National health spending rose a slight 3.9 percent in 2010, as Americans delayed hospital care, doctor’s visits and prescription drug purchases for the second year in a row, the Obama administration reported Monday.

The recession, which lasted from December 2007 to June 2009, reined in the growth of health spending as many people lost jobs, income and health insurance, the government said in a report, published in the journal Health Affairs.

from The New York Times

There are a couple of takeaways from this news.

First, the reduction in spending on healthcare could mean a welcome, albeit temporary relief to those governments and organizations that pay for healthcare….BUT…no real relief for state and local agencies which provide/finance healthcare for poor people. Recessions, of course, result in greater numbers of people qualifying for government-supported care.

The other point is a reminder that some portion of healthcare services are discretionary. When healthcare spending was growing by 10 percent or more each year in the 1980s, that growth probably wasn’t driven by an increase in the need for services. Likewise the slower growth over the last several years is probably not due to the population getting healthier and needing fewer services. Instead, people moderated their demand for healthcare. They put off diagnostic tests, or did not follow through on treatments or prescriptions. Going in the other direction, hospitals routinely see increases in elective surgeries near the end of a calendar year, as people have already met insurance deductibles, and decide to seek care before those deductibles are reset in the new year.

Is this good news? Not necessarily. To the extent the people put off truly necessary tests and treatments, those delays may cost us more in the long run. To some extent, though, tough economic times force us to be more cautious about discretionary spending, and there may be very little impact on long run health status. There is the old saying that if you get a cold, it will take 7 days to go away, but if you see a doctor you’ll be cured in a week! One important element of effective healthcare reform is to introduce that sense of caution in our population. It is a delicate balance – not wanting to interfere with early testing and early, cost-effective treatment, but also discouraging care that has less impact on long term health.

Prices for medical care services and supplies also stayed roughly on par with general inflation during this last year, which is a change from the decades of the 1980s and 1990s where the medical care component of the consumer price index routinely outstripped regular price increases.

I wouldn’t have to polish my crystal ball very much to predict that spending increases for healthcare will pick up speed as the economy recovers. This remains the single most important issue in our nation’s federal deficit struggles.

Lipitor Brand

Generic Lipitor

Like most first world countries, the United States uses the patent system to encourage research and development. If a pharmaceutical company can develop a new drug, they can maintain a government approved monopoly on the sale of that drug for up to 17 years. Monopolies drive higher prices, which helps the inventor, Pfizer in this case, recoup their research costs, and return a handsome income to their shareholders. Once the patent runs out, other manufacturers can apply to produce the drug. This increased competition then quickly drives down prices. So far, this is a classic example of market forces at work.

Pfizer has been planning for this day for a number of years, and with annual sales figures like those in 2010, this is vital to the company’s fortunes. The company has triggered a number of legal and regulatory efforts to delay the arrival of generic equivalents. For a compilation of news articles on Lipitor, see this page in The New York Times.

Two particular strategies twist prescription drug coverage in favor of the brand name. Many prescription drug plans have incentives to encourage patients and their physicians to use generic drugs. Often this is done with a lower co-payment on the part of the patient. The lower co-payment provides an incentive for the patient to accept a generic equivalent, and the insurance plan saves money by paying the lower, generic price. Pfizer (and other drug companies facing similar out-of-patent challenges) is trying to subvert this incentive. Here’s a hypothetical example.

These figures are illustrative – made up – but make the point.

Typical Brand vs. Generic Comparison for a Drug Plan

Brand:  Patient Copay: $30 – Total Cost of Drug: $200 – Insurance Pays: $170

Generic: Patient Copay: $10 – Total Cost of Drug: $50 – Insurance Pays: $40

Now Pharmaceutical Company Offers a Copay Discount
(Pfizer discounts its price of the brand drug to cover reduced copay)

Discount Brand: Patient Copay: $8 – Total Cost of Drug: $178 – Insurance Pays $170

With this discount arrangement the patient is happy, the drug store doesn’t lose any money, but the insurance company still pays the larger cost. This puts upward pressure on insurance premiums.

