EVGENIY GENTCHEV

ASSOCIATE PROFESSOR OF MANAGEMENT

NORTHWOOD UNIVERSITY, CEDAR HILL, TX

GENTCHEV@NORTHWOOD.EDU

BLOG
HTTP://ATLEASTONEWHY.BLOGSPOT.COM

[HEALTH CARE COSTS &

REFORM - MISSING THE
FOREST FOR THE TREES ]
If the US health care industry were its own economy, it would be large enough to have a seat at the G8
table. It provides the most expensive health care in the world, but not necessarily the best, and it’s not
accessible to millions. It is becoming an unsustainably large burden on Americans and on the US
economy. Both conservatives and liberals have enough reasons to demand a significant reform in the
way the system operates but current reform efforts are largely misdirected. The real cause of high and
rising health care costs is either misidentified or ignored by lawmakers. Artificial villains are designated
(malpractice lawyers, health insurers), which further detracts the public discourse, policy analysis, and
political decisions from focusing on and removing the true drivers of costs. This paper attempts to show
that the key underlying problem in our health care system is the inefficiency of doctors and hospitals,
something the current reform efforts largely ignore.
Missing the Forest for the Trees
A Macro Analysis of the US Health Care Costs and Reform Efforts

The Largest Forest in the World

When President Eisenhower, in his 1961 farewell address, warned the nation of the danger of the rising
power of the military-industrial complex, the US was spending 9.4% of its GDP on military defense.
Today the size of the US military-industrial complex as percentage of the nation’s economy is half of
what it was then. (Office of Management And Budget)

But there is another industry which, under the auspices of helping us in our most challenging moments,
has become the dangerous behemoth most deserving of the Eisenhower warning. At $2.2 trillion, the
US health care industry is more than 16% of the US economy and is growing steadily and rapidly. (The
Henry J Kaiser Family Foundation, 2009) Our health care industry is nearly 50% larger than the entire
world’s (including the US’s) military spending. (Sharp, 2009) (See Appendix A for graphical
representation). Growing at its present rate, the industry would be 100% of the US economy by 2082.
(CBO, Nov 2007)

Consequently, fewer Americans can afford to access even simple health care services, and for those who
still have access the cost presents a heavy financial burden. But the financial burden is placed also on
employers and on our government—American-made products cost more and are thus less globally
competitive, and our government runs larger deficits—all in order to pay for the rising health care cost
of employees and retirees. In a country where your mobile phone has more computing power and costs
less today than the computer you purchased three years ago there is no reason why a the same medical
procedure today shouldn’t cost less than the same procedure did three years ago. Our ever more
expensive health care threatens to bankrupt the US economy the same way that expensive employee
benefits drove General Motors and Chrysler into bankruptcy.

This makes an unreformed health care system a real danger to the nation, and makes reform
imperative. One of the challenges of reforming the industry, however, may be its sheer size. There is no
historical precedent of a reform that encompasses an industry, or even an economy, that is comparable
to the size of the US health care industry. Perhaps the only one that comes near in size is Gorbachev’s
perestroika and the subsequent economic changes in the former Soviet Union, whose entire GDP may
have been, at best, comparable to what we today spend on health care. (Bergson, 1997)

This paper attempts to identify and bring attention to the real major underlying cause of the US health
care problem—exorbitant costs due to inefficiency caused by lack of competition among health service
providers.

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“Something is rotten in the state of Denmark”

Have you seen lately the friendly Geico gecko or Flo, the Progressive Insurance lady on TV? Or maybe
you’ve seen actor Dennis Haysbert, who portrays the US President in the TV series 24, assure you that
with All State you are in good hands? If you watch television, chances are that all three are very familiar
to you. Each one tries to convince you that you will save more money and get better service if you
purchase your auto insurance from their company. Given the average auto insurance premium in this
country is about $1,000 per year (Insure.com, 2008) and there being roughly 250 million cars and trucks
registered in the US (Bureau of Transportation Statistics, 2009), this makes auto insurance
approximately a $250 billion industry.

Ominously missing from our television diet are advertisements for insurance in an industry that is nine
times larger (The Henry J Kaiser Family Foundation, 2009) and contains even more risks—the $2.2
trillion health care industry. Why aren’t health insurance companies fighting for our dollars? This
simple observation is just a small manifestation of one of the many issues in our current health care
system.

