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May 31, 1977

Health Care Costs and the Free Market

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May 31, 1977 HEALTH CARE COSTS AND THE FREE MARKET INTRODUCTION In recent years the American health care system has become the subject of controversy. Though nearly all critics agree that the quality of health care has improved, many find that the improvement in quality has not been commensurate with the Limcreases in costs. In 1975, the United States spent $118.5 billion, or 8.2% of its GNP, on health care; this was an increase from $38.9 billion, or 5.9% of the GNP, in 19

65. From 1965 to 1974, the per capita expenditure for medical care increased from 197.75 to $485.36, or by an annual average increase of 9.4 These cost increases are growing more andmoreburdensome both to the consumer and to the taxpayer as the government assumes an increasing share of the burden. They have led to a.':loss of faith in the American health care system and to proposals which call for vast changes in its present, semi-private status and fu n ding. However, some argue that this loss of faith is misplaced and that, if health care were more responsive to market forces, its costs would not be as exorbitant as they have be come. They suggest that in place of government control and funding of the h e alth care sector, a free market approach Would be preferable HEALTH CARE AND THE FREE MARKET In economic theory, prices rise and fall in response to changes in the supply and demand for goods and services. In the real world, and es pecially in regard to h e alth care, a number of factors serve to insulate the costs of health care from the.operation of the free market. It is these insulators that are the primary cause of the cost increases in health care Critics of the American health care system (and of the f ree market often say that health care cannot be responsive to the market, that de mand for it is Lnelastic because when people are sick, they must pur chase health care regardless of the cost. Health providers, it is argued therefore have a captive market which cannot exercise consumer prefer ences or simply refuse to buy if they dislike the product. Furthermore because of the highly technical nature of health care, the average per son lacks the3nowledge to make intelligent choi-ces as he would in other ar e as. Because of these peculiarities, say the critics the government i 2 9 2 e I NOTE i iaoFtii ng wr 3 t t e,n h.6 re.;:i. s.Lkoi:.lj e cb'ns trued as c Ic a $1 %my ref 1 e cEng the vi-ews'of'-'The Heritage Foundation or as an attempt to aid or hinder the passage of any bill before Congress. -2 should be responsible for seeing that every American receivesproper health care at no-:.or very cheap cost' and that such health care is a basic right of a citizen in an affluent, industrial society.

There is some tr uth to the charge that health care cannot be responsive to the market, but it is greatly exaggerated. The demand for health care is no more inelastic than the demand for food, which is also neces sary. It is true that people must have health, but there ar e any num ber of ways they can improve and protect their own health in easy and inexpe.nsive ways. Furthermore, they are just as capable of exercising a choice among doctors and hospitals, given differences among them of prices and the quality of services o ffered, as they are of buying a car a television, or of performing any other economic transaction that in volves technical knowledge. It should also be pointed out that techni cal considerations are not the only criteria. involved in deciding which health providers to purchase from. Considerations of cleaniness, cour tesy, comfort, co.fivenience, and:trust, as well as many other factors often determine our choice of a doctor or hospital lects to care for his health or fails to inform himself of available o p tions in buying health care can no more complain of its costs than can a person who fails to eat for a considerable time complain about the high costs of food in the expensive restaurant in which he is finally forced to seek sustenance A person who neg No r can we be content to let the advocates of National Health Care suc ceed in pe.rsuading us that we have a right to cheap or free health care.

