Thursday, December 20, 2007

Government, free markets, and healthcare

Can government solve our problems?
I want to make the case that government cannot solve our problems, but it can and often does make them much worse. The typical argument of my progressive friends is that it should be the role of government to fix our problems. Government is needed to ensure people make a living wage, prevent corporations from having too much influence, redistribute income so that the distribution of wealth is fare, and provide us with necessary services such as healthcare.

Libertarians would argue that the fundamental premise is immoral. In order to provide these services, government must take from one set of people in order to give to another set of people. People should not have to give up the fruits of their labor. Let’s set this aside for the time being and assume that the aforementioned goals are moral and should be pursued. What if it turned out though that in creating more government to accomplish these goals, the exact opposite effect was achieved instead?

In this entry, I will take up healthcare as the example because I feel it is one of the most important issues affecting this country and it will be an important issue in the next election for what role government should play.

Many of the supporters of universal healthcare argue that healthcare in this country is completely broken and the reason is the free market has failed. I agree that healthcare in this country is a large failure, but it is not because the free market has failed. It is because we don’t have a free market for healthcare at all and haven’t since the 1930’s. And this is because of government interference with the free market.

Employer-Provided Healthcare
For those who have access to regular healthcare in this country, it is generally paid for by the employer. This already is a strange state of affairs. Employers don’t generally provide auto insurance for their employees. Employers don’t pay for people’s groceries or clothing. Employers generally don’t provide us with housing. How is it that we ended up with a system where the expectation is that employers provide us healthcare? And is it a good system?

Most people would say it’s a bad system. If we started from scratch, very few would think this is a good idea. People don’t want to lose their healthcare when they change jobs. And people don’t really want their employer knowing any of the details of their medical issues. So how did a system that most people wouldn’t want come to become the norm? Of course, the free market didn’t create it – the government did.

According to Princeton Professor Ewe Reinhardt, who worked on the original Clinton healthcare plan, the employer-provided health care model is now being called an "accident of history."
Employer-provided health care was born in the 1930s after Franklin Roosevelt decided not to try for universal socialized medicine. In a move that seemed ingenious then because health care was comparatively cheap, the federal government passed laws offering economic incentives to businesses that provided health care to employees.1
Calling this an “accident” is missing the point. It wasn’t an accident at all. It was an unintended consequence of bad policy. The reason we have employer-provided healthcare now is because the government subsidized it. The government also froze wages during World War II via the National Labor Board, another way government interfered in the free market.2 This made employer-provided healthcare a way for employers to compete for labor.

When an employer provides healthcare to its employees, the cost is tax-deductible. When an individual pays for healthcare, the cost isn’t. As basic economics tell us, when you subsidize something, you get more of it. When you tax something, you get less of it. Just as organisms evolve, small economic advantages magnify over time. The model of employer-provided healthcare was subsidized by the government so it didn’t take long for it to become the winning model. It was the result of the government choosing to prefer it over a different system. There is nothing free market about that. The free market will pick the most efficient model, but in this case, the government interfered with the free market. It turned out be a bad system. And now we’re stuck with it.

Employer-provided Healthcare Made Costs Rise
There are many obvious problems with employer-provided healthcare. As mentioned above, employees have to change their healthcare when they change jobs and they also have to deal with their employer potentially knowing intimate details about their medical problems. But this isn’t the worst of the problems.

When employers were made responsible for paying the healthcare costs of their employees, the natural price signals necessary for a free market to function correctly were removed. When an employee and his family members went to the doctor, they didn’t care what the cost of the service was because a third party was paying for it. In normal free market conditions, producers compete on price and consumers find the lowest cost provider. In the market that developed under employer-provided healthcare, there was no incentive for consumers to find the lowest cost alternative. This didn’t mean that doctors could necessarily charge whatever they wanted because at some point, the employers would push back. But it did mean that the consumer in general wasn’t looking for the lowest cost option and the suppliers of medical services weren’t under normal market pressure to continuously innovate and reduce costs.

