Healthcare: Health Care and the Profit Motive

According to the latest Congressional Budget Office figures (excluding the illegal-immigrant population), about 87% of Americans have health insurance. Most of them — about 57% of those insured — get their coverage through an employer. Another 17% are over the age of 65 and so get their coverage through Medicare, while 15% are covered by government programs for the poor (mainly Medicaid and the State Children's Health Insurance Program). Only 10% of Americans with coverage buy their own health insurance directly, in what is commonly called the "individual market."

This last fact is the key to understanding the peculiarly distorted character of our health-care market. Ninety percent of Americans with health insurance neither choose it on their own, nor pay for it directly. Analysts use the term "third-party payment" to describe the fact that insurers reimburse hospitals and doctors, bypassing policyholders. But in practice, the 235 million Americans with employer- or government-sponsored health coverage actually have fourth-party insurance — since they don't even choose their insurers, let alone pay directly for care.

For most Americans, health care looks something like this: A patient purchases health insurance, or receives it from his employer. The insurer then directs the patient to use physicians in its network, with whom it has negotiated reimbursement rates. The patient is given little or no information about the comparative cost or quality of any particular doctor. The patient then visits his doctor. After an interview and an examination, the physician orders tests, procedures, or medications on the patient's behalf. The insurance company reimburses the doctor for a large share of these costs, though it might occasionally haggle if it feels the doctor has spent too much on the patient. The patient receives a bill in the mail from the insurer for his part of the expenditure; that bill is only vaguely related to the services rendered to the patient,

Arrow argued that health care is different from traditional market commodities in several important ways, and enumerated the elements of the health-care system that, in his view, distort the normal functioning of market forces. We can organize these distortions into five categories.

• First, people's needs and demands for medical services are unpredictable and therefore differ from other basic expenses such as food and clothing, and yet access to health care is more critical than access to many consumer goods.
• Second, there are daunting barriers to entry in health care: Physicians must be licensed in order to practice, and in order to gain licensure they must endure years of expensive training. As a result, the sale — and therefore consumption — of medical services is constrained by the limited number of new doctors produced each year.
• Third, health care requires meaningful trust between doctor and patient, far more than the typical market relationship. A patient cannot test-drive a surgical procedure before undergoing it; if the procedure fails, or has adverse consequences, he is stuck with the outcome. The patient must trust that the surgeon knows what he is doing. And if the surgeon does not, the consequences for the patient could include serious injury or death — outcomes for which there is no complete economic remedy (even if the prospect of lawsuits helps make doctors more cautious).
• Fourth, there are significant asymmetries of information in health care. Medical knowledge is complicated; the physician usually knows much more than the patient about the treatment of a disease. Therefore, the buyer of medical services is at a serious disadvantage relative to the seller. It is difficult for patients to make independent, informed decisions about their care — and third-party insurers know even less than patients about the particulars of each case.
• And fifth, there are distortions in the method of payment. Patients pay for health care after, not before, it is received, and frequently pay indirectly for their care via insurers. Because patients don't see the bill until after the non-refundable "product" has been "consumed" — and because there is virtually no transparency about costs — patients are rarely able to shop around for a medical service based on price.

For more, see Health Care and the Profit Motive by Avik Roy, Spring, 2010.