Health care consists of economic goods and services; someone had to work to produce and distribute them. If we ha ve a "right" to these goods and services at free or .very cheap prices, then their producers/distributors have a corresponding duty to provide them at:.little or no charge. The recognition of such a duty in law would be nothing less than a form of slavery or forced labor, a concept against which Americans have histori cally rebelled. Health care, in short, miist be paid for, and it must be paid for at a price which offers adequate compensation and incentives to attract efficient providers With these princi p les in mind, let us examine some of the forces which artificially insulate health care from the market and which are respon sible for cost increases. Some of these forces are the result of govern ment action which,intended to prevent a health crisis, have actually contributed to the growing problems of health care. Other forces are not the fault of the government (at least not directly) but still re flect social and economic trends which government sometimesencourages SOCIAL AND ECONOMIC CAUSES: y Three of these must be examined; the reimbursement system by third parties; the consequences of malpractice litigation, and the rising bur den of new and technologically advanced equipment and laboratory tests. -3 A. Third Party Reimbursement: Payment for most hea l th care costs are borne not directly by the consumer (patient) but are apportioned out among three different sectors: the :consumer, the-private insurer, and the government. This system of reimbursement increases the cost of health care in several ways. F i rst, it relieves the burden of payment for any one of the three sectors. Thus, none of the three has -mucK-in centive in seeing the costs reduced or stabilized. Secondly, cokerage by insurance serves to stimulate demand, which in turn:forces prices up ass u ming no comparable increase in supply Thirdly, because the patient has already paid his insurance premium, health providers can raise their charges (as well as the quality of their services) without placing the burden on the patient As of 1974, about 85% o f the American people had some form of private health insurance (87.1% were covered for hospital care and 81.1% were covered for surgical care The cost of insurance Rr'emiums as a ratio to disposab1.e personal income rose from 2.14% in 1960 to 2.57% in 19 6 5 and to 3.59% by 1975, or by little more than 1% for the past ten years Dr. Martin Feldstein of Harvard University has demonstrated that insur ance coverage increases demand fbr.-health services Insured families use hospitals and physicians more, stay in hospitals longer, and have more ancillary services (tests and examinations) than do non+insured families.

Thus, the extent of private coverage may be counted as a factor serving to increase demand, reduce the burden of cost, and stimulate price 1 increases.

However, the federal government is responsible for encouraghg:?pr.iva-te coverage as well as for public insurance. The government subsidizes private health insurance by offering a deduction of up to $150 plus all medical expenses that exceed 3% of inco me. The government also subsi dizes employers for their contributions to their employee's health in surance by not taxing these contributions as income. In 1974 the govern ment lost in revenue about $3 b.illion for employers' contributions and about $2.6 billion for personal income tax deductions.

The government also acts as the largest single contributor to third party payments. In 1974, 64.6% of the health care burden was borne by third parties: 25.6% by private health insurers and 37.6% by government (1 .4 was borne by philanthropy and other sources From 1965 to 1970, the portion of health costs carried by private insurance fell from 24.7% to 24 though it .increased again by 1974) and the government portion in creased from 20.8% to 34.2 This increase was due to the implementation of Medicare and Medicaid programs in 1966 The government portion of the third party payments was not felt at all by the consumer (though it was certainly felt by the taxpayer) and there was no consumer incentive to hold down cost s . Nor do private insuners feel such an incentive. The higher the cost of health care, the more de pendent the consumer is on health insurance, and as a ratio of .the.'c.o:n- gumer s dispos2ab1e in'cpme i.n$u-rance p.rem5.ums. have- iriC-i..eaS.e by oniy'. -T i T iiry;.thq tc azt decade.

We may conclude then that the system of third party reimbursement is an inflationary force on the cost of health care; that it acts as an infla- I tionary force because it serves to stimulate demand and is a disincentive to reduce or stabilize costs; and t hat government is a primary contribu- I tor to this system through its fiscal and medical benefits policies B. Malpractice Litigation: Between 1970 and 1975, malpractice claims against physicians grew st6adily from lis38 to around 5,000--an increase of 22 5 The size of c1,aims increased significantly also; in 1974, in California alone, there were 15 suits with claims of..over $1 million.

About 30% of claims reaching court are won by the plaintiffs, but legal costs are still incurred by physicians and hospitals and their insurers.

By 1975 malpractice insurance had increased in cost by about 600% in the previous 3 or 4 years. In 1975 ftsxost. was estimated at $1 billion 3'5Omillion in premiums paid by doctors and $650 million paid by hospi tals. Some doctors have stated that they pay 10-20% of their gross in comes in malpractice premiums;.

