Medical care cost control requires both demand and supply management

Vijay K. Mathur

Published in Standard-Examiner, April 14, 2013, Ogden, Utah

It is well known that the price people pay for medical care either directly or indirectly is increasing at a rapid rate. In 2011 the national expenditure for health care was $2.7 trillion, a 92 percent increase since 2000. If the medical care market is competitive, the interaction of demand and supply would determine its price, and that price will be efficient and welfare maximizing.  However, despite the usual rhetoric of politicians and free market ideologues, the medical care market suffers from what economists call market failure. Competition in the medical care market, for example, requires a large number of buyers and independent providers of services, a relatively small size of providers to avoid dominance, full information about quality and prices of services.

On the demand side, competition works when consumers are well informed about the quality of medical care services and prices actually paid by them so that they can shop for services. Usually though, patients depend upon their doctors for information about medical procedures, need for those procedures, drugs, and hospitals’ quality.

Physicians are the agents who look after patients’ interests. However, when doctors are either employed by hospitals or have privileges in using hospital services, their loyalty is split between patients and hospitals.

Doctors have incentive to overuse medical services, because their own compensation is based upon the amount billed to insurance companies and/or to government programs such as Medicare and Medicaid. Third-party payment systems encourage doctors to create demand for hospitalization and/or medical services.  For example, a Rand Corporation study, “ Health Insurance Experiment” in 1982, found that when patients shared in the cost of medical care in an HMO, their use of all medical services was much less than those who had free care, without affecting quality of care and health outcomes.

Most of the discussion about medical care costs centers around demand and not much attention is paid to the supply side (cost). There is no doubt that something has to be done on the demand side, such as, increasing means tested and capped co-pays as a percent of the total bill of services as opposed to flat amounts. This will make consumers aware of their costs in relation to prices charged.  In 2011, those 65 years old and over constituted 13 percent of the total population while federal spending on Medicare and Medicaid was 30 percent of the total health care spending. Per capita spending on older people in 2011 was close to $14,000.

On the supply side, hospitals operate in a non-competitive market. The March 4, issue of Time magazine presents an in-depth investigation by Steven Brill on hospitals’ pricing strategy. He finds that hospital pricing cannot be explained by costs of medical services and procedures. It resembles monopolistic pricing strategy, in which hospitals dictate prices as opposed to being subjected to market prices. Steven Brill states, “ No hospital’s Chargemaster prices are consistent with those of any other hospital, nor do they seem to be based on anything objective — like cost — that any hospital executive spoke with was able to explain.” Chargemaster prices are prices most hospitals use in their billings, however they are discounted for insurance companies and Medicare. Even with discounts hospitals earn abnormal profits, unlike other businesses.

Contrary to other industries, improved technology in medical care, has led to an increase in costs. This is partly due to more ease in conducting various tests, fee for service pricing and efforts to ward off complaints.  The evidence does show increase in costly tests and medical procedures, a result of lack of attention to preventive care. 

Tests have increased by extending the population group, e.g., screening younger groups for breast cancer (extensive margin), and by increasing the number of tests on the same population group, e.g., more frequent colonoscopies (intensive margin). This has increased cost as well as profits of hospitals and physicians’ compensation.

Since evidence-based tests and treatments have not been extensively implemented either in hospitals or physicians’ clinics, we find a great variation in tests, procedures and hence, cost of medical care. In addition, since physicians are not sole agents of patients, they have no incentive to shop around for best prices on behalf of their patients. Also, control of prices due to monopoly power puts no pressure on hospitals to restrain abnormal compensation packages for administrators, physicians and other personnel, hence escalating total costs of care.

It is ironic that we regulate gas and electricity prices but not prices of medical care services, even though this market is monopolistic. It is only through Medicare, Medicaid and to a certain extent through insurance system that the cost of medical care for most consumers is kept below Chargemaster price level. The Affordable Care Act also contains provisions to contain costs of medical services (e.g., payments based on treatment outcomes) and insurance premiums.  However, a single-payer Medicare system for all, with a means tested increase in Medicare tax and supplemented by private insurance system, would be more cost effective than the mish-mash system we have now.

Mathur is former chairman and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio. His articles also appear in mathursblogonomics.blogs.com. He also writes a blog for the Standard-Examiner at http://blogs.standard.net/economics,etc.