Guidelines for Reforming Healthcare

The Affordable Care Act will continue to govern healthcare as Republicans failed to agree upon a replacement. This does not mean that the issue is settled as the long term financial viability of Obamacare is precarious. Furthermore, politicians and voters on both sides of the aisle have ambitions to remake the healthcare system according to their ideals. Visions of a perfect system range from government having an extremely limited role in the sector to the industry being completely controlled by the state. Since healthcare is likely to be the subject of much debate in the years to come, it is imperative to have a basic understanding of the economic laws that govern it. Failure to account for these laws will lead to policies that create unintended consequences (regardless of the party that proposes the policies).

From an economic standpoint, healthcare goods and services are no different than other goods and services. Prescription drugs behave no differently in the market than smartphones or automobiles. The services of a doctor are governed by the same laws that apply to plumbers and wedding planners. This reality can seem harsh and many are likely to object. Prescription drugs can be a matter of life or death. How callous must one be to compare them to an iPhone? Millions of people can live perfectly fine without the services of a wedding planner. The same cannot be said of a doctor when people suffer from illness. Just because healthcare goods are services and deemed more important or even a “right” does not mean that they behave differently in the market. This may be sobering, but that does not make it any less true.

To properly discuss healthcare, it is vital to understand how markets function. “Supply and demand” is a phrase that has migrated from economics to the popular vernacular. Despite being commonly heard, few people outside of the world of economics stop to consider its meaning. Supply and demand serve to determine the prices of countless numbers of goods and services.

Figure 1

Demand is depicted as a downward sloping line on a graph of price and quantity (Figure 1). At high prices, there is less demand for a good or service. As the price falls, the demand is increased. This is simple to understand with a concrete example. In Michigan, a six pack of craft beer sells for around $10. At this price, a certain amount is sold. If the price were reduced to $5, more people would be enticed to consume craft beer (Q2). These new consumers might be selecting the craft beer over mass produced beer. They might be substituting another form of alcohol for the now lower priced beer. Regardless of their motives, it is easy to understand that if craft beer were cheaper, a greater quantity of it would be consumed. Conversely, if a weevil devastated hops in the United States, there would be less craft beer manufactured. The price would rise as a result of the reduced output, say to $15 for a six pack. In this scenario, only those who valued craft beer at least $15 would purchase it (Q3). Other consumers would migrate to alcohols that are not made from hops. Consumers who do not imbibe would be unaffected by any changes to prices as they were never a part of the demand.

Figure 2

It may seem sacrilege to compare something as trivial as craft beer with life saving pills or medical procedures. The truth is that the same principles of demand apply in the wholly more important healthcare sector. Consider the market for a new, innovative cancer treatment. An individual with advanced stage cancer would probably be willing to pay quite a bit this treatment. Someone diagnosed early would be willing pay less, as other treatments may be effective and have a lower price and less risk. Furthermore, those who do not have cancer would be unwilling to pay anything.

Supply is the yin to demand’s yang. When prices are low for a given good or service, few people or firms will be willing to supply the good or service. At high prices, suppliers will want to produce a larger quantity (Figure 3). Returning to the example of craft beer, if the beverage fell out of fashion or more consumers preferred wine, the price of a six pack might fall to $5. At this price, fewer breweries would be willing to manufacture craft beer (Q2). Conversely, if a six pack could sell for $15, more firms would rush to enter the market (Q3). The latter scenario has already occurred with the rise of craft beer. What started as a small industry now includes multinational beverage corporations who have bought microbreweries or launched their own craft brands.

Figure 3
Figure 4

The supply of healthcare is governed by the same laws. The new, innovative cancer treatment discussed in relation to demand can also be used to understand supply. Cutting edge medical treatments are often initially very expensive. These high prices motivate more pharmaceutical firms and doctors to provide the goods and services required.

Supply and demand are opposing forces. Consumers want to buy things at the lowest possible prices. A chocolate lover would be thrilled to walk into the supermarket and find that a Hershey’s bar cost only 10¢. Companies want to charge the highest possible price. Hershey’s would love it if their customers would spend $100 on a candy bar. Prices are created when these interests collide. The supply line intersects the demand line at the point of equilibrium (Figure 5). This point determines the price paid for and the quantity sold of a particular good or service. Everyday, countless free markets are struggling to find their equilibrium. Prices fluctuate to clear surpluses (when supply exceeds demand, prices must decrease) and fulfill shortages (when demand exceeds supply, prices must increase).