Another strategy – Pfizer offers a significant discount on the price of brand name Lipitor to pharmacy chains as long as they agree to not provide generic equivalents. The chains save money, and can pass some of that on to patients, but the insurance plans that pay for the drugs don’t enjoy any savings.

Is this legal?  The second, discounting strategy with pharmacies, smells a lot like restraint of trade/anti-trust concerns to me. The earlier example, offering a discount on copays, seems legal. Are either of these good social policies? Not a chance.

These creative approaches illustrate one of the problems that insurance introduces into a market. In healthcare, patients have enough discretion that they can alter their buying behavior, based on prices they face. Yet the patients don’t see or feel the full price of their purchase decision. In a regular market the patient balances the benefit of the purchase against the price, and makes a good decision on allocating resources. That good decision helps society. With insurance the patient sees only a small fraction of the total price, and may make a decision that is not socially optimal. This breakdown in market forces is one of the challenges our healthcare reform goals face. Ideally we would like patients to be full partners in the decisions made about their care. Insurance blunts that participation.

Alain Enthoven, recently retired from the Stanford School of Business, has been on the same soapbox for decades. His preferred model uses competition to spur innovation and cost control. Here is a recent article in the Health Affairs blog on his current thinking. It is a good read.

Gawande acknowledges that the cost of health care “…will essentially devour all our future wage increases and economic growth.  The cost problem, people have come to realize, threatens not just our prosperity but our solvency.”  “So what does the reform package do about it? …Does it institute nationwide structural changes that curb costs and raise quality? It does not. Instead what it offers is …pilot programs.”

Gregory Mankiw leans more towards the supply side argument, and is concerned that the current healthcare reform bill has very high marginal tax rates. You can read his analysis from The New York Times here.

New York Times - Sunday, November 1

However, let’s put aside the specifics of the healthcare reform proposals and go to the heart of the supply side argument. From Mankiw,

[S]ubstantial evidence supports the more modest proposition that high marginal tax rates discourage people from working to their full potential.

The phrase marginal tax rates means the rate applied to an additional amount of income. It is different from average tax rate which applies to the family’s entire income. Imagine that you are earning $30,000 currently and have a chance to earn an extra $10,000  by taking a night job. If, though, your marginal tax rate is 20 percent, the tax on that additional $10,000 is $2,000. So your take home page as a result of taking the second job is $8,000.

Now the questions start lining up. Would you be less willing to take that job if you knew your marginal tax rate would be so high? And if you take that second job, will the economy benefit from your added participation? The answer to the first question lies in your opportunity cost – what you give up, in the form of leisure, to take the job, and what you give up, in the form of added income, if you decided to spend your evenings at home. The impact on the economy comes from your higher income, some of which you would spend. What is harder to estimate is whether your participation is more effective than someone else who might take the job if you did not.

As Mankiw reminds us, “the verdict on supply side economics is mixed.” Some argue that there is no compelling evidence to support supply side strategies, while at least two Presidential administrations (Reagan and George W. Bush) based their economic platform on this principle. To my mind, supply side strategies are not very effective in stimulating demand, and have earned political support mostly as a justification for a less-government-is-better-government platform.

You are a utilitarian social planner. You have a limited number of H1N1 vaccines. How do you allocate them? Do you (A) give them to specific groups, such as high-risk populations, or (B) sell them to the highest bidder and rebate the revenue lump-sum to everyone? If you choose (A), do you allow those individuals allocated the vaccine to sell their dose to someone else? Be sure to specify the economic environment as carefully as possible. And remember: Your goal is to maximize total utility.

Not only is this relevant to our current flu situation, it raises parallel questions in healthcare reform – on government or society’s ability to ration scarce resources.

courtesy www.npr.org Morning Edition

This story ran on NPR’s Morning Edition – October 21.

Pet health care is now crossing the same magic threshold that human health care crossed decades ago: It’s getting good, and it’s getting expensive. Veterinary bills are becoming large enough that people are starting to think it would be nice to have someone else pay for them — like an insurer.

For political junkies the next several weeks should be very interesting, as the Senate and House (and various splinter groups within each chamber) try to construct a healthcare reform package that works and will garner enough votes.

