Actually, Mr. President--our health care is too cheap!!

President Obama spoke to the nation Wednesday night on health care. He gave an impassioned speech, projecting sincerity and concern. Sadly, all of that charisma and eloquence is devoted to leading us in the wrong direction. The President correctly pointed out that we can not tolerate the status quo, but he has tragically misdiagnosed the cause of our health care ailments. Based on an erroneous understanding of the problem, his recommendations will continue and augment the very policies which have caused them. His plan is a prescription which can only further undermine the quality and quantity of affordable medical care.

President Obama states:

Then there's the problem of rising costs. We spend one-and-a-half times more per person on health care than any other country, but we aren't any healthier for it. This is one of the reasons that insurance premiums have gone up three times faster than wages. --Pres. Obama, Joint Session 09/09/09

Yes, we are spending more. Yes, insurance premiums are going up. Yes, out of pocket expenses are increasing. Yes, more and more people and businesses are choosing to drop their health insurance plans because of the expense. Yes, the cost of Medicare and Medicaid is soaring. Yes, these are all serious problems--but NONE of this addresses the question of WHY.

The President and supporters of his plan offer a multitude of causes: too much expensive new technology--except there's not enough information technology; too much spent on administrative work--except not enough oversight into fraud and waste; higher prices from cost shifting because of the uninsured--but we must continue strict price control of Medicare/Medicaid reimbursements; too many insurance companies which duplicate services--but not enough competition, so we need a public option. On top of all that, we are told that doctors are overpaid and perform unnecessary treatments, and insurance company earn unnecessary profits. Some of these explanations simply miss the point, while others are flatly wrong.

The primary cause of the dysfunctions within our health care delivery system is that consumers of medical care pay too little, not too much!¹ The system of third party payment for medical care, which has been in place and rapidly expanding since WWII, has disconnected the consumption of health care services from its cost. Prices no longer reflect the real balance between supply and demand. This prevents consumers of goods and services from making accurate evaluations as to how to best allocate scarce resources to alternative uses.

Prior to WWII, Americans paid for most of their health care out-of-pocket. Insurance², when it existed, was true insurance,³ a way of financing risk to pay for large and unexpected health expenses, in the exact same way that homeowners, car and life insurance still operate. Because of the current misuse of the term "health insurance" to refer to 3rd party payers of health care, if we now desire to refer to true insurance for health care, we have to give it a special name: "catastrophic health insurance." Most of what is now called "insurance" is actually either 1) prepayment for the consumption of known and/or predictable medical expenses (thus removing it from the realm of what is actually insurable) or 2) entitlement programs (Medicare, Medicaid, SCHIP, etc.) --which are redistribution of taxpayer money posing as "insurance." (Calling things "insurance" does not make them so in any fundamental or relevant way. Just one more example of how the imprecise use of words prevents proper analysis.)

By the early 1990's, patients were paying only 5 cents out of every dollar spent on hospital services, 19 cents out of every dollar spent on physician fees, and over all, less than 24 cents out of every dollar spent on health care of all types^{(4, 5)}. The rest was being paid by someone else. This disconnect between the money being spent and the direct financial cost to the patient drives up demand, which drives up prices.⁶ This is simply the law of supply and demand and its effect on prices.

A report referenced by Pres. Obama bemoans the accelerated growth in the cost of premiums and co-pays for employees since 2000. However, this is simply the to-be-expected rebound following decades of health care financing in which patients have only paid a small fraction of the full cost of their health care. Any good which is made available at artificially low prices will be over-consumed and under-produced.

Some health care costs are large and unpredictable. For these rare events, it makes sense to pool risk and purchase insurance. Appropriately underwritten, this type of insurance can be profitably funded. Other expenditures, such as health maintenance, treatment of routine minor illnesses and the increased need of health care as we age, are predictable expenses, just as predictable as the need to save for retirement, the need to budget for food, shelter, clothing and education. These are all known costs of living for which we must make long term funding plans. They are simply part of the normal requirements for living a responsible, independent life.

As long as we love life and wish to avoid pain and disability, our desires for health care will exceed our ability to purchase treatment. The fact that all resources are limited requires us to set priorities and make choices, doing our best to allocate our personal (scarce) resources according to what we value most. Done voluntarily, resources are allocated via price discrimination; when mandated by government, it is called rationing.