In the health care reform debates, both in Congress and in the media, there are countless discussions of
one point or another. The Senate bill, which was passed on Christmas Eve 2009 is over 2,000 pages
long. But in all of these pages something simple seems to be missing: The fact that the United States
spends 50% more per person on health care than the second-highest spending country—Switzerland—
and nearly twice as much as Canada and Denmark. (The Henry J Kaiser Family Foundation, 2009) At the
same time our infant mortality rate is 50% higher than Switzerland’s and Denmark’s, 20% higher than
Canada’s, and our life expectancy is a few months lower than in Denmark, two-and-a-half years lower
than in Switzerland, and nearly three years lower than in Canada. (CIA, 2009)

In short, we spend much more money than anybody else on health care and get measurably less for our
dollars (Elmendorf, 2009), as evidenced by the substantially higher infant mortality rates and noticeably
lower life expectancy. Despite the patriotic-sounding claim that we have the best healthcare in the
world, the facts and figures, as collected by the US Central Intelligence Agency, do not support that
claim. In addition, 45 million Americans below the age of 65 lack health insurance. (Congressional
Budget Office, 2009).

Cost is the fundamental problem

The cost of health care is so large and is growing so fast that it could potentially bankrupt the United
States economy the way that the large and ever-growing benefits negotiated by the United Auto
Workers drove General Motors and Chrysler into bankruptcy.

Since 1970 health care costs have grown on average 2.4 percentage points faster than our Gross
Domestic Product (GDP). In 2007 we spent $2.2 trillion, or 16.2% of our entire GDP on health care. (The

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Henry J Kaiser Family Foundation, 2009) Next year we will spend $2.6 trillion, and by 2019 we will be
spending $4.7 trillion annually. (Department of Health and Human Services, 2009) If the current trends
continue unchanged, by year 2082 all 100% of the US GDP would have to be spend on health care. (CBO,
Nov 2007)

The high cost of health care leads to high health insurance premiums and makes not only health services
but also health insurance unaffordable for 45 million Americans in 2009, and this number is projected to
rise to 54 million by 2019, if the system is not reformed. (Congressional Budget Office, 2009)

We, the people of the United States, paid all of the $2.2 trillion in 2007. A small portion of this amount
we pay directly to the health services providers. Some we pay through health insurance companies, in
the form of insurance premiums. And the last portion we pay through the government (state and local),
in the form of taxes. Every dollar we spend on health care, whether directly or through insurance
companies or through government agencies, we surrender irreversibly, and forgo the opportunity to use
it for anything else. We can spend that money neither on housing, nor cars, nor travel, nor education,
nor anything else.

Why does US health care cost so much?

This seems to be the obvious question that nobody is asking: if health care costs so much, where does
the money go? The related question is why do health care costs grow so much? Implicit in the public
discourse are several possible answers (hypotheses). All of them assume that somebody gets
inordinately wealthy at the expense of everyone else:

Hypothesis (1): Medical malpractice litigation and the corresponding jury awards consume much of the
dollars we spend on healthcare and drive much of the cost increases.

Hypothesis (2): Monopolistic health insurance industry keeps much of the insurance money we pay as
profit.

Hypothesis (3): Providers (hospitals and doctors) charge ever higher rates and get very wealthy at
everyone else’s expense.

Let’s consider each hypothesis separately.

Medical malpractice litigation

This issue periodically comes to the forefront of national news. The claim is that the growing number of
malpractice lawsuits, the correspondingly growing number and size of malpractice awards to plaintiffs,
and the resulting growth in malpractice insurance premiums for doctors play a significant role in the cost
of health care in America.

One five-year study by a University of Texas at Dallas PhD candidate, which was published in the journal
Health Economics, estimates the cost of medical malpractice litigation somewhere between 2% and 10%

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of medical expenditures. (Roberts & Hoch, 2009) The question of the costs of medical liability is
addressed much more comprehensively in a report by the Robert Wood Johnson Foundation (RWJF),
which considers a number of studies, including reports by the Congressional Budget Office. The RWJF
report concludes that while there are shortcomings in the medical liability system, these are neither a
significant driver of costs nor a large factor behind cost increases. (Robert W. Johnson Foundation, 2008)

Put simply, the vast majority of research on the topic demonstrates clearly that, despite our gut feelings,
the cost of malpractice litigation is not the reason for the high and rising cost of health care.

