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!

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.

Why Aren’t Prices Transparent in Healthcare?

Image credit: presentermedia.com

I had a friend ask me that (the title of the post) a few days ago. He prefaced the question by saying he’s asked a few different people and knows already that there isn’t a simple answer to it. But those other people he asked misled him. The answer actually is quite simple. And why nobody is explaining this clearly, despite all the talk about price transparency in healthcare these days, is a symptom of a general lack of understanding of how industries actually function.

Prices are transparent in healthcare–the insurer knows exactly how much they’ll pay each healthcare provider for every service they cover. The problem isn’t transparency. The problem is that the party making the decision on where to seek care is not the same party that bears the financial consequence of that decision. Who chooses where to seek care? The patient. Who bears the financial consequence of that decision? The insurer. Therein lies the rub.

Think about two different scenarios. In the first, the patient will have both responsibilities. Patients would start to actually consider whether the extra $5,000 they would have to pay to go to Provider B for their cholecystectomy would be worth it as opposed to just going to Provider A. Is Provider B’s quality actually that much better to make it worth the extra $5,000? If not, patients will probably choose Provider A. And what happens when patients all start being unwilling to pay unjustifiably high prices? Provider B will either have to lower prices (goodbye crazy price variations!) or continue to deal with a large number of unused operating room hours. Patients win because they get better value, and high-value providers win because they get patients. In this situation, the decreased expenditures on healthcare are taken from the low-value providers. Who would argue against that? In this case, even the “I’m better than the average physician” belief that 100% of physicians have (statistically impossible as it may be) will help to decrease healthcare expenditures.

This pairing of both responsibilities in patients is actually happening, by the way. Why do you think insurers are trying out reference pricing, where they just commit to put a set dollar amount toward a given procedure and have the patient cover the difference if they choose a provider who charges more than that? And what about tiered plans, where patients choosing to go to the more expensive hospitals (the ones in the higher tiers of the insurance plans) have to pay a larger copay? And what about high-deductible plans for services below the deductible? These are all doing the exact same thing but in different ways: making the person who chooses where to get care the same person who bears the financial consequences of the decision. And providers with higher value are being rewarded with increased market share (volume).

In the second scenario, the insurer will have both of those responsibilities. It’ll still bear the financial consequences, of course, but now it’ll also be the one that tells patients exactly where to go for care. Patients wouldn’t like this, of course, but what would happen? Insurers would send every patient to the cheapest provider that meets minimum quality standards. Unlikely to ever happen? For run-of-the-mill procedures, probably it won’t ever happen. But for incredibly expensive one-time procedures, it already has. I heard a story about an insurer that did this with liver transplants (which, all told, is estimated to cost over $500,000 dollars). The insurer asked around to all the reputable local hospitals and got the cheapest bid for each patient. Then they sent each patient to the lowest-bidding hospital. The insurer saved a bundle. And the hospitals that could offer lower prices (possibly because they had lower costs somehow) were rewarded with volume. Ah, that whole reward value with volume thing again. It’s beautiful.

One final real-world example. ACOs. So far, one major way they’ve saved money is by sending patients to cheaper specialists. Let’s apply the principles we’ve just talked about to understand what’s going on. The referring provider is generally the party charged with making the decision of where the patient will go for a specialist visit. (The doctor says, “You need a specialist to look at this. Here’s the phone number for a good doctor, so go see her.” The patient says, “Okay, Doc, whatever you say. I’ll go see her.”). And when the referring provider is getting a bonus for keeping overall costs down, he now also bears the financial consequence of sending patients to expensive specialists because it’ll cost him his bonus. Now that you understand the principle of those two responsibilities needing to be invested in the same party, the world starts to make sense; you start to actually be able to predict whether something will work or not.

So now when you hear people complaining about our “horrendously evil system of third-party payment,” you’ll know that it’s not intrinsically a bad thing. It’s only bad when it results in a separation of those two responsibilities, the decision-of-where-to-seek-care responsibility and the financial responsibility.

How to Make the Cost of Care Cheaper

I’ve been leading up to this for a long time. Lowering the cost of the actual provision of care is one of the most important things all countries with unsustainable health spending growth need. And, at the outset, I’ll say I don’t have all the answers. But here’s what I’ve got, explained in maybe a roundabout way, but hopefully it makes sense by the end.

Think about providers’ incentive to innovate. Do they have one? Hopefully your initial response is “yes,” because you’d be right (partially). Assuming this is a provider that operates as most in the country do, its prices are determined based on market power, not costs. So, with the assurance that prices will stay the same regardless of costs, providers have a great incentive to lower costs! Any cost decrease will go straight to their bottom line.

