Making it up on volume

I haven’t read David Goldhill’s book, but it is on my list. As such, I’ve more-or-less deliberately avoided reviews, analysis, and interviews. I want to read it myself and draw my own conclusions. But I did read his recent WaPo op-ed, the gist of which is:

[Medicare’s] low prices are a mirage. As any businessperson knows, with enough market power — not to mention political power — you can always make it up in volume.

This is the supplier induced demand hypothesis and there’s something to it. Now, want to make it more interesting? Try to reconcile it with the cost shifting hypothesis. If providers can shift costs, that would take the pressure off inducing demand, wouldn’t it? Of course, they mostly can’t shift costs. Why not?

Well, the classic reason is that they’re profit-maximizing (yes, even not-for-profits do it). A firm that has already used all its market power to maximize profit can’t profitably raise prices. Therefore, it can’t cost shift. But what else would a profit-maximizing firm do?

One thing it wouldn’t do is raise volume in a sector with lower prices. It’d volume shift to the sector where the prices are higher. That is, what one expects from profit maximization theory is that when Medicare prices are lower, volume is shifted away from Medicare and toward private payers (insurers) that offer higher prices. It’s all in the charts right here.

It’s actually a bit difficult to articulate an economic theory of health care providers that accounts for all the observations — demand inducement, degree of cost shifting or lack thereof, cost cutting, etc. — or at least for what we think we observe. It should be noted, however, that casual observation of bivariate relationships can be deceiving. Without a proper research design that accounts for confounding factors, we could be deceiving ourselves as to what is really going on.

My guess is that volume increases are not isolated in one sector, that there is a general trend toward more intense utilization, not just in Medicare but overall. The economist in me says that the more important driving factor of more intense utilization is not lower Medicare prices but higher private ones. We do think higher prices induce greater supply, don’t we? This is America, right? If so, then that’s what one should expect from the commercial market.

Perhaps what we see in Medicare is a spillover effect. Once the MRI machine is warmed up, it’s hard not to use it on everyone.

@afrakt

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