Winning the Hardware Software Game Winning the Hardware-Software Game - 2nd Edition

Using Game Theory to Optimize the Pace of New Technology Adoption
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The configuration of our current healthcare system is a product of its history: It has evolved into its current form as a consequence of two primary sets of factors. First, the healthcare system has evolved into its current form due to historical laws and regulations that have generally catered to the interests of healthcare payers and providers. And second, the system has evolved based on self-serving actions taken by payers, providers, and patients in response to those laws and regulations.


On the Patient Side

The current healthcare system is extremely convoluted, in large part because laws have been established to achieve an “unnatural” – inorganic – outcome: the cross-subsidization of healthcare for the old, sick, and poor by the young, healthy, and rich. Under a system of cross-subsidization, some groups (the young, healthy, and rich) pay more than their “fair share” of the total costs to support others (the old, sick, and poor) who pay less than their “fair share.” What is problematic with the current system is not the use of cross-subsidization per se. Many systems do fine with reasonable amounts of cross-subsidization between payer groups. Rather, the problem is the extent to which the level of cross-subsidization has evolved. Over time, the lower cost groups in our society – the young, healthy and rich – have been forced to take on increasing portions of the costs incurred by higher costs groups.

A victim of the increasing extent of cross-subsidization in the current system is any meaningful relationship between risk and payoff for different sets of participants in the system. The loss of this risk-reward relationship has created massive moral hazard situations for parties in the system. More specifically, people don’t bear the full healthcare costs of their risky – unhealthy – lifestyles. As such, they choose to take on more risks and unhealthy behaviors than they would if they had to pay the full costs of doing so. Our unhealthy populations simply offload their higher associated healthcare costs onto the rest of society. This has created a vicious cycle: As people have become less healthy, healthcare costs have increased. But costlier groups haven’t been able to afford to pay the costs they have incurred, so the degree of cross-subsidization has further increased. In turn, this has further decreased the portion of costs paid for by the unhealthy, which has led them to make even poorer choices.

Figure 1: The Vicious Cycle of Cross-Subsidization

1 vicious cycle

On the Provider Side

As if the lack of risk-reward relationship for patients weren’t enough, there’s another exacerbating factor in the system: The payment system rewards over-provision of services by providers. Our healthcare system utilizes a fee-for-service (FFS) payment model. If patients were responsible for paying the full costs of their care, the FFS model would be fine. However, in our system, it is not individual patients who pay for services, but rather, society as whole (through government and private insurance payers). Significantly, under the current system, there is no responsible party overseeing patient-provider transactions to restrain the prices or quantities of services negotiated. The lack of responsible oversight has led both to excessive prices as well as excessive quantities of services provided.

So we see the system as a whole suffers from two sets of distortions: Patients are led to invest too little in healthy lifestyles, while providers are led to provide too many costly services. Each of the two sets of distortions feeds on the other. As a result healthcare costs spiral rapidly out of control.


A Simple Model of Healthcare Costs

Let’s consider a simple model of healthcare costs to illustrate the two sets of distortions: Too much unhealthy care by patients and too many costly services by providers.

Let’s make the following assumptions:

♦ Genes

◊ People may either have good genes (G) or bad genes (B) (column [D] in Figure 2).

◊ Assume healthcare costs for people with bad genes are 3 times the healthcare costs for people with good genes.


◊ People may either choose healthy lifestyles (H) or unhealthy lifestyles (U) (column [E] in Figure 2).

◊ Assume healthcare costs for people with unhealthy lifestyles are 8 times higher than healthcare costs for people with healthy lifestyles.

◊ Healthy lifestyles require greater time and money costs than unhealthy lifestyles.

Provider Services

◊ Providers may either provide reasonable prices and quantities of services (R) or services that are costly (too many and/or too expensive) (column [F] in Figure 2).

◊ The costs to all providers of providing healthcare services increase with average price of healthcare services. As prices rise, rents and other input costs will rise. So even if providers choose reasonable prices and quantities of services, their prices will still be higher when the prices other providers are higher.

◊ Assume healthcare costs in a costly system are 4 times those in a reasonable cost system (columns [F] and [J] in Figure 2).

Costs of Patient Care

◊ Similarly to healthcare spending in today’s society,[1] the majority of spending is concentrated among a few high-cost patients (column [C] in Figure 2).

◊ Total costs of patient care are spread evenly among all patients so that all patients pay the same price for healthcare, regardless of their healthcare need (columns [H] and [L] in Figure 2).

