Let’s Get Started. The Drivers of High Prices in Healthcare

15181671_1034193363376989_5637224603249359637_nAs we recover from the Thanksgiving holiday let’s start to come up with some solutions to the health care crisis. In light of the string of federal budget deficits, combined with a U.S. national debt approaching $21 trillion, the largest in the world – it is understandable that observers are scrutinizing health care costs which accounted for 17.9 percent of the nation’s GDP in 2010, or almost $2.6 trillion and presently even more. As the second highest component in national health expenditures at 20% (hospital care is 31 percent), physician/clinical services have captured everyone’s attention. Physician/Clinical services include health care services within the Department of Defense (higher costs in times of war), Indian Health Services, laboratory services, outpatient care centers and the portion of medical laboratory services and physician services in hospitals that are billed independently. Some critics have suggested that physicians’ incomes and the fact that physicians direct most health care spending (80% is a frequently used number) are the real culprits in rising health care costs. But let us look at all of the relevant components that contribute to health care costs. The rising cost of healthcare in the United States is a major concern for both citizens and policy makers.  In order to have a productive conversation about solutions to this cost increase problem and to coming up with a solution to the problems with our present system, it’s important to have an understanding of the drivers of high prices in various parts of the overall healthcare landscape.

Drivers of high prices that will be discussed here include:

  • Moral hazard in insurance markets
  • Adverse selection in insurance markets
  • Lack of price transparency and competition
  • Monopoly pricing in pharmaceutical markets
  • Lack of excludability
  • Technological advances and Telemedicine
  • Malpractice
  • Cost of medical education

This list is most likely not exhaustive, but it still provides a useful starting point in order to understand the problem at hand.

Moral Hazard in Insurance Markets: The term “moral hazard” refers to inefficiency created when a decision maker in insulated from the costs and/or benefits of her decisions.  In many cases, people purchase health insurance in order to help pay (and smooth out) their healthcare expenses.  Once an individual is insured, she often doesn’t have to pay the entire cost of the medical treatments that she undergoes.  This increases the cost of healthcare for two reasons.

First, to the degree that an individual can choose whether to undergo treatment, she might choose more treatment than is efficient.  For example, if an individual had to pay only a $5 co-pay each time she went to the doctor, she might go to the doctor every time she has a hangnail.  (Fortunately, the fact that going to the doctor isn’t an inherently pleasurable experience mitigates this problem to some degree.)  That doctor visit, however, may cost $150 in total, but may not be worth $150 to the individual.  This increases cost because the individual ends up paying for the $150 treatment indirectly via increased insurance premiums but doesn’t get $150 of value.

Second, the sharing of cost reduces the incentive for an individual to shop around to get the best prices for healthcare services.  (If you are going to pay the same $5 regardless of where you go, why not just go where is most convenient?)   This, in turn, reduces the incentive for healthcare providers to offer competitive prices and results in higher prices.

Health insurers and, to some degree, policymakers, try to reduce the amount of moral hazard by introducing high deductibles and increasing the share of the cost that an individual must cover.  Unfortunately, this can cause some individuals to procrastinate on getting valuable healthcare services because they don’t want to have to pay for them.

Adverse Selection in Insurance Markets: In economics, the term “adverse selection” refers to systematically doing business with parties that end up not being profitable to do business with.  Adverse selection is a phenomenon in markets where participants in a market that are at an information disadvantage are more likely to transact with those who will end up being unprofitable to do business with and less likely to transact with those who will end up being profitable to do business with.

For example, adverse selection is a common problem in unregulated markets for insurance.  If a consumer can sign up for health insurance whenever he finds it optimal to do so, he will sign up for health insurance when the cost of the treatments that he expects to need are larger than the premiums he would have to pay for the insurance (with some adjustment for risk aversion).

This of course means that health insurers are likely to have customers that disproportionately cost the company more money than they pay in premiums, thus being unprofitable for the insurer.  This situation arises because the potential customers generally have more information regarding their health and lifestyle habits than the insurance company has about them. To see how this affects markets for health insurance, consider the following example:  A health insurance company offers an insurance policy for $250 per month, and people can sign up at any time.  Unless people are exceedingly risk averse,  they won’t purchase the insurance unless they expect to spend at least somewhere in the neighborhood of $250 on healthcare per month. Risk aversion, as its name would suggest, is a characteristic of an individual who seeks to avoid risk.  More specifically, risk aversion refers to a characteristic where an individual prefers a certain outcome over a risky gamble (i.e. a scenario where the specific outcome is not known in advance).  For example, let’s suppose that an individual was presented with the following two options:

  • Receiving $50 for sure
  • Flipping a coin and receiving $100 if the coin comes up heads and $0 if the coin comes up tails

Both options have an expected value of $50, but a risk-averse individual will strictly prefer the certain $50 to the coin flip.

