Health Care

Health care is different from other goods and services: the health care product is ill-defined, the outcome of care is uncertain, large segments of the industry are dominated by nonprofit providers, and payments are made by third parties such as the government and private insurers. Many of these factors are present in other industries as well, but in no other industry are they all present. It is the interaction of these factors that tends to make health care unique.

Even so, it is easy to make too much of the distinctiveness of the health care industry. Various players in the industry—consumers and providers, to name two—respond to incentives just as in other industries.

Federal and state governments are a major health care spender. Together they account for 46 percent of national health care expenditures; nearly three-quarters of this is attributable to Medicare and Medicaid. Private health insurance pays for more than 35 percent of spending, and out-of-pocket consumer expenditures account for another 14 percent.1

Traditional national income accounts substantially understate the role of government spending in the health care sector. Most Americans under age sixty-five receive their health insurance through their employers. This form of employee compensation is not subject to income or payroll taxes, and as a result, the tax code subsidizes employer purchase of employee health insurance. The Joint Economic Committee of the U.S. Congress estimated that in 2002, the federal tax revenue forgone as a result of this tax “subsidy” equaled $137 billion.2

Risk of illness and the attendant cost of care lead to the demand for health insurance. Conventional economics argues that the probability of purchasing health insurance will be greater when the consumer is particularly risk averse, when the potential loss is large, when the probability of loss is neither too large nor too small, and when incomes are lower. The previously mentioned tax incentive for the purchase of health insurance increases the chances that health insurance will be purchased. Indeed, the presence of a progressive income tax system implies that higher income consumers will buy even more insurance.

The 2002 Current Population Survey reports that nearly 83 percent of the under-age-sixty-five population in the United States had health insurance. More than three-quarters of these people had coverage through an employer, fewer than 10 percent purchased coverage on their own, and the remainder had coverage through a government program. Virtually all of those aged sixty-five and older had coverage through Medicare. Nonetheless, approximately 43.3 million Americans did not have health insurance in 2002.3

The key effect of health insurance is to lower the out-of-pocket price of health services. Consumers purchase goods and services up to the point where the marginal benefit of the item is just equal to the value of the resources given up. In the absence of insurance a consumer may pay sixty dollars for a physician visit. With insurance the consumer is responsible for paying only a small portion of the bill, perhaps only a ten-dollar copay. Thus, health insurance gives consumers an incentive to use health services that have only a very small benefit even if the full cost of the service (the sum of what the consumer and the insurer must pay) is much greater. This overuse of medical care in response to an artificially low price is an example of “moral hazard” (see insurance).

Strong evidence of the moral hazard from health insurance comes from the RAND Health Insurance Experiment, which randomly assigned families to health insurance plans with various coinsurance and deductible amounts. Over the course of the study, those required to pay none of the bill used 37 percent more physician services than those who paid 25 percent of the bill. Those with “free care” used 67 percent more than those who paid virtually all of the bill. Prescription drugs were about as price sensitive as physician services. Hospital services were less price sensitive, but ambulatory mental health services were substantially more responsive to lower prices than were physician visits.4

National health care spending in 2002 was $1.55 trillion, 14.9 percent of GDP. By comparison, the manufacturing sector constituted only 12.9 percent of GDP. Adjusted for inflation, health care spending in the United States increased by nearly 102 percent over the 1993-2002 period. Hospital services reflect 31 percent of spending; professional services, 22 percent; and drugs, medical supplies, and equipment reflect nearly 14 percent.

David Cutler and Mark McClellan note that between 1950 and 1990 the present value of per person medical spending in the United States increased by $35,000 and life expectancy increased by seven years. An additional year of life is conventionally valued at $100,000, and so, using a 3 percent real interest rate, the present value of the extra years is $135,000. Thus the extra spending on medical care is worth the cost if medical spending accounts for more than one-quarter ($35,000/$130,000) of the increase in longevity. Researchers have found that the substantial improvements in the treatment of heart attacks and low-birth-weight births over this period account, just by themselves, for one-quarter of the overall mortality reduction. Thus, the increased health spending seems to have been worth the cost.5 This does not mean that there is no moral hazard. Much spending is on things that have no effect on mortality and little effect on quality of life, and these are encouraged when the patient pays only a fraction of the bill.

