Economics 101 and the Rising Costs of Health Care

As an economist, I’m bothered by gross oversimplifications underlying the glib statement that costs of health care are rising.  Mistaken notions of cost, in combination with shallow political discourse, help explain why health reforms consistently fail to solve deep-seated economic problems of American medicine.

Cost is only one factor in the equation of total spending.  If we really want to limit the number of dollars flowing through the medical economy, we must develop coordinated policies that impact all variables.  A quick review of the fundamentals of Economics 101—production theory and supply & demand—reveals the range of variables that policy-makers should be addressing to reform health care.

Cost means cost of production.  It is represented by U-shaped curves showing how much a producer pays for various combinations of inputs that produce a particular good or service.  Costs can be lowered with a less expensive combination of inputs (e.g., substituting advanced practice nurses for physicians) or economies of scale (e.g., consolidating underutilized clinical services into a single unit) that yield the same product. 

Price is the producer’s charge for selling its goods and services.  Obviously, producers cannot stay in business if production cost exceeds market price, so they must constantly lower costs and/or convince consumers to pay a higher price by differentiating their product through advertising and other promotional activities.  

Total expenditure on a good or service is determined by the price that consumers pay, multiplied by the quantity they purchase.  Expenditures can be reduced through economic policies to lower costs of production and/or to curtail demand (e.g., disease management programs). 

The health “reforms” of 2010 were not directly focused on reducing production costs, prices, and demand in ways that would stop the relentless increase in total spending on health care.  Instead, the new laws’ focus on insurance overhaul will almost certainly have the opposite effect, first by increasing demand and then by increasing production costs by creating chaos in the marketplace.  Ideally, the spending outlook could have been more promising if sound economic analysis had not been derailed by hard-ball politics.

However, the outcome would be bleak even if lawmakers had acted in accord with the lessons of Econ 101.  Effective (i.e., paying) demand for health care is going to be severely constrained for years to come because consumers are being expected to pay a growing share of their total bills while consumer income is stagnant.  Patients simply won’t have money to cover the additional expenditures that reform is shifting to them.  Congress may ignore the basic laws of economics, but providers and payers cannot.  I think that their survival requires cutting costs of production, providing acceptable medical services at affordable prices, and helping patients reduce demand—in spite of the new reform laws.  What do you think? 

A Down-to-Earth Idea for Health Reform

As a futurist on the speaking circuit, I am generally asked to make my comments from the “30,000 foot” perspective. Meeting planners seem to assume that something as uncertain as the evolution of health care can only be viewed from a high level. Fortunately, audiences seem interested in my assessment of the probabilities of a broad array of possibilities—especially in the context of recent health reform laws. Listeners would rightly reject my forecasts if I told them exactly what was going to happen. Nobody knows. Any number of things, many unforeseeable, could occur in the medical marketplace.


I was caught off guard in a speech last week when a prominent elected official in the audience asked me what could be done right now to address serious threats to health care at the state and local level. He wanted a “down-to-earth” example of a homegrown solution, independent of federal reform. Specifically, he asked, what responsive action could be initiated locally in 2010 without waiting to see what happens in Washington between now and 2014?


The pointed inquiry gave me an opportunity to share an idea that has been on my mind for some time. (I just wish I had been smart enough to plant the question.) The solution begins with finding a provider, a payer, and an employer who are all tired of blaming each other for the ever-rising costs and uneven quality of health care. All agree that they need to change their practices that contribute to today’s mess. The parties then agree to a few key rules for the new relationship.

• First, the partners agree contractually to work together for at least five years—long enough to reap the collective benefits of investing in health promotion and disease prevention and changes in benefit design (e.g., restructured incentives).

• Second, they agree to develop a health plan for the 21st century with input from all parties, including beneficiaries. They adopt a common goal for the new approach to employee benefits, such as achieving specified improvements in the health of employees and dependents.

• Third, they make the difficult agreement that significant trade-offs will be made; more of the same won’t do. It’s time for strategic decisions that rearrange resources and relationships, seeking synergies in goal-directed change.

• Fourth, and most important from an economic perspective, the partners agree to freeze spending on health care at the current (2010) level—no increases, no decreases. The business relationships shift from arguing over unaffordable annual increases to seeking the best value for today’s spend.


In other words, the partners agree to a budget constraint—the essential step toward efficiency and effectiveness. Government’s role would be to relax rules and regulations that prevent the new partners from working accountably and transparently to do a better job with what they’ve got. It’s just an idea…what do you think?

Solving the OSFA Problem: Process Standards or Standard Processes?

Journalists often ask me to summarize the future of health care in one word. To me, the word is diverse. The realm of possibilities for delivering good medical services is growing at warp speed. Why? I believe the #1 reason is our new knowledge about genetic and molecular characteristics of common medical problems. Clinicians have a growing array of tools to identify the biologic instructions built into an unhealthy cell. With this information, they can select an intervention that interferes with the pathological process—bypassing the historically common approach of trial-and-error.

Diseases that were once thought to be the same in all patients are now recognized as being different conditions requiring different treatments, even though they have the same physical appearances. Simultaneously, clinical protocols are shifting from seeking cures to managing chronic conditions. The one-size-fits-all (OSFA) paradigm of 20th century medicine is rapidly yielding to personalized health care that reflects differences in patients and their diseases. The new disease model improves quality and reduces costs in a variety of ways, such as matching a disease’s specific biological characteristics with a drug specifically targeted to interfere in the disease process.

Believing that the medical care system should be organized to support state-of-the-art medical science, I am disappointed because recent reforms reflect OSFA thinking. Providers and payers are being pushed to fall within narrow, rigid guidelines while the scope of good medical science is expanding. For example, I do not see evidence that reform’s approach to comparative effectiveness research is sensitive to the emerging principles of personalized medicine. I also fear that reform’s regulatory mechanisms will not be able to keep up with the rapid changes in clinical science. Guidelines are likely to be outdated by the time they are adopted.

I propose a radical shift in thinking about the best way to reduce costs and improve quality—by replacing the imposition of performance standards across all providers with the expectation of standardizing performance within each individual provider organization. (For details, see http://bit.ly/aG9Zuq.) Rather than telling providers what OSFA results they must achieve to be reimbursed and assuming that they will figure out how to meet the standards, let’s require health care organizations to use proven performance improvement tools and assume that they will do the right things because they are doing things the right way.


In other words, the current approach to reform is headed in the wrong direction. It does not reflect the diversity of possibilities for improvement in American health care. Reform shouldn’t be based on OSFA outcome standards. Instead, I think that reform policy should promote business processes that help producers to do the best possible job. What do you think?

Wanted: Questions and Ideas for Future Posts

No blog this week due to a prolonged holiday weekend; I'll return to the regular schedule -- mid-day posts on Tuesday -- next week.  In the meantime, please suggest topics or pose questions that you would like to have addressed in future blogs.  Your input is much appreciated!