Being Stupid about Prices

Why does health care in the United States cost more than it does in other developed countries? In 2003, Gerald Anderson, Uwe Reinhardt and two coauthors gave their answer in a classic Health Affairs article, “It’s the Prices, Stupid.” The argument: Even though Americans make fewer trips to the doctor, spend fewer days in the hospital, take fewer pills, etc., the prices we pay are higher than the prices people pay in other countries — making the total amount we spend also higher.

This idea was revived the other day by Alec MacGillis who wrote in The Washington Post that the great failure of health reform was the failure to control the prices we pay for health care services. Chris Flemming at the Health Affairs blog also chimed in, reminding everyone that Bruce Vladeck and Thomas Rice reiterated the argument last year in Health Affairs.

Now although I like Gerald and Uwe and Bruce and Tom, and have great respect for all of them, I’m sorry to say that they are wrong, wrong, wrong, wrong, wrong and wrong.  (That’s wrong six times over.)  In particular:

  1. Prices are a completely unreliable guide to the social cost of health care in all developed countries.
  2. The real social cost of health care is reflected instead in the opportunity cost of the resources used.
  3. When comparing real resource use, it is not obvious that the United States is spending more than other developed countries; we may be spending less.
  4. Although the state can use its monopsony (buying) power to suppress provider prices, this behavior only shifts costs from one group of citizens to another; it does not lower the real social cost of health care.
  5. Although squeezing provider prices may have a level effect on the amount payers spend, it appears to have no effect on the rate of growth of spending over time.
  6. The real problem (and the implied solution) is completely different:  Prices appear to be reasonably controlled in every health care market when providers compete for patients based on price; prices are a problem only when third parties are paying them.

As my colleagues and I pointed out in our international survey of health care systems, the market for health care has been so completely suppressed throughout the developed world that participants in it almost never face a real price for anything. Consequently, when you sum over all the artificial prices and arrive at a total, no one knows what the number really means. The fact that the U.S. number is larger than the number for France or Germany tells us almost nothing about the real cost of care.

As every student learns in Econ 101, in a guns/butter world, the social cost of one more gun is the amount of butter you have to forgo, and vice versa — whether or not this cost is reflected in the prices people pay.  In other words, the real social cost of health care is the value of the resources used to produce it — resources that could have been used to produce something else.

On this score, the United States actually looks pretty good.  We use fewer doctors per capita, fewer nurses, fewer hospital beds, fewer pharmaceuticals, etc. than the average OECD country. The only thing we use more of is technology. And the care we get is as good or better than the care delivered elsewhere. (See the international survey, for a summary of the evidence.)

What does government accomplish when it suppresses provider fees? Suppose it could somehow cut them in half; and in so doing, cut in half the (accounting) cost of care. Does this maneuver lower the social cost of care? Of course not. It merely shifts costs from patients and taxpayers to providers. Exactly the same result could be achieved by a 50% special tax on provider income, used to reimburse patient medical expenses.

But isn’t it a good thing to lower the net cost of care for patients? Maybe. But no one has ever shown why doctors, nurses and paramedical personnel should bear this cost. Why not instead tax NFL football players? Or rock stars? Or Seventh-Day Adventists? Or everyone in the state of California? Or every member of the Democratic Party? Aside from a special tax on doctors being arbitrary and unfair, there are supply-side effects. The more we suppress provider incomes, the fewer providers we will have. At least we will get less of the best.

Some have argued that we can replace the doctors we lose with immigrant doctors. But that same argument also applies to steelworkers. Or to the whole of manufacturing. Theoretically, we could greatly lower the cost of manufactured goods in the U.S. by suppressing worker wages and replacing those who quit with immigrant labor. Does this appeal to you? If not, why pick on doctors?

[Parenthetically, yours truly is one of the few health policy analysts who appears to actually like and respect those in medical practice. It's amazing how many of my colleagues seem to hold them in contempt.]

What happens to nominal spending when government exercises its monopsony power and suppresses provider incomes? This results in less income for doctors relative to other occupations. There also appears to be a onetime dip in the level of health care spending. But from that new level, there appears to be no effect on the rate of growth of spending over time. Over the past four decades, the rate of growth of real per capita U.S. health spending is just below the European average! (See data for 1960–1998 here and data for 1994–2004 here.) 

