (“highway robbery”)”

    Prices are only loosely related to costs. Does he think that the last drop of water in the desert should be priced based on its cost? His assertion is untenable and was debunked over a century ago.

    • JD says:

      That is exactly right. Prices are determined by subjective valuation (and in the case of health care, government meddling). A price well above cost isn’t highway robbery. In fact, let’s take a look. If the price for a kidney transplant is $100,000 (I have no idea, just imagine), but we have mandated that prices be set at cost, how about $10,000, then more buyers will be attracted to having the procedure. Before, only the most dire cases would be willing to undergo the operation, now, the limited supply of kidneys are going to people who require them less urgently, hurting the people who needed them most. Also, if the price is set below market price, fewer resources will be allocated toward this purpose because they will be more valuable elsewhere, resulting in a decreased supply of this service.

      Bottom line: prices reflect value. Perverting them means that goods no longer go to the people who value them most.

  5. Randall says:

    The system is wrong and corrupt, the doctors are not.

    • Tomas says:

      What makes you think doctors can’t be wrong and corrupt?

      • Gerald Clarke, M.D. says:

        Some doctors and health systems are un-ethical, but most are trying to do the best they can for their patients, and that often means doing ‘unnecessary’ (by government or insurance company decision) procedures. Most of us put ourselves in the patient’s place, and that is our job as advocates. It may look unethical to outside eyes, but the only fair judge of this will be other physicians, not the IPAB, insurance companies, and congress…

  6. Keith says:

    On the fraud issue, it is worth noting that the ObamaCare cap on administrative costs of insurers includes in those capped costs all the money the insurers spend on fraud detection, correction, recovery and litigation. Yet another disincentive that would not exist in a more free market.

  7. Raymond Wooldridge says:


    This one “hits the nail on the head”!

  8. Saul says:

    Another ethical problem that has come to light recently is quotas that doctors are required to meet regarding admitting patients. Doctors should only admit a person that NEEDS to be admitted, not because a computer program thinks they need to be admitted, or to meet a requirement.

  9. Allan (formerly Al) says:

    Former Senator LeMieux proposed a prevent health care fraud bill about 5 years ago. He stated that he used credit card companies as a model. I think the bill died, but the parts of the bill he emphasized at the time seemed quite reasonable.

    Instead of restricting the number of DME companies that could deal with Medicare which is what I believe is being done now he emphasized knowing the companies and restricting payments until all elements were verified. Where fraudulent activity was frequent he was going to set up a risk scoring type of management withholding checks until the bill was verified. In south Florida there seemed to be a lot of Medicare abuse from DME companies that collected funds for a short while and then disappeared and reopened before the feds could figure out who they were.

  10. Greg Scandlen says:

    Good points, all. But everything is not just economics. This is what Michael Novak said about Smith’s views —

    “In the “Theory of Moral Sentiments,” (Adam) Smith points out that every self is both individual and social, and has both selfish and benevolent interests. As to which represents the higher virtue, it is absolutely clear to him ‘that to feel much for others, and little for ourselves, that to restrain our selfish, and indulge our benevolent affections, constitutes the perfection of human nature….’”

    “Virtue” sounds like a quaint idea to modern ears, and that is a tragedy. The value of virtue — honesty, civility, duty, thrift, self-discipline, etc — is taught absolutely nowhere today. Yet all of the Founders believed it was a prerequisite of liberty. A society without a sense of virtue is doomed.

  11. Morris Bryant, MD says:

    So, I was sitting down to review and prepare for my value in health care lecture that I present to medical students next week. After reading this, I suppose its time for a major modification to the talk. Sincerest thanks, John.

    As to the comment about the system being corrupt and not the doctors: perhaps. But please consider this: We doctors can and should be the the thought leaders for the provision of value in medical care. If the system is corrupted (and it is, in the complete definition of that word), then it is up to us to provide the moral outrage. If we do our best to uphold value for patients both individually and collectively, the systems in which we work will improve. It will take time and patience and persistence, but it will improve.

  12. Beverly Gossage says:

    The points that you make are precisely why I bristle when policy conversations point to the “fee for service” model as the medical over utilization culprit and advocate for capitation and ACOs. I have taken care of my health and been blessed with little need for any medical care. Under an ACO model, my physician would have been rewarded for having me as a patient. This makes no sense. All other services and industries function very well with the FFS model. Putting consumers in charge of paying for services gives physicians and patients the proper incentives.

    • Morris Bryant, MD says:

      I concur with your viewpoint, but unfortunately more than a few physicians are of the belief that most of the general public are not capable of taking charge and/or making their day to day health care choices and purchases. They most certainly won’t if the systems and society do not provide incentive to do so.

    • Wanda J. Jones says:

      You are right. And the new forms of payment being considered for hospitals and medical groups via the ACO model –bundled payment, capitation, block grants, and perhaps, periodic interim payments, will Still require accounting at the same level of detail used to create FFS bills, or after one or two years, there will be no way to create the level of funds flow that any given mix of patients should generate.

