While market mechanisms should, over time, be able to cope with many
of the simpler forces affecting supply and demand curves related to health
carewith the occasional regulatory nudge, perhapsthere are
other problems that may be more unwieldy than the Invisible Hand is capable
of managing. Even the Economist magazine, a free market advocate
if ever there was one, concedes that "there remain some genuine problems
that limit the ability of unfettered markets to deal well with health
care." These problems stem from market imperfections or failures
that result in a less than socially optimal allocation of resources.
More simply put, we could do better. In theory, anyway.
The problems fall into several categories: those inherent to insurance,
those resulting from imperfect information, those due to too few
players buying or selling health care services and those caused
by unequal access to health care. These problems permeate the relationships
within the intimate triad of partners in the health care market:
consumers, providers and insurers. Further complicating the picture
is the influence of those who often pay for and regulate health
care: employers and the government. And like a Rubik's cube, as
you try to solve one problem for one side, it often exacerbates
a different problem for somebody else.
The trouble(s) with health insurance
Health is an uncertain state of being and health care insurance
is our usual economic means of dealing with that uncertainty. (Daily
apples and prayer are the standard noneconomic alternatives.) Because
we don't know whether, when or how seriously ill we might become,
or what it will cost to treat that illness, we financially buffer
our uncertainty by joining a risk pool called a health insurance
plan. God willing, we'll rarely need it, but just in case, here's
the monthly premium.
But there are two problems inherent to insurance: moral hazard
and adverse selection. Moral hazard is the idea that if someone
doesn't bear the full cost of something, they're likely to consume
more of it than they would otherwise. "Our third-party payer
market has our consumers virtually disconnected from the cost of
health care," noted Rep. Fran Bradley, chair of a Minnesota
legislative committee that's investigating the state's health care
Others echo that view. "If I pay the entire amount of the
trip to a doctor, and only get the insurance company to pay if I
had to have surgery or something significant, then I think the overall
costs would go down," said John Bouslog, vice president of
the National Travelers Life Co. "Then it would be easier to
manage from an insurance company perspective." Like several
other insurers, NTL is pulling out of the health insurance business
in South Dakota because "over a period of four years, we could
not increase our premium rates fast enough to keep up with the rate
of medical inflation.
Related to this is what economists call a principal-agent problem.
When insurers rather than consumers pay physicians, they may create
the wrong incentives, pushing the doctor (the agent) in a direction
that may not act in the best interests of the patient (the principal),
either skimping on care or providing too much. "There's lots
of market failure up here," noted Kay Unger, professor of health
economics at the University of Montana at Missoula. "There
are care providers who, if you're an insured patient, they'll do
lots of tests and they'll prescribe lots of drugs." Fee-for-service
insurance may tend to encourage oversupply while "capitated"
care (paying providers a fixed fee per patient) could lead to skimping.
Shifting costs back to the consumerthrough vouchers, higher
deductibles or co-payments, for examplemight diminish principal-agent
problems. Having patients pay directly would also reduce excess
consumption of medical care. But it thereby weakens the benefits
of risk sharing, the reason we buy insurance in the first place.
Designing optimal insurance policies in the face of moral hazard
is difficult, an exercise in second-best. The solution gets tougher
still because government tax policy subsidizes health insurance
and encourages overconsumption. By excluding employer-paid health
insurance premiums and roughly one-quarter of employee-paid insurance
premiums from calculations of taxable income, estimates David Cutler,
a Harvard health economist, federal income tax revenues were reduced
by about $60 billion in 1999.
While this subsidy is substantial and its impact on moral hazard
is no doubt significant, Cutler says there may also be substantial
gains to society. Government subsidization of health insurance may
indirectly fund medical research and innovation; it probably raises
overall rates of insurance coverage; and it may reduce a second
inherent problem with health care insurance: adverse selection.
Competition is generally a good thing in the marketplace, lowering
prices to efficient levels and encouraging product innovation. But
in health insurance, competition is a mixed blessing. The problem
stems from the fact that for health insurance, unlike most products,
the identity of the buyer can dramatically affect costs. Simply
put, unhealthy people cost insurance companies more money than healthy
people. But generally speaking, health insurers charge people not
according to their precise actuarial risk but by the average cost
of service for all members of the insurance pool. High-risk people
(likely to cost more) will be charged the same as low-risk (low-cost)
In a process known as adverse selection, high-risk people are drawn
to insurance plans with generous benefits because their costs are
implicitly subsidized by the healthy, and healthy people will be
attracted disproportionately to less-generous plans to avoid the
extra costs of the sick.
