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Healthcare Markets Are "Less Rational"

Clearly, the Current System Has Problems

How to Solve the Current Healthcare Problems


Healthcare Markets Are "Less Rational"

Over the past several months there has been an absolute deluge of articles in the media regarding how out-of-hand US healthcare spending has become. Many are convinced that the provision of healthcare involves various unique situations, which make the private markets unable to efficiently provide healthcare. For example, Jim Heskett of the Harvard Business School presents 10 reasons why participants in the healthcare market may be "less rational" than participants in other markets:

  1. Consumers have personal fears and lack of information that don't exist with food and fuel,
  2. They equate cost with quality, turning the idea of rational markets upside down,
  3. Individuals' decisions regarding wellness affect the rest of us,
  4. Rationing is necessary but difficult to achieve,
  5. There is an agency problem when neither payers nor providers (including pharma) are penalized by higher costs,
  6. There is a "fee for services" vs. a "fee for results" payment system,
  7. The U.S. has too many high-cost specialists performing work that could be performed more effectively by general practitioners and registered nurses,
  8. High levels of liability encourage the practice of "overly-safe" and expensive medicine,
  9. Providers have fragmented and often incomplete information, and
  10. Consumers either have too little information with which to make rational decisions or don't make good use of the information they have.

In the same vein as why participants in the healthcare markets are not rational, many of these same “irrationality” issues have been blamed for causing excessive waste in the provision of healthcare services. For example, Parija B. Kavilanz at cites information from the PwC Health Research Institute describing "Health care's six money-wasting problems", which have caused $1.2 trillion in wasted spending, and provides government measures Obama has proposed to reduce this waste:

  1. Too Many Tests
  2. Those Annoying Claim Forms
  3. Using the ER as a Clinic
  4. Medical Errors
  5. Returning to the Hospital
  6. Infections Acquired During Hospital Stays

The proposed healthcare legislation contains the following provisions:

  • Greater access to insurance for all patients
  • Lower patient premiums
  • Lower payments for healthcare products and services
  • Funding for electronic medical records, insurance forms, medical information technology
  • Standardization of procedures
  • Implementation of "evidence-based" guidelines for patient care
  • Funding to ecourage individuals to practice preventative care
  • Penalization of hospitals for readmission of patients and funding to reduce readmissions


Clearly, There Are Problems with the Current System

Before launching into the problems associated with the current healthcare system, I find it interesting that the same types of issues mentioned in the numbered lists above appear in private markets other than healthcare, yet you don’t see politicians clamoring to have governments take over the practice of law, car mechanics, or computer repair. (For more discussion on decision making in complex situations when you don’t have as much information as you’d like, see my earlier post, “How Do You Know If You're Getting Good Advice?”)

In a nutshell, here are the big problems for each group of healthcare market participants:


Fear and incomplete information => agree to unnecessary tests and services

Equate cost with quality => accept prices that are too high

Can’t judge doctor quality => illegitimate/inappropriate malpractice lawsuits

Don’t pay full costs of care => too little preventative care, too little compliance


Don’t know what the patients have => too many tests and services

Fear of lawsuits => too many tests

Fee for treatment, not results => too many tests and services

Doctors don’t pay for services they recommend => too many tests and services

Conflict of Interests (e.g., doctors own clinics) => too many tests and services

Healthcare Mistakes => waste, lawsuits

Medical errors => waste, malpractice lawsuits

Patients released from hospital too early => waste associated with readmission

Insurance Companies

Inefficient administration => waste

Onerous claim forms and processes => increase costs to doctors and patients


Use hospitals for everyday treatment => cost of care too high

Don’t pay full costs of care => too little preventative care, too little compliance


How to Solve the Current Healthcare Problems

The real issue here, though, is the escalating cost of medical care, and whether or not the solutions proposed by government will actually help us administer healthcare more effectively and efficiently. In other words, are the irrationalities, profit-mongering and waste at the heart of the problem, or will healthcare spending continue on its path to the stars even after government has instituted its new legislation?

I maintain that while some of the proposals will help reduce waste, others will unnecessarily devastate, if not altogether destroy the US healthcare system. And none of the proposals will actually solve the issues that are at the heart of the problem.

The problems with the current healthcare system are inter-linked. The system has evolved in such a way that it has become wrought with cross-subsidies that horribly distort prices at all levels of the system. For this reason, we cannot simply decide that patients should pay lower premiums or that doctors should receive less for their services, without disrupting the operation of the entire system. Rather, what is needed is to untangle all the interlocking issues so that price mechanism can once again be used to allocate resources effectively and efficiently.

Here are reasonable measures whose simultaneous implementation will enable the free markets to provide care to individuals more efficiently and effectively:

1. Make patients pay a larger portion of their own healthcare costs

One of the biggest reasons the US spends so much money on healthcare is that individuals don’t pay the full costs of their own care, and as a result they get too much care. Sure, individuals do pay the full costs of the healthcare system, through monthly premiums and annual taxes. But they don’t pay for the full costs of individual treatments, only co-pays, which often amount to a small percentage of the cost of the care. Large monthly and annual payments that are only superficially linked to the number of doctors they see or the number of tests that are performed lead individuals to use too much healthcare.