At this point, I picture in my head a little map of the United States with a vertical pin sticking out of it for each hospital, with the height of the pin representing that hospital’s costs of delivering care. The taller the pin, the higher the costs. So, the incentive for each hospital is to lower their costs as much as possible in order to maximize profits, and different hospitals succeed to varying degrees. The pins get pushed down with each successful cost-cutting initiative, some more than others.

Now let’s say there is a hospital that finds a really innovative way to deliver care, and their costs are way lower than everyone else’s. They want to get more customers in an effort to continue generating more wealth, but they’re stuck! Why are they stuck? Because even though their costs are so much lower, they don’t really get to set the prices the patients actually pay when choosing which hospital to go to for care. High-value providers can’t expand to new cities because they’d have to set their prices lower than existing providers’ prices, steal a whole bunch of the market share, and most likely force some of the lower-value incumbents out of business. But if they could, do you see what would happen to the pins? The one really low pin would start spreading, making the tallest pins get taken off the map completely with each market that it spreads to. It would be beautiful! Different kinds of cost-saving innovations would be spreading all over the country.

So, to repeat David Cutler’s question, Where are all the healthcare innovators? They’re out there, all over the country, but they’re stuck in their current markets; thus, we don’t see or even hear about most of them.

In summary, think of the two ways a company can make more money:

  1. Sell items at a higher margin
  2. Sell more items

Providers in our healthcare system can only do the first one. The second one is mostly not functioning, and thus we don’t have the harsh (and absolutely crucial) evolutionary force of putting lower-value providers out of business and lowering the cost of healthcare.

I’ll admit, the proliferation of high-deductible plans and new kinds of deals between providers and insurers are starting to overcome this. But there are probably other ways to increase the pace of the elimination of these barriers, and I would think the government should be focused on figuring out what they are if they want to solve this country’s budget problems. Or they could continue to argue over how to how to reduce volume and price while largely ignoring costs.

Why Is Innovation the Main Driver of Healthcare Spending Increases?

I have this demand: Every weekday, I want to get from home to school and back again with as little travel time as possible. I could fulfill this desire in various ways: drive a car, ride a bike, walk, fly a helicopter. Let’s pretend my demand is currently being fulfilled by a helicopter because that’s the fastest way available. So, you could say that my demand to get to school as quickly as possible is being fulfilled to some extent, but it’s not being completely fulfilled, which would entail getting to school and back with zero total travel time. Technology is limiting my demand from being completely fulfilled.

I will call my fulfilled demand active, because I’m actively spending money to fulfill it, and my unfulfilled demand latent, because it exists but is not currently being fulfilled.

What does this have to do with innovation? Well, not much, except that it lays the background for understanding my next sentence. Innovation (which I will define as finding a new way to fulfill demand) comes in two varieties: (1) the variety that creates cheaper ways to fulfill active demand and (2) innovation that activates latent demand.

Let’s make this concrete. If a new helicopter company comes up with a cheaper way to sell a similar-quality helicopter as the one I have, then I could have gotten that one instead. This would be an example of fulfilling active demand in a cheaper way. And if a teleportation company comes along, then I could get one of those and all of my latent demand would be activated.

All of this assumes money is no object, which, when we’re talking about healthcare, it often isn’t. But this post isn’t about that.

So now you should understand that when innovation has the net effect of increasing total spending in an industry (like healthcare), it’s probably because a lot of latent demand is getting activated (i.e., we’re spending money to fulfill demands that weren’t previously being fulfilled). This is great! . . . Except when it bankrupts us. So we probably need to somehow ration (especially the high-cost-yet-marginally-better-outcome stuff) and encourage innovation of the cost-lowering kind.

Ignoring (for now) the rationing suggestion, here are my thoughts about who we can expect/encourage to provide the cost-lowering innovation.

Providers (doctors and hospitals). I don’t see providers as activating much latent demand in healthcare. They kind of have to just use what treatment techniques they’re provided and find the most cost-effective way to administer them to the right patients. So, provider innovation should be a major source of the cost-lowering variety (think about IHC or Mayo Clinic).

Suppliers (device manufacturers and pharmaceutical companies). When thinking about supplier innovation, they do both kinds. Often they are coming up with miracle drugs and devices that activate latent demand (think about insulin, which prolonged the life expectancy for diabetics from months to decades), and sometimes they are also coming up with devices that make it cheaper to fulfill already active demand (think about at-home dialysis machines).