Skip to main content

Beyond supply and demand

The reasons for increased health care costs go beyond simple supply and demand, and solutions are tougher than they seem

May 1, 2002


Douglas Clement Senior Writer
Beyond supply and demand

While market mechanisms should, over time, be able to cope with many of the simpler forces affecting supply and demand curves related to health care—with the occasional regulatory nudge, perhaps—there 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 problems.

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 consumer—through vouchers, higher deductibles or co-payments, for example—might 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.

Adverse what?

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) people.

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 intervention—the opposite of free markets—and substantial income redistribution. Aside from the political obstacles to such a policy, universal health insurance incurs the economic inefficiencies of taxation, transfers and administrative costs—deadweight losses that economists abhor.

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 in town.

Thus, asymmetric information leads to severe market inefficiencies in the provision of medical care. The perfect knowledge—of prices, quantities, qualities—that is a precondition for efficient competition and optimal resource allocation is inherently absent in health care markets.

Market power

Two other requirements for competitive markets—and therefore for the lowest sustainable prices—are 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 welfare.

"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 consolidation—which gave HMOs more bargaining power over providers—and 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 existing markets.

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."

Medical traplines

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."

Unequal access

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 elsewhere.

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.

Going bare

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 else.'"

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," said Lyon.

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 politically implausible.

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."

Douglas Clement
Senior Writer

Douglas Clement was a managing editor at the Minneapolis Fed, where he wrote about research conducted by economists and other scholars associated with the Minneapolis Fed and interviewed prominent economists.