"The real problem with adverse selection," said Roger
Feldman, a health economist at the University of Minnesota, "is
that it confronts the decisionmakers with the wrong set of prices."A
person of average health faces "a price which is actuarially
unfair" for their state of health, while an unhealthy person
pays a lower, subsidized price. This can lead to a "death spiral,"
said Feldman: When premiums go up, the healthiest people in the
risk pool drop out, leaving behind the sickest and costliest, who
then face still higher premiums. The spiral continues downward until
the plan has to close.
So for health insurance, the efficiencies that might result from
pure competition among health plans and their customers is negated
by the loss of diminished risk pooling. The only guaranteed means
of dealing with adverse selection is compelling everyone to purchase
insurance and insisting that everyone pays their share. But such
"universal" insurance requires government interventionthe
opposite of free marketsand substantial income redistribution.
Aside from the political obstacles to such a policy, universal health
insurance incurs the economic inefficiencies of taxation, transfers
and administrative costsdeadweight losses that economists
Knowing more (or less)
In essence, adverse selection arises from what economists call
"asymmetric information"one party in a transaction
knowing more than the other. (The problem exists, famously, in a
used car lot: The dealer knows better than a potential buyer whether
a used car is a lemon, and prices and purchases may not reflect
actual quality.) In health care, some people might be "lemons"
but they probably won't want their insurers to know that. Of course,
no one knows his or her health risks with total certainty, but the
insured will have an incentive to hide risks from insurers if they're
charged according to their risk profile, and a patient might hide
information from a doctor if it will affect insurance coverage.
Not a good thing for effective medical treatment.
But the stream of asymmetric information runs in reverse too. For
example, doctors usually know far more than the patient about a
given ailment, available treatments and the costs involved. This
puts the doctor at a considerable advantage in making a decision
to purchase health care services, especially given the emotional
duress that often surrounds medical decisions. Comparison shopping
isn't always an option.
"You're not buying shoes and there's very little repeat business,"
observed Unger, the Montana economist, who noted that people tend
to have very inaccurate concepts of risk probabilities, treatment
costs and care quality. So the market signals that work in other
markets aren't equally effective in health care. "If a [car
mechanic] fixes your carburetor poorly the first time, the next
time you'll take it to somebody else," said Unger. But if a
surgeon does a so-so job on your kidney transplant, you might not
know it, you probably won't be shopping for another one, and you
really won't care whether he did the job cheaper than anyone else
Thus, asymmetric information leads to severe market inefficiencies
in the provision of medical care. The perfect knowledgeof
prices, quantities, qualitiesthat is a precondition for efficient
competition and optimal resource allocation is inherently absent
in health care markets.
Two other requirements for competitive marketsand therefore
for the lowest sustainable pricesare adequate numbers of buyers
and sellers, and unrestricted entry to the market. In many health
care settings, neither condition is satisfied.
In rural areas, there may be too few customers to sustain a hospital
at an economically efficient scale. A local hospital might even
have a monopoly, but still won't be able to survive because there
are too few patients to cover fixed costs. Also, rural hospitals
without large patient bases can't survive through the cost-shifting
that goes on in urban hospitals, where the uninsured are implicitly
subsidized by the insurance of others.
But in urban markets, a more common concern is too much concentration
among health care providers and/or insurers, allowing individual
firms to set or influence the price of care or insurance. In Minnesota's
Twin Cities, local observers have long been worried that insurance
companies would acquire too much market power, allowing them to
increase premiums at will.
Feldman, the University of Minnesota health economist, studied
a 1992 merger of two local health maintenance organizations (HMO)
that gave the new company over half the total Twin Cities HMO enrollment.
The merger, said supporters, would create "the right kind of
competition" by eliminating inefficiencies. Such benefits are
a theoretical and often real result of consolidation as merged firms
trim administrative costs and develop economies of scale. But Feldman
calculated that the merger was likely to increase health insurance
premiums within a few years and would significantly reduce employee
"I think I actually got a prediction right," he now jokes.
Indeed, health insurance premiums in the Twin Cities, where four
HMOs control 95 percent of the market, began their ascent earlier
and have risen faster and higher than in any of the other seven
major markets studied by Alan Baumgarten, an independent health
care analyst based in the Twin Cities. In the other markets, HMO
concentration levels are much lower. "You don't need to be
a health economist,"wrote Baumgarten, "to wonder what
the impact would be of having more organizations competing to serve
employers in Minnesota."
Insurers in white hats
Curiously, though, Feldman says the real problem may be with concentration
of providers, not insurers. "There's a real tug of war here
in the market between HMOs and providers," he said, "and
I think HMOs are generally the guys with the white hats here. They're
breaking up provider monopolies, and I think that's going to become
harder to do when the providers are totally concentrated."