If one considers innovative industries like the computer market, we have seen dramatic decreases in prices and improvements in products over the years. This is because we have normal market conditions where there is healthy competition and suppliers are constantly innovating to provide better and lower cost products. This attracts investors and capital because there is profit to be made when a producer can provide a better product at lower costs. This further spurs innovation and the cycle repeats. This is the virtuous cycle of the free market. And this all happens when consumers provide pressure by pursuing the best product at the lowest cost.

When government introduced employer-provided healthcare, the law of unintended consequences took hold. The suppliers of medical care did not have the incentives to constantly lower cost. In fact, it may have caused the opposite incentive where consumers would prefer much higher cost products when they thought they had even a slight advantage. This is similar to how an employee will purchase a first class airplane ticket that costs 5x more when the employer is paying for it but not when he is paying for his own trip because he knows the benefit isn’t justified by 5x the price. With airplane tickets, employers can crack down. It’s easy for them to distinguish between the benefit of a first class seat and a coach seat. But with medical services, employers don’t have the expertise to know what services their employees should purchase and in any case, privacy issues prevent them from exercising that type of control even if they could.

Introduce the HMOs
As prices rose due to a non-functioning market, healthcare became more and more expensive for companies to provide. They needed to do something about it. This brought about HMOs. HMOs basically were introduced to keep costs down since the consumers of the healthcare weren’t doing it themselves. HMOs negotiate with the doctors on prices and what services are allowed. But this is not a free market at all. This is a managed market. In a normally functioning free market, producers and consumers negotiate on price and producers compete to provide the lowest costs to consumers. With HMOs, the market is further distorted. The consumer doesn’t have much choice which HMO to use because the employer is paying for it. The employer is most interested in using the lowest cost HMO that just does enough to meet the expected obligation of employer-sponsored healthcare. Like any profit-seeking company, the HMO has an incentive to keep prices down as much as possible but its customers are captive and have no alternatives should the HMO fail to provide good coverage. This is a complete market failure.

Let’s just take another look at the complete market failure of the participants. Employers pick the HMO that is cheapest and just barely meets its obligation. The employer is happy as long as the cost is low and the obligation does not go below a certain threshold where they clearly aren’t meeting their obligation. Therefore, we can assume that the HMO, in order to maximize its profit, will always stay just above this threshold.

The healthcare providers negotiate deals with the HMOs to give them a steady stream of patients. The HMOs negotiate rates for different procedures with the doctors, but they can’t possibly be involved with every decision to determine if it’s cost effective. This means doctors have an incentive to game the system to provide the highest cost procedures that are just below the threshold for what will arouse the HMO’s ire. They don’t have an incentive to reduce costs on a case-by-case basis because the patient has no real choice except to go to another doctor that’s part of the same HMO that has the same exact incentives. There is no virtuous cycle here that occurs under normal free market conditions.

How the Free Market Should Work
To recap, this little bit of government interference during World War II had this gigantic unintended consequence of reshaping the entire healthcare system into a very inefficient and non-free market system. Imagine if the government had decided that employers should provide their employees with computer systems. The computer industry would look very different today.

Even when somebody drops out of the employer-provided healthcare system and decides to purchase healthcare on their own, they still have to participate in the same market that is already heavily distorted by the vast majority of the people who are in the system. There is no way for the free market to work effectively.

In a real free market for healthcare, we wouldn’t have seen all these distortions. Consumers would shop around to find the most cost-effective healthcare. There would have been enormous pressure and competition over the last 70 years to innovate and reduce costs. This is because the medical providers who found lower cost solutions would have made a large profit by catering to the majority of people who couldn’t afford it otherwise. As mentioned above, this would have attracted investors and capital. We would have seen innovation that we can't possibly even imagine. We would have seen a huge diversity of options catering to all points on the demand curve like we see with other items that exist in the free market. For example, we have computers at many different price points. We have inexpensive cars with few options such as the Dodge Neon all the way up to the cars that cost hundreds of thousands of dollars. We would have seen healthcare work this way as well. Except even the cheapest healthcare would probably be better than the average healthcare we see today just like the cheapest car produced in the free market was still much better than the average car produced by Communist Soviet Union.

