Healthcare Reform Meets Economics 101

Troy Ahlstrom writes…

I don’t know about you, but I don’t understand health care reform.  That’s not to say that I don’t think we need a helping of regulatory medicine to fix what ails the country’s cobbled together healthcare “system.”  I just can’t work the pieces into a functioning whole.

The basic tenets of health care reform debate, 2009-2010 edition, have been:
1)    Provision of universal, or near universal, healthcare to the citizenry of the U.S.
2)    Limiting the costs of healthcare in the U.S. by reducing the growth rate of health care costs to the U.S. government, and thereby, the American taxpayer.
3)    There shall be no rationing of healthcare in the new system.

Given that I can’t model the platitudes and punditry into a functional system for further examination, I’ll just cast them aside and look at the practical aspects in the healthcare economy.  Leaning heavily on microeconomics/price theory to sort through the three tenets listed above, the first two are easily convertible to the principles of supply and demand with #1 ratcheting up demand while #2 contains costs, which constrains supply.  The third represents another take on the demand side.  Healthcare is the commodity in play.  See Figure 1 and Figure 2 for a graphical description.

One assumes that we have a current equilibrium between the supply and demand curves in the U.S. healthcare market to begin.  This is where curves D1 and S meet.  Thus, a certain quantity of healthcare is delivered (Q1) to consumers at a certain price (P1).  Tenet #1, providing universal coverage, creates more demand for healthcare services and the demand curve shifts to the right, from D1 to D2.  There is a new equilibrium point where a higher quantity (Q2) is delivered, now at a higher price (P2).  Increasing demand without increasing ability to meet demand results in higher prices by putting more consumers in competition for the same service.

However, the mandate is to control costs or to limit their growth rate per tenet #2.  Thus, we will hold the price at the initial price point, P1.  Draw another line horizontally across from P1 to the new demand curve, D2, to derive the higher quantity of healthcare services that would be consumed at that price on curve D2, which we’ll label Q3.  There’s a big difference between the quantity of healthcare being demanded (Q3) relative to the supply (Q1) at this constrained price.  That’s the problem!  We’ll generate more demand at this artificially low price, but no more supply.  What shall we do?

The system now needs to further manipulate supply or demand to achieve balance.  Other industrialized nations have generally controlled the increase in demand by rationing the amount and types of care delivered.  Rationing decreases demand and shifts the curve back to the left (from D2 back to D1).  In other words, all people will have access to healthcare, but only a limited amount of access.  Thus, more people consume the same amount of healthcare that a few consumed previously.  But, per tenet #3 – NO rationing, that’s off the table.   Obviously, this decision is political, yet completely predictable.  All of the political benefits rest on the premise of providing more benefits and services to constituents.  Hence, the pragmatic economic solution to limiting costs while increasing access – rationing – shall not intervene.  We shall have to deal with higher demand compared to limited supply.  And that requires that costs for healthcare MUST increase without other intervention.  It’s really that simple.  One cannot increase demand for a service in limited supply and not see costs rise.  The only answer is to increase supply to control the costs, and I don’t see a big supply of doctors and nurses out there twiddling their thumbs.  Do you?

Microeconomic principles also assume supply and demand to be elastic, or to change rapidly based on the pressures placed on price by supply or demand.  Yet, the healthcare economy lacks elasticity.  Consumers will pay high prices to save their lives, improve their quality of life, or to do so for loved ones.  Meanwhile the supply of healthcare available for delivery is limited as well.  The U.S. medical education system has seen fewer doctors and nurses available with predictions for further difficulties in numerous important areas including: Family Medicine, Internal Medicine, General Surgery, Obstetrics, and Hospital Medicine.

In my home state of Michigan, we’re seeing an encouraging trend of opening new medical schools which could eventually double the states output of new physicians.  Yet, I’ve seen nothing that addresses the escalating costs of undergraduate programs, medical school, and graduate medical education.  How are we to constrain the system cost of physician pay, or encourage students to train in the lower paying fields so badly needed to meet the demand of universal care and an aging population, if we don’t rein in the staggering debt levels burdening these same professionals who will earn less than their predecessors?

I believe, as is the case in other economic systems with limited supply and price controls, that our healthcare system will address these difficulties by resorting to a gray market solution.  Gray markets are legal versions of black markets.  Both develop when price controls are enacted to prevent a system from reaching equilibrium at a higher price point.  Price controls further exacerbate the supply shortage as fewer producers enter the market due to the low price.  The black market examples could include any illegal substance where legal production ceases.  Consumers still find the products they desire by paying much more than they would for that same product if the system were allowed to increase supply and establish a new price point.  Gray markets exhibit similar behavior seeking to balance supply and demand for a highly regulated, yet legal, commodity.

We already have numerous examples of gray market solutions to price controls in healthcare in the U.S. and abroad.  My wife’s grandmother avoided undergoing her hysterectomy in a state run European health system forty years ago by paying much more to undergo the procedure in a private hospital that had earned her trust.  Such private hospitals flourish still today.  Here in the U.S., we’ve seen more providers limit their Medicare and Medicaid participation.  We’ve also seen the emergence of “boutique” or “concierge” primary care practices which eschew Medicare in favor of an annual membership fee ranging from around $1,000 to $15,000 per year depending on locale, number of members, level of service, and ability to bill a medical insurance provider.  Participants often enjoy prolonged visits with physicians, 24 hour access to their provider, and may have the ability to have the same provider care for them in the hospital or even attend a subspecialty physician consultation with their primary provider present during the visit.  Once again, the gray market solution represents a more expensive alternative than that which would develop were there no price control in force.

As for me, I’m watching to see where this all settles out.  I’ve emailed and faxed my Senators and Representative with my opinions.  And I think SHM is pushing in the right direction by focusing on improving quality, efficiency, and evidence based approaches to care that seek to improve processes and decrease variability in care delivery.  But the part that nags at me is the unforeseen consequence which could easily play out here.  We intervene in natural systems to manipulate the outcomes with good intentions.  Yet, the unintended consequences of our interventions often result in more difficulties down the line.

(Graphics obtained from Wikipedia.  For further detail on microeconomic principles, see http://www.econlib.org/library/Enc/Microeconomics.htmlMicroeconomics by Arnold C. Harberger.)

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