Cost Theory in Healthcare — Part 3

In Part 1, we discussed price theory in general. In Part 2, we defined the market-clearing price, and discussed how this affects price-fixing schemes like Medicare uses.

In some respects, “price” and “cost” are two sides of the same coin.  If I am able to sell an bottle of vitamins at a price of ten bucks, the guy who buys that is going to say it “cost” $10.  By that he is specifically referring to something called “opportunity cost.”  Meaning, he had to give up the opportunity to spend $10 on something else, or to just hang on to his money.

Likewise, the producer is looking at opportunity costs also. If it costs him $8 to produce something, he is giving up the opportunity to spend eight bucks producing something else, or else just spending the eight bucks on himself.

While price and cost are related, believe it or not, they are not always the same number.  In health care, they are almost never the same number.  Because there is an intermediary between the producer and the consumer.  This intermediary — an insurance company, or the government — pays one price to the producer, and charges a different price to the consumer.  

If we look at it that way, we can actually look at interventions that affect both sides of the demand curve.  I can think of four different scenarios.  Here, “cost” to the consumer, and “price” paid to the producer are compared to the market-clearing price.  

Cost high, price low
Here, we can expect an undersupply of product, but that’s OK because nobody will want to buy it anyway
Cost high, price high
We can expect an oversupply of product, but nobody will want to buy it.
Cost low, price low
Here, we can expect an undersupply of the product, and people will line up for it
Cost low, price high
Here we can expect an oversupply of the product, but people may still line up to get it.

The top right corner is where the new drug game is played.  Pharmaceutical companies have to spend millions of dollars to bring a drug to market, due to burdensome regulation.  In exchange, we grant them a monopoly on production for several years, driving up the price for their product.  Then, the insurance company charges the consumer a price greater than most are willing to pay.  So the end result is, few demand the product.

The top left corner is where insurance companies add value to the health care system.  Consider for example the case of epidural steroid injection, which, like astrology, is popular among consumers even though there is no evidence that it works.  You can nip that in the bud by setting the price lower, and the cost higher than the market clearing price.  Should take care of that problem promptly, thereby reducing waste on unnecessary procedures.

The bottom row is where Medicare does mischief. Here, the results of unintended consequences apply.

The main reason why people buy insurance is to insulate themselves from cost.  Consumers agitate for low deductibles and low copays, in the  hope to get timely access to the care they want and need.  As it turns out, their care is virtually never timely, and it’s an open question whether they will have access at all.  

In the lower left corner, Medicare has set the price too low, discouraging people from providing the service, resulting in a shortage.  In the lower right corner, Medicare set the price too high, resulting in an oversupply.

There’s an obvious result, if you simultaneously set the price too low, as we see in the lower left.  You have a shortage of the service, with virtually unlimited demand.  You can expect long lines to form.

If you set the price too high, you’ll get more of the service than you really need.  But because the service is being offered at such a bodacious sale, there may still be a line.

In healthcare, lines can form for just about any service. Lines will definitely form if the service is in short supply. But even if a service is well-staffed, sufficient to meet the needs of sick people, lines can still form under a regime of price-fixing.

Photograph courtesy of the New York times. See “China’s Health Care Crisis: Lines Before Dawn, Violence and ‘No Trust’” (link). Great article. A few comments.

  1. The “barefoot doctor” approach — staffing a developing country’s healthcare needs with civilian medics — seems to be a popular approach. Is there a comparable program in US healthcare?
  2. Note the strategies for skipping line.
  3. While I am an advocate for malpractice reform, even I will admit, the alternative — getting stabbed in the neck — leaves something to be desired.

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