Does Supply and Demand Work in Healthcare? (Updated!)

This post is an update to my popular post, Does Supply and Demand Work in Healthcare? It explains the same things, but this version is shorter and clearer.

Supply and demand carry with them a few assumptions. When those assumptions are met, supply and demand works. When those assumptions are violated, supply and demand don’t work as we would expect. Healthcare is very different from most markets in the United States, especially in a couple key ways that violate the assumptions of supply and demand. The first violated assumption is that consumers have price and quality information. The second violated assumption is that consumers actually pay the price of what they buy. There are others, but these are the biggest ones, so let’s focus on them one at a time.

Assumption 1: Consumers Have Price and Quality Information

Think about how most markets work. People spend their own money to buy things they want. And because people don’t have unlimited dollars to spend, they’re weighing the value (Value = Quality/Price) of their different options–if something is higher quality but also higher priced, they have to decide if it’s worth it for them to spend that additional money to get that additional quality.

Think about how that impacts companies competing in a market. If one company makes a really high-value product, tons of people will buy it, and the company will increase supply so it won’t miss out on all those potential sales. If another company makes a dud of a product, it won’t get many sales, and it will decrease supply. (Yes I recognize that this is ignoring many complicating factors, but those factors don’t affect the point I’m trying to make here.)

Now, let’s look at how healthcare is different . . .

When patients choose a healthcare provider, they mostly aren’t using price and quality to make their decision. So even if a hospital is super high value, it won’t generally win the market share that it should, so it isn’t building additional wards like it would if it were competing in almost any other industry. Conversely, a low-value hospital will continually get more patients than it should, and it will keep its wards open.

Taking this one step further, a hospital will have a hard time investing in value-improving innovations if it’s not going to win more market share (i.e., additional profits) as a result. And, unfortunately, our current system often financially penalizes value-improving innovations. See here for more explanation on that.

Assumption 2: Consumers Actually Pay the Price of What They Buy

As I said above, a consumer in almost any other market will think carefully before buying a really expensive good or service. “This is way more expensive than the other one. Is it better enough to be worth it?” Same goes for deciding how much of something they’ll buy; people (usually) won’t buy more of a good or service than they think they can afford.

So, in other words, when customers actually have to fork out the dough for the thing they’re buying, their demand is appropriately limited. And, when demand is limited, that in turn constrains the quantity supplied–companies don’t want to spend a bunch of money making tons of goods that are unlikely to ever get sold without drastically reducing the price.

Now, let’s look at how healthcare is different . . .

The most obvious example I could bring up is end-of-life care. Think about a patient who had a massive stroke and is now in the ICU on life support, showing no signs of life for multiple days. There’s always the slightest chance they could recover some function, so it’s not unreasonable for families to cling to that hope and keep dragging it out. . . . Except that estimates of the cost for each additional day in the ICU run around the $5,000 mark. But, the family has probably already hit the out-of-pocket max for the year, so they won’t be paying a single cent more even if they drag the ICU stay on for another few days. My point is that demand is almost unlimited in a situation like this, and the hospital is happy to continue supplying the care as long as they’re getting paid for it. I’ve written elsewhere about the problems that arise when the party choosing how much care to get is not the same party that foots the bill.

These are just two examples of broken assumptions of supply and demand in healthcare. I am not saying that supply and demand will never work in healthcare; I’m just saying that the way our system is currently organized violates some of those assumptions. I’ve also written about how to fix that.

I’ll end with one other implication of all of this. Critics of “market-driven healthcare” abound because they say we’ve been trying it for a long time and look where it’s gotten us. But we actually haven’t truly tried it yet because we haven’t ever made the changes necessary to remove the barriers to supply and demand. Without explaining it fully here, I’ll assert that we can remove enough of those barriers for supply and demand to work well in healthcare. And the changes that would be required to accomplish that are compatible with any structure of healthcare system, be it a private system, a single-payer system, a fully government-run system, or whatever.

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Why Drug Companies’ Medication Coupons Are Bad for the Healthcare System

Have you had the experience where you need a medication, and the brand name actually is cheaper for you because your doctor gives you a coupon for it? It’s great for you, but it’s bad for the healthcare system, and here’s why.

I have written before about the principle that is relevant to this, but it bears repeating: The party making a purchase decision must be the one who also bears the price differential between those options.