There are three reasons why most people under age sixtyfive get their health insurance through an employer. First, employed people, on average, are healthier than those who are unemployed; therefore, they have fewer insurance claims. Second, the sales and administrative costs of group policies are lower. Third, health insurance premiums paid by an employer are not taxed. Thus, employers and their employees have a strong incentive to substitute broader and deeper health insurance coverage for money wages. Someone in the 27 percent federal income tax bracket, paying 5 percent state income tax and 7.65 percent in Social Security and Medicare taxes, would find that an extra dollar of employer-sponsored health insurance effectively costs him less than sixty-one cents.

Workers, not employers, ultimately pay for the net-of-taxes cost of employer-sponsored health insurance. Employees are essentially paid the value of what they produce. Compensation can take many forms: money wages, vacation days, pensions, and health insurance coverage. If health insurance is added to the compensation bundle or if the health insurance becomes more expensive, something else must be removed from the bundle. Perhaps the pension plan is reduced; perhaps a wage increase is smaller than it otherwise would have been.

A recent study demonstrates the effects of rising insurance premiums on wages and other benefits in a large firm. This firm provided employees with wages and “benefits credits” that they could spend on health insurance, pensions, vacation days, and so on. Workers could trade wages for additional benefits credits, and vice versa. Health insurance premiums on all plans increased each year. When all health insurance premiums increased, the workers switched to relatively less expensive health plans, took fewer other benefits, and reduced their take-home pay. A 10 percent increase in health insurance premiums led to increased insurance expenditures of only 5.2 percent because many workers shifted to relatively cheaper health plans offered by the employer. The bulk of these higher expenditures (71 percent) was paid for with lower take-home pay; 29 percent by giving up some other benefits.6 Thus, if insurance premiums increased, on average, by $200, the typical worker spent $104 more on coverage and paid for this by reducing take-home pay by $74 and giving up $30 in other benefits.

These so-called compensating wage differentials, reductions in wages due to higher nonwage benefits, have important policy implications. They imply, for example, that a governmental requirement that all employers provide health insurance will result in lower wages for the affected workers.

The health care industry has undergone fundamental changes since 1990 as a result, in large part, of the growth of managed care. As recently as 1993, 49 percent of insured workers had coverage through a conventional insurance plan; in 2002 only 5 percent did so. The rest were in health maintenance organizations (HMOs), preferred provider organizations (PPOs), or other forms of managed care. Unlike conventional insurance plans, managed care plans provide coverage only for care received from a selected set of providers in a community. The basic idea with managed care is to limit the moral hazard that comes from overuse of health care, thus keeping insurance premiums lower than otherwise and potentially making the insured person, his employer, and the insurance company better off. An HMO typically provides coverage only if the care is delivered by a member of its hospital, physician, or pharmacy panel. PPOs allow subscribers to use nonpanel providers, but only if the subscriber pays a higher out-of-pocket price. Conventional plans allow subscribers to use any licensed provider in the community, usually for the same out-of-pocket price.

Managed care changed the nature of competition among providers. Prior to the growth of managed care, hospitals competed for patients (and their physicians) by providing higher-quality care, more amenities, and more services. This so-called medical arms race resulted in the unusual economic circumstance that more hospitals in a market resulted in higher, not lower, prices. Conventional insurers (as well as government programs) essentially paid providers on a cost basis. The more that was spent, the more that was received. So providers rationally competed along dimensions that mattered. Managed care changed this by the use of “selective contracting.” Not every provider in the community got a contract from the managed care plan. Contracts were awarded based on quality, amenities, services, and price. Research has demonstrated that in the presence of selective contracting, the usual laws of economics apply: the presence of more providers in a market results in lower prices, more idle capacity results in lower prices, and a larger market share on the part of an insurer results in lower prices paid to providers. As a consequence, health care costs increased less rapidly than they otherwise would have and health care markets have become much more competitive.7