Furthermore, because individuals don’t pay the full costs of their own care, they take too little precautionary care. They don’t eat right, they don’t exercise, they drink too much and smoke too much. And they don’t always do what the doctor tells them to do. If people had to pay for the consequences of their own actions, they would be much more likely to take proper care, which would go a very long way towards reducing the ultimate costs of healthcare.

The system needs to be changed to more closely resemble the auto insurance system. That is, individuals would pay out-of-pocket for the majority of their regular maintenance costs -- like paying for gas and repairs for cars, people would pay for annual check-ups and doctor visits for minor illnesses. And individuals would use insurance to help pay for major illnesses, where the insurance company would pay up to a maximum amount, depending on the type of policy the individual paid for.

Sure, part of the reason people need insurance for run-of-the-mill healthcare is that the evolution of the payment practices has lead to an extremely tangled and twisted system of cross-subsidies. If patients paid more of the direct costs of their care, and if the other changes I describe below are also implemented, then the costs of individual procedures would drop to much more manageable levels.

(In an earlier post I provide a numerical example showing that when individuals don’t pay for their own costs of care, then people who use less care end up paying very large premiums to cover the costs of people who use a lot of care.)

2. Refuse more than basic treatment for the uninsured unless they prepay

A large contributor to the high costs of medical care for people who pay for care is the costs of care for individuals who don’t pay for it. If people who don’t pay into the system were limited only to basic care, and not to expensive tests and procedures (more tests and procedures will become more affordable, as discussed in “Subsidize costs of new medical technologies” below), then the costs of care for people who do pay will be significantly lower.

(In an earlier post I provide a numerical example showing that when individuals don’t pay for their own costs of care, then people who pay into the system end up paying very large premiums to cover the costs of people who don't pay into the system.)

3. Subsidize costs of new medical technologies

By reducing access to medical procedures for people who cannot pay for them (see “Refuse more than standard treatment for uninsured unless they prepay” above), some of the costs to users are reduced. By limiting user lawsuits (see “Cap malpractice awards” discussed below), more of the costs to users are reduced. And then if the government increases subsidies and thus defrays even more of the costs of the development of new medical technologies will be even further reduced. Without the costs associated with inappropriate lawsuits and users who don’t pay, and with (higher) subsidies from the government, new technology developers can charge more affordable prices to users.

4. Cap malpractice awards and accept that healthcare providers make honest mistakes

Patients need to understand that there are risks associated with all pharmaceuticals and medical procedures. There is plenty of information available about potential risks associated with every drug and procedure. Patients should be responsible for understanding the risks, and they should be forced to sign legally binding agreements releasing doctors and drug companies from liability when a documented problem arises.

Patients also need to understand that, despite what some physicians may believe, doctors are not gods. They are human, and they make mistakes. I certainly do concede that malpractice and negligence happens, and the perpetrators of these crimes should be held accountable. Howeer, when a negative outcome occurs, it is more often due to the risky nature of the procedure or honest mistakes on the part of healthcare providers.

Capping malpractice awards would reduce a significant portion of the costs associated with healthcare by reducing malpractice insurance premiums and by reducing the costs associated with the unnecessary tests doctors perform to reduce their chances of being held liable if something goes wrong.

5. Subsidize the digitalization of medical systems and records

Clearly, electronic medical records, insurance forms, and other inter-party communications will decrease the costs of healthcare administration, and they will decrease a significant portion of the medical errors that occur from miscommunications.

The healthcare system has been slow to adopt digitalized medical records because of the economics of doing so. There are many interactions associated with the provision of healthcare: communications occur between doctors, patients, nurses, pharmacists, technicians, and so on. It is expensive for a doctor to digitalize his medical practice. Yet, in order for him to benefit from doing so, a large portion of the other players he communicates with must also have digitalized their practices; otherwise the communication reverts back to the traditional fragmented, scribbled record system. So until many other players have also upgraded their systems, individual early adopters will not receive much benefit from upgrading themselves. In other words, it’s a chicken-and-egg problem: no one player will adopt until many of the other players adopt. Many will be followers, but no one will be a leader.

If the government were to subsidize the costs of switching over, they could make doing so cost effective for enough early adopters to get the ball rolling and make it worthwhile for later adopters to follow suit.

6. Prevent physician conflicts of interest

Conflicts of interest arise whenever doctors profit from sales of medical products or tests to their patients. In these cases, doctors have an incentive to recommend that patients use more products or have more tests than they would if patients were forced to purchase these products and tests elsewhere.

Though such profit mongering is certainly wasteful, not to mention distasteful, when it occurs, I don’t think it has nearly the impact on creating such a problematic healthcare system, as do the other issues discussed above. And while it would be nice to eliminate this type of problem, it would definitely be a slippery task to precisely define what doctors are and are not allowed to do.

7. Implement healthcare guidelines, but not standards

Most people don’t realize how complex the human body is. What works for one person will not necessarily work for someone else. It is therefore imperative that doctors have plenty of leeway when treating their patients.

On the other hand, a system of guidelines would be helpful in assisting doctors in knowing what has worked for other patients. Such guidelines could reduce some of the waste associated with diagnosing and treating patients. As with the previous issue, though, I don’t think lack of standardized care has nearly the impact on creating such a problematic healthcare system, as do the other issues discussed above.

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