Source: OECD Health Data, 2006.

Finally, the real problem in health care is not now, and never has been, prices. It is the suppression of real markets. Third-party payment prevents providers from competing for patients based on price and quality. Wherever third-party payers are absent (cosmetic surgery, Lasik surgery, walk-in clinics, surgi-centers, concierge doctors, medical tourism, etc.), the price system in health care works just fine and dandy.

Comments (24)

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  1. Paul H. says:

    Thanks for posting this. It clears up a lot of nonsense.

  2. Ken says:

    Good post. Long over due.

  3. Bruce says:

    How come these health economists don’t seem to know anything about economics?

  4. Shirley Svorny says:

    As to holding medical professionals in high regard, I’m with you in wanting them to make a lot of money (so as to attract talented individuals), but one legitimate reason to rag on them as a group is that their professional organizations have restricted access to care by heavily lobbying state legislatures to limit both entry (by raising education requirements) and the scope-of-practice of their competitors and that is not good for consumers. I know you agree!

  5. Devon Herrick says:

    The wages you pay health care workers do not cause the problem of high costs; so suppressing wages will not be the solution to high costs. The problem is perverse incentives that lead to unnecessary care, inefficient care and lack of competition. Get the incentives right and nobody but doctors will care how much they are paid.

  6. Al says:

    Thank you John Goodman for protecting our sanity from the ideologues “prices are a problem only when third parties are paying them.”

  7. I believe that it was Dr. Goodman who claimed that our IQs drop at least ten points when we discuss health policy.

    Does anyone think that homes, cars, groceries, clothing, etc., would be more affordable if the government instituted a “single-payer” system and exercised it’s monopsony power? I’ve never met anyone who advocated that: They know that our homes would be leaky and mold-infested, our cars belching smoke and unsafe, our diet consisting almost solely of spoiled potatoes, and our clothing rough and ill-fitting.

    Yet, when it comes to health care (and K-12 education), this presumption is taken seriously by large sections of the population.

    I think there’s something else going on with physicians’ remuneration, and I haven’t seen it addressed adequately (which may mean I just need to read more). The graph above does not lead to a robust conclusion: The UK single-payer system pays doctors (proportionately) almost as much as the US does, but Canada’s single-payer system pays more like the Swiss social-insurance system, but much more than the Australian single-payer system.

    I think it would be helpful to look at physician-payment relative to the payment of lawyers, investment bankers, and similar professions within one country. I suspect that a variant of Baumol’s effect for highly skilled professions comes into play. These professions are limited in their ability to become more productive versus software entrepreneurs and certain other occupations, so their pay will be relatively higher in countries that are highly productive, especially the US.

  8. Cordelia says:

    On the question of physician compensation, it is a big mistake to lump general practitioners in with medical specialists. One major way in which relative prices are out of whack in medical care is that we pay far more for procedural-driven specialist care in comparison with primary care of all sorts. While the US ratio for general practitioners is roughly in line with OECD averages, the ratio for specialists is far higher in the US than in other developed countries. The reason for this imbalance is that relative compensation rates are set, not by markets, but (effectively) by an AMA group that is dominated by specialists. Medicare adopts the recomendations of this group with little change, and private insurers tend to pay fees that are determined relative to the Medicare physician fee structure. Thus the ridiculous situation where 3% of medical students plan to pursue primary care, despite acute and growing shortages, while there are backlogs of students trying for limiting residency slots available for higher paid specialties. The distortion in relative prices also springs from differences in the degree of transparency involved in the product – when you purchase Lasik or cosmetic surgery it is fairly clear what you are getting. However, there is very little agreement on the benefits associated with the specific options for care for many medical conditions. Even doctors themselves do not really agree – as the Dartmouth Atlas work on variations shows, there is enormous variability in patterns of treatment (and even in diagnosis!). Patients, of course, are at even more of a loss in assessing the complex and uncertain clinical information that is relevant to decision-making. Do I need to see an additional specialist? There is no research that can give us that information. But as we pay primary care physicians less and less in relative terms, the incentive only grows to push care out of primary care, towards specialist care. Ironically, one conclusion that is fairly firm is that systems where primary-care plays a larger role tend to produce better outcomes! All of this just goes to say that the magnitude of the market failure associated with high costs of information (and assymetrical information) should not be underestimated. Greater cost-sharing is a necessary aspect of a movement towards a more efficient provision of care, but must be very carefully designed – coinsurance or indemnity makes more sense than flat copays or high deductibles. But above all we need a mechanism for relative physician fees to respond to market conditions, rather than being mediated by a committee of physicians.