Risk aversion results when an individual experiences diminishing marginal utility over the outcomes being considered.  In other words, if an individual finds each incremental unit of the outcome to be less useful or happiness inducing than the one before, then the individual will exhibit risk aversion.

Under this system, customers are going to cost insurance companies more than $250 on average, and the insurance company won’t be able to stay afloat.  If they increase price, however, they just further whittle down the pool of health insurance customers into a smaller, sicker group.  When adverse selection is present, insurance premiums are higher than what they would be if everyone bought in, and, if adverse selection is strong enough, private individual insurance markets may not be feasible at all.

For this reason, insurance companies have historically focused on insuring diverse groups of individuals as opposed to taking individual customers one at a time.  (This, of course, can make it impossible to get an individual insurance policy.)  This is also the reason that insurers historically has rules about not covering pre-existing conditions- otherwise people would likely wait until they got sick to start purchasing insurance, which is not how insurance works!  The mandate aspect of the Affordable Care Act is an attempt to overcome adverse selection, and overcoming adverse selection makes it more feasible to relax restrictions on pre-existing conditions.

Given that even the mandate doesn’t result in perfect compliance, health insurance premiums are likely higher than they would be if everyone purchased insurance.

Lack of Price Transparency and Competition: Overall, healthcare providers make it incredibly difficult to discern how much any given medical procedure costs until an individual undergoes the treatment and gets the bill.  this means that, even if an individual cares about price, there is a significant hurdle to shopping around.  This feature leads many (even uninsured) individuals to not even try, and again gives healthcare providers little incentive to offer competitive prices.

The value created for society by a well-functioning unregulated competitive market is equal to the sum of consumer surplus- the amount of value that the market creates for consumers- and producer surplus- the amount of value that the market creates for producers. (This is because, in a well-functioning unregulated market, no one but the consumers and producers in that market are affected by the market’s existence.)

One question that is of interest to many economists is whether a social planner (i.e. someone who has the authority to direct production resources and distribute the output) could create more value than what is generated by the market forces of supply and demand alone. As it turns out, the answer is no, and economists can in fact conclude that the market forces present in well-functioning competitive markets maximize the amount of value that is created for society.

Monopoly Pricing in Pharmaceutical Markets: Patent protection for pharmaceuticals, medical devices, and other related items grants (temporary) monopoly power to producers of these items, and, as a result, causes the prices of such items to be higher than they would be in competitive markets.  Competitive markets sometimes referred to as perfectly competitive markets (or perfect competition), have three specific features.

The first feature is that a competitive market consists of a large number of buyers and sellers that are small relative to the size of the overall market. The exact number of buyers and sellers required for a competitive market is not specified, but a competitive market has enough buyers and sellers that no one buyer or seller can exert any significant influence on the dynamics of the market. You can think of competitive markets as consisting of a bunch of small buyer and seller fish in a relatively big pond.

The second feature of competitive markets is that the sellers in these markets offer reasonably homogenous or similar products. In other words, there isn’t any substantial product differentiation, branding, etc., in competitive markets, and consumers in these markets view all of the products in the market as being, at least to a close approximation, perfect substitutes for one another.

The third and final feature of competitive markets is that firms can freely enter and exit the market. In competitive markets, there are no barriers to entry, either natural or artificial, that would prevent a company from doing business in the market if it decided that it wanted to. Similarly, competitive markets have no restrictions on firms leaving an industry if it is no longer profitable or otherwise beneficial to do business there. While this seems less than ideal from a consumer perspective, there is a fairly widespread belief that these monopoly profits are necessary in order to provide adequate incentives for private firms to undertake costly up-front research and development programs, without which the products wouldn’t be available to consumers at all.

Whether there is a way to mitigate this cost problem depends on whether there is a more cost-efficient way of undertaking and/or financing research and development.