      Then, it gets more abstract: how does a regulator determine who should get the block grant and how much should it be? And how would one determine how much that grant should be increased each year? Any policy-maker that thinks that ACO compensation should increase only at the same rate as the GDP plus 1% is simply advertising that he or she does not have a clue how to dole our revenue to a complex industry. And they complain that market pricing does not work.

      Wanda Jones, President
      New Century Healthcare Institute
      San Francisco

  13. David C. Rose says:

    Here’s the other problem. Morality expressed as objectives doesn’t provide good standards for behavior while morality expressed as constraints does. This is for a shockingly simple reason: objectives are things we strive for and therefore achieve as matters of degree. They therefore resist clear categorization. Constraints, however, are normally categorical in nature.

    Here’s an example.

    If I say “be generous to beggars,” that provides direction for my behavior but no standard. Reasonable people can disagree over how generous is generous enough. But if I say “don’t steal,” it not only provides direction, it provides a clear standard (steal nothing).

    Gilbert Welch argues that if everyone was more virtuous we’d solve our problems. Well I’d love to see everyone more inclined to be more virtuous, of course, but it does not follow that all of our problems would then be solved. Let’s go back to the beggar.

    In a society in which everyone was as Gilbert Welch thinks we all should be, how much should you give the beggar? How much relative to Greenpeace? You see the problem. Moral earnestness cannot make up for the absence of a standard.

    In a society in which public matters of morality were only matters of constraint (don’t lie, cheat, steal, murder, etc.), then how much should you lie, cheat, steal, or murder with respect to persons A, B, C, D, and so forth? The answer is easy: zero.

    I lay this all out, and much more, in my book “The Moral Foundation of Economic Behavior,” (Oxford 2011).

  14. Rick Jackson says:


    I enjoyed your blog today.

    If hospitals are raping healthcare as the person who wrote the article claims, then why don’t they make any money. As you can see, they lose on just patient revenues.

    Hospitals do have to do “perverse” things to work within the “payment” system we have today. Since 60% of their business in Medicaid/Medicare and is a loser, then we all have to pay to make up. That looks like taking advantage, but is it is just surviving.


  15. Sean Parnell says:

    “…Are there heath care markets that come closer to the ideal? Yes. Cosmetic surgery, Lasik surgery, walk-in clinics, other retail medical outlets, online mail order drug houses, telephone and email consultation services, domestic medical tourism, international medical tourism ― in short, wherever patients are primarily spending their own money and third-party payers are relatively unimportant, economic incentives and medical ethics seem to be very much aligned.”

    Well put! And there’s actually quite a bit more ‘free market’ health care activity going on out there – cash-only doctors, direct care practices, online bidding for medical procedures, and more. I’ve actually created a blog,, specifically to provide information to self-pay patients (either uninsured, or those with high-deductible plans – sometimes also people with ‘comprehensive’ insurance too who can’t get a treatment covered by their insurer), to help provide information to the public about all the self-pay choices that exist, including insurance or insurance-like options that manage to avoid the excessive regulations I think most of us here see as an impediment to a real market for health care.

  16. Bob Hertz says:

    Medicare could quit paying hospital facility fees tomorrow morning.

    Medicare could quit paying extra charges for proton beam therapy tomorrow morning.

    Every country has a constant tug of war between providers and payers. In America, the payers are generally very passive. (see the writing of Uwe Reinhardt.)

    The question of hospital bills is a little more subtle. If every American had health insurance, then the bloated chargemaster rates would be an accounting quirk of no particular interest to the public.

    Americans without insurance are indeed left vulnerable to price gouging.

    Congress could protect them tomorrow morning by passing a national version of the California or Colorado laws about balance billing in emergencies.

    So once again, we do not have great sin or great crime. We just have passive public institutions.

    Note that Pres Obama has done nothing about price gouging the uninsured. Sure he wants them to be insured, but he knew he had a window of 2010 to 2014 which could have protected them.

    Why the passivity? Because most voters either have Medicare or secure employer coverage. The uninsured are not a political block. George Bush won landslides in Texas while 25% of its population was uninsured.

    I guess that doctors could have stood up for the uninsured in a public way. Many doctors do help the uninsured privately.

    Bob Hertz, The Health Care Crusade

  17. John Sweeney says:

    In May, I had an aortic valve replaced. When the consulting cardiologist was giving us the pre-op briefing he was about to wind up when I asked,”How much is this going to cost?”

    His answer, “Who cares!?”

    None of us were faced with any economic aspect of the elaborate procedure.

    Just a report from the trenches….

  18. Bob Hertz says:

    This excellent anecdote should be kept in mind next time any commentator goes off on the evil of Canadian rationing.

    Canadians may do a lot of things wrong in health care, but one cannot accuse them of ignoring the costs of procedures.

    An alternative way to confront costs would be high deductibles……in that way the patients do a certain amount of self rationing.

    Assuming that a high deductible patient would even be told the cost that he/she was about to face — that does not always happen.