To understand why, let’s pretend you have a medium risk of heart attack or stroke in the next 10 years, so your doctor recommends you start a moderate-intensity statin medication. They’re all pretty close to equal in terms of efficacy and side effects, so the best money-saving decision would be to choose the cheapest one, right? Well, if your doctor says, “I’m happy to prescribe any of these for you. Which would you like?” You are the party who now gets to make a purchase decision. So you look at the monthly prices below (these are real prices):

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But then your doctor hands you a pitavastatin $100 off coupon some drug rep from Kowa Pharmaceuticals (the manufacturer) dropped off. You, a rational person, opt for that one since it’s now the cheapest (free)!

Now the monthly cost to the healthcare system for you to be on a statin totals $0.00 (your copay) + $101.36 (what your insurer has to cover) = $101.36. That’s about 20 times more expensive than it should have been!

What just happened here? The party making the purchase decision (you) did not bear the price differential between the options. Your insurer originally set it up so that you would pay more if you chose a more expensive statin, but the coupon interfered with that.

This same situation plays out over and over every day in our healthcare system with medications and with every other health service. It’s why I keep saying that we need to make the party who makes the purchase decision the same party who bears at least some part of the price differential between the options, which leads to a value-sensitive decision. Reference pricing does it, high-deductible insurance plans do it (for services below the deductible, at least), multi-tier prescription programs do it (when they’re not being subverted by manufacturer coupons). But these, collectively, are not influencing nearly enough of the purchase decisions being made in our healthcare system! And we waste money. Even worse, the higher value options are not rewarded with market share, the lower-value options are allowed to persist as is, and the overall value delivered by our healthcare system remains much lower than it could be.

So that’s why medication coupons–and any other thing that interferes with purchasers bearing the price differential between options–are bad.

The Problem

This post is part of my How to Fix the American Healthcare System series. The index post containing links to all the articles in the series is here.

Image credit: Gary Larson
Image credit: Gary Larson

Before something can be fixed, the problem must be defined and the causes of that problem diagnosed.

The problem with the U.S. healthcare system is that its prices are too high, its quality too low/patchy, and not enough people have insurance coverage.

But I’m going to change that a little bit. Since price and quality are the two variables that determine value, we could say there are only two problems: suboptimal value and not enough insurance coverage.

The insurance coverage piece is kind of separate from the value piece because solving it primarily relies on government policies that subsidize the purchase of health insurance for those who wouldn’t be able to afford it otherwise. Those government policies are a (purposeful) distortion to the healthcare market. Distorting a market for a good reason is fine, but before you do it, you need to understand how the market should be structured to optimize value so you don’t accidentally ruin its value in the process.

So, in short, this series is going to explain how the U.S. healthcare market should be structured to optimize value.

And the nice thing is that value improvements will primarily come in the form of lower prices —> insurance coverage will become cheaper —> fewer people will be priced out of the market. Therefore, fixing value partially fixes the insurance coverage problem too!

How to Fix the American Healthcare System

This is the index post for my series on how I would go about fixing the American healthcare system. The link for each post will go live as soon as I’ve written it:

  1. The Problem
  2. The Role of Incentives
  3. Giving Providers the Right Incentives
  4. Giving Insurers the Right Incentives
  5. Proofs

This is what I’ve been wanting to blog about for a long long time, but I wanted to wait until I publish the ideas (thus the scarcity of posts lately). Well, my publication is out! It covers much of the same material only with more nuance. Check it out!

What Is an ACO? What Is a Medical Home? What Is Bundled Billing? What Is P4P?

Image credit: shutterstock.com
Image credit: shutterstock.com

Our healthcare system is currently in experimentation mode–we are trying thousands of experiments to figure out how providers can be rewarded for “value instead of volume.” All the new terminology and reimbursement ideas accompanying these reforms can be hard to keep straight if you’re not steeped in this stuff every day, but guess what? There aren’t actually that many different ideas being tried; there are just a bunch of the same ideas being tried in various combinations. First I’ll describe those four basic ideas, and then I’ll show how they are the building blocks of all the main payment reform experiments out there.

Quality bonus: Give a provider more money when he hits performance targets on whatever quality metrics are important to the payer.