Lack of Excludability-Healthcare providers, especially emergency treatment facilities, don’t generally require customers to pay up front before they receive service- in other words, healthcare providers restrict treatment to paying customers far less than sellers of, say, an iPhone.  This makes sense for both ethical and logistical reasons, since people are likely not always in the proper state to make up-front consumption decisions.

But it also means that a lot of consumption decisions are made by doctors rather than the parties that end up paying, and it’s unclear what priority doctors should place on cost savings rather than focusing on the treatment itself.  Furthermore, these logistics create situations where some customers end up not paying, and these costs can get shifted onto other paying customers in the form of higher prices.

Technological Advances: Lastly, costs tend to increase because increase in technology provide a wider, more sophisticated array of treatments- it shouldn’t be surprising to anyone that providing sophisticated treatment is more expensive than simply saying “sorry, we don’t have any way to deal with that, so just sit tight and deal.”                Medicine in the 21st century is increasingly dependent on technology. Unlike in many other areas, the cost of medical technology is not declining and its increasing use contributes to the spiraling healthcare costs. Many medical professionals equate progress in medicine to increasing use of sophisticated technology that is often expensive and beyond the reach of the average citizen. Pediatric heart care is very technology-intensive and therefore very expensive and beyond the reach of the vast majority of children in the developing world. There is an urgent need to address this situation through development and use of appropriate technology in accordance with the needs and priorities of the society. A number of simple and inexpensive quality measures that have the potential of improving outcomes substantially without the need for expensive equipment should be instituted before embracing high-end technology. Innovations to reduce costs that are commonly used in limited resource environments should be tested systematically. Today, healthcare is increasingly driven by digital technology. Most medical equipment today runs on digital platforms. Hospitals, clinics and many other healthcare facilities are increasingly dependent on hospital information software. Yet, healthcare is becoming increasingly expensive and out-of-reach for the common man. Clearly, there are many other elements that contribute to the spiraling healthcare costs. Digital technology does not seem to empower the average patient. Rather it sometimes does the reverse. It makes them more vulnerable and helpless. Two examples are worth studying, especially because they represent applications in digital technology that have tremendous potential to meet the needs of the common man. However, they have not developed along the lines that would have improved their reach

Telemedicine: Today we have the technology to transfer large amounts of digital information effortlessly at relatively low costs. While telemedicine holds considerable promise we have not done enough to translate this powerful tool to help the common man. Today it is easily possible to listen to a patient’s heart remotely, look at and opine on an electrocardiogram (ECG), X-rays, computed tomography (CT) scans and other imaging data obtained several hundred miles away. While this technology has been available for at least 10 years very little systematic effort has been made to use it to make a real difference in the lives of people in India and much of the developing world.

Health expenditures continue to grow very rapidly in the U.S.  Since 1970, health care spending has grown at an average annual rate of 9.8%, or about 2.5 percentage points faster than the economy as measured by the nominal gross domestic product (GDP).  Annual spending on health care increased from $75 billion in 1970 to $2.0 trillion in 2005, and is estimated to reach $4 trillion in 2015.  As a share of the economy, health care has more than doubled over the past 35 years, rising from 7.2% of GDP in 1970 to 16.0% of GDP in 2005, and is projected to be 20% of GDP in 2015.  Health care spending per capita increased from $356 in 1970 to $6,697 in 2005, and is projected to rise to $12,320 in 2015.1

The particularly rapid increases in health insurance premiums over the last few years have focused the health policy community on the issues of cost containment and health insurance affordability.  A key question from policymakers is why spending on health care consistently rises more rapidly than spending on other goods and services.  Health care experts point to the development and diffusion of medical technology as primary factors in explaining the persistent difference between health spending and overall economic growth, with some arguing that new medical technology may account for about one-half or more of real long-term spending growth.  This paper briefly describes what health policy analysts mean by medical technology and the mechanisms by which it affects the growth in health care costs.


The technology is used on the consumer and not by the consumer: The actual “consumer” is still the patient because it is he or she that eventually pays for the product (and the service). This is particularly true in most of the developing world where healthcare delivery is completely disorganized with a very tiny proportion of the population having health insurance. While the patient (consumer) pays for the product (to the manufacturer) and the service (to the health professionals), the demand is not necessarily created by the consumer. When the demand is artificially created to justify the use of technology, it becomes exploitative. Further, with time the cost of service often increases.