Figure 2

2 model

Under these assumptions, if patients with good genes choose:

  • Healthy behavior, then their costs of care are $1 if providers choose reasonable costs ([1][G] in Figure 2), or $4 if providers choose costly services ([1][K]).
  • Unhealthy behavior, then their costs of care are $8 if providers choose reasonable costs ([2][G]) or $32 if providers choose costly services ([2][K]).

In the model configuration presented, the healthcare costs of unhealthy behavior are 8 times the costs of healthy behavior. Yet, regardless of the amount of costs a patient in this scenario incurs, he will have to pay the same price for healthcare services, $3.3. More specifically, if a patient with a healthy lifestyle decides to change to more unhealthy behavior, his costs of care will increase by a factor of 8, yet the price he will have to pay won’t change. As in the actual healthcare system in operation today, excess costs incurred by patients are spread across all other patients in the system. Since patients don’t have to pay the costs of their unhealthy behaviors, they will choose too much unhealthy behavior from a social standpoint. In other words, too many patients will end up in rows [2] and [4] and too few will end up in rows [1] and [3].

Over time, the model suggests more patients choose unhealthy lifestyles and off-load their costs of healthcare onto others. Total spending on healthcare rises rapidly (the figures in columns [H] and [L] increase over time), and the extent of cross-subsidization of the costs incurred by unhealthier patients, but paid for by healthier patients, increases (the black and blue bars in Figure 3 increase over time). This is exactly what has been happening in our society over the past decades.

Figure 3: Cross Subsidization of Costs of Care for Unhealthy Patients Increases Over Time

3 PtoC


A New Healthcare Alternative: Cash-Based Models

Our healthcare system is becoming increasingly unsustainable and thus ripe for change. As with other industries in the past that have become similarly unsustainable, there arise moments in time when the door to such convoluted industries opens to opportunities for increases in efficiency. These moments generally come when industries are deregulated or when landmark laws are changed. Other moments of opportunity occur simply when such industries become particularly ripe for change or when entrepreneurs present viable alternatives.

In society today, entrepreneurs are stepping up to offer alternatives to the traditional healthcare model. One interesting alternative to the traditional model that has appeared in different forms is a cash-based model for non-catastrophic care. While the traditional insurance-based model enables people to externalize the costs of unhealthy lifestyles, a cash-based model enables people to internalize the benefits of healthy lifestyles. Under a cash-based model, providers charge reasonable (affordable) prices and patients pay the costs of their own care. In this case, any financial savings patients realize by living healthier lifestyles, thereby incurring lower healthcare costs, goes right back into their own pockets.

Under the traditional insurance model, it is the insurance companies who capture most of the savings generated by patients who choose healthier lifestyles. In contrast, under the cash model, it is the patients themselves who capture the full benefits of any savings in healthcare costs. So unlike the traditional insurance model, a cash-based model provides the proper incentives to patients to choose healthier lifestyles.

There’s another essential feature of cash-based healthcare systems: The administrative and compliance costs associated with our insurance-based healthcare system have become unmanageable. In fact, these costs have become a significant contributor to the unaffordability and unsustainability of today’s system. Under a cash-based system, however, providers are able to bypass these administrative and compliance costs entirely, thereby drastically reducing the costs of providing healthcare services. A cash-based healthcare system is thus able to sustain reasonably low prices that are actually affordable to patients who self-finance their own care.


The End Game?

Regardless of the nature of the spark, the first thing to happen at these moments of change to historical industry configurations is cream-skimming: New suppliers steal away high-margin customers. Customers who have been paying much more than their fair share in the historical system become attracted to new products tailored to their particular needs. Yet, these high-margin customers are precisely those customers who have been enabling the functioning of the inorganic, or “unnatural,” historic system. Once enough elite customers leave the old system to enter a new system that better addresses their needs, the old system will collapse. At that point, a new system that better addresses the less-profitable (less-viable) part of the industry must be established to replace the old system.

The cash-based models of healthcare we are seeing today are most attractive to younger people who are already living healthier lifestyles. These are the people who incur fewer healthcare costs themselves, but who are being forced to pay exorbitant costs for healthcare in support of poorer and sicker patients. More of the “cream” – young and healthy patients – can be expected to leave the current system as new, cash-based (and other alternative) systems gain traction. Eventually, the traditional system will collapse. The good news is that cash-based systems are paving the way for a return to more affordable care. What new configuration will arise? 


[1] See, for example, JPMorgan Chase Institute’s 2017 report, “Paying Out-of-Pocket- The Healthcare Spending of 2 Million US Families.”

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