Freeman

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The Free Market Works Fine, Except . . .

Government Failure Is at the Root of the Health Care Crisis

SEPTEMBER 01, 1994 by MARK SKOUSEN

Filed Under : Health Care

“In health care today, fundamental principles of the marketplace do not apply. Prices are not determined by supply and demand . . .”
—“America’s Economic Outlaw: The U.S. Health Care System,” The New York Times, October 26, 1993

I don’t know why I keep picking on The New York Times for my column. Maybe it’s because it reflects the conventional wisdom of today’s policy-makers, which is wrong more often than not about the basic principles of economics.

Late last year, as health care became a national issue, The Times ran a cover story contending that America’s health care system “operates with almost total disregard for basic economic principles” and therefore deserves special treatment by government. “Prices are not determined by supply and demand or by competition among producers. Comparison shopping is impossible. Greater productivity does not lower costs.”

But are medical services really that different from soap, cars, or baseball tickets?

Let’s go back to Economics 101 to analyze the health care debate. We shall see that, contrary to The Times’s statement, supply and demand are working all too well in the health care industry. Below is a graph of supply and demand for product x.

This simple graph teaches us three grand principles which, if followed, will easily explain (and resolve) the health care crisis.

Market Principle #1: Supply and Demand

First is the principle of supply and demand. When supply is free to adjust for changes in demand, prices move quickly toward equilibrium without creating shortages or surpluses. As demand increases, prices rise; as supply increases, prices decline.

Why is the cost of health care rising so rapidly? Two reasons: first, increasing demand from Medicare and Medicaid, which today accounts for 65 percent of all medical expenses; second, restrictions by the American Medical Association on the number of students admitted to medical school and limitations on what services nurses and paramedics are permitted to perform.

Market Principle #2: Non-Discrimination

Second is the principle of non-discrimination. Note in the graph that everyone tends to pay the same price for product x. No matter what your income, religious beliefs, or color of skin, you pay the same price as everyone else. Republicans and Democrats pay the same amount, Pc, for the same product. So do rich and poor, Christians and atheists, secretaries and engineers. In the free market, as customers compare prices and producers compete, price discrimination is minimized and products are universally available.

Maintaining the principle of non-discrimination in the marketplace is essential. If prices were based on income, there would be little incentive to work harder and earn more income, or for businesses to compete and shoppers to compare prices.

However, this principle is being eroded. Private insurance premiums are still the same for each participant, but an increasing share of medical costs is being borne by taxpayers based on income level. The Medicare tax is now an unlimited tax on income (2.9 percent). The Clinton health plan would make matters worse by making monthly medical insurance premiums a percentage of income, not a fixed amount.

Market Principle #3: Accountability

Third is the principle of accountability. The graph above suggests that you, the customer, pay a specified price, P¢, for each product you buy, or for each unit of service you use. In other words, there is a direct link between beneficiaries and payers. Those who benefit from a service should pay for it. That’s a cardinal principle of sound economics. If you buy one loaf of bread, you pay $1. If you buy two loaves, you pay $2.

When people don’t pay for the services or products they are using, there is a tendency to overuse the benefits and less incentive to keep costs down. The connection is obvious: If you use a doctor’s services, you should pay for them. If you use more, you pay more. And if you use less, you shouldn’t have to pay the same amount as someone who uses more.

The principle of accountability is also disintegrating. The link between payers and beneficiaries is breaking down. In more and more cases, Medicare users are not paying the bill, taxpayers are.

Another major source of trouble is the pervasive use of employer-paid medical insurance to pay for even routine doctor visits. When employees know that someone else—the insurance company—is going to foot the bill, there is less incentive to shop around and to limit the number of visits to the doctor or the hospital’s emergency room. Fortunately, the insurance companies do attempt to maintain some form of cost control on hospitals and doctor services, but the current system is less than optimal.

Who’s to Blame?

The author of the Times‘s article blames the market for America’s health care problems, but the real cause is the government’s failure to let the market operate fully. Even employer-paid medical insurance is, in a way, a government creation. High corporate taxes encourage businesses to offer a wide variety of fringe benefits, which are tax-deductible to corporations and tax-free income to employees.

Contrast the health care industry with the dental industry. The dental market does not suffer from the problems facing the medical industry (spiraling costs, bureaucracy, long waits at medical facilities) largely because (1) most dental services are paid for directly by the patient, and (2) the number of dental students is not restricted. These two factors, patient accountability and expanding supply, have worked to keep the price of dental care down. Despite The Times‘s dire pronouncement, market principles do work.

How to Resolve the Health Care Problem

What should be done to improve the situation? Imitating national health programs in Canada and Europe won’t do because they violate market principles. (If you want to know the weaknesses in each country’s health care system, analyze each according to the three market principles.) Analyzed according to these three market principles, Clinton’s health care plan won’t work either. The cost of medical services would vary according to income, beneficiaries wouldn’t pay directly for medical services, and a new federal agency would impose cost controls on drugs and other medically related services. The result would be shortages, bureaucracy, higher costs, reduced services, and less research and development.

The solution to the so-called health care crisis is to get government out of the picture. Private insurance would be able to solve the problem on its own through flexible deductibles and co-payment arrangements. This would encourage competition and comparison shopping to control costs, stimulate further medical advances, and encourage preventive care and exercise. The United States would then be reassured of her position as the nation with the world’s best health care system.

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September 1994

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