Another Supply-Side Revolution Is Needed
By Josh Hendrickson : 01 May 2007

With health expenditures rising relative to GDP, most pundits and health economists believe that the U.S. health care system needs to be reformed. Those who favor reform can be separated into two groups. The first group believes that due to the insulation from premiums and the medical expenses themselves, individuals consume more health care than they would if they paid for these services out-of-pocket. Economists refer to this phenomenon as moral hazard. The second group believes that without more government intervention, those who are poor and/or sick will not be able to afford insurance. While the former is certainly important, there is little evidence to support the latter. Additionally, effective reform must also address the supply-side.

There is certainly reason to believe that moral hazard exists. While individuals may not go to the doctor simply because they have insurance, they will likely consume excess care on the margin. For example, suppose an individual goes to the emergency room for severe stomach pain. The doctor suspects that the patient may have appendicitis and administers a series of tests. After inconclusive results, the doctor tells the patient that it is unlikely that they have appendicitis, but that a CAT scan could completely rule it out. If the patient is insulated from the cost, they will surely agree to the scan regardless of the fact that it is not likely to change their diagnosis.

The problem with spending on the margin is that it often involves spending on expensive procedures that offer the patient little benefit. Arnold Kling refers to this as premium medicine.

The second group believes that the biggest problem facing the U.S. health care system is that the sick and the poor cannot afford insurance. These individuals argue that more government intervention (and possibly a single-payer system) is necessary to provide the poor and the sick insurance. However, this is simply not true. Lisa Dubay, John Holahan, and Allison Cook found that 25% of the uninsured were eligible for public coverage, but were not enrolled. They also found that an additional 20% of the uninsured live in households that could afford insurance. Similarly, Kate Bundorf and Mark Pauly estimated that, depending on the definition of affordability, 25% to 75% of the uninsured could afford insurance.

While these findings are certainly important when designing effective reform, what is missing from the debate is a discussion of supply-side reforms. In The American Economic Review in 1963, Noble Prize winning economist Kenneth Arrow tackled the idea of uncertainty and medical care. Included in the paper was a section on the unique aspect of the market for medical services. Especially prescient were Arrow's thoughts on the supply-side.

The supply-side is riddled with inefficiencies. For example, the supply of doctors is restricted by licensing and medical school enrollments. Physicians also often act to exclude substitutes such as physician assistants and nurse practitioners. What's more, doctors effectively act as a collective monopoly because of the lack of price competition within their ranks. These restrictions on supply lead to higher prices for patients and higher incomes for doctors. This is especially inefficient considering that patients often lack price information until they receive their statement of benefits in the mail. Although the insurance system was quite different in 1963, many of the inefficiencies of the market are consistent with what is seen today.

Arrow's article also studied insurance and, using a mathematical model, stated that the ideal form was full coverage above some deductible. He also stated that if insurers were risk averse, which undoubtedly they are, they would also require a co-payment above the deductible.

While some may condemn Arrow's theory as outdated, they would be erroneous to do so. Requiring consumers to pay a deductible would give individuals the incentive to obtain pricing information and would thus cause doctors to be more forthright with their billing methods. Additionally, a market with consumers who no longer lack price information will begin switching to physicians that they perceive as offering better quality service and thus may induce some level of price competition among doctors. This type of policy is consistent with that advocated by demand-side reformers.

Unfortunately, the battle for price competition will also require additional reform. On the supply-side, economist Robin Hanson suggests "replacing doctors with cheaper alternatives." This is quite possibly the best way to induce price competition without reducing the patients' quality of treatment. Hanson justifies this by highlighting a study in the Journal of the American Medical Association that finds that there is no difference in health status among patients receiving care from a nurse practitioner and a physician. Along the same lines, it may also be prudent to re-examine the licensing restrictions on physicians and the medical school admissions policies.

So as policymakers take a step back and design some type of reform, they should keep in mind the lessons learned from Arnold Kling, Kenneth Arrow, and Robin Hanson. The United States health care system does not need a major overhaul. The system merely needs to reduce inefficiencies and realign incentives on the demand-side and the supply-side.

Josh Hendrickson teaches economics at Wayne State University. He also maintains the blog entitled, "The Everyday Economist".