Monday, October 22, 2012

Healthcare and Cars are Not Isomorphic

I've recently been doing some thinking about health care, and my thoughts aren't yet complete. However, when reading many of the conservative commentaries on health care, I was very peeved by their treatment of the market for health care just like the market for any other good or service, and this was aggravated by the fact that I agreed with most of their other arguments. As a result, I wrote the following NextGen article to collect my thoughts on this issue before I move on to more substantive analyses of some recent posts.

"Healthcare and Cars: Why They're Not the Same"

How is the market for health care different from that for cars? And how does this difference change our understanding of health care policy?

Let us start from the basics: health care is a service, while a car is a good. While this does not prevent market competition from improving society's welfare on the margin, it does mean that there are fundamental limits to how far the market can improve. In particular, it means that one productive hospital cannot simply “export” its health care services across the country. And as we know from the car industry and international trade theory, that lack of export markets and distant competitors can impede the creative destruction that makes markets work.

But this is an incomplete justification. Haircuts are also services, but few people think barbershops require regulation. Yet, they differ in one key respect. While it is easy for me  to determine the quality of my haircut, it is much more difficult for me to determine what counts as “good” health care. A large part of this is linked to the uncertainty inherent in any kind of biological process. How does one determine if one is receiving sufficient care? Of course, if there is any gross negligence, it can be detected. Yet if the care is just slightly worse than it should be, there's no real way for the consumer to know. The problem is compounded by the fact that most people rarely get sick. If you go to get a haircut every month, you can quickly determine which barbershop is the best. Unfortunately for neoclassical economists but fortunately for society as a whole, people need catastrophic care substantially less often than they need haircuts, thereby impeding the market from finding the most efficient solution.

Chronic care does change the calculation, but it introduces other factors that again prevent the market for health care from functioning like the market for cars. To take a concrete example, consider the 40 million elderly individuals who suffer from arthritis. Does it make sense to ask them to “shop around” to find the perfect hospital? Does it make sense to ask them to trust in an online service like Yelp to decide where to get care? And when they are fatigued by chronic pain, does it make sense to think they can make the “optimal” choice, and not just the most convenient?

Other problems make it difficult for the market for health care insurance to function like a regular competitive market. Again, a parallel to the market for cars, in particular used cars, is helpful. A problem with used car markets is that it's not entirely clear whether the car you wish to purchase is good or bad. This depresses the market value of used cars, both good and bad. But then producers of the more expensive good cars exit the market, further lowering the average quality of a used car until the market spirals out of existence. The market for health care is subject to similar pressures, but in the opposite direction. For insurers, they cannot easily tell whether an applicant is healthy or not. As a result, they charge the same premium to all individuals, which leads to healthy individuals dropping out of the market because they value the insurance less. This process repeats itself until premiums spiral upwards and no market for health care insurance exists.

This describes what economists call adverse selection, and although it is a market failure, it doesn't mean the government always needs to step in. However, understanding how the market circumvents the problem helps us understand why a simple solution for the health insurance does not exist. For example, markets for used cars can exist because the salesmen can offer warranties, so that if the car does break down you can “turn back the clock” on the purchase and return the car. This reduces the incentive for used car salesmen to trick you into buying lemons, because if the car does turn out to be a lemon you can always return it.

But what would a similar system mean for health care insurance? In that market, it's the consumer who has the private knowledge, therefore it falls to the consumer to make the “warranty”. This would mean the consumer would have to be able to guarantee that he or she won't become more unhealthy in the future – an impossible task. Alternatively, insurance companies can “turn back the clock” and refuse to pay for the consumer on the ground that the consumer was unhealthier than was expected. This hardly seems like an efficient or moral outcome, and is precisely the reason why the protections for preexisting conditions is so popular in the ACA.

With these stylized facts, it should be abundantly clear that the markets for health care and insurance are very different from what the standard competitive model predicts. Hence, we need to be very cautious when we draw glib analogies from health care to cars. However, the implications for policy are mixed. On one hand, certain regulatory reforms such as cutting the employer health care deduction, reducing occupational licensing barriers, and relaxing privacy laws can result in substantial advances towards improving health care. Yet the presence of these government failures does not mean that there is no role for the government to ameliorate the market pathologies that I have listed above.