As a reaction to HMO consolidationwhich gave HMOs more bargaining
power over providersand also in response to employers calling
for expanded health care networks, hospitals and physicians have
gone through their own dramatic bouts of merger activity.
Measuring provider concentration is difficult because it can be
hard to define the boundaries of a health care market, but most
observers agree that it's a real concern. "It's hard to put
your finger on the actual empirical analysis of the problem,"
said Jon Christianson, of the University of Minnesota's Carlson
School of Management. But "the thing is, provider consolidation
always trumps health plan consolidation."
Christianson noted that entry for new competitors is fairly easy
in the insurance market (although Minnesota prohibits for-profit
HMOs), but difficult for physicians or hospitals. Licensing requirements
and group practice restrictions, especially for specialists like
anesthesiologists, prevent physician competitors from easily entering
a local market. And the massive start-up costs and political roadblocks
facing hospital construction prevent new hospitals from easily entering
The problem is even more severe outside major metropolitan areas.
"As soon as you drop below a large city like [Minneapolis-St.
Paul], it's absolutely a locked market," said Christianson.
"You go into places like Fargo, Bismarck and Sioux Falls, and
you've got one or two hospitals, and all the docs are aligned with
one of those two hospitals."
To some, that's not a problem. "I think there's enough competition
in there that I don't think anybody has a monopoly," said Dean
Krogman, director of governmental affairs for the South Dakota State
Medical Association. Competition among insurers, the influence of
Medicare's fixed reimbursement rates and the ability of patients
to simply drive to a different hospital prevents anyone from having
monopoly power, according to Krogman.
"If you go to my hometown of Brookings, we have a clinic there
and you might think they have a monopoly," he said. "But
you don't know that until you find out how much of that health care
is on the interstate heading down to Sioux Falls, because that's
where their competition exists."
Indeed, that's why defining the boundaries of a health care market
gets complicated. Critics say that because provider and insurer
networks are often integrated geographically, a hospital in Brookings
may actually act as a feeder to a hospital in Sioux Falls, rather
than a competitor. "We refer to that as 'medical traplines,'"
said Michael Myers, a professor of health services administration
at the University of South Dakota, and former CEO of major hospitals
in Minneapolis and Rochester, Minn. "The traplines are laid
from the city out into these rural communities. ... You lay out
your clinics and your little hospitals and you buy a helicopter
to bring [patients] in. What you lose on subsidizing the country
doc you more than make up when the patient hits the front door."
That kind of geographic influence discourages patients from traveling
to competing hospitals or doctors, said Myers, as does the growing
integration of providers with insurers. The South Dakota medical
association owns one of the state's largest HMOs, DakotaCare, and
Myers said that "doctors who rage against HMOs or insurance
carriers behave very much like business school graduates once they
get in the ownership position."
Powerful rhetoric, but the reality is hard to gauge. Calibrating
the extent of monopoly power remains analytically difficult; measuring
whether the efficiency gained from consolidation outweighs the loss
of competition-based pricing is a complex exercise. And the political
will to monitor such activities may also be problematic. "This
is not a short-term problem," said the Carlson School's Christianson.
"You'd have to have a major review of antitrust policy, and
I don't see that happening."
Americans have long felt that all citizens, regardless of income,
should have access to basic levels of health care. But the market,
left to its own devices, does not guarantee such access. The government
has stepped into the breach with a patchwork of programs; the largest
are Medicaid (which covers low-income people) and Medicare (which
provides for the disabled and those 65 years and older).
Medicare covers about 14 percent of the country's population, and
accounts for about a fifth of all health spending. As the elderly
population grows, expenditure will increase, roughly doubling over
the next decade. The government tried to curb this growth, but providers
now complain that they're being underreimbursed. And state officials
in North Dakota, Minnesota and Wisconsin complain that Medicare
reimbursement rates, because they're based on outdated cost formulas,
force the elderly in their states to pay far more than those living
Medicaid, which provides coverage for about 10 percent of Americans,
costs the federal government over $100 billion annually, nearly
matched by over $80 billion from states and local governments. As
eligibility standards were loosened in the late 1980s and early
1990s, to address concerns that mothers were encouraged not to work
or to marry in order to stay eligible, costs grew significantly.
Some economists have been concerned that programs like Medicaid
induce some people who have private insurance to drop their policies
and join Medicaid. The extent of crowd-out, as it's termed, has
been estimated between 10 percent and 50 percent, that is, for every
10 people joining Medicaid rolls, from one to five are dropping
private insurance. "Even with this crowding out, however, some
evidence suggests that Medicaid spending is worth the cost,"
writes Harvard's Cutler. "Because health is worth so much,
even small improvements in health from additional insurance can
justify its high cost."