Utilization bonus: Utilization metrics and quality metrics are not usually separated, but they should be. Here’s the difference: improved performance on a quality metric increases spending; improved performance on a utilization metric decreases spending. They both improve quality, but they have different effects on total healthcare spending. So, for example, ED utilization rates and readmission rates would be considered utilization metrics. And childhood immunization rates and smoking cessation rates would also be considered utilization metrics because they tend to be cost saving. Insurers love giving providers bonuses on utilization metrics because they are stimulating providers to lower the amount being spent on healthcare.

Shared savings: If a provider can decrease spending for an episode of care (which could be defined as narrowly as all the care involved in performing a single surgery or as broadly as all the care a person needs for an entire year of chronic disease management), the insurer will share some of those savings with him.

Capitation: The amount a provider gets paid is prospectively determined and will not change regardless of how much or how little care that patient ends up receiving. Again, this could be defined narrowly, such as all the care involved in performing a single surgery (in which case it’s actually called a “bundled payment”), or it could be defined broadly, such as for all the care a person needs for an entire year.

By the way, did you notice that shared savings and capitation are almost the same thing? The only difference is who bears how much risk. In shared savings, the risk is shared, which means that if the costs of care come in lower than expected, the insurer gets some of the savings and the provider gets some of the savings. In capitation, the provider bears all the risk, which means that if the costs of care come in lower than expected, the provider gets all of the savings.

Okay, now that I have listed out those four ideas, take a look at the popular payment reforms of the day . . .

Medical Home

General idea:

  • Give a primary-care provider a per member per month “care management fee” (in addition to what he normally gets paid) for providing additional services (such as care coordination with specialists, after-hours access to care, care management plans for complex patients, and more)
  • Also give the primary-care provider bonuses when he meets cost and/or quality targets

Breaking down a medical home:

  • A care management fee is actually a utilization bonus (because the net effect of the provider offering all those services is to avoid a lot of care down the road)
  • A bonus for meeting quality targets is either a quality bonus or a utilization bonus depending on the specific metrics used
  • A bonus for meeting cost targets is shared savings

Accountable Care Organization (ACO)

General idea:

  • Give a group of providers bonuses when they lower the total cost of care of their patients (but the bonuses are contingent upon meeting quality targets).

Breaking down an ACO:

  • A bonus for lowering the total cost of care is shared savings
  • When a bonus is contingent upon meeting quality targets, that means it’s also a quality or utilization bonus (depending on the specific quality metrics used)

Pay for Performance (P4P)

General idea:

  • Give a provider bonuses when she meets quality targets.

Breaking down P4P:

  • This is either a quality or utilization bonus (depending on the specific quality metrics used), but it tends to be utilization bonuses because insurers especially like when providers decrease the amount of money they have to fork out

Bundled Payment/Episode-of-care Payment

General idea:

  • Give a group of providers a single payment for an episode of care regardless of the services provided.

Breaking down bundled payment:

  • A bundled payment is a narrow form of capitation

There you have it. They are all repetitions of the same ideas but combined in different ways.

The Three Different Ways We Could Set Prices in Healthcare

Image credit: AP Photo/Damian Dovarganes
Image credit: AP Photo/Damian Dovarganes

Out of the three general ways we could set prices in our healthcare system, one is best. Too bad we’re using the other two.

First, I’ll describe each method:

  1. Administrative pricing: This one is very straightforward. The government says, “For procedure A, healthcare providers will be paid X dollars.” Usually the methods for coming up with that dollar amount are sophisticated and rely on the best available data, but not always because they are subject to various political influences and government budgets.
  2. Bargaining power-based pricing: This one is easiest to explain using an example. Think of a small town with only two family medicine docs. One, Dr. Awesome, treats 90% of the town’s residents; the other, Dr. Mediocre, treats the other 10%. All patients are insured by one of four different private insurers, each of which has approximately equal market share. Now think of Dr. Awesome sitting down at the bargaining table with one of the insurers to decide on prices. He says, “If you don’t pay me at least Medicare rates times 1.4, I won’t accept your insurance. I’m serious, I won’t accept anything less.” And the insurer says, “Hey, that’s a horrible deal, but if we stop covering care you provide then most of our policy holders in your town will just switch to one of our three competitors and we’d lose out on even more profit!” Now think of the conversation between Dr. Mediocre and that same insurer. Dr. Mediocre says, “Pay me Medicare rates times 1.4.” And the insurer responds, “No. We’ll pay you Medicare times 0.8. If you say no and we don’t have you listed as a provider in our network anymore, that’s okay because only a tiny percentage of our policy holders are your patients. And we know that you don’t have many patients, so you can’t afford to risk losing 1/4 of them by saying no to the price we offer.” Relative market share between the two parties is the primary determinant of bargaining power, so a bigger market share means you can get a better price.*
  3. Competitive pricing: This is the method used to determine prices in almost every other industry. Here’s basically how it plays out: Competitor A says, “Everyone knows that our product has similar quality to our competitor’s product, so we can’t price it higher than theirs without sacrificing quite a bit of market share. We could sell it for less than theirs to win more market share, but then the price is perilously close to our costs, so we’ll have to do some math to see what the profit-maximizing price/market share combination is likely to be.” Note the one huge condition that is required for this to work: Potential customers must be able to compare the price and quality of all their options, which is starting to happen more and more as better quality information is starting to become available and as prices are becoming more transparent.