The result of such increases in malpractice litigation and'ths cost of insurance has been twofold: first, to increase the fees of both doctors and hospitals to cover the co st of the insurance; and secondly, to con tribute to the growth of defensive. aiedicinef1--ii-e doctors taking longer and .making more certain of their diagnoses Sefore-:prescribing therapy or surgery. According to former Secretary of HEW Casper Wein be.r ger?, malpractice litigation andlnsurance cost the country between $3 and $7 billion in 1975.

The causes of this rather sudden upsurge in malpractice litigation are not entirely clear. The most prominent cause is likely to be the in creasing estrangement b etween doctors and hospitals on the one hand and their patients on the other. The family doctor and the generalpracti t5oner have become virtually extinct as the medical profession becomes more specialized and "professional Hence, patients no longer know o r trust their doctors as friends or neighbors and are more willing to sue them for what they believe to be negligence or incompetence. Also, as medical care has become more complex, it is probably easier to make mis takes in diagnosis and as surgical tech niques have become more sophisti cated, the results of surgery have become more serious.

Government probably does little to encourage malpractice litigation though the size of some of the claims raises questions about the respon sibility of the judges invo lved. However, an important aspect of .the propaganda for national health insurance is the gradual discrediti-ng- of the medical profession. The leftwing radical group, the Medical Commit tee for Human Rights, with which Dr. Quentin Young (whom President C arter recently considered for the post of Commissioner of the FDA) has been associated, has referred to the AMA .as the American Murder Association and,indulged in extreme rhetoric about the medical profession. Even more responsible groups have fostered s u ch propaganda which tends to bring disrespect and distrust upon the nation's health providers t -5 C. Technological Costs Another factor which increaseS':the4-:cost. of 1 health care is the technologkcally advanced equipment which mhy hospitals install. I t is quite true, as the critics charge, that such equipment is very quickly outdated by even further scientific advances; but their other charge, that such equipment is unnecessary and:of only limited usefulness, is more controversial.

Among the more advan ced techniques now being used are the Computerized Axial Tomography (CAT) Scanner, used for the diagnosis of cancer; the In tensive Care Unit (ICU) for cardiac problems; renal dialysis techniques for the treatment of kidney failures; and isolation units w h ich duplicate life-support systems for newborn children. There is no doubt that such techriiqu-es save lives. Renal dialysis alone is estimated to have saved about-30,000 lives. However, the controversy arises over whether these lifesaving machines are wo rth the cost. Critics charge that they are not that the number of lives saved is not enough to justify the extra costs.

They also point to the reduced quality of the lives' of many-patTents: who liaue to.depend on technology to exist. This argument, howeve r, is a very subjective one; those who face death (often a painful one) without the new technology may not agree that it is useless and should at least have the choice of using it or not--a choice which many critics would deny them by discouraging the pur chase of advanced technology by hospitals or doctors A.second reason why the use of advanced technology is spreading among health providers is the fear of malpractice litigation that they have.

Advanced techniques of diagnosis and treatment (and laboratory tests also) serve to reduce the errors that health providers make and many of them feel insecure unless they can take advantage of them.

Finally, it should be pointed out that such new technology and medical care tends to reduce the length of stay in a h ospital. According to Blue Cross, in 1947 hos italization for pneumonia lasted for an average duration of 16 days at i 10 a day; by 1966 hospital charges had increased to about $40 a day, but the duration 6f a stay for pneumonia had dropped to 5 days. Thu s , though the cost of a day in the hospital had increased by 4, the cost per stay had increased by only 1.25, plus the time saved by the patient in returning to work sooner. The reduction in time was due to the improvement in techniques of treating pneumon ia.