Figure 5

Over the course of history, markets have proven to be the most effective method to distribute scarce resources. Human beings are cursed by having unlimited wants and limited means. Everyone wants more of something. Since that something is usually not available in infinite quantities (thus it is scarce), the market allows those who value that something the most to have it.

With these fundamentals of economics in mind, it is now possible to analyze the challenges facing lawmakers in regards to healthcare. The industry is already subject a vast number of regulations that prevent a truly free market from functioning. This is not to say that it desirable or undesirable for healthcare to operate free of government restraint. Rather, this is to acknowledge that the following examples do not depict the exact behavior of healthcare goods and services. They do, however, provide a powerful tool in understanding the underlying issues that must be confronted when one suggests a policy to reform the system.

Since cancer treatment was previously brought up as an example, it will be used going forward. Assume that its market is currently in equilibrium. A certain number of patients pay a given price to be treated by a certain number of healthcare professionals, pharmaceutical companies and medical equipment makers. Equilibrium means that supply equals demand. There are still potential consumers who would purchase the good or service if the price were lower. Potential suppliers also exist if only the price were higher. This is perfectly acceptable in the markets for craft beer or candy bars. Few people would regard a person’s inability or lack of desire to purchase these items as a social problem. Cancer treatment, on the other hand, is viewed differently. A person who is part of the demand for this treatment is a person who has been diagnosed with cancer. If they are unable or unwilling to pay the equilibrium price in this market, they will likely die. These potential fatalities are represented by the demand line extending past the point of equilibrium (Figure 6).

Figure 6

No compassionate person would want to see people die from untreated cancer. A compassionate person would want to see every single patient diagnosed with cancer to receive life saving treatment. The question that must be asked, however, is how would the market respond to treating every patient? Imagine that the U.S. government decreed that no citizen would die from untreated cancer. The total number of people diagnosed with cancer will be represented as Qa (Figure 7). To achieve treatment for this number of patients, the price would have to fall so that even the poorest could afford it (Pd). Of course, fewer healthcare professionals would want to treat cancer at this price. In fact, the price for treatment would have to increase to entice more professionals and companies to treat everyone (Ps).

Figure 7

The difference between points 1 and 2 has to be reconciled. Private charity or hospitals providing some services pro bono could reduce the gap. Yet, both of these methods have limits. To treat everyone with cancer, the government would need to get involved. The simplest way to achieve universal treatment would be to subsidize the cost. Patients would pay Pd and then government would pay the difference to healthcare providers so they received Ps. The subsidy would be Ps-Pd. This would have to be funded with tax revenue or government debt. The question of whether or not this expenditure is worthwhile is a political one that economics cannot answer. What economics can do, though, is provide insight to the effects of instituting such a policy.

First, it is important to recognize that the government wouldn’t subsidize everyone’s treatment. The motivation behind such a policy would be to assist those who could not afford the market price for treatment. Those with the means to afford it (or with insurance to cover the cost) would not initially need any government money. However, to provide for those who need it most, the cost of treatment would have to rise for everyone. The government subsidy would increase access to cancer treatment. To meet the increased demand, the price must increase for suppliers. It is easy to understand when one remembers that healthcare resources are scarce. A doctor specializing in oncology cannot specialize in cardiology. Time and money spent developing medication for cancer is time and money not spent on producing drugs for diabetes. In a free society, the only way to influence individual actors to satisfy the increased demand is to raise the price.

Second, with this understanding, it is possible to anticipate the future effects of the policy. The price of the subsidy would not remain constant if the government was truly committed to preventing a single death from lack of cancer treatment. If, for example, there is an increase in the number of patients diagnosed with cancer in the second year after the legislation passed, the subsidy would need to increase. Why? To meet the increased demand, the price would have to be lower for the patient and higher for the healthcare providers.

