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Friday, December 11, 2009

Perverse Health Care Incentives

Markets or bureaucracy?


Ronald Brownstein of The Atlantic is the only mainstream reporter I am aware of who glimpses what the debate over health care economics should be about.

Last month he wrote, “To save costs, Democrats mostly want to change the incentives for providers. Republicans mostly want to change the incentives for patients by shifting toward a model where insurance covers only catastrophic expenses and people pay for more routine care from tax-favored health savings accounts. In essence, the Republican view is that the best way to hold down long-term costs is to directly expose patients to more of them. Few Democrats accept that logic though and it has little influence on either chamber’s legislation.”

Brownstein gives the Republicans too much credit, but my focus is on the contending ideas, not who may or may not hold them. The economic issue is incentives (no slight intended toward the moral issue), and the choice is between having government micromanage incentives and letting the free market’s natural incentives work.

If we have to sum up the problem of the American health care system in a single phrase, it would be: perverse incentives. Tax and other government policies make it look smart for each individual to do socially stupid things, such as abandoning cost-consciousness under the influence of apparently low-cost comprehensive coverage and having “insurance” for uninsurable things like pregnancy, abortion, contraception, well-baby care, physical and dental exams, eyeglasses, and more. Few if any people would find it worth the price to buy such “insurance” in a free market since the premium would include the cost of the future services plus administrative overhead. I find it hard to believe that companies would offer policies with such coverage, since the actions giving rise to the “need” for the services are largely discretionary. (A lot of other coverage we are used to, such as for diseases brought on bad habits, might also become extinct.)

Yet government policies that make employer-based coverage preferable to independently purchased coverage induce us to do things we would not do in the absence of those policies. The system hides the true costs, encourages consumption, and turns active consumers into passive patients. We end up paying higher (though hidden) prices than we would find in a free market. That’s why the current system has so many bad features, which people have erroneously blamed on the marketplace.

Spending Too Much

As a result of the constellation of perverse incentives, Americans spend more than other populations on “health care.” And because the incentives are perverse we may safely say that we on the whole pay too much. How much is hard to say. Surely one reason our medical bill is so high is that we are a rich society and there are many new and valuable services to buy that were unavailable even ten years ago. But that does not exhaust the explanation for why we pay so much or why the price of “health care” rises faster than the price the average product. We have been taken for a ride. From the perspective of the average person’s well being, the system is irrational. But it is not irrational from the perspective of those making money off it, or of the politicians who benefit one way or another.

So we have an incentive problem. What do we do about it? The dominant view in Washington is, as Brownstein notes, that provider incentives must be changed. That’s why there is so much talk about abolishing traditional fee-for-service and going to a system where doctors are rewarded for the quality not the quantity of care. That’s also why there are plans for new commissions that will issue advisories—and perhaps ukases—regarding “best practice.”

In other words, the prevailing thinking is that doctors ought to be induced or ordered to practice medicine they way politically anointed “experts” think they should practice it. Consumers would still be passive observers, and those who wanted a different form of practice would be out of luck.

The problem with this is not that fee-for-service is sacred. Maybe it’s as bad as the planners say. The point is that the best provider-incentive arrangement(s) will be the outcome of a competitive—not bureaucratic—process. Competition is a discovery process, F. A. Hayek taught. Doctors, health economists, and bureaucrats sitting around a conference table in front of a whiteboard and PowerPoint presentation may agree unanimously that some new arrangement is optimal. But we really can’t know if it is as good as they think until it’s tried out in a competitive environment with real people. However, if bureaucrats impose their scheme and it comes a cropper, we’ll all suffer. Bureaucracies are slow to admit mistakes.

Consumer Incentives

That brings us to the other way to change incentives: on the consumer side. People choose differently depending on whether they face the full costs of their actions or, instead, artificially depressed (and therefore shifted) costs. If public policies make services look cheaper than they are to those lucky enough to have comprehensive coverage and encourage overconsumption and cost-obliviousness, then it stands to reason that abolishing those policies would bring down real prices and introduce consumer responsibility. We don’t need government to create incentives to lower costs. It just needs to back off and let the market work. “Back off” is shorthand for a long list of repeals, including the protectionist regulatory regime for the insurance industry and medical profession, and subsidized consumption through Medicare and Medicaid.

The common impulse for “health care reform” is entirely honorable. It is distressing to know that so many people are vulnerable to bankruptcy-threatening medical bills or to raw deals from State-cartelized insurance companies. Who wouldn’t change that if he could? The question is: Which approach has a better chance of changing it? Centralized bureaucratic decision-making by self-serving politicians and their “private sector” patrons? Or decentralized, cooperative, entrepreneurial efforts to satisfy cost-conscious, freely choosing consumers?

It’s time we junked the intolerable system we have, rejected further state control, and tried freedom.


  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.