Monopoly profits of insurance companies

The media have recently carried images of people marching for health care reform with signs such as
“INSURANCE PROFITS ARE BAD FOR MY HEALTH.” The statement is emotionally compelling, implying
that insurance companies retain as profits much of the money they charge as insurance premiums, that
the premiums rise as a result of the insatiable desire for higher profits or that in a never-ending pursuit
of ever higher profits insurers drop people requiring expensive treatments. An informal survey among
my university students indicates they believe the insurance companies make between 20% and 40% net
profit after tax. At the other end of the industry, doctors and hospital continuously lament the low
payments health insurers agree to pay for expensive procedures. No wonder, then, that in public and
political life the health insurers seem to be the real focus of health care reform efforts.

For the claim that insurance profits are a key driver of rising health care costs to have merit, two
conditions must be met: (1) health insurance companies’ profits must be indeed very high, most likely
driven by their monopoly position and (2) health insurance companies must be the ones through which
we pay most of our health care expenses. In reality, none of these are true.

Of the $2.2 trillion paid for health care in the US in 2007, 35% was paid by the health insurance
companies. This means that nearly two thirds of our health care expenses are NOT connected to the
health insurance industry, and two thirds of the costs of health care have nothing to do with insurance
premiums. (The Henry J Kaiser Family Foundation, 2009)

Monopoly position in the market means that a company faces no real competition and is thus able to
charge very high prices, resulting in very high profits. Both Republican and Democratic reform efforts
are targeting the monopoly position of health insurers. The Democrats propose to have a “public
option”—a national health insurance plan that would compete with the existing insurance plans, driving
insurance premiums down. Opponents of the public option contend that there already many insurance
companies, but that the lack of competition is the result of an indecipherable mix of state and federal
regulations, making it very difficult for insurance companies to compete across state lines. Their
contention is that allowing the sale of health insurance policies across state lines would create a
competition among the health insurers and would lower insurance premiums. (Shadegg, 2009)

So how many insurance companies are there in the United States, and is there a health insurance
monopoly? Google Finance (finance.google.com) lists 22 publicly traded health insurance companies.
America’s Health Insurance Plans (www.ahip.org), the national association of health insurers, provides
direct links to over 250 health insurance companies on its website, and claims 1,300 member providing

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health insurance. All of this suggests that, at least in terms of number of providers, the health insurance
industry cannot be described as monopoly.

But it takes more than simply considering the number of insurers to judge their eventual monopoly
power. Economists use the Hirschman-Herfindahl index (HHI) as a measure of the concentration of
market players in a particular market. The higher the concentration, the fewer players and less
competition there is. In other words, the higher the HHI, the closer to a monopoly we are in the
observed market. The Congressional Research Office cites research by the American Medical
Association (AMA) and others who conclude, based on HHI calculations, that the health insurance
market is highly concentrated. (Austin & Hungerford, The Market Structure of the Health Insurance
Industry, 2009) This concentration is relevant only if it correlates with high profit margins for the
insurance companies.

Let’s consider the numbers. A December 2008 report by PriceWaterhouse Coopers (PWC) titled The
Factors Fueling Rising Health Care Costs 2008 prepared for the insurance industry indicates that the
overall administrative costs of health plans, including profit, are 13% of revenues. 3% of revenue is net
profit, while the remaining 87% of insurance premium revenue pays income taxes and health care
benefits for the policy holders. (PWC, 2008) While this research by PWC could be viewed as self-serving
to the health insurance industry, its numbers can be corroborated. Journalist Chad Terhune, in a
Business Week podcast interview regarding his August 17, 2009 cover story, states that, with some
exceptions for individual and small business plans, the general amount paid for medical benefits by
insurance companies to health service providers is in the range of 80% to 85% of insurance companies’
revenues. (Terhune, 2009) These benefit payout ratio numbers are further confirmed by examining the
annual reports of the four largest (by revenue) publicly traded health insurance companies. Their
annual report data also show net profit after tax for 2007 and 2008 as indicated in the following table:1

Net profit as % of revenue United Health Group, Inc. WellPoint, Inc. Aetna Inc. Humana Inc.
2007 6% 5% 7% 3.3%
2008 4% 4% 4% 2.2%

The largest insurers may reasonably enjoy greater economies of scale and other advantages, allowing
them to generate above industry average profits. This seems to be the case since the health insurance
industry has 2.2% average profit, which ranks it 35th among US industries, according to Fortune
magazine’s annual ranking. (Fortune, 2009) Some may argue that we should not rely on the SEC filings
of the health insurance companies, as they may be ‘cooking the books’ like Enron and others in the past
decade. Such speculation, at this point, is unfounded, and the annual reports are publicly available for
anyone to evaluate, as the Cornell MBA students evaluated Enron’s annual report and identified the
problems as early as 1998. (Scherer, 2007)

1
Own research. Four largest health insurers by revenue are United Health Group, Inc., WellPoint, Inc., Aetna Inc.,
and Humana Inc. Sources of financial data: Google Finance (finance.google.com) and the companies’ annual
reports.