  9. Uwe Reinhardt says:

    John:

    I’m beginning to believe that 10 point IQ loss John Graham mentions. How could you have been so wrong in reading our paper?

    Let me quote from our paper:

    “Second, the distinction between financial and real resource flows in health care raises the fundamental question of what is meant by the “cost” of a country’s health system.27 Because labor and other productive inputs are allocated to health care rather than to the next most valuable productive enterprise, there is an “opportunity cost” associated with devoting more resources to health care. Alternatively, the “cost” of the health care system could be measured by health spending (that is, the percentage of GDP spent on health). If one ranked countries by the costliness of their health systems on each of these two cost measures, the two rankings might be very different. Consider, for example, that Country A might devote a larger fraction of its GDP to health care providers than does Country B but uses fewer real resources in its health system than does nation B. In other words, Country A spends more per capita on health care than Country B, and yet economists might rate Country A’s health system less costly than Country B’s because fewer actual resources are devoted to health care.”

    What is it about this statement, John, that you did not understand? Where does your comment add major new insight to what we say here? We then go on:

    “To explore this possibility at the empirical level, Mark Pauly sought to estimate the opportunity costs of the human labor represented by physicians, nurses, and other medical workers in a set of OECD countries for the year 1988.28 Although the United States spent a far greater share of its GDP on health care than did the other OECD countries in 1988, Pauly found that in terms of the opportunity cost of real resource use, the U.S. health system ranked somewhere in the middle of the OECD cohort.”

    Finally, we wrote:

    “A study by the McKinsey Global Institute followed that more in-depth approach. The research team, which was advised by a number of prominent health economists, based its analysis on four tracer diseases: diabetes, cholelithiasis (gall stones), breast cancer, and lung cancer.31 Using PPP-adjusted U.S. dollars as the common yardstick, the McKinsey researchers found that in the study year of 1990 Americans spent about $1,000 (66 percent) more per capita on health care than Germans did. The researchers estimated that Americans paid 40 percent more per capita than Germans did but received 15 percent fewer real health care resources. A similar comparison revealed that the U.S. system used about 30 percent more inputs per capita than was used in the British system and spent about 75 percent more per capita on higher prices.32″

    Where in our paper do we claim that dollar spending on health care, rather than real-resource flows, is the correct way to measure total SOCIAL opportunity costs?

    Now prices and dollar spending CAN visit opportunity costs on micro entities within a larger society. The dollars a waitress forks over to the doctor does have an opportunity cost to her. It is balanced from society’s viewpoint by the added benefits enjoyed by the physician. Similarly, the state of California’s health spending, given its budget of revenues, has opportunity costs in terms of state-funded education. But once again, these opportunity costs are balanced by the benefits the providers of health care there reap from health care.

    I agree with John Graham, though, that the physician’s own perceived opportunity cost may have to do with the prices they charge. I teach both: premeds who become doctors and pre-Goldman-Sachs people who go to Wall Street. I often ask myself: what must go through the minds of alumni who became physicians when they meet their classmates who went to Goldman Sachs at the 10th Princeton alumni reunion?

    But these arguments slouch towards sociology.Roger Feldman, every inch the economist, was once quoted in the NYT that health spending in the US was so high because American physicians are overpaid. I think he meant that we could get the supply of physicians we want even if we paid them less. On that criterion, physician fees probably still are higher in the US than they need be and would be in a perfectly competitive market.

    Take more time reading papers, John. There are strongly diminishing and sometimes negative returns to speed reading.