No one from Washington has called me – asking for my preferences, but in the interest of illuminating both current events and economic theory, here’s what I would say.

These are elements of a healthcare reform package that we need in order for it to work:

1. Universal coverage: every resident, regardless of immigration status, needs to be covered. Every time we carve out an exclusion the resulting system becomes much more complex and less effective.
2. No exclusions or limitations on pre-existing conditions, current claims history or the like. From a cost control point of view we need to lop off this part of the insurance industry business process. Insurance plans (public and private) need to accept all comers, and do away with the costly and disruptive denial processes that are designed to lower risk profiles among an insured population.
3. Item #2 is a big concern and issue for any plan (again, either public or private). To be fair and to keep these plans from imploding, we need mandatory coverage. If individuals can opt out of insurance, then the incentive structure will encourage healthy individuals to go bare, and will increase the level of risk and exposure and premiums for those people who want insurance.  In the insurance industry adverse selection is a valid concern. Insurance works best if a broad, large population is insured, made up of a wide distribution of risks.
4. The mandated coverage should be a basic plan, with good catastrophic coverage, and a core (but not very large) set of early intervention, preventive services covered. This core of preventive services should be limited to those that actually save expenses over the life of the resident. Many preventive services extend life, which we can agree is good, but not all of them save money.
5. Residents, at their option, can choose plans with greater coverage, at their own cost. There have been discussions of “cadillac” plans (with the interesting ironic twist on the current condition of General Motors…) and this is essentially that topic. For the healthcare market to work more efficiently, patients and their physicians (who act as their agents) need to feel the economic costs of diagnosis and treatment decisions. People who are more risk averse can choose a more comprehensive plan, but they should pay an actuarially adjusted premium for that protection.
6. Patient exposure to costs is not a silver bullet in healthcare reform, but it is an essential element. One of the market failures in our current system is that the costs of treatment decisions are often hidden from both the patient and the prescribing physician. For efficient, effective decisions each player needs to understand the costs of the decision, including opportunity costs.
7. We should phase out the tax benefits for employer sponsored health plans. These benefits distort the market, leading to costly and comprehensive benefit packages, with less attention to cost control. I’m not sure that our current system places our companies at a global disadvantage, but I am convinced the employer-based benefits add unwelcome torque to the market. This change has to be done carefully, of course, using new tax revenues to help individuals afford their growing share of premium costs. And we will need to design a way to keep this change from being a windfall to corporate profits.

Supply Side Reform

Universal, mandated coverage is hugely important – on the demand side of the healthcare market. We know, though, that increasing coverage will increase costs. More people will seek treatment, which is good – to a point. This increased demand will also increase prices, as the supply side ramps up to handle the increased demand. While many people will get more appropriate, early treatment and preventive care, there are not enough cost savings from fewer ER visits to offset the increased costs.

So, there are elements we need in healthcare reform that address the supply side.

1. Malpractice reform is an important piece. We want to protect victims from poor treatment, but the balance needs to shift to identifying and correcting fraudulent and negligent care, and away from using the tort system to punish all bad outcomes. This is not a sop to the medical community, beset by very high premiums. Instead malpractice reform will release the physician to make reasonable diagnosis and treatment decisions, without having to practice defensive medicine.
2. Physicians are smart people, and they respond to incentives just like all of us. We also know that medical care is done differently in different locales, with significant differences in costs, and often no differences in quality or outcomes. Our newly designed incentives should encourage movement towards more cost effective care. We can’t be distracted by labels like rationing, or government control of medicine. Instead we need to encourage more wide spread use of treatment strategies already in place in the private sector.
3. The supply side of healthcare needs more vertical integration. Physicians, hospitals, and other care providers need to manage patients and their risks collectively, and make decisions that result in good outcomes and lower costs, regardless of the treatment setting. This approach has worked for fifty years in organizations like Kaiser Permanente, InterMountain Health, the Mayo Clinic, Geisinger, Group Health of Puget Sound, and the VA.