These are the principal forces which serve to increase the costs of health care in the United States. As we have seen, some, such as the re imhrsement system, are directly related to government intervention and serve to insulate the costs from the exer cise of consumer preference in the market. Others are more directly related to social and economic de velopments in American society. However, there are a broad range of still other forces which are directly or indirectly related to government in terventi o n which increase the costs even more D. Government I. Direct Causes of Health Care Increases -6 a) Government Regulation: The Methodist Hospital of Memphis Tennessee, recently estimated that it spends over $500,000 a year in com plying with government reg u lation A recent-estimate by Patricia s Coyne, writing in Private Practice magazine, of the total cost of govern ment regulation to the hospital sector of health care p-laces it at $4 billion or about 8% of the total hospital cost. This estimate includes n o t only the cost of compliance with the regulations themsekves, but also of-.the salaries of the additional employees necessary to administer com pliance b) Medicare and Medicaid: In 1974, Medicare programs spent 11.3 billion and Medicaid spent 11.2 billio n , together,composing 55 of all public me.dica1 care spending and nearly 22% of the total cost of health care in that year 104.2 billion This expense in itself amounted to about 2% of the GNP for that year, but the cost increases which this kind of expendi t ure causes are also expensive. The provision of health care by.the federal government under these two programs at greatly reduced costs to the utilizers serves to increase the demand on health care,and this pushes up the price of theiremaining supply for o ther consumers. A second aspect of the programs which increases costs to other cons.umers is that the federal government compensates parti cipating hospitals for Medicare expenses only for actual care, and not for overload expenses (therapeutic facilities , equipment costs, etc.J.

The result is a gap between the value of the services expended and the value of the reimbursements received from the government, and 1io.spitals must pass this discrepancy on"To;paying patients by increased costs. In FY 1966-7, he alth spending increased by 13.7% as opposed to only an 8.3 increase in 1965-6 The per capita:-amount also increased from 7% in 1965-6 to 12.5% in 1966-7 Nor did these rates of increase drop signi ficantly until the imposition of wage and price controls in the early 1970's. Furthermore, between 1965 qd;1970, the government portion of payment for personal health care expenditures increased by 13.4%,(as opposed to an increase of only 1.1% in the previous five years In the years from 1965-to 1970, the cost of h ospital care increased by $13.8 billion (as opposed to $4.5 billion in the previous five years Physi cians' services also increased steeply in.price in the:same years. From 1960 to 1965, they increased by $3':'6i:lliO.n From 1965 to 1970, physi cians' ser vices increased by '3 d'5.,6 b511T6firn The Medicare program served to increase doctors' fees in three different ways. First, the program caused an increase: in the overhead by requir ing additional paperwork, office help, and administrative equipment.

Sec ondly, the statistical average of doctors' fees increased due to Medi care because under the program some former charity patients began to pay for services received. The figuring in of these new patients thus in creased the final statistical average of do ctors1:fees. The third and probably most important increase in doctors' fees due to Medicare has de rived from the reimbursement procedures for doctors under the program.

This procedure stipulates that doctors be paid on the basis of their usual, customary, and reasonable UC.R) fees. Physicians now began to -7 pay much closer attention to their fees than they,,had before, to calcu late carefully what their "usual" fees wer e , what those of their col leagues were, and what they had been in the past. Anticipating infla tion or tighter government contro1;of their incomes in the future, some doctors inflated their reportings in order to cover future cost .in creases. Othersincre a sed their fees in.the belief that only by doing so for the more affluent patients could they afford to treat poorer patients under the Medicare 0.r. Medicaid :programs. Finally, as with hospital costs, Medicare and Medicaid increased doctor's fees by stim u lating the demand for doctors' services without increasing the supply of doctors. The average annual increase in doctors' fees between 1960 and 1965 was 2.8 before implementation of the.programs, but afterwards between 1965 and 1970, it was 6.6 c) Hospit al Construction: Between the passage of the Hill Burton Act of 1946 and..1974, the federal government provided more than $2.8 billion for the construction of about 370,000 hospital beds.