A bottom of the pyramid (BOP) model has not been developed for many medical specialties. While the “Jaipur foot” and “The Aravind eye network” stand out as successful examples of implementation of the BOP model in healthcare, many specialties require complex systems and expensive infrastructure that would challenge the development of a BOP approach. Pediatric cardiac care is perhaps an example where the BOP approach may be difficult with the available technology. Novel approaches will be needed to deliver heart care in large numbers using inexpensive models. This requires the collective will of a large number of committed individuals that includes those developing technology, entrepreneurs and health professionals. Visionary leadership, teamwork and external support (such as from the government) are also vital requirements.

Most multinational companies that manufacture echo machines (and other equivalent digital products) are not convinced about the BOP approach. They do not seem to be inspired by the success story of the cell phone technology. A generous profit margin for every individual item is still the most important strategy used to offset research, development and marketing costs. They are not completely convinced that “economics of scale” with small profit margins for every unit can be applied to their products. They often use similar strategies as they would in developed countries and essentially concentrate on selling their products to select affluent facilities in metros.

Malpractice and the Effect on Health Care costs: Medical malpractice costs are an important and increasing component of physicians’ costs. More than two-thirds of malpractice awards are physician related. Trends indicate that malpractice costs will continue to increase for the near future. The American Medical Association (AMA) (1984-85) describes the problem as reaching “crisis” proportions. Pressures to limit physician costs under Medicare present a concern on how malpractice-related costs will be absorbed.

Physician malpractice costs include two parts—the cost of liability insurance premiums and defensive medicine costs. Malpractice insurance premiums are recognized as a part of physician overhead expenses, and the costs of increased premiums are passed on to patients and their insurers as part of the physician’s fee. A recent study showed that for every 100-percent increase in premiums, physician fees are estimated to increase 9.1 percent. The fear of malpractice lawsuits also provides an incentive for physicians to order medically unnecessary services, such as an increased number of tests or confirming opinions. Such defensive medicine costs are difficult to measure, but the AMA (1984-85) estimates that $15 billion per year is added to the cost of health care. Defensive medicine costs are also passed on to patients and insurers.

Malpractice insurance premiums for physicians have increased at an average rate of over 30 percent per year. This rate is significantly higher than health care cost inflation and the increase in physician costs. Trends indicate that malpractice related costs, both liability insurance and defensive medicine costs, will continue to increase for the near future. Pressures to limit physician costs under Medicare raise a concern about how malpractice costs can be controlled.

Medical Education: I have already reviewed the exorbitant cost of medical education ($150-$340 thousand), which the physician has to find some way of paying back whether they are the bank or parental loans. With the shrinking reimbursements given to physicians, no wonder why less students want to pursue medicine as a career or most graduating doctors become employees of a hospital or health care system.

What about the different views between doctors and health administrators and health care? Most doctors are looking to do better and better for the individual patient who comes to them. They often do not think of those who do not reach them. Progressive improvements in outcomes require increasing resource deployment. The relationship is exponential. Initially, small investments in basic resources result in impressive improvements in outcomes. But after a certain level considerable material (equipment and infrastructure) and human (personnel) resources are required to accomplish small improvements in outcome. In situations where healthcare is not organized in accordance with the needs of the population, health facilities that strive to achieve exceptional results (state-of-the-art) are completely out of reach of the average citizen. Indeed the poorest are seriously intimidated and are completely excluded from the ambit of these facilities. Pediatric cardiologists and cardiac surgeons who spend most of their lives inside hospital environments often completely lose sight of the situation in the community. The fact that only 2-3% of children born with significant congenital heart disease reach hospitals to undergo surgery or interventions has not been internalized by most of us.

We need to rethink about how we should define progress in the healthcare sector. We should find a way to measure the proportion of patients who are excluded from a healthcare facility because of costs of care and this parameter should perhaps be a part of the evaluation process for accreditation of institutions that aspire to meet acceptable standards of healthcare.

A paradigm shift in healthcare delivery is desperately needed. The facts and figures on the actual proportion of patients that are being excluded from access to available technology will need to figure in the collective consciousness of doctors, entrepreneurs, policymakers and members of the healthcare industry. Realistic business models that are aimed at least at a part of the population that is completely excluded and marginalized will need to be pursued recognizing that there are vast numbers that can allow the economics of scale to become operational.

Are there any realistic solutions? Stay tuned!

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