A notable example of this is the individual mandate. The individual mandate, by forcing people to purchase insurance, massively expands the market for health care. In doing so, this increases the incentive for firms to pursue innovative new projects to increase productivity. And even though consumers still rarely need catastrophic care, the larger market allows transparency and reputation to have an effect as hospitals are at greater risk to lose customers. For the insurance market, an individual mandate can help pull us away from the adverse selection death spiral by preventing self selection and thereby keeping most of the population insured.

In other words, the government is not perfect, but neither is the market. By noting that the market for health care is fundamentally different from that for other goods such as cars, we can recognize why the standard assumptions for regular markets may not apply in the case for health care. As such, we must move forward with caution, with an understanding that true reform lies not with complete liberalization or complete regulation, but rather with a judicious mix of the two.

Update 10/24/12 -- I was pleasantly surprised to find that this post was heavily discussed in Reddit. I just wanted to put a few points to defend myself from a series of very informative critiques.

  • I never oppose market reforms like HSA's or cutting the employer healthcare tax deduction. That's not in my post at all.
  • The point of the post is to highlight some frictions in the healthcare market that justify some sort of intervention -- market based (preferably) or command and control (not ideal).


  1. What do you mean, a productive hospital can't export its services? Ever heard of expansion?

    (WalMart and Southwest Airlines, two examples Cochrane uses, are also providing a service.)

    "While it is easy for me to determine the quality of my haircut, it is much more difficult for me to determine what counts as “good” health care. A large part of this is linked to the uncertainty inherent in any kind of biological process. How does one determine if one is receiving sufficient care? Of course, if there is any gross negligence, it can be detected. Yet if the care is just slightly worse than it should be, there's no real way for the consumer to know. The problem is compounded by the fact that most people rarely get sick. If you go to get a haircut every month, you can quickly determine which barbershop is the best. Unfortunately for neoclassical economists but fortunately for society as a whole, people need catastrophic care substantially less often than they need haircuts, thereby impeding the market from finding the most efficient solution."

    Try replacing healthcare with "financial", "educational" or "legal" services, and run the argument again.

    Let me quote some of the latest Cochrane article to you, which you still clearly haven't read:

    This is a breathtaking aristocratic paternalism. Noblesse oblige. The poor little peasants cannot possibly be trusted to take care of themselves. We, the bien-pensants who administer the state, must make these decisions for them.

    Let me ask any of you who still agree, does this mean YOU? When you are faced with cancer, do you really want to place your trust in the government health panel? Or is this just for the benighted lower classes, and you, of course, know how to find a good doctor and work the system?

    And choice is always between alternatives. Sure, some people make awful decisions. The question is, can the ACA bureaucracy and insurance companies really do better? Yet you would not trust them to buy your shirts?

    Really? Does this entire bureaucratic garganuta follow, not on the proposition that there is some fundamental economic market failure, but because…Americans are no good at shopping?

    If anything, the opposite seems to be true. Where is it easier to shop, Southwest Airlines, or your average hospital? In the name of the consumer, who finds it hard to shop, we have created an arcane system where it is, in fact, nearly impossible to shop.

    No. It’s not “health is too important to be left to the market.” It’s “health is so important --and so varied, so personal, and so subjective – that it must be left to the market.” If you don’t trust the vast majority of people to make the most important decisions of their lives, you’re a devout patrician, not a “devout capitalist.”

    Moreover, the pockets of health care that are out of the insurance system and allowed relatively competitive free entry operate reasonably well. Plastic surgery and dentistry are not disasters. Radial keratotomy (corrective eye surgery) is a good example, as specialization and competition has led both to lower costs and increased quality. I am not the first dog owner to notice how easy and relatively inexpensive cash-and-carry veterinary medicine is compared to the same treatment for humans.

