How does healthcare economics in the U.S. differ from traditional economics?

Excerpts from the book

Confronting Complexity

X-Events, Resilience, and Human Progress


John L. Casti

Roger D. Jones

Michael J. Pennock



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The concept of supply and demand is the cornerstone of economic theory. For simple commodities, the theory predicts that the demand for a product decreases as the price of the product increases and consumers are unwilling to pay the higher price. The supply increases as the price increases and suppliers increase production to capture increased profits. The actual price of the product is a compromise between the desires of consumers and the acumen of suppliers.

This simple equation breaks down when applied to the healthcare market. A person at the end of his or her life may be willing to spend an entire life savings on a few months of extended and more comfortable life. The demand for those healthcare services that can satisfy this desire is effectively infinite. Traditional economic theory would say that the supply would meet the demand and the price of healthcare products and services would become effectively infinite.

Healthcare differs from simple commodity economics in another key aspect. For simple commodities, the user of the commodity is the buyer and the supplier of the commodity is the seller. In healthcare in the U.S., there are three players rather than two. The person who prescribes the product or service is the provider; the person who uses the product or service is the patient; and the person who pays for the product or service is the insurer.

Why is the cost of healthcare not infinite? In many countries, such as the U.K., the cost is regulated. Americans, however, tend to prefer market solutions to government regulation. Market solutions have not been effective at controlling costs in the United States. Healthcare costs are increasing at a 6.7% annual rate—much higher than the current inflation rate of 1.7% and the current GDP growth rate of less than 2%. In 2010, healthcare costs of $2.6 trillion consumed 17.9% of the US GDP. This is the highest rate in the world. At the same time, the quality of care fell behind most industrialized countries. Healthcare costs in the U.S. are rising to meet the demand. About one-quarter of Medicare outlays are for the last year of life.

Healthcare in the U.S. is not in a state of equilibrium in which supply meets demand. Supply is lagging behind demand. What is holding back supply? One answer is the pace of invention. Over the last half century a number of life-extending procedures have been developed, from open-heart surgery to advanced chemotherapy. A common property of these procedures is that they are expensive. It has taken time to develop these procedures. As more expensive procedures are invented, healthcare costs will rise to meet the demand. Unfortunately, these costs are becoming a larger proportion of GDP, which adversely affects the ability to pay for other activities that make life worth living.

Medicare and Medicaid were established in 1965 to manage the healthcare of the elderly and poor. In the early ’70s Health Maintenance Organizations (HMOs) emerged as the dominant decision maker. These are organizations controlled by payors that can employ physicians directly or indirectly and that control the flow of patients among those physicians. In 1982, Diagnosis-Related Groups (DRGs) were developed to capitate the costs of hospital treatments. This enhanced the decision-making focus of the payors. Then, providers banded together in Planned Provider Organizations (PPOs)[10] to create enhance their negotiating power of the providers with respect to payors. Point of Service Plans (POS) evolved as hybrids of HMOs and PPOs, thus setting up a pick-two process in which the payors and providers are favored over patients. In 2010, the Affordable Care Act (ACA) provided for the creation of Accountable Care Organizations (ACO) to shift the focus to the patients, specifically to basing reimbursement on patient outcomes. The complexity of insurance has increased with time. Several experiments have been done; none have been very successful.

As we can see from technology innovation and the changes in payor dynamics over the last half century, healthcare economics in the U.S. is not in a stable state of supply/demand equilibrium supply/demand state as assumed in traditional economic theory. In fact, if equilibrium of supply and demand existed, it would make the cost of healthcare so high that Americans will would not be able to spend their income on anything except healthcare. Equilibrium almost certainly exists, but that equilibrium will certainly it is not be based on anything as simple as traditional supply-and-demand economics. One might expect an equilibrium involving three entities rather than the just the two: supply and demand. We already see the beginnings of this tripartite equilibrium. Patients represent demand, providers represent supply, and payors are the third and regulating party in the triad. Patients represent demand, and providers represent supply, then the and payors are the third and regulating leg of the stool, regulation, is provided by the payorsparty in the triad. Stay tuned. The interaction and dynamics of this three-way interaction will be the subject of upcoming blogs.

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