Making treatments cost less to the user than the full cost of providing them (labor, materials, etc.) guarantees the demand for those goods and services will rise faster than the supply and thus drive up prices. As patients, we have had decades of insulation from the full cost of our medical care--and the plans currently before Congress will further increase that insulation, attempting to postpone the inevitable head-on collision with that basic truth of economics (and of reality): There is no such thing as a free lunch. That is why the current plans can only drive prices even higher, further aggravating the problems of affordability and access.

The solution?

John Mackey, CEO of Whole Foods, has a great start.

Another way of formulating those ideas are as follows:

Remove existing legal barriers to responsible consumer-driven health care, i.e. the government mandates, regulations and tax laws which interfere with free-market contracting for real insurance.

Allow competition, supply and demand (rather than political agenda) to set prices, and to award profits and losses commensurate with a provider's ability to meet patient needs with quality and efficiency.

Protect both patients and providers by enhancing the enforcement of contracts, and punishing fraud.

Reestablish equality before the law by eliminating discrepancies in how health insurance and health care expenditures are taxed.


Our economy is a mixture of free exchange and government interventions. Following the caveat "First do no harm," it is crucial to understand the harmful consequences that government mandates perpetrate on free-market price signals. Artificially lowering the price of a good or service below its real cost in scarce resources means that individuals will make purchase decisions based on faulty information. Insulating patients from experiencing the full costs of their choices, and providers from experiencing the profit and loss consequences theirs, disconnects everyone from the corrective forces we need to make better choices over time. We need to move closer to a system which is run by the laws of supply and demand, instead of bolstering a system run by special interests and political agenda.

Because they reflect real supply in relationship to real demand, free-market prices are more efficient. Because they are based on voluntary exchange, free-market prices are also more just.


Addendum: Check out a recent post which illustrates the problem of 3rd party payers, written by The Rational Capitalist while "Litterally Experiencing the Broken Window Fallacy".

Footnotes:

1. I am grateful to John Goodman and Gerald Musgrave (see references) for reminding me of this insight which my dear friend Dr. Karen Tierney tried to get me to understand over 20 years ago.

2. Wikipedia has a brief outline of the Principles of Insurance obtained from Mehr and Camack “Principles of Insurance”, 6^th edition, 1976, pp 34 – 37. These principles include a) A large number of homogeneous exposure units, b) definite, accidental, large calculable loss, c)Limited risk of catastrophically large losses and d) affordable premiums. See here for further elaboration.

3. Doug Reich explains:The whole purpose of insurance is to pool risk in such a way that most of the time, premiums from some members of the pool are sufficient to cover claims from other members in the unlikely event that they have a claim. The premiums are priced based on the probability of a claim in such a way that the pool is almost guaranteed to take in more than it pays out. That is why on a private market, people choose policies with deductibles and/or policies that only pay in the event of catastrophes. The less likely a payout, the less the premium and vice versa.

4. Goodman and Musgrave, , 1992

5. Current estimates are that 86% of health care expenditures are paid by 3rd parties, leaving patient expenditures at 14 cents out of every dollar spent on health care. That's quite a discount! (pg 45 in Kling, Crisis of Abundance, 2006)

6. For more detailed accounts of the history of health care financing in the U.S. see Dattilo and Racer (2006) pg 83-136 and Zinser, Lin and Hsieh, Paul, "Moral Health Care vs. "Universal Health Care'" in The
Objectivist Standard, Vol. 2 No. 4, 2008

Additional Resources:

Cannon, Michael and Tanner, Michael, Healthy Competition: What's Holding Back Health Care and How to Free It, Cato Institute, 2007

Dattilo, Gregory and Racer, David, Your Health Matters, Alethos Press LLC, 2006

Goodman, John C and Musgrave, Gerald L. Patient Power, Cato Institute, 1992

Gratzer, David, The Cure: How Capitalism Can Save American Health Care, Encounter Books, 2006

Kling, Arnold, Crisis of Abundance: Rethinking How We Pay for Health Care, Cato Institute, 2006