    A more private system could easily inspire resources to be devoted to helping people make sense of the offerings of market, as opposed to resources being devoted to making sense of laws (H&R Block). " thousands of pages of the ACA, tens of thousands of pages of subsidiary regulation, and the mass of additional Federal, State, and Local regulation applying to every single person in the country. "

    1. I've actually read the Cochrane article quite a few times, and this issue of choice is something that I want to address in a later post. Suffice to say, the purpose of this one was just to outline some basic reasons why glib analogies to car markets make me suspicious, not a complete defense of the ACA.

  2. On adverse selection:

    "Does a patient, with knowledge of aches and pains, really know so much more about likely cost than an insurance company, armed with a full set of computerized health records and whatever tests it wants to run? Life, property, and auto insurance markets at least exist, and function reasonably well despite the similar theoretical possibility of asymmetric information. Life insurance is also “guaranteed renewable,” meaning you are not dropped if you get sick.

    Now, the “adverse selection” phenomenon, that sick people are more likely to buy insurance, and healthy people forego it, is a big problem. But the insurance company charges the same rate, not because it can’t tell who is sick – a fundamental, technological, and intractable information asymmetry. The insurance company charges the same rate because law and regulation force it not to use all the information it has. If anything, we have the opposite information problem: insurers know too much.

    This source of adverse selection is a legal and regulatory problem, not an information problem, and easily solved. If insurance were freely rated, nobody would be denied. Sick people would pay more, but “Health status” insurance shows how to solve that"

  3. On shopping around:

    what fraction of health care and its expense is caused by people with sudden, unexpected, debilitating conditions requiring immediate treatment? How many patients are literally passed out? Answer: next to nothing.

    What does this story mean about treatment for, say, an obese person with diabetes and multiple complications, needing decades of treatment? For a cancer patient, facing years of choices over multiple experimental treatments? For a family, choosing long-term care options for a grandmother?

    Most of the expense and problem in our health care system involves treatment of long-term, chronic conditions or (what turns out to be) end-of-life care, and involve many difficult decisions involving course of treatment, extent of treatment, method of delivery, and so on. These people can shop! We actually do a pretty decent job with heart attacks.

    And even then... have they no families? If I’m on the way to the hospital, I call my wife. She’s a heck of a negotiator.

    Moreover, health care is not a spot market, which people think about once, at 55, when they get a heart attack. It is a long-term relationship. When your car breaks down at the side of the road, you’re in a poor position to negotiate with the tow truck driver. That’s why you join AAA. If you, by virtue of being human, might someday need treatment for a heart attack, might you not purchase health insurance, or at least shop ahead of time for a long-term relationship to your hospital?

    And what choices really need to be made here? Why are we even talking about “negotiation?” Look at any functional, competitive business. As a matter of fact, roadside car repair and interstate gas stations are remarkably honest. In a competitive, transparent market, a hospital that routinely overcharged cash customers with heart attacks would be creamed by Yelp reviews. Competition leads to clear posted prices, and businesses anxious to give a reputation for honest and efficient service.

    More generally, there is an income paternalism at work in health care policy, somewhat more reasonable than the “they can’t shop” paternalism I decried above, worth making explicit. Most people, when spending their own money at the margin, are likely to choose less health care than we, the self-appointed advisers to “policy-makers” would like. Already, they evidence tradeoffs that imply less health than we would like – they drink sugared sodas, eat fast foods, and don’t exercise enough. In my example that patients were offered an MRI or $1,000 in cash, I think we suspect that a lot of patients would choose the cash.

    A good libertarian would say, well, let people choose more iphones and less health if that’s what they want. But we don’t have to have this argument. If you think people will spend too little on health overall, give them vouchers in a health-savings account. This maintains the efficiency of patient-driven choice, distorts the overall health vs. non-health price, without distorting relative prices or writing ten thousand pages of regulations and supply-side restrictions that gum up the entire system.

    I would add that there are still many thousands of people each year needing catastrophic care. Large enough for competitive pressure from insurers representing their clients to work magic over a few years, just as retailers negotiate with suppliers. We can easily find out about catastrophic care providers that have a bad record.

