A Health Economics Top Ten List

by John B. Horowitz, Chair, Department of Economics, Ball State University

I presented a version of this list to an Orthworx Health Economics Conference in Syracuse, Indiana November 2015.

One of Ball State’s most famous alumni is David Letterman who is renowned for his top 10 lists. Here is my top 10 list for healthcare.

1) Scarcity.

Scarcity is the fundamental concept in economics. Scarcity means you can’t get all you want for free. With over a trillion dollars spent on Medicare and Medicaid in 2013 that means that there are over a trillion dollars worth of other things not produced. The government has an incentive to look for ways to reduce health care spending. https://www.cms.gov/research-statistics-data-and-systems/statistics-trends-and-reports/nationalhealthexpenddata/nhe-fact-sheet.html

2) High fixed costs.

Healthcare tends to have high fixed costs. For example, pharmaceuticals have high costs for research and development but the cost per pill is very low. For hospitals much of their costs are in the infrastructure of the hospital but adding an additional patient has a fairly low additional cost. I was at one hospital in Indiana where the employees told the joke where they said we need to “feed the beast.” I asked them what this meant. And they mentioned that their average cost was lower when the beds in the hospital were filled. If only part of the hospital had patients then their costs were higher and their profits were lower.

Telemedicine is an example of high fixed cost and low marginal cost. A hospital president mentioned that to cover hospitals in his system, they have a building in Virginia where specialists are available to practice medicine for the hospitals in their system. This lowers cost since they don’t have to have specialists at each hospital 24 hours a day. This helps make it so they have services available at rural hospitals. Amwell and MDlive do online doctor’s visits and minor prescriptions.

Interestingly, when there are high fixed costs, and near zero cost of adding an additional customer then there tends to be a fight for the market. For example, internet companies such as Facebook and Linkedin fight to be the dominate company in their respective markets.

3) Innovation.

Many people have heard of the iron triangle in healthcare. The iron triangle means you can’t improve access, quality, and cost at the same time. If you improve access, that will raise costs. If you improve quality, that will raise cost. If you lower cost, then either access or quality will be reduced. However, you can improve access, raise quality and reduce cost when you innovate. Adjusted for inflation, cars are lower cost, better quality and more people have a car than 100 years ago.

It is hard to know what the future innovations will be. For example, will the fall in MRI machine prices cause more and more procedures to leave the hospital and be performed in the doctor’s office or even through apps in the patient’s home so that each patient’s bedroom becomes the clinic of the future? There is a story about doctors re-growing fingers using pig’s bladder powder. In the future, will orthopedics companies regrow hips and ankles using pig bladder powder? http://www.huffingtonpost.com/2013/09/18/finger-regrows-pig-bladder_n_3949720.html

4) Demographics:

People are getting older and want to stay mobile increasing the demand for orthopedic products. The epidemiological transition means that fewer people are dying from communicable diseases and that more people are living longer. And Robert Fogel argues that in the past, demographers have been much too conservative in their estimates of how long people will live.

For geographic demographic differences in demand for health care see: http://adage.com/article/adagestat/demographics-health-care/233878/. For an example of the epidemiological transition see: http://www.ncbi.nlm.nih.gov/pmc/articles/PMC2937133/. For Fogel’s arguing that life expectancy estimates are normally wrong see: http://www.bloombergview.com/articles/2011-07-21/business-class-longer-lives-and-lower-health-costs. For a view of family life in the 1800s in America, see: http://www.encyclopedia.com/doc/1G2-2536601450.html

5) Insurance:

When someone else pays, people don’t care about cost. Someone else paying rotates the demand curve and assuming no deductible or coinsurance rates, people treat healthcare as if it is a free good. In a class, I had a student who said that “when my boyfriend pays I don’t treat it as if it were free.” I asked, “What about when your Mom pays?” Her response was that her mother owed her and when her Mom paid, she didn’t care about cost. When the government or an insurance company pays for the whole cost of care, people treat healthcare as a free good. This increases costs and insurance companies and the government try to control their costs. Joseph Califano mentioned that when Medicare was first implemented, there was cost plus pricing. Costs were much greater than they expected and the Government tried to reduce these costs by various cost control mechanisms such as Diagnostic-Related Groups (DRGs) or price bundling.

 Unfortunately, many of these cost controls are price controls. Prices are an important part of well-functioning markets where high prices signal that a good or service is scarce. These high prices 1) motivate buyers to conserve on the use of scarce resources, 2) motivate suppliers to provide more of a scarce good, 3) create incentives for firms to innovate and find ways to provide the good at lower cost and 4) create an incentive to develop and substitute into other less scarce goods.