Managed care savings have been called illusionary. The plans have been accused of enrolling healthier individuals and providing less intense care. It is true that managed care plans disproportionately attract healthier subscribers. If this was all there was to managed care, the differences in costs between managed care and conventional coverage would be illusionary. However, a 2001 study demonstrates that the innovation offered by managed care is its ability to negotiate lower prices. The authors examined the mix of enrollees, the service intensity, and the prices paid for care among Massachusetts public employees in conventional and HMO plans. The focus was on enrollees with one of eight medical conditions. Across these eight conditions, the HMOs had per capita plan costs that were $107 lower, on average. Fifty-one percent of the difference was attributable to the younger, healthier individuals the HMOs enrolled; 5 percent was attributable to less-intense treatments; and 45 percent of the difference was attributable to lower negotiated prices. The conventional plan paid more than $72,600, on average, for coronary artery bypass graft surgery while the HMO plans in the study, on average, paid less than $52,000.8

Selective contracting arguably led to the slower rate of increase in health insurance premiums through the mid-1990s. Since that time insurance premiums have increased more rapidly. Health economists believe that this change is a result of consumers’ unwillingness to accept the limited provider choice that comes with selective contracting, as well as from the reduction in competition that has resulted from consolidation in the health care industry.

Medicare is a federal tax-subsidy program that provides health insurance for some forty million persons aged sixtyfive and older in the United States. Medicare Part A, which provides hospital and limited nursing home care, is funded by payroll taxes imposed on both employees and employers. Part B covers physician services. Beneficiaries pay 25 percent of these costs through a monthly premium; the other 75 percent of Part B costs is paid from general tax revenues. Part C, now called “Medicare-Advantage,” allows beneficiaries to join Medicare-managed care plans. These plans are paid from Part A and Part B revenues. Part D is the new Medicare prescription drug program enacted in 2003 but not fully implemented until 2006.

In 1983 Medicare began paying hospitals on a diagnosis-related group (DRG) basis; that is, payments were made for more than five hundred specific inpatient diagnoses. Prior to DRGs, hospitals were paid on an allowable cost basis. The DRG system changed the economic incentives facing hospitals, reduced the average length of stay, and reduced Medicare expenditures relative to the old system. In 1999 Medicare began paying physicians based on a fee schedule derived from a resource-based relative value scale (RBRVS) that ranks procedures based on their complexity, effort, and practice costs. As such, the RBRVS harkens back to the discredited labor theory of value (see marxism). Medicare payments, therefore, do not necessarily reflect market prices and are likely to over- or underpay providers relative to a market or competitive bidding approach. Thus, it is not surprising that physicians have argued that the system pays less than costs and some have begun to refuse to accept new Medicare patients. Moreover, the Medicare program effectively prohibits physicians from accepting payments higher than the fee schedule from Medicare beneficiaries. The result is a system of price controls that will result in shortages whenever the fee schedule is below the market-clearing price.

Medicaid, a federal-state health care program for the poor, covers more than forty million people. The federal government pays 50-85 percent of the cost of the program depending on the relative per capita income of the state. States have considerable flexibility in determining eligibility and the extent of coverage within broad federal guidelines. Medicaid is essentially three distinct programs—one for low-income pregnant women and children, one for the disabled, and one for nursing home care for the elderly. Approximately 47 percent of recipients are children, but the aged and disabled receive more than 70 percent of the payments. Much of this is due to nursing home expenditures; Medicaid provides approximately 40 percent of nursing home revenue.

State governments have gamed the system to obtain federal matching Medicaid funds. The state would tax a hospital or nursing home based on Medicaid days of care or the number of licensed beds. It would then match the taxes with federal matching dollars at a ratio of two to one or three to one, and essentially return the taxed dollars to the provider. When the federal government said this was not permissible, the states dropped the taxes and asked for “provider contributions” from the hospitals, nursing homes, and so on. Most states used the new federal money for health care services. Others simply reduced general fund expenditures by the amount of the new federal dollars—essentially using federal Medicaid dollars to fund road construction and other state functions. Neither “taxes” nor “contributions” may now be used. The states do, however, funnel state mental health and other state health program dollars through Medicaid to take advantage of the matching grants.