The Role of Competition

In this post I’ve attempted to set aside the issue of political feasibility. That is for others to evaluate, and it is a mistake to “give in” on these checklist items too soon, if ever, in order to curry votes. One exception to this is that I’m not considering or proposing a single payer plan. There is much about single payer to like, but it flies so much in the face of American social attitudes that I can’t bring myself to consider it realistically.  Which leaves us with a multi-faceted system, involving both private and public elements.

As an economist, I have a basic belief in markets, and their ability to help individuals, families, and suppliers make efficient allocation decisions. I also understand that in the case of market failures or the presence of externalities, that government intervention is warranted and necessary. Generally, the best solution is to defer as much allocation decision making to markets, and for government to put a very light hand on the tiller.

1. Healthcare reform should leave individuals and families with choices. Choices should have different prices, depending on the benefits they deliver. Insurance and delivery systems that figure out how to improve healthcare and make it more efficient should enjoy lower costs and premiums, attracting more people to them. Health insurance purchasing cooperatives, while also not a silver bullet, are worth exploring.
2. The competitive playing field should be reasonably level. The basis of competition should be on outcomes and costs, not on risk-shedding or underwriting.
3. Assuming that some portion of the population will have their premiums paid or subsidized by the government, those payments should be risk-adjusted. For example, a disabled person with significant medical needs who is unable to work should bring with him a government subsidy that is higher than an average person. This way plans will be less concerned about the underwriting risk, and the good plans will be able to manage this person’s care thoughtfully and efficiently.
4. Insurance plans should be community rated. This means that everyone with the same set of benefits in a plan should pay the same premium. Experience rating is the current norm, where groups pay premiums based on their own experience. This pricing encourages aggressive underwriting – insurance companies compete to enroll young, healthy groups, and avoid older, sicker populations. And even without underwriting experience rating drives sicker populations away due to higher premiums.
5. The earlier points established, a public option is not really a necessity. It is a favorite rallying cry in the current debate, but mostly because some of us do not trust the government’s ability to regulate a competitive market of private plans. There are other, successful economies that have universal coverage without a public option.

Demand Side: The most talked-about element of healthcare reform is expanded, almost universal coverage for everyone in the U.S. This would put us closer to the status of just about every other industrialized, first world country, and would help meet our moral, social obligation to provide access to basic, better health.

What this does to the demand curve for healthcare services is rotate it clockwise (see graphic). No rocket science here – we would expect that if more people had health insurance there will be more demand for services. Conceptually we would move from Pt. A to Pt. B. The important question (see later in this post) is, “What kind of services will these newly insured people demand?”

Supply Side: We learn in class that a shift or change in demand (in this case higher demand) increases the number of services provided and increases price. Left to its own, invisible hand, forces the healthcare market would see a dramatic increase in the use of healthcare services and total costs.

If this were the end of the story, and we were left with our current methods of financing healthcare we could expect many of the following:

• premiums for existing health insurance would rise as prices for individual healthcare services increase.
• employers who provide health insurance as a benefit would face increasing costs, and many of them would choose to drop this benefit.
• states and localities that provide our safety net would see higher costs – particularly in Medicaid. Medicaid is probably the most important funding issue for states today.
• the Medicare system for the elderly would be strained as prices rise. Medicare has some built-in restraints against increases in fees, but the pressure on the system would be immense.
• to the extent that the Federal government absorbs costs of insuring people who would otherwise be uninsured, the Federal cost would rise significantly – hence the objection from the Blue Dogs.
• …and much more…

So, cost controls are important. As a nation we could not afford taking on that added costs at any of the local, state, or federal government levels, and there doesn’t seem to be much enthusiasm for new taxes to cover these additional costs.

But, aren’t there some built-in cost savings if we introduce universal coverage? Yes, but probably not enough. One example would be the impact of providing easier access to early, preventive care for those who don’t currently have health insurance. We know that the uninsured get less preventive care, make more use of expensive and inappropriate emergency services, and do not have the advantages of a sustained relationship with a physician or other healthcare provider. Improving these would certainly help the quality of life (and length of life) for the uninsured. It is not as clear, however, how much money would be saved. Many preventive services do improve the health of individuals, but only a few preventive services actually save money in the long run.

