Price, Volume, Mix

The health care debate seems to center on fixing two important problems. The first is the people who do not have any insurance, and the second is the rising cost of insurance premiums, which have been going up over 10% a year for a number of years. The latter issue is a very important one, and one I am very familiar with. When I owned a couple of businesses, I had to deal with 10%+ increases each year and finally had to stop absorbing the increases and pass them on to the employees, either through taking the money out of their pay or reducing the benefits. The politicians are promising us the reform will reduce cost and improve the quality of health care. As a person with a lot of business and academic experience, this one is a little strange because there are few examples of reducing cost and improving quality in any industry. The one question I have always had is: what is really driving the increase in health care cost? Because once you understand what is driving the increase, then it might be possible to figure out how to reduce the cost.

Simple cost accounting will tell you that an increase in total cost is attributable to a combination of increases in the price per unit, increase in the number of units, or a change in the mix of products to those that are more expensive to provide. The question becomes, which of these (or combination of the three) is driving the increases in health care costs? Increases in the price per unit would suggest that seeing a doctor for the same procedure is going up each year, but that does not seem to be the case. There are tight controls on the cost of a procedure by both the government (for Medicare and Medicaid) and the insurance companies. The cost of new medical devices and technology may be driving some of the increase in health care costs, but labor costs do not seem to be increasing enough to make a difference. This is one area the government can have significant influence on, but not without unintended consequences. Squeezing doctors to lower fees (which is what the government does with Medicaid and Medicare) may help in the short term, but eventually doctors cannot make enough money to make it worth their time. In a previous post I debunked that insurance companies are making millions, they have low margins and cannot get much lower and stay in business. The government can certainly reduce the cost for procedures, but only at the expense of poor quality of service.

The second is the quantity of procedures, and whether each person is seeing the doctor more than they did in previous years. It makes sense that this is at least a partial driver in the increase in costs, but fixing it becomes difficult. People are living longer, which comes with more medical expenses to facilitate a longer life, and our lifestyle is not known for reducing the need for medical help. The only way to fix an increase in quantity is to force people to see the doctor less, which in turn will decrease the total cost of health care. This is also why people are concerned about more health care rationing than exists today.

The third is more people are having health care issues that cost more money to fix. If cancer, heart disease and other medical issues that cost a lot of money to fix are on the rise, then this will also increase the cost of health care, even if people are not seeing the doctor more or the cost of a procedure is not going up. Again, how do you solve this one from a public policy standpoint? You cannot tell people not to get cancer or heart disease. Intuitively, this also seems to be one of the bigger drivers in the increase of health care costs.

It is unlikely any law passed would have a meaningful effect on either the price, quantity, or mix of health care unless you ration care more than it is now, which is supposedly off the table. In fact, if you look at industries that have had significant cost reductions, there are usually unintended consequences which may be worse. Consumer products have reduced the cost of most things we buy, but that has been done by outsourcing overseas at the expense of US manufacturing jobs. And Wal-Mart may be known for low prices, but quality is not part of the equation. The cost of food has been forced down over time, but at the expense of the commercialization of food, which brings with it low wages, lots of fertilizer, and a compromised food system. Computers are one industry that has seen a reduction in price and improvement in quality, but it is driven by technology and innovation. Technology and innovation are expensive and the computer industry has the benefit of being able to spread those costs over millions of computers and one breakthrough can help every computer system. Health care also has technology and innovation, but each one is for a particular disease or procedure and therefore the costs are spread across fewer units and therefore cause the price to increase not decrease.

Anytime a politician says we can reform the system to lower the cost and improve the quality, the public has a right to be skeptical. How exactly is cost going to be lowered, and are we reducing price, quantity or mix? I have yet to hear a politician coherently articulate how costs are going to be lowered. Everyone should be cynical of the pledge because frankly it is a promise no politician can deliver. It is virtually impossible to meaningfully reduce the cost of health care in America, while maintaining the quality of care and not ration people’s access to treatment, at least not without major lifestyle changes.