Another excerpt from my book-in-progress, Economics in Two Lessons (partial draft here). As usual, praise is welcome, useful criticism even more so.
On most measures, health care is among the largest industries in a modern economy, and its share is likely to grow in future. Health costs are a major item of expenditure for Individuals, families, employers and governments, amounting to 16 per cent of national income in the US (costs are lower, but still substantial in other developed countries with more sensible policies). Yet only a tiny fraction of this expenditure takes the form of standard consumer market transactions; that is, purchases of medical services by patients at a price equal to the opportunity cost of their provision.
The majority of private health expenditure is funded, in whole or part, through insurance. Once the premium is paid, all or most of the cost of visiting the doctor or going to hospital is borne by the insurer. So, the opportunity cost to the household of using medical services is far below the opportunity cost of providing those services.
The same is true of publicly provided health care. Public health services are funded from tax revenue, sometimes specifically allocated to health care and sometimes derived from general revenue. Either way, the opportunity cost for patients of using these services is far below the opportunity cost to society of providing them.
More generally, the health sector of a modern economy involves a complex mixture of public provision, for-profit corporations, non-government organisations and individual professionals such as doctors. Systems for providing and financing health care differ radically, from comprehensive public systems like the British National Health Service to predominantly private systems like that in the US. But nowhere are such services provided primarily on the basis of prices that reflect the opportunity cost of their provision.
This was not always the case. Until the late 19th century, markets for health care were much the same as other service markets. Doctors and pharmacists provided services and medicines as patients (at least those who could afford them) demanded, and were paid fees, out of the patient’s pocket, in return. Those who could not afford to pay (the majority of the population) relied on charity or went without. This ‘fee-for-service’ system has not entirely disappeared, and remains dominant in some poor countries. But developed countries have abandoned it almost completely.
To understand why health care systems are the way they are, we must apply the Second Lesson. This will help us to understand why simple markets for health care do not work to tell us about social opportunity costs. The more difficult problem is to work out the best way of making prices and other market signals work where they can, and how to replace them where they do not work.
Rationing and opportunity cost.
Economists are frequently criticised for assuming (as they mostly do) that the wants of consumers are limitless. Why, it is reasonably asked, can we not learn to be satisfied with what we have?
One field in which the assumption of limitless wants seems plausible is that of health care. New and improved treatments are being developed all the time, offering us longer and healthier lives, and cures for previously entreatment ailments and disabilities. Whatever we might think about consumption in general, few of us are so stoical that we would willingly choose to accept death or disability if it can be prevented or cured by medical treatment.
The problem is that, while the range of potentially beneficial treatments is effectively limitless, the resources available to the health care system are not. In a simple market system, this problem resolves itself automatically; those willing and able to pay for health care services receive them, and those who are unwilling or unable do not.
As we have already seen, however, markets in health care do not work well. For this reason, they have been replaced by a mixture of public provision and insurance. Both for public health services and insurers the problem then arises: which health services should be funded?
The general idea may be seen by an example. Consider a hospital which finds that it has a small amount of additional money that can be allocated either to the orthopaedic ward, where it would fund additional knee reconstructions, or to the emergency ward, where it would increase the survival chances of patients involved in car crashes.
The opportunity cost in this example is clear. The opportunity cost of improving the mobility of orthopaedic patients is that fewer emergency patients will survive. The patients involved may or may not be the same people (since car crashes are a common cause of severe injuries requiring orthopaedic surgery). T
There is no simple way of making this choice. Obviously, saving a life is of greater significance than a knee replacement, but the opportunity cost trade-off is unlikely to be one for one.
There are various ways in which the trade-off may be assessed. Some methods rely on the expertise of doctors. These face the problem that, being human, most doctors regard the conditions treated by their own speciality as being more significant than those treated by others.
Another approach is to rely on the expressed preferences of potential patients. In the example above, we might ask people who are not currently in need of a specific treatment to make judgements of the general form “I would (or would not) prefer a treatment yielding 20 years of additional life with full mobility to one yielding 25 years of additional life with a requirement to use crutches to move about”. [A formal version of this approach, using the concept of Quality Adjusted Life Years or QALYs is sometimes used. This approach and its strengths and limitations will be discussed in an Optional Extra section]
Judgements about the relative benefits of alternative outcomes may be translated into medical decisions in various ways. The simplest is to specify a list of treatments approved for funding. An alternative, referred to as case mix or activity-based funding relies on providing a specified payment for each kind of treatment, based both on the cost of provision and the requirement that benefits should exceed costs.
These price-based approaches can provide useful signals when hospitals or other health care providers are making treatment decisions in combination with their own judgments about what policies are most consistent with a mission of providing care. The price paid for an activity provides an indication of the social benefit perceived by the government. However, given a sufficient surplus, providers can choose to provide services that they judge to be desirable, even though they are funded at less than the cost of provision.
As with other price-based policies however, activity-based funding models are vulnerable to exploitation in a system dominated by profit motives. Profit motives are obviously dominant when services are provided by for-profit corporations. The may also dominate when resource constraints are so tight that a non-profit provider has no alternative but to maximise returns by providing only those services with a price sufficient to cover the opportunity cost of provision.
In these cases, various forms of cost-shifting may emerge. For example, doctors funded on an activity-based model may attempt to divert ‘unprofitable’ patients to the emergency wards of public hospitals rather than spending the time necessary to treat them. Similarly, it may be cheaper, from the provider’s perspective, to give a patient a prescription (the cost of which is borne elsewhere in the system) rather than to spend the time necessary to treat the underlying condition.
Ultimately, given scarce resources and effectively unbounded wants, some form of rationing is inevitable. The opportunity cost approach makes explicit the fact that, for any given level of resources, providing one kind of medical treatment comes at the expense of the alternative treatments that are not provided.
No approach is perfect, but reliance on markets and incentives is likely to lead to highly unsatisfactory outcomes. The best options involve a combination of explicit policy judgements on the general value of particular treatments and reliance on the expertise and commitment of medical professionals to provide the best possible treatment within the constraints of those policies.