Fixed prices often distort these price signals, can create shortages as people treat scarce goods as if they were abundant, and often reduce incentives to innovate. Not competing on price also creates an arms race as hospitals compete on amenities rather than price. That is assuming that the insurers are paying high enough prices so that firms want to provide the good. http://www.heritage.org/research/reports/2013/08/legislating-low-prices-cutting-costs-or-care

The problem with high prices is access. The poor might not have the money to pay for access to health care. On the other hand, the poor also may not have access to health care when the government sets Medicaid reimbursement rates too low. For example, 56% of psychiatrists and 40% of orthopedic surgeons won’t accept new Medicaid patients. http://content.healthaffairs.org/content/32/7/1183.abstract

6) Cost-Benefit Analysis:

Cost benefit analysis is one of the major ways that health care providers can show that their products are safe and effective and thus gain reimbursement for their products or increase the level of reimbursement. Sellers want to honestly show that their products’ benefits are greater than the costs. For products like orthopedics that last many years, the interest rate used in discounting future benefits has a major effect on how large future benefits are. Products like orthopedics where you get the hip replacement now but receive the benefits over the next 20 years look better with lower interest rates. Higher discount rates mean that future benefits are not valued as highly, so the investment does not look as good. The federal government uses 7% for many public investments but lower interest rates for other projects. 7% will make future benefits look much lower than at 2%.

For a discussion on discount rates in federal government programs see: https://evans.uw.edu/sites/default/files/public/Federal_Agency_BCA_PS_Social_Programs.pdf, https://www.whitehouse.gov/sites/default/files/omb/assets/a94/a094.pdf and http://www.ncbi.nlm.nih.gov/pmc/articles/PMC2759615/.

Comparing risks, benefits, costs and alternatives is not only important for regulatory review but also for doctors and patients when they make health care decisions. Patients who heavily discount the future are less likely to choose a procedure with high present costs and benefits that are many years in the future. See: http://www.aaos.org/news/aaosnow/dec14/clinical4.asp

When programs are paid for by the government such as Medicare and Medicaid, the cost of public funds is important. There are a variety of estimates of the cost of raising a dollar in revenue. Estimates for the US Federal income tax find that it costs about $1.40 to raise a dollar in tax revenue. This is a cost that is often left out of cost benefit analysis when the revenue comes from income taxes. The 40 cents extra is because of enforcement costs, compliance costs, and deadweight losses. See: Table 2 in: http://econjwatch.org/articles/saying-too-little-too-late-public-finance-textbooks-and-the-excess-burdens-of-taxation

Taxes such as the tax on medical devices may not have the same excess burden as the Federal income tax but will also have enforcement costs, compliance costs and deadweight losses. The benefit to the government from the medical device tax is the revenue gained. This revenue if spent on healthcare may mean more money to provide medical care and some of that is likely to be spent on medical devices. On the cost side, this tax means that revenue is transferred from producers to the government and there are costs to enforce the tax, costs for the companies to comply with the tax and deadweight costs from the tax that creates a wedge between the price producers receive and buyers pay. These tax costs are likely to lead to a decrease in profits, lower output and perhaps less incentive to innovate.

7) Income:

As people get richer, they spend a smaller percentage of their budget on food (Engel’s Law) and a larger percentage on health care. In fact the income elasticity of demand for healthcare is about 1.6. This means that when a family’s income increases by 1 percent, they spend about 1.6 percent more on health care. This is one of the primary reasons for increases in healthcare expenses. People are likely to spend more on healthcare even when someone else is paying. However, since the government is paying over a trillion dollars, the government has the incentive to reduce healthcare spending. http://gregmankiw.blogspot.com/2009/09/why-are-we-spending-more-on-healthcare.html

People’s incomes change quite a bit from year to year. Economists call this income mobility. When we were working on the Earned Income Tax Credit (EITC), we thought that there would be quite a bit of mobility in the Phase-in range of the EITC since people would earn too much to be in that range at the time if they worked full time at a minimum wage job. Most people had to be part time workers. We were surprised that there was great income mobility in all of the ranges of the EITC. Most people were in and out of the EITC after just a few years. That is reduced now that the EITC has been greatly expanded. For more on the EITC and income mobility see: http://pfr.sagepub.com/content/39/5/619.abstract

 Income mobility means that many people are likely to be eligible and then lose eligibility for Medicaid. Some estimates are that half of all the poor eligible for Medicaid will have a change in eligibility within a year. On the other hand, there is some evidence that children who had Medicaid when they were young had higher income later in life. http://content.healthaffairs.org/content/30/2/228.short http://www.irp.wisc.edu/publications/dps/pdfs/dp142815.pdf

As countries develop, peoples’ out-of-pocket expenditures on health care decrease. In low income countries, more than 60 percent of health care expenditures are out-of-pocket. Out-of-pocket expenditures fall to 40 percent in middle income countries and 20 percent in high income countries http://siteresources.worldbank.org/INTHSD/Resources/topics/Health-Financing/HFRFull.pdf

Some argue that raising health care costs is one reason workers’ money wages are increasing slowly which leads to an increase in measured income inequality. http://www.epi.org/publication/bp358-increased-health-care-cost-sharing-works/

