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The Unconventional Economics of Health Care

By Jack M. Balkin

In a response to one of my posts on the public plan, Tyler Cowen noted that it was "hard to translate" my points into "econspeak." I agree, and I think that's one reason why we need to pay attention to "alternative economics of health care," to use the title of Geoffrey M. Hodgson's excellent article. In a series of posts over the next few days, I will focus on the many ways in which classical economic reasoning fails in the health care context, and what that means for law.

For an accessible opening example, consider Charles Morris's description of the "bargaining" between doctors and insurers in his book "The Surgeons." From a chapter entitled Money, here is a fascinating and counterintuitive insight on the interplay between incentives and medical care:

There is a strongly held opinion, particularly among conservative think tanks, that with multiple competitive private payers, the normal interactions between vendors and payers will gradually create a more efficient health care system. I saw no evidence to support that belief.

What actually happens [at the hospital division he observed was that] the billing staff sit down each year; lay out the various payment plans on a spreadsheet, and decide on the division strategy--which surgeons will join which plans, and which carriers will be carried on a nonplan basis, trading higher payments for greater collection risk. Once that strategy is set, it is managed entirely by the collections staff. The surgeons simply join the plans they're assigned to.

It is an interesting collision, I think, between two quite rational, but alien, thought systems. Classical market economists tend to define rationality as maximizing economic outcomes. The division's equally rational strategy is to neutralize the plethora of payment incentives so the surgeons can practice their craft according to their lights, with minimum economic penalty.

This is a contest that the surgeons will almost always win. Health care pricing doesn't work like a grain auction. The terms of insurance company health plans are set bureaucratically and changed only infrequently with very little feedback on actual vendor behavior. And the plans are so complex, and the course of a difficult case so unpredictable, that it is often impossible to know in advance what a final price will be. For all those reasons, game theory would suggest that the surgeons' "neutralization" strategy is the sensible choice.

It is not that classical economics has no relevance to big-ticket health care--the proliferation of specialty hospitals suggests otherwise. But it is not the dominant paradigm within the Columbia-Presbyterian cardiothoracic division, or even a particularly important one. In other words, attempting to re-envision big-ticket medicine as a conventional problem in microeconomics may be what Alfred Whitehead called a "category error."

Anyone familiar with the "health claims arms race" shouldn't be surprised by this. But it is still refreshing to see it so clearly and compellingly explained.

Hodgson explains in some detail why these "slippages" between economic theory and practice occur. Here's a precis of his approach:

Leading mainstream health economists suggest that health care has special features that make it different from other domains of application, posing restrictions on the appropriateness of some neoclassical assumptions. . . . [T]he literature points to the presence in health care of externalities, information asymmetries, uncertainty, supplier-induced demand, and derived demand. But while all these features are important, they are neither universal in health care systems nor unique to them.

I try to identify the peculiarities of health care systems by building on the neglected but vital concept of need. By contrast, mainstream economics starts from the subjective satisfaction or utility of the individual. Modern mainstream economics rejects or ignores the concept of need, but many leading economists from Adam Smith to Alfred Marshall have acknowledged objective needs as well as subjective satisfactions.

Does recognition of need for care obliterate the role of markets? No, but it does help us see why so much nonsense is being spouted in the current debate. And it leads us to shift from the classical economic problem of market design to the broader social science project of proper institutional design:

While shifting the analysis from a utility-based to a needs-based approach, it is not naively assumed that health authorities or professionals always know best. Indeed, the problem is one of institutional design where knowledge is developed and distributed, and where mistakes become useful cues for learning and adaptation.

The better we understand the counterintuitive economics of health care, the more we are able to see the need for a "public option" to shake up the entrenched dynamics of a broken health care marketplace. As Michael Grunwald notes, "If Medicare takes the lead in reform, private insurers should follow."

PS: For the best recent cases made for the public plan, see these articles by Nate Silver, John Jacobi, Nicholas Kristof, Robert Reich, and the NYT Editorial Board.)

Hat Tip: Andrew Sullivan and Daniel Goldberg.

X-posted: Concurring Opinions.

Full post as published by Balkinization on June 26, 2009 (boomark / email).