Additionally, if the government remained motivated to treat everyone, those on the supply side would have an incentive to raise their prices. It would be easy to increase profits by increasing the price since the government would provide the money needed so every patient could afford treatment. This would result in larger subsidies. It would also cause the insurance premiums to increase to account for the higher costs. Those who might have been able to pay for treatment before the subsidy might now need government assistance should they be diagnosed with cancer.

Rising prices are inevitable when the government takes it upon itself to increase access to a good or service. Before the housing crisis, the price of homes increased substantially as government directives encouraged financial organizations to provide mortgages to individuals and families without the requisite credit. These new buyers increased demand for houses which in turn lead to higher prices. A similar situation is currently playing out in American universities. Government backed loans for students allow many young people to obtain an education that would not otherwise be affordable. (I, myself, am a beneficiary of this system.) Student loans have undeniably increased the amount of students in universities across the country. They have also contributed to the skyrocketing cost of higher education.

To those on the left, this explanation may serve as evidence that doctors and “big pharma” are greedy. Those at the top of the industry already have more than enough material wealth. The government is not powerless in the face of the market. If rising prices are the problem, it might be best to simply control them. These sentiments are not uncommon. Governments of every level around the world impose maximum prices in various markets. Unfortunately, few people stop to think of the consequences of these impositions.

Returning to the hypothetical cancer market, it has already been demonstrated that in order to treat all cancer patients, the price charged would have to be Pd. Instead of using subsidies to achieve this price, what if the government simply mandated that this become the legal maximize price? Instituting such a price ceiling wouldn’t require any additional government expenditures. Furthermore, it could be politically beneficial as it would reduce the “unfairly” large profits of healthcare providers in the name of making treatment accessible to those who could least afford it.

Figure 8

If Pd were made the price ceiling (Pc), providers would want to decrease the amount of treatment they supply (Qs, Figure 8). The difference between quantity demanded and supplied represents a shortage of treatment (Qd-Qs). This is the consequence of price controls. In this scenario, doctors would gravitate towards specialties that were not governed by price ceilings. Pharmaceutical companies would shift resources to develop medications that could be sold at market prices. Patients who were admitted to hospitals before the disease became fatal would benefit from the lower prices. Those who were unable to receive treatment in time would suffer a much higher cost.

Shortages occur when a price ceiling is established. Consider large cities which implement controls in response to rising rents. Promising affordable housing is an effective tactic to gain votes. Certainly, there are beneficiaries of such a policy. Those who manage to rent a controlled apartment pay less than market price for their accommodation. Much to chagrin of city officials, however, these controls do not create an increase in affordable housing. Luxury apartments, for example, are exempt from price ceilings. To combat this, some municipalities require developers to create rent controlled units in the skyscrapers that house extravagant penthouses. Depending on how much affordable housing is required and the amount of the price ceiling, construction firms may continue building apartments or they may instead devote their efforts to office and commercial spaces which are not price controlled. Either way, price ceilings have resulted in a shortage of affordable housing in the nation’s largest cities.

A solution that may be suggested in response to the shortage would be to set price ceilings on all medical services. This would prevent a migration of resources from cancer treatment to other healthcare needs. Unfortunately, a universal price ceiling would create shortages across the entire healthcare sector. Hospitals and doctors’ offices that could not lower their cost below the ceiling would go out of business. Those with the academic ability to graduate medical school would have incentives to pursue other, uncontrolled, professions. The resources allocated to prescription drugs and medical equipment would be better served in other applications.

Government has the ability to profoundly affect markets. Regrettably, politicians do not have much incentive to consider the future implications of their policies. A subsidy or price ceiling may have immediate benefits that appease constituencies and pave the way for reelection. By the time the consequences of such policies are realized, it may be someone else’s problem.

Healthcare is bound by the laws of economics, as much as it might be wished otherwise. Declaring healthcare a “right” may earn politicians applause. It may signal regular citizens’ virtue. While the sentiment may be noble, it is useless by itself. Creating a system that provides the highest possible care to the most possible patients requires one to face the cold reality of scarcity. This is not to say that the ideal solution involves religious adherence to laissez-faire capitalism. Nor does it necessarily require an expansive role of the state. There are brilliant thinkers of all political persuasions working to find a solution to the nation’s healthcare problems. For their proposals to be viable, they must acknowledge the laws of markets.