There is also great inequality in healthcare costs. The most expensive 5 percent of the population accounts for about half of health care costs in the United States. These people tend to be elderly. Also, those who are high cost one year are normally not the high costs a few years later though there is some persistence for some. http://archive.ahrq.gov/research/findings/factsheets/costs/expriach/

8) Regulation:

Regulation is derived from Latin regula meaning a rod for measuring and drawing lines, to adjust to some standard or requirement. Some regulations can increase coordination. Other regulations are barriers that are hard to overcome especially for smaller companies. Many regulations are implicit in a mutual understanding of how things should be done. An increase in complexity normally means an increase in explicit rules. In building Windmills and Gothic Cathedrals, for hundreds of years the builders had a mutual understanding though the rules were not written. In modern buildings with many subsystems, there have been large increases in explicit rules.

 The FDA has an incentive to delay drug development. This is to avoid embarrassment from allowing harmful drugs or devices. (http://www.fdareview.org/incentives.shtml) This also http://www.fdareview.org/history.shtml. Interestingly, the 1938 law created a new class of prescription only drugs, though a House committee reported that the bill was not intended in any way to restrict drugs used for self-medication.

9) Information:

In healthcare, most hospitals normally don’t want patients to know what their prices are. Before I went into surgery, I asked the nurse “how much is this going to cost?” She answered that she did not want to know the cost since she wanted to give all of her patients the best care possible. I was excited that she was going to give me the best care possible. On the other hand, I was scared that I was going to have to pay for the best care possible. If I walked into a car dealership and they refused to discuss price until after I bought the car, I would go somewhere else.

This is similar to the Monroney Sticker after Senator Mike Monroney of Oklahoma who sponsored the Automobile Information Disclosure Act of 1958. The act mandated the disclosure of information on new automobiles and their prices. The increased transparency increased the buyers bargaining position.  http://www.nytimes.com/2009/01/04/automobiles/04MONRONEY.html?_r=0

In gas prices, many states have laws that mandate that gas stations post their gas prices. This increases competition so that the most profitable items are for the convenience foods inside the station, which is why most stations would prefer that people pay inside. http://www.cbsnews.com/news/why-do-gas-stations-post-their-outrageous-prices-because-well-they-always-have/

Currently, apps such as GasBuddy are increasing price competition between gas stations by revealing gas prices at all of the gas stations in a city. Likewise, apps and sites like Kelly Blue Book (KBB) reveal the fair market value and locations of cars being offered all over the country. When I recently bought a used car, I used several services and negotiated. Afterward, the business manager was willing to tell me that they had made about $300 and that most of their profits on selling cars came from selling warranties. He mentioned that before the online pricing services when there was less price transparency, dealerships would often make $5,000 a car in profit.

Likewise, in Medicine increased transparency of prices should increase the bargaining power of buyers. A JAMA article argues that using the Monroney analogy in allowing consumers to obtain pricing information from US hospitals may help keep cost down. http://archinte.jamanetwork.com/article.aspx?articleID=1569849

However, with cars people are usually spending their own money while for health care they are mainly spending someone else’s, which is why Health Savings Accounts try to get people to spend more of their own money. People are more careful when their own money is on the line. On the other hand, some argue that getting people to spend their own money (cost sharing) burdens low income patients who need the care the most. http://www.epi.org/publication/bp358-increased-health-care-cost-sharing-works/

10) Who Makes the Decision Matters:

The architect John Habraken stated that the uniform appearance of mass housing such as what existed on the south side of Chicago, public housing in Europe, and apartment complexes in the old Soviet bloc looked the same regardless of country because professionals and governments made the decision about what were best practices for their users. Users often opposed the standardization of plans and structures because they said it made them feel like serfs, dependents or herd animals. Rather he argues for user participation and control in decision making. https://www.mcgill.ca/files/mchg/chapter3.pdf

Insurance companies and doctors make many of the health care decisions, especially since patients are not directly paying. If there is a new pacemaker with a battery that can last 8 years rather than 4 years, doctors and hospitals may prefer the 4 year battery since they make more money from more surgeries. Insurance companies may prefer 4 years since a 4 year pacemaker is likely to be cheaper than an 8 year pacemaker and most patients are only with the insurance company from 3-5 years. The patient, on the other hand, prefers the 8 year battery since it is nice to be cut open only once rather than twice.

Centralized decision making creates uniformity which can be valuable when you are trying to produce the same product consistently. This is especially valuable when the leaders who are making the decisions can be trusted and have the information they need. On the other hand, dispersed decision making tends to create diversity which is important to innovation. This is especially valuable when either centralized decision makers are not trustworthy or information is dispersed among many different people so that leaders don’t have important information.

To conclude, these ten economic concepts affect how much we pay, how innovative health care is and our access to and the quality of health care services. These economic concepts affect how healthy we are, the quality of our relationships with patients, with health care providers, and with family members. These are life and death decisions.

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