As painful as it is for an economist to say that the government needs to step in and reshape the healthcare marketplace, I believe that is what we must do. Those steps will each require their own posts, but let me suggest that two current policy arguments swirling around Washington are mostly red herrings.

Should the government sponsor a public plan to compete with private insurance companies? Perhaps, but the reform will just as easily fail if we don’t design insurance coverage, payment options, mandated actions, and government support correctly. It is just as possible to have a successful reform effort with no public plan, if the design is right.

Should we tax the wealthy to pay for healthcare reform? If we need more tax dollars, then the wealthy are a good target. Wealth and income gaps have widened considerably in the last couple of decades and there are good arguments why a little redistribution of income can be good. The tax on the wealthy, though, just papers over the underlying cost issue. A well-designed healthcare system should reduce national expenditures (public and private combined). If we need a tax, then that means we have not found a better way to organize healthcare. Here’s a simplistic simile. If a town ran a school bus service, and the bus was old, creaky, expensive to maintain, and at times not safe, we could tax the wealthy to hire more mechanics, and to buy repair supplies. Or we could replace the bus.

As I was sitting and watching the concerts I was impressed by the wide range of talent represented on the stage. There were performers from every corner of the music world, and here in Southern Oregon that world is breathtakingly broad and rich. Yet, I bet that very few of those performers have health insurance. The recipient of all this support is widely known and extremely active. He conducts/directs at least three large choral groups, gives music lessons, and performs both on his own and with groups. None of those choral organizations, though, provide health insurance – so he has none, despite being at the pinnacle of activity and visibility in our valley. I thought about all of those talented performers who were sharing their talents and enriching our community, while leading those (as Thoreau put it) “lives of quiet desperation” – cobbling together a living from countless gigs, lessons, and the occasional minimum wage job.  These people are very different from the images of the uninsured that we conjure up when reading policy papers on healthcare reform.

In terms of cultural support Ashland is unusually generous. We are the home to the Oregon Shakespeare Festival, which has an acting corps and production company of 500 souls. Rare in the theater industry OSF operates in reperetory for 10 months of the year, with contracts that run from 6 – 10 months. And in most cases those company members are given health insurance benefits – unlike their colleagues even in other parts of Ashland who perform or support the several other “off-Bardway” venues. And we have a medium-size university and a hospital and city government and school district, all of whom provide insurance benefits. At a rough guess, though, those top five employers (OSF, SOU, Hospital, City, Schools) probably employ less than 20 percent of the Ashland households. Other than these our biggest economic base is tourism, supported by retail and service jobs all earning low wages, and seldom with health insurance.

This is why we need universal coverage.

[...T]hese programs [technology, preventive care, and effectiveness research] will not yield the significant cost savings we need. Rather, this trio of planks must be placed firmly upon the foundation of organized health-care delivery and aligned incentives.

I had the pleasure of talking with Enthoven earlier this spring, at a memorial service for a long time friend of my father. Enthoven has been on the faculty of the Stanford Business School and continues as a consultant to Kaiser Permanente. He has been talking consistently about realigning organizations and incentives in healthcare for the 25+ years that I’ve known him.

Here’s the challenge. We know that bringing all Americans under some kind of healthcare insurance plan will increase demand for services, which in turn will put upward pressure on prices. The result – significantly higher healthcare costs. Some of those new services will improve the lives and quality of life for the currently uninsured, and will reduce some future expenses. However, much of the additional care delivered and much of the care delivered today will be wasteful – not improving health outcomes and often making them worse.

Healthcare reform will need reform on the supply side, as well as the demand side. It is a continuation of our discussion on scarce resources and rationing. In a market where demand is increasing, quantity and prices go up. If resources are scarce and the opportunity costs of those resources too high, then it helps to change the supply/production part of the equation.

Enthoven’s long association with Kaiser Permanente is consistent with his position. He has seen the benefits of reorganizing care – better outcomes using fewer resources. He also believes in incentives as a way to change both patient and provider behavior. As he and Cortese point out, the three cost saving initiatives proposed by the Obama Administration are necessary, but not sufficient.