The Real Causes of Rising Healthcare Costs

According to the Los Angeles Times:

U.S. healthcare spending grew 3.9% a year in 2009-2011, according to government data, the lowest growth rate since the government began tracking it in 1960, and down significantly from annual growth averaging 8.8% in 2001-2003.

That sounds like good news. But the article also cites research from the Kaiser Family Foundation that finds “economic factors related to the recession accounted for 77% of the reduced growth in national health care spending”. As a consequence, we should expect “more rapid growth as the economy strengthens”. Given that health care spending already stood at an estimated $2.8 trillion in 2012—nearly 18 percent of GDP—this is cause for concern.

Many health reform advocates believe the main driver of spiraling health costs is the absence of universal coverage, which results in uninsured patients “free riding” via costly emergency room visits, leaving the insured to foot the bill in form of higher premiums. And it’s true that this and other forms of legally mandated cross-subsidization (like Medicaid, Medicare, and community rating) make healthcare more costly than it would otherwise be for many Americans. But it certainly isn’t the main factor.

The real issue is that policymakers—despite their good intentions—have managed to design a health care market in which the supply of services is both unnecessarily constrained and inefficiently organized, while also doing their best to eliminate any effective checks on demand. Put those two things together and rising costs are an inevitable outcome.

Let’s start with the supply side. As John H. Cochrane points out in this excellent paper, there are plenty of examples in the corporate world of better products being provided more cheaply than they were ten or twenty years ago—think Southwest Airlines, Amazon, Toyota, or Wal-Mart:

These revolutions are not just about technology. In most of these cases, we see process innovation, reorganizing activities to deliver complex services at lower cost and with better and more uniform quality. This process efficiency is most glaringly absent in healthcare.

But why is health care provision still so fragmented, so lacking in consumer focus, and so far behind in computerization? Cochrane cites a lack of intense competition: “certificate of need” requirements severely restrict market entry in 36 states, and occupational licensing rules artificially constrain the supply of doctors while preventing nurses from offering competing, lower-cost treatment. Then there are rules that hold back the “corporatization of overall health service provision”, promote inefficient non-profit institutions that have little incentive to innovate, and block mergers and consolidations that could deliver greater economies of scale.

Cochrane’s solution is a commendable one: “Look for every limit on supply of health services, especially entry by new companies, and get rid of it.”

On the demand side, the problem is straightforward enough. The dominance of third-party payment and the prevalence of employer-provided health insurance—both of which are supported by regulation and the tax code—mean that patients and providers almost always have an incentive to maximize care, irrespective of cost. Patients do this because their up-front premium has already been paid and they want to extract as much value from it as possible. Providers do it because they want to earn as much fee-for-service income as they can. In the long run, this is not a sustainable model.

Ultimately then, the prospect of more rapidly rising health care spending serves as a timely reminder that US healthcare really does need a comprehensive overhaul. It’s just too bad that the reforms currently under way do so little to move things in a positive direction, and will likely make things worse, rather than better.