Where’s the private sector cost control?

This is a TIE-U post associated with Jonathan Kolstad’s The Economics of Health Care and Policy (Penn’s HCMG 903-001, Spring 2012). For other posts in this series, see the course intro.

Mark Pauly’s Taxation, Health Insurance, and Market Failure in the Medical Economy (ungaged PDF) [1], published in 1986, is a review of much of the health economics literature and thought as of the mid 1980s. It’s interesting to see what has changed since then. For instance, we are now aware of several examples of adverse selection death spirals, and we now better understand the nature and consequences of the employer-sponsored health insurance (ESI) tax subsidy. The latter is a principal focus of Pauly’s paper.

Since it covers a great deal of territory, one could use the paper as a springboard for just about anything in health care. I’ll use it to return to a question I posed on Twitter and by email to colleagues last week. Pauly asks,

The fundamental question that has yet to be answered is […] why did not market forces induce individual insurance firms to supply “cost control” of some type, and so obviate the need for government regulation? […]

One answer [A] is a conspiracy or pressure theory. The notion is that providers of hospital and physician services would prefer fewer to more restrictions. Physicians in particular have been alleged to move collectively in overt and covert ways to resist insurer cost controls that exist and to discourage their introduction. […]

A second argument [B] relates to the nature of the industry. […] An insurer that imposes a cost-control program on its insureds, at some explicit or implicit cost to them, may be unable to recoup all of the benefit from lower-service intensity in the form of lower premiums, because service intensity falls for all users of health care, not just for the firm’s insureds. […]

Partly it is due to the inability of firms, either doctors or hospitals, to offer different quality levels at the same time to those with different types of insurance. […]

A third [C] explanation finds the cause of undersupply of cost-control activity to be the tax subsidy directly. […]

I find the first two, labeled A and B, especially plausible. The third, C, that the ESI tax subsidy deserves some blame, is also plausible, but becoming less so as health care costs are exerting an ever-greater strain on businesses and workers. There is a documented outcry for lower-cost insurance. Market participants on the demand side want to lower costs (spending). My question is, why has there not been a private sector revolution in evidence-based medicine to squeeze out the waste?

Perhaps the best complement to Pauly’s explanation  is that the private sector has concluded it is not profitable to invest in the type of research that is needed. As I’ve written before, comparative effectiveness research is a public good. Also, at least as of the mid-1990s or so, insurers were highly constrained by the law and the courts as to what they could get physicians to do (and not do).

Co-blogger Kevin suggests things have changed, however. Plans are getting smarter about how they define benefits and coverage. Moreover, some insurers are moving toward global payment (or capitated) models with quality- and cost-based bonuses, much like Medicare’s ACOs. If this trend holds, it should be providers, not just insurers and self-insured employers, that demand information on how to provide care of equivalent (or better) quality at lower (or the same) cost.

In other words, cost control will not merely be a demand-side concern. The supply-side will care too. By itself, that does not mean the cost cutting will be efficient. A lot rides on how providers are monitored, what incentives they face. I don’t expect that our current plans are the solution. There’s no good reason to believe that we have somehow figured it all out.

Pauly’s question is a good one, and I think it will remain relevant for years to come.


[1] Pauly, Mark, “Taxation, Health Insurance, and Market Failure in Medical Care,” Journal of Economic Literature, 24(2), June 1986, 629-675.


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