A more immediate concern to state governments is the tremendous
growth in the fraction of their budgets devoted to Medicaid. Nearly
20 percent of state spending went to Medicaid in fiscal year 2001,
second only to elementary and secondary education spending, and
the only expenditure category other than corrections whose share
of the total grew during the past 15 years. At its most recent meeting
in February 2002, the National Governors Association proclaimed
the escalation of state Medicaid costs "a major crisis"
that was forcing states to cut programs and hike taxes, and with
a series of proposals, the governors pleaded for relief from Congress
and the White House.
Despite the growth of government programs, there remain substantial
numbers of Americans who fall through the cracks, people who have
neither private nor public health insurance. These people "go
bare," hoping that they won't fall ill. If and when they do,
of course, those treatment costs have to be paid. Some payment will
come from the patient's pocket, but other costs are swallowed by
the provider and then cost-shifted to other patients.
It's estimated that roughly 14 percent of Americans go without
health insurance coverage, about 40 million people. Montana has
one of the country's highest rates of uninsured, with nearly one
in five residents under 65 years lacking health insurance. As elsewhere
in America, these uninsured Montanans tend to be the working poor.
"The people without insurance are working for small employers,
and health insurance may not be an option," said health economist
Unger. "Or the employer will say 'I can either cover half the
cost of medical insurance or give you an increase in wages.' Most
small firms are not high-wage payers and that means the [workers]
say, 'no, give me the money and I'll take the risk.'"
Jerry Driscoll, executive secretary of Montana's AFL-CIO, said
his union members tend to resent the uninsured because they drive
up hospital costs through cost-shifting. But with doctors constantly
raising their rates, he said, union members may themselves be forced
to go bare. In recent years, any raises the unions negotiate go
to insurance premiums, not wages. "If it all goes to health
insurance and nothing goes on the check again for the third year
in a row," said Driscoll, "the members are going to say,
'The hell with the doctors, we just won't have insurance, like everybody
Uninsurance rates are lower in South Dakota but still a real concern,
according to Darla Lyon, director of the South Dakota Division of
Insurance. Complaints to her office usually have to do with not
having access to affordable plans. Many people fall in the gap where
they "make a little bit too much to be eligible for a Medicaid
program and they're not old enough to be in Medicare, but yet they
don't have enough money to pay for the [private insurance] premium,"
Wisconsin and Minnesota have among the lowest uninsurance rates
in the country, but their low overall rates obscure dramatic disparities.
In Wisconsin, Hispanics were four times more likely than non-Hispanic
whites to have been uninsured in 2000. A Minnesota survey similarly
found that in 2001, African Americans, American Indians and Hispanic/Latinos
were three to four times more likely to have been without health
insurance at some point during the year than non-Hispanic whites.
Many worry that rising insurance premiums and a slowing economy
will worsen the situation. "Evidence is already appearing that
small employers are dropping coverage in response to sharp premium
increases," said a late 2001 report in Health Affairs,
a leading health policy journal.
Layoffs heighten the threat; in Minnesota, state analysts estimate
that about 13,000 people and their families lost health insurance
between January 2001 and January 2002. At a national level, experts
predict that if trends continue, the percentage of the under-65-year-old
population that is uninsured will increase from the current 16 percent
to 21 percent over the next decade.
Limited prospects for change
Business owners, legislators and individuals across the country
are hoping for reforms that will stem the rise in premiums while
still providing quality health care and reasonable access to the
hospitals and doctors they prefer.
Unfortunately, low costs, high quality, universal access and freedom
of choice are irreconcilable goals in health care because each demands
tradeoffs from the others. With vested interests championing one
goal over the others, significant change becomes practically and
In 1993, on the eve of the nation's last serious debate over health
care reform, Stanford economist and president-elect of the American
Economic Association, Victor Fuchs, published The Future of Health
Policy. He predicted that, barring a change in political climate
on the order of a war, depression or large-scale civil unrest, "We
should expect modest attempts to increase coverage and contain costs,
accompanied by an immodest amount of sound and fury."
A decade later, as the nation again confronts its health care crisis,
does Fuchs still hold to that forecast?
"The short answer to your question is 'yes,'" said Fuchs
in a letter to the fedgazette. "It is true that the
'reform advocates' are stepping up their efforts, but I don't think
they will accomplish much in the present political climate. Moreover,
even the little that they do get enacted will probably have much
less real effect than was promised."