The expansion of the Medicaid program, particularly for children, also has had the effect of crowding out private coverage. One estimate suggests that for each two new Medicaid children enrolled, one child lost private coverage.9

The health care industry is one of the most heavily regulated industries in the United States. These regulations stem from efforts to ensure quality, to facilitate the government’s role as purchaser of care, and to respond to provider efforts to increase the demand for their services. Hospitals and nursing homes are licensed by the state and must comply with quality and staffing requirements to maintain eligibility for participation in federal programs. Physicians and other health professionals are licensed by the states. Prescription drugs and medical devices are regulated by the Food and Drug Administration (see pharmaceuticals: economics and regulation). Some state governments require government permission before allowing a hospital or nursing home to be built or extensively changed. All of the above regulations restrict supply and raise the price of health care; interestingly, those who lobby for such regulations are medical providers, not consumers, presumably because they want to limit competition.

Some state governments limit the extent to which managed care plans may selectively contract with providers. All state governments have imposed laws governing the content of insurance packages and the factors that may be used to determine insurance rates. While these may enhance quality, they do impose costs that raise the price of health insurance and increase the number of uninsured. In testimony before the Joint Economic Committee of the Congress, one analyst reported the annual net cost of regulation in the health care industry to be $128 billion.10

In 2002, there were 4,949 nonfederal short-term hospitals in the United States. Over the last decade the hospital sector has been consolidating: the number of hospitals declined by 6.4 percent and hospital beds per capita declined by more than 18 percent.11 In addition, the sector has been reorganizing itself into systems of hospitals that are commonly owned or managed. Nearly 46 percent of hospitals were part of a system in 2002, up from only 32 percent in 1994. The hospital sector has long been dominated by not-for-profit organizations. Only 14.4 percent of the industry is legally for-profit; this ratio has been constant for the last decade. There is some evidence that the consolidation and reorganization have been a reaction to the competition generated by the selective contracting actions of managed care. In 2001, the average cost of a stay at a government hospital was $7,400—24 percent more than at a private for-profit hospital. A study released in 2000 found that for-profit hospitals offer better-quality care.12

There were 272 private sector physicians per 100,000 population in the United States in 2002, an 8 percent increase since 1993, but a decline since 2000. There has been a steady decline in the proportion of physicians in solo practice; by 2001 more than three-quarters of physicians were in group practice or were employees.13 Physicians have been accused of inducing demand for their services because of the information asymmetry they hold relative to their patients. However, this argument has lost much of its impact in the last decade. Physicians’ inflation-adjusted average income has declined. Primary care physician incomes declined by 6.4 percent between 1995 and 1999, and specialist income declined by 4 percent.14

The industry is faced with rising health care costs and an increasing number of uninsured. In the private sector the cost increases have led to an interest in consumer-directed health care. The idea is to provide health insurance payments only for expenditures in excess of a high deductible. The expectation is that consumers who must pay the full price for most health services will buy such services only when the expected benefits are at least equal to the full costs. Others see the reemergence of more aggressive selective contracting by managed care firms as a way to keep costs under control. The government is expected to be more aggressive in promoting competition among providers as well.

The retirement of the baby boom generation will put more pressure on Medicare. Indeed, the Medicare trustees reported in 2004 that the costs of the Medicare program will exceed those of Social Security by 2024. Medicare Part A—hospital coverage—is estimated to be unable to cover its expenses starting in 2019.15 Interestingly, the 5 percent of Medicare fee-for-service beneficiaries who die each year account for one-fourth of all Medicare inpatient expenditures.16 Tax increases, benefit reductions, and/or wholesale reform of the program will have to occur. The number of uninsured will increase if health insurance continues to be more expensive. Some have proposed expansions of existing public programs; others have proposed “refundable” tax credits as a means of subsidizing targeted groups.17 Still others argue for reductions in regulations and a greater reliance on consumer-directed health plans as a means of lowering costs and expanding insurance coverage (see health insurance).