Medicare Makes it Worse
In some ways, one can think of Medicare as just providing employee-provided healthcare to senior citizens. In that way, it works like an employer except the employer is the government.

Medicare makes it worse though. At least with employer-provided healthcare, the costs burden is placed on a profit-seeking company. The management of that company has the incentive to keep costs down. If they don’t, the company will see its profits decline or even turn to loses and the shareholders will fire the management. On the other hand, if they are able to keep costs down, the company will make more money and the management will be rewarded with lucrative stock options and benefits. When the government is providing healthcare, the decisions are made by government bureaucrats. These bureaucrats are spending taxpayer money. They don’t get fired if the costs are too high and they don’t make more money by reducing costs. The government can run a deficit for years or even decades. On the other hand, senior citizens are a very powerful voting lobby. If they see their care get worse, they will vote their politicians out of office. Therefore, there is very little pressure on almost all fronts to keep costs down. That sends the wrong price signal to the healthcare providers who then don’t have the correct incentives to innovate and lower costs.

Medicare also distorts the market in another way. At any one time, there is a fixed amount of healthcare resources. By practically providing infinite funds to take care of senior citizens, this reduces the number of resources that are available to take care of everybody else. In this way, Medicare causes there to be less healthcare available to children and non-senior adults because they don’t have an entity with infinite resources and very little price sensitivity paying for their healthcare

Big Government Further Makes it Worse
The country’s resources at any one time are fixed. There is a fixed amount of labor able to do all the things we want done. The healthcare industry uses some percentage of this labor. When the government spends a huge portion of the nation’s resources on the military-industrial complex, farm subsidies, and other corporate welfare, it causes those industries to use a disproportionate amount of the nation’s resources. That means there are fewer resources available for other things, such as healthcare. Only the free market which perfectly aggregates everybody’s demand for products and services can efficiently allocate the resources. The government causes misallocation of resources because central planning never results in the right allocation (for example, the Soviet Union and Maoist China) and because the government caters more to special interests than to the needs of the individuals in the population.

Fixing this Mess
If government caused the problem, the answer shouldn’t be more government. Unfortunately, there are many cases where government caused the problem and the answer we come up with is to add more government (e.g. housing bubble and bad mortgages). This is the wrong approach and it will make healthcare worse.

The first step is to get rid of the distortion where employer-provided healthcare is subsidized. We should make all healthcare tax free. This will make the free market start to take hold in that many employees will prefer to just take the money their employer would have used to purchase healthcare as an increase in salary used to purchase healthcare themselves.

Beyond that, I am not sure what all the steps should be. We have some path dependence where we can’t go back and undo everything that led to the current system. We may never be able to get the system we would have had if we had never interfered with the market in the first place. Some say that it would help if doctors had the right to collectively bargain with insurance companies (currently this is illegal).

What I do think is that we want a system where the price signals and market pressures are restored between consumers and healthcare providers. Otherwise, we will forever be stuck with a system where the costs continue to rise out of control.



Eugene said...

Jon - Think you got most of this argument, although I would have never thought I would hear it from you :). Another point is that healthcare is also regulated state by state I belive, which makes matters even worse. Good HBR article with some of these points from a couple years back, to bad it's not free:

Vijay said...

Fantastic! I hadn't seen that Reinhardt quote before. Good find.

Tony said...

Excellent summary of free market "fixes", but I believe you left off perhaps the most important issue: EMTALA.

What are your thoughts of the prudence and fairness of EMTALA? Should it be repealed?