How Payment By Third Parties Distorts Health Care Decisions
Following is the third installment of a nine-part series excerpting the chapter on medical care from the new edition of Thomas Sowell's "Applied Economics." All installments can be found online at www.investors.com/IBDeditorials.
IBD Exclusive Series:
Thomas Sowell on The Economics of Medical Care
Third-party payments are at the heart of much confusion about the cost of medical treatment— and are a major factor in the increased cost of that treatment.
In government-run medical systems, the public pays in taxes for its medical care, either wholly or in part, with a share being paid directly by the individual patient.
Political slogans about "bringing down the cost of medical care" are almost invariably about programs or policies directed toward lowering the price paid directly by the patient. But the fact that only part of the costs are reimbursed by direct out-of-pocket payments from individual patients to doctors, hospitals or pharmacies in no way indicates that the total cost of the particular medical treatment is any lower than before.
When the public pays part of its medical costs in taxes that the government uses to subsidize medical treatment, or in premiums paid to health insurance companies, none of that lowers the total cost in the slightest.
To the extent that the direct payments by patients are lower than they would be if they had to cover the full costs, medical treatments tend to be sought more often — and that alone is enough to cause the total cost of medical care to rise, not fall. Whether these lower payments are due to price control or to supplementary payments by insurance companies or the government, the net result is that lower prices tend to cause more of any goods or services to be demanded, including medical treatment.
To the extent that third-party payments require a bureaucracy to administer these payments — whether a government bureaucracy or a private insurance company bureaucracy — the people in those bureaucracies have to be paid, adding still more to the cost of medical care.
Finally, there are costs of medical care not counted in any economic statistics comparing costs in different countries with different medical payment systems. These are the costs in pain, debilitation and premature deaths, as well as costs in lost income while unable to work for medical reasons.
All these costs tend to be greater in countries with government-run medical systems, which almost invariably have longer waiting times between diagnosis and treatment, and especially for treatment that requires a referral from a primary care physician to a specialist.
To compare "the costs of medical care" in countries with such systems to the costs in countries with privately financed medical care is to compare apples and oranges. Even within a predominantly private medical care system, such as that in the United States, many payments for medical care are made by third-party payers, whether insurance companies or the government.
The particular system of private third-party payments for medical care in the United States, with health insurance provided by employers, was a fortuitous consequence of tax laws and wage controls during the Second World War— and had nothing to do with any special qualifications of employers to deal with medical care issues.
Because employers were prevented by wage controls from raising pay rates to attract more workers during the labor shortages brought on by those controls, they resorted to increased "fringe benefits" to achieve the same results, and these benefits were not taxed, so that their value to the workers exceeded their costs to the employers. Before the war, in 1940 only 10% of Americans had private health insurance, but a decade later half did.
Given the situation in which employers could pay workers something worth more to the workers than the cost to the employers, it is hardly surprising that the proportion of the population covered by private insurance plans — many, if not most, provided by employers — continued to increase, just as other "fringe benefits" grew to be such a substantial part of total worker compensation that the word "fringe" disappeared over time.
Even in the absence of the price-control factor, having medicines or medical care paid for by third parties changes the way individuals use medical care. Despite a tendency to regard medical care as a more or less fixed "need," the amount that is demanded can vary greatly according to who is paying.
For example, the use of tax-free medical savings accounts in the United States has tended to increase sharply in December, since unexpended money in those accounts is not carried over to the next year. One chain of eyeglass stores reported that its sales were 25% higher in December than in any other month "as people scoop up a second or third pair of fashionable frames."
As one such customer, who already had eight or nine pairs of glasses, put it, "They go out of style after a while."
Even if it is medically necessary for a given person to wear glasses, is keeping up with fashions also medically necessary? More to the point, would this same customer have bought eight or nine pairs of glasses with her own money?
If not, then medical savings accounts have led to a misallocation of resources to buy things that are not worth what they cost, but which are purchased anyway because the government is helping to pay for them by exempting from taxes the income that goes into medical savings accounts.
Eye glasses are not the only goods or services that can be charged to these accounts. Condoms, birth control pills and massages have also been paid out of medical savings accounts. So long as a physician signs off on the expenditure, it is legal — and the physician has no strong incentives to hold back on the spending of someone else's money.
Free market prices, paid by the customer, do not simply convey more or less inevitable costs. They restrain costs by providing incentives for the individual to use a given good or service only to the extent that its incremental value to that individual is greater than its incremental costs.
But when third parties cover all or part of these costs, then additional increments continue to be used beyond that point.
Often a given medical problem can be treated in more than one way. For example, an arthritic knee may be treated by taking medication, having therapeutic exercises or undergoing surgery. Eyesight problems can be treated not only with glasses of varying degrees of fashion, but also with the use of contact lenses, eye exercises or laser surgery.
Choices among these and other treatments depend not only on how serious the medical problem is, but also on how much each of these treatments costs — and who pays those costs. When third parties pay, the more expensive treatments become more likely than when the individual pays.
Because medical care is so often discussed in politics and in media as if there is a more or less fixed amount of "need" and the only question is how to pay for it, much attention has been focused on those who do not have any form of health insurance. But these financial arrangements are not ends in themselves.
The real question is: How much medical care is available, whether or not particular individuals have health insurance?
The most poverty-stricken person living on the streets in the United States will be treated in an emergency room, with or without health insurance. Abandoned babies are likewise treated without regard to their ability to pay.
No doubt those with insurance, and still more so those with wealth of their own, can get more comfortable accommodations with more amenities in a hospital and can afford more elective or even cosmetic, medical procedures. But to discuss people without health insurance as if they were also without access to medical care is very misleading. The availability of medical care, regardless of health insurance, in fact reduces the incentives to become insured.
Some uninsured people have low incomes, but others with incomes sufficient to purchase health insurance simply choose to use their money for other things, especially when they are young and feel less at risk of medical problems.
Forty percent of uninsured Americans are under the age of 25 and more than 60% are under 35. Fewer than 10% of people over 55 are uninsured, despite the widespread political use of an image of old people who have to choose between food and medical care. That may be the political image of the uninsured, but it is hardly the reality.
Third-party payments for medical care transfer the decision-making ability to determine how much medical care, and of what kind, each individual will receive. Given that economic resources of all sorts are scarce — that is, insufficient to provide everyone with enough to satisfy all desires — rationing is going to have to take place, whether for medical goods and services or for anything else, and whether those decisions are made by each person individually or by a government agency collectively for the population at large.
But the location of that decision-making power can change the decision itself, with consequences that can be very different from what they would have been if the decision were made elsewhere.
We have already seen what can happen — quantitatively and qualitatively — when the government simply provides or subsidizes medical treatment and leaves individuals free to determine what they want. Skyrocketing costs have forced either restrictions on individual choice or have rationed those choices with waiting times — whether waiting hours in a doctor's office or months for surgical or other procedures.
Other options include having government officials approve or disapprove particular medical treatment for certain conditions.
In Britain, medical care officials determine who can and cannot receive certain expensive treatments, based on those officials' judgment or on formulas or guidelines about how much quality of life is likely to be achieved and for how many years. Thus an 80-year-old man is unlikely to be approved for receiving a heart transplant. While some medical choices and trade-offs may be obvious, many others are more complicated.
Here, as elsewhere, the most important decision can be: Who makes the decision?
Monday: The real cost of medical malpractice insurance.
From the book "Applied Economics" by Thomas Sowell. Excerpted by arrangement with Basic Books, a member of the Perseus Books Group. Copyright 2009.