  19. Wanda J. Jones says:

    John and Friends:

    Some additional points about ethics, pricing and costs. One of the great values in Medicine is to to make decisions about patient treatment without cost considerations. Doctors don’t want to be seen as favoring rich patients while shorting poor patients. Some old medical record rules deliberately omitted the form of insurance for that reason. Now there is a cultural movement toward considering costs at the point of deciding among several care alternatives.

    I recall when a former director of Medicare made a statement to the effect that future care decisions might be affected by the age of the patient and the likelihood that they would survive long enough to amortize the cost. That was, as I recall, about 30 years ago. Now that point of view crops up very often. The growth of both hospice and Palliative Care programs should be charted to show the speed of that transition. Most organ transplant programs have to use that philosophy, not because of costs per se, but because of shortages of organs.
    Nevertheless, surgeons can charge what the market will bear, whether there are many cases or a few.

    But there is another set of cultural/professional norms that are at play–the power positions of the hospital administrator, the attending physician and the organized medical staff. Hospitals, in general, are the only professional workplace where the individual does not actually work for the organization, which means he does not report to the CEO. The CEO, traditionally, does not interfere in patient care decisions, unless it is an egregious error, in which case he will call the Chief of Staff or the Medical Director of the specific program, and ask that the attending physician be counseled, audited, or kicked off entirely. He is acting as the agent of the Board of Trustees, to whom the medical staff reports. The CEO is not expected to see that the individual doctor or the whole staff are up to date, that they are bringing in the latest scientific concepts, or are making sure that follow-up care happens. So, it’s a mixed bag; some doctors do a good job and some do not.

    The power equation is very uneven. If a CEO is seen to be too hard on a doctor whose work is marginal, but who admits a lot of patients, the affected doctor can set up a negative attack, and urge a vote of no confidence on the part of the whole staff, which will lead to the CEO’s loss of his position, whereas nothing happens to the doctor.

    One change to note is the reformatting of these power positions, where the hospital and its doctors are creating partnerships that can contract together with health plans. In this case, the CEO will have the power to shut down a practice that is not working well, as well as implement care standards. This format also leads to the implementation of team care, rather than only MD care, which will be the only way to reduce the waiting times that are to be expected with our aging population, the shortage of physicians, following retirement of Boomer age doctors and of those who are opting out of government-funded care.

    I would be remiss if I did not point out the influence of Medicare’s original payment method on incentives to over-treat. One of my preceptors, who was on the President’s commission on Medicare reimbursement in 1976, explained why cost-based reimbursement was selected rather than billed charges. “It was to encourage (bribe) hospitals to sign up to be Medicare providers, because so many were afraid of becoming dependent on the government. It worked–most hospitals signed up. But the incentive to catch up on staff numbers, salaries and benefits, as well as add modern buildings, hire the number of accountants needed to deal with the transition from cash accounting to accrual accounting was so great that the field will abuse it (‘cost-based reimbursement.’) so the government will have to substitute another method just when we have become accustomed to a richer way of working.” private conversation, 1965. Government policy makers take no responsibility for the flood of dollars they let loose in the industry. It’s really an ethics problem when the perpetrator in chief blames the victim of this form of financial bribery. What did they think would happen? The problem is not fee for service as a payment method; think of how hard it will be to choose a more abstract form of payment; to whom will it go? How much and how soon? Do you pay a medical group based on historical fee for service utilization while introducing an opposite incentive? People will long for fee for service, as they do want to be served, not neglected.

    Also, I wish people would notice how much care is migrating to a retail model. This is what happens when a good or service becomes too costly–a different provider with a different cost level comes in and pulls business away from the traditional model. Day surgery, rehab and physical therapy, cosmetic procedures, weight loss, home care, and more.

    And if you are gulled into believing that the healthcare system is “inefficient,” in the sense of how resources are used, take a look at the great reduction in numbers of hospitals, numbers of beds, and use rates (patient days per 1000 population.) The influences were many, both regulatory and healthcare redesign.

    As Obamacare sinks, the country should observe how rapidly lower cost, distributed care flowers. Those will be voluntary business decisions. There is a lot of entrepreneurial energy in the medical profession that can do a good job for the future patient, particularly if managers and doctors get on the same side of the cost/profit/value equation. And if we have a surge in the number of “activated patients.”

    “It’s going to be a bumpy ride…” Bette Davis, All About Eve.

    This is a very important topic and should stay live for the foreseeable future.


    Wanda J. Jones, MPH, President
    New Century Healthcare Institute
    San Francisco


  20. Bob Hertz says:

    With all the efficiencies that Wanda describes, still the amount of money spent on hospitals goes up year after year.

    The manipulation of fee schedules enables hospitals to take in more revenue on fewer patients. An entire cottage industry of consultants shows the way to do this.

    Many innovations including new drugs are justified on the grounds that they will decrease hospital spending. Well, they do reduce hospital admissions and days of care, but spending goes up nevertheless.

    I am painting with a broad brush here and not dragging out my research statistics, and if I have mis-stated the problem let me know.