About one-third of these were in-new hospitals and the other in older ones. This program has also served to increase the cost of hospital care. The poor and indiscriminate planning of these new hospitals has 947,000 hospital beds, 200,000 are empty at any given-time and'i-O0,000 of them are unnecessary. According to Secret a ry of Health,- Education and Welfare,Joseph Califano, each excess bed costs $20,000 a year to maintain a total of $2 billion for the unnecessary beds Hospitals of course, are very popular with politicians, since they create the il lusion-of concern with p u blic health and give employment both to con struction workers and to the hospital staffs themselves. In 1974, the Hill-Burton Act was modified to require certification of need by a state before new construction is allowed. However, these restrictions have not been implemented fully resulted in an excess capacity. HEW estimates that of the nation's In addition. to poor or politically inspired planning, another factor in increasing the costs of hospital care due to hospital construction has been the improvem e nt in hospital care itself. The average length of stay in American hospitals has decreased from 8.3 days in 1969 to 7.8 days in 1973 (this is the same length of stay as in 1965 As the length of stay has declined, two effects on prices have occurred. First , the same number-of services is provided in a shorter time, and thus the cost per day -h?isl increased(though the total cost of the stay may remain the same Secondly, decline in length of stay reduces the growth of patient days; as this declines at the sa m e time that bed supply increases, oc cupancy rate also declines. The cost per empty bed must thus be spread among the remaining patients and their costs increase It may seem that it is contradictory to blame rising costs on both in creased demand (as we h a ve emphasized up til now) and at the same time on increased supply of hospital beds. This apparent discrepancy is re solved when we reflect that the increased supply of beds would meet the demand only for increased demand of in.atient services. From 1969 t o 1973, outpatient visits to community ospitals increased by an -8- annual average of 9.13 while the-%.ccupancy rate in h s:am pe?i-dd de clined by an average of 1.1 There has thus been a decreasing demand for beds at the same time that there has been an i ncreased demand for out patient services Outpatient visits have increased from 328.9 per 1,000 civilian.:resident population in 1955 to 859.9 per 1,000 in 1973 11 Indirect Causes: Among these might be included the reimburse ment system discussed above, bu t also the costs of labor and inflation for which government bears direct responsibility a) Labor: Hospitals are labor intensive institutions. A hos pital, according to Blue Cross statistics, requires 14 times the labor used by a hotel of comparable size. M oreover, unlike private industry hospitals cannot increase production and thereby avoid the cost prob lems associated with labor cost inflation. Also, as a hospital improves its services, this is likely to mean an increased mployment of labor and not the r eplacement of labor by technology, as'.in other sectors of the economy As hospital..services have become more sophisticated, the labor employed in them 1.h-a-i had to be more and more skilled; this too has pushed up its costs, as has minimum wage legislat ion. The number of em ployees necessary to care for the average patient has increased from 1.8 in 1950 to 3.2 in 19

73. According to HEW Demand for hospital services, especially after the in troduction of Medicare and Medicaid, forced hospitals to compete for skilled labor in increasingly tight labor markets. Collective bargahing agreements, while still not pervasive, have been increasing in the hospital in dustry, adding to pressures for higher wages. Finally the application of the minimum wage law to hos p ital em ployees has helped to close the earnings gap':batween traditionally low-paid hospital workers and workers in other service industries .It Medical Care Expenditures Prices and Costs: Background 1, Boo

CONCLUSION As we have seen, there are.a-numb.e r of factors that serve to increase the cost of health care in the United States. Several important causes are due to the efforts of the government to make health care available to more people at less cost, to stimulate demand but not necessarily to -9 in c rease supply or at least not in the right sectors manitarian point of view, such policies may seem commendable, a strong case can be made that in reality they are cruelest of all, since they raise costs for others who could previously afford health care a n d also for those who now have the expectation of receiving health care more regu larly. For the past several years, many different national health care plans have been devised and submitted to Congress, and President Carter has promised to support and sub m it such a plan of his own by March 1978 Most of these plans have not dealt with the problems of health costs as they have been outlined here; they have not tried to reduce demand for health care or to insure that an adequate supply of health care is main tained under their proposals.

Most national health care plans seem to approach health problems with the traditional ideas of government regulation and control of the .health services. However this approach in the past has only resulted in increas ing the c osts of health care; and it would not be surprising if a more comprehensive program such as is apparently contemplated by the planners would have similar effects. Perhaps a more viable and more timely al ternative to more of the same kind of government in tervention in health care would be a truly radical approach; to rely on the voluntary pric ing system of the free market and the adjustment of costs to supply and demand that would ensue While from a hu By Samuel T. Francis Policy Analyst

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