  4. And be honest, you were just looking for an excuse to use the word "isomorphic" in a post, weren't you? ;)

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  6. Saturos, I was going to go comment by comment but suffice to say that I agree with the general gist of the Cochrane article -- my disagreement comes down to implementation. I want to explore these issues in some later posts, as this post was just meant to introduce some issues that I feel differentiate the market for healthcare from other markets. As such, this is meant to be a starting point before I address all the other critques.

  7. A successful hospital can export its services like any other business. Ask McDonalds, or Mayo Clinic.

    Haircuts are massively regulated. In California, you need to complete something like 2 years of tests and training to get a license, and rules about shaving caused barbers to stop offering the service long ago.

    You made it to your third paragraph before bringing in 'sick people aren't in a position to be good consumers'. All arguments against market reforms in medicine are isomorphic to it. It's wrong. Because:

    1. Yes, they are.*
    2. Even if they weren't, it's not enough just to say so. You have to say who could do a better job. Given the patient's relationship to the patient, there never will be anyone better.

    * Even for the handful of truly acute conditions like appendicitis, people could select a hospital/surgeon ahead of time. Anyway, a majority of spending is for well visits, chronic conditions, prescriptions, long-running cancer therapies, etc.

    You say premiums go up because healthy people drop out of insurance pools. The two case studies in the Cutler paper are interesting but for the population as a whole it seems the healthiest people tend to have jobs and insurance, while private insurance pools are protected from the sickest people by medicare and medicaid.

    The dramatic rise in premiums mostly reflects a dramatic rise in costs. The market failure is not in the insurance market, but in the market for medicine itself:
    1. Patients can't discover costs in advance, and often can't discover them even after treatment. And they don't pay them on a per-treatment (unit) basis.
    2. Most people get insurance through their employers and don't even know what the *premiums* cost. For instance, my family pays $450/month and I estimate that the full premium is $1500-2000/month, modulo the tax benefit of buying it before distributing salaries. Then there are copays and deductibles, which make estimating total costs practically impossible.
    3. Insurers have no incentive to keep costs down.
    4. Insurers essentially run protection rackets for doctors, bullying them into joining their "networks" and making it difficult for patients to choose an out-of-network provider.
    5. Doctors operate on an ancient guild/practice model, and use tactics like control of patient records to further stymie patient efforts to seek second-opinions. They'll even ask the FDA to force DTC companies like 23andMe (who provide services directly to patients) to send results to the patient's MD instead of the patient.
    6. Insurers have incentives to prevent employers from offering HSAs. And they succeed at many small- and medium-sized firms because HR departments at such firms often rely on the insurance company's sales people to walk them through the logistics of running the benefit. Try getting an HSA from a startup if you don't believe me.

    The result is a classic market failure. Not only are prices failing, supply screwed up -- there's a shortage of doctors! And if someone wanted to open franchise of clinics staffed by, say, salaried PhDs instead of MDs, well, that'd be illegal. So the differentiation companies like Qliance or One Medical can offer is small. (But you can do it with PAs who don't have any scientific training whatever.)

    continued at

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  9. Healthcare is not transparent to consumers like the automobile sector. It lacks the regulatory framework and in the US the accountable care act didn't and won't address that major issue. If I can't predict the cost of something to me or my insurers...I cant effectively shop around. I am a price consious consumer but it means nothing in healthcare for my family. I could of course illustrate with many real stories but won't bother to recant them here.

  10. If you expand demand you have to expand supply or face a shortage. With more people getting government supplied health care the government has to make doctors, nurses and hospitals. That means removing barriers to becoming doctors like tuition and no pay for years. Low cost loans to build or expand hospitals.

  11. The demand for health care is relatively inelastic with respect to price: People will pay for services no matter the cost, if only to extend their lives for a few months. And both the best doctors and private payers require the latest medical procedures and cutting-edge technologies, each of which translates into higher costs to the consumer.

    The solution, therefore, must reflect the complexity of the problem:

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