  10. Scott says:

    Thank you for the much needed reason, in what I hope is a continuing debate for sensible solutions.

  11. LAURENCE BRODY says:

    Thanks John for putting this together.
    Never minds that physicians have to invest 4 years Pre medical Studies at a credible university, 4 years of medical school, and then more years if they wish a specialty, including General or Family Practice. What is that time, from teen age years to 30’s valued?

    Then there is the dollar cost of education. What is the return on invested capital? A recent medical school publication, available to you, John, on request, indicated annual costs of medical education including board at $60,000. At this accredited medical school, the average debt of a graduating student was $ 170,000. How do you amortize that cost?

    At a lecture with a professor of economics, he pointed out that becoming a physician, is a very poor investment.

  12. Frank Timmins says:

    Cordelia, your last sentence “But above all we need a mechanism for relative physician fees to respond to market conditions, rather than being mediated by a committee of physicians” is pretty much all that needs to be said regarding pricing of healthcare.

    John Graham notes the odd public perception of healthcare costs as opposed to those of other human essentials such as shelter, food, etc. This myopia is not all that unexpected when one considers that the public has been barraged by incessant brainwashing from the left for the past 4 plus decades. Fortunately, the left’s ultimate triumph in its quest to control healthcare took place smack dab in the middle of a horrible economic downturn. The reality of the economic situation impelled many who were dutifully marching to the sweet siren’s song of entitlement to remove their heads from the sand and fire those responsible for this debacle.

  13. Linda Gorman says:

    “…Using PPP-adjusted U.S. dollars as the common yardstick, the McKinsey researchers found that in the study year of 1990 Americans spent about $1,000 (66 percent) more per capita on health care than Germans did…”

    How was the “amount spent” calculated if (inaccurate) prices were not used?

    And what about the well known difficulties with the use of PPP to compare the price of non-traded goods across national borders. Those problems are not trivial, even for the purposes of health policy. For example, the Big Mac Index suggests that the U.S. dollar was overvalued by 22 percent in 2001. If accurate, this would suggest that US per capita health spending was over-stated relative to that in Germany.

  14. Gail Wilensky says:

    It’s not the prices anyway as much as it’s the volume and mix of services used that makes our spending so high. We see that most clearly in Medicare where the government sets the prices and Medicare spending growth pretty much tracks spending in the private sector and most clearly of all in Part B Medicare where fees have been held more or less flat since 2002 and spending for Part B has been growing 10-12% per year.

    -Gail

  15. Clark Havighurst says:

    Prices are too high in the private sector, John, and it matters to the premium payers who ultimately pay them — even if you, like most economists, are more interested in allocative efficiency than in distributive fairness. As usual, it’s third-party payment that creates or exacerbates the problem (and it will always be with us it even if you wish it could be otherwise).

    Specifically, it’s the combination of insurance and monopolies possessed by hospitals, physician groups, and drug companies in many lines of business that drive prices to the skies – although neither the antitrust agencies nor economists generally have recognized this very large point. U.S.-style health insurance greatly enhances the pricing freedom of firms possessing market power in health care markets, resulting in much larger monopoly profits and much greater redistributions of wealth than would result from comparable monopoly in other markets, where consumers face prices directly. The combination of health insurance and monopoly, together with the ubiquity of nonprofit, tax-exempt providers (bound to plow their profits back into health care), also fosters inefficiency in the allocation of resources. Ironically, the inefficiency here takes the form of overconsumption rather than the underconsumption of the monopolized product that economic theory normally associates with the exercise of monopoly power. (I’ve written about these things in Law and Contemporary Problems, 2006.)

    A huge problem with ObamaCare is that, in expanding the population enjoying generous health coverage, it also expands the scope and pricing freedom of providers exercising market power. Experience in Massachusetts (reported by the MA Attorney General) and in California (reported by Bob Berenson and Paul Ginsburg in Health Affairs), shows how provider monopolies loom as a huge barrier to affordable health care. The challenge to those of us who prefer market solutions over price regulation or a single-payer monopsony is to empower private payers to circumvent monopolies by inducing insureds to prefer lower-priced new entrants or to seek their care outside their local market.