Our healthcare system currently relies primarily on number 1 (think: Medicare and Medicaid) and number 2 (think: private insurers and providers setting prices with each other). But which method is best?

If you want to have the lowest possible prices, administrative pricing is the obvious best choice. But that’s only for the short term (as you’ll see), and it does nothing to encourage quality improvement unless you start getting into the treacherous area of performance incentives.

The only thing I’ll say about bargaining power-based pricing is that I don’t like it. I’d rather not have prices that are totally unrelated to costs or quality and instead are determined by relative market share.

Now let me tell you why I like competitive pricing so much. I want our healthcare system to deliver better value right now (Value = Quality / Price), and even more than that I want that value to go up over time as providers and insurers innovate in ways that allow them to decrease prices, increase quality, or both. Competitive pricing is the only method that provides an incentive for competitors to innovate because it rewards the highest-value offerings with increased market share and profit. The other two options don’t do that, which seems like a pretty big downside, don’t you think? I’d be willing to forgo short-term super-low administratively set prices in favor of stimulating innovation that will improve value way more over the long term.

In my next post, I’ll explain how we can shift from bargaining power-based pricing to competitive pricing.

* Do you ever hear those arguments that if public insurers lower their prices any more, providers will just raise their prices for private insurers? Well, now you know why those arguments are mostly hogwash. Providers are already leveraging their relative market share to get as high prices as possible from private insurers, and getting paid less by public insurers doesn’t change that relative market share.

If We Lower Total Healthcare Spending, Who Will the Money Come from?

Image credit: academyhealth.org
Image credit: academyhealth.org

At the recent AcademyHealth Annual Research Meeting in Baltimore, I went to a session on the accomplishments and challenges of community collaboratives. A community collaborative is a pretty cool idea that goes something like this: for a specific community (i.e., city), let’s get all the leaders of the providers and payers in a room (plus a bunch of other stakeholders committed to improving health) and make some decisions collaboratively on how we can fix healthcare in the community. The Robert Wood Johnson Foundation has provided the money to make these things happen in 20 different communities in the U.S. (see Aligning Forces for Quality, and Value-Based Payment Reform).

Sounds like a great idea, right? Well, an interesting challenge has arisen. More and more, these collaboratives are expected to find ways to reduce the total healthcare spending in that community. But so far, they’ve pretty much failed miserably. Why? Well, think about it. Here are all the leaders of payers and providers in that community sitting in a room together saying, “We need to reduce total spending,” but the savings are going to have to come from someone in that room, and none of them are going to say, “Sure, my organization will take one for the team! I’ll have to cut everyone’s pay, but because it’s for a good cause, they’ll love it.”

Does this mean these kinds of collaboratives are utterly useless in terms of lowering total spending in communities? That was the question I (carefully) asked at the end of the session, and one of the panelists gave a really insightful answer. To paraphrase/translate/elaborate on what he said, his answer went something like this:

Yeah, we’re not going to convince anyone in that room to just give up money like that. But what we can do is come up with standardized ways of reporting prices and quality. And when those are standardized across all payers and providers, patients will be better equipped to choose higher-value payers/providers, which, in the U.S., usually means ‘cheaper’ payers/providers. So this standardization will allow total spending to go down by getting more people receiving services from cheaper competitors. Thus, the higher-priced competitors will be the ones who are losing money when total spending goes down, all because we helped standardize quality and price reporting.

I agree. There are still many barriers to getting patients to choose these “higher-value” providers/payers, but this would help solve one of the biggest ones. And with each barrier we overcome, more patients will be enabled to receive higher-value care, which is what everyone wants, right?