  16. Dan Koon says:

    Thanks John – great article. It is like the live birth argument. The US is the only country to report all births. The input varies from country to country, but no one meets our standards of reporting. Ergo, we get hammered for being honest.

  17. Donald Devine says:

    Really first rate, as always. You make things in a way people can understand and you can tell anyone who is interested!

  18. Al says:

    Without being critical of Dr R’s above statement I wonder what the word social means in “total social opportunity costs” from the viewpoints of the progressive and the fiscal conservative.

    By the way Dr. R. I was away so I posted my response to you a bit late on “Race to the Bottom”. I thought your follow up response to be inadequate.

  19. Linda Gorman says:

    Deregulation usually gets rid of provider monopolies. And would likey reduce US health spending by more than 10 percent.

  20. John Goodman says:

    @ Clark Havighurst
    I agree that monopoly power is a problem. In fact I wrote a whole book about it: “Regulation of Medical Care (Cato 1980), describing the 150 year history of the AMA’s effort to effort enlist government to help create monopoly rents.

    @ Uwe Reinhardt
    If you title your article, “It’s the Prices Stupid,” don’t you think other people are justified in inferring that you really mean it.

    @ AI
    “Total social opportunity costs” is an awkward term that means costs to society as a whole. You can think of it as the sum of all the individual costs. It is a technical, non-ideological term.

  21. Uwe Reinhardt says:

    John:

    In response to your latest comment. The article was structured around HEALTH SPENDING in various OECD countries and why US SENDING was higher than in other contries. The higher prices we pay for similar services (incl. drugs) do play an often overlooked major role here. We believe that the health-care cost control debate is too much focused on the idea that as Americans we consume excessive volumes of services. That was the point of the article, and hence the title.

    Our article was not primarily about the opportunity cost of real resources, although we did remark on them in passing.

  22. John Seater says:

    As usual, the discussion leaves me wondering what all the fuss is about. In the absence of significant market failures, *all* the issues discussed above would be solved just fine by the market setting prices and allocating resources accordingly, except for the distributional issue, which could be solved by subsidizing the poor rather than by interfering with the market itself.

    Many times I have asked in posts to this site for some examples of significant market failures in the health care market, and every time I have received no answer. My conclusion: There are none. My conclusion from that: We can fix just about everything wrong with the health care market by getting the government (at all levels) out of it and letting it work. Does anyone notice any serious problems in the food or clothing markets, which provide goods more essential than health care? Does anyone notice any problems in the housing market that are not the direct result of government intervention in that market? We used not to have problems in the housing market before there was Freddie Mac or the Community Reinvestment Act or Barney Frank. If the market can handle food, shelter, and clothing (and also life and other insurance, personal computers, pick-up trucks, mechanical pencils, household appliances, gasoline, Halloween candy, etc.), why not health care?

  23. bob hertz says:

    The free market can and should handle voluntary health care, for example executive physicals, diagnostic tests on healthy persons, etc.

    Whereas accidents, injuries, and life-saving care is not voluntary and should be funded like fire or police services– i.e. with broad-based taxes.

    Virtually all of inpatient care falls into the involuntary sector. Medicare Part A could be expanded to cover the entire population, probably for about 3% of payroll.

    Health insurance would still be desirable but not necessary. Most Americans would save thousands of dollars. They could apply those savings toward paying their doctors.

    The last element needed to make this work is price ceilings for drugs. Every other industrial nation has them, it is not rocket science. Also there needs to be better consumer protection from phantom bills and price-gouging by a minority of doctors.

    This is the overall program of The Health Care Crusade. It is, in effect, a combination of free markets for voluntary care and socialism for involuntary care. Many other parts of American life have worked that way for many years —
    the fire department is socialist, but fire insurance is free market. Police are socialist, but lawyers are free market.

    Bob Hertz
    Director, The Health Care Crusade

  24. Bob says:

    1. Insurance through your epyolmer is group health insurance . The premium is based on the health of the entire group and not on you as an individual.2. Employers often subsidize at least a portion of your premium as part of your compensation.