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The conclusion that all of these numbers lead to is that private health insurance companies are not the
reason for the high andd rising cost of healthcare because (a) they deal with and pay out only 1/3 of all
health care costs and have no direct impact on the other 2/3, and (b) their profits are relatively low. So
neither the public option nor health insurance market deregulati
deregulation,
on, either of which some may consider
virtuous in some way, will lead to noticeably lower costs.

The Congressional Research Office arrived at the same conclusion in its Nov 17, 2009 report to Congress:
“Policies focused on health insurance sector reform may yield some results, but are unlikely to solve
larger cost growth and problems of limited access to health care if other parts of the health are left
unchanged.” (Austin & Hungerford, The Market Structure of the Health Insuran
Insurancece Industry, 2009)

The evidence and analysis render the one remaining question

question—how
how large is the largest health insurer
and is it a monopolist—moot.
moot. Nonetheless, here is the data, based on all 2007 figures: In 2007, we
spent $2.2 trillion on health care.. Of this amount, 35% or ($770 billion) was paid by the private health
insurers. (The Henry J Kaiser Family Foundation, 2009) The top four largest health insurers accounted
for slightly less than 1/5 of the $770 billion paid out by the health insurance industry.2

Who pays the $2.2 trillion?

Out of pocket &

Government other private
programs - funds
Medicare, 19%
Medicaid, and
CHIPS
46%
United Health
3%
All other
Insurers WellPoint
28% 2%
Aetna
Humana 1%
1%

Greedy hospitals and doctors overcharge us, generating hefty profits

While some of our health care dollars go for prescription drugs, nursing homes, dentists, home health
care, medical devices, health insurance company profits, and a variety of other health care related
products and services, all of this amounts to around 46% of the total. More than half we spend on
hospitals (32%), and doctors and clinics (22%). (Americna Hosptial Association, 2009), (The Henry J
Kaiser Family Foundation, 2009)

2
Own calculations based on annual report data and 80% benefit payout ratio assumption.

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Of the total of 5,815 hospitals in the United States 982 are investor-owned for-profit businesses. The
rest are both private and government owned non-profit hospitals. (AHA, 2009) Fortune magazine
estimates the net profit of the medical facilities industry at 2.4% of revenues. (Fortune, 2009) The
American Hospital Association annual survey data, covering about 5,000 of the 5,815 hospitals in the US,
shows aggregate total hospital margins at the same level as Fortune magazine. The AHA survey data
shows these margins ranging between 3% and 7% since 1980. (Steinberg, 2009) Another survey based
on the Florida Hospital Uniform Reporting System between 2003 and 2005 shows average patient care
margin of 3.1% and average total margin (including margin from non-patient-related services) of 4.8%
before taxes. Interestingly, this survey notes that non-patient-related revenue was more important in
generating profit margins for non-profit hospitals than it was for for-profit ones. (Gapenski & McKay,
2009)

The only conclusion that can be drawn from these data is that while hospitals receive the single largest
piece of the $2.2 trillion dollars spent on healthcare, they in turn spend the money to care for patients,
and generate little in terms of profits. In other words, even if hospitals lowered their fees to achieve 0%
profit, we would have reduced total health care spending by only 0.7% in 2007.

The Bureau of Labor Statistics (www.bls.gov) is the source for the health care industry employment and
compensation data presented in the table below. (BLS, 2008)

# of practitioners Average annual salary Total compensation

Anesthesiologists 34,230 $ 197,579 $ 6,763,129,170
Family & general practitioners 106,210 $ 161,490 $ 17,151,852,900
Internists 46,980 $ 176,740 $ 8,303,245,200
OBGYN 19,750 $ 192,780 $ 3,807,405,000
Pediatricians 29,170 $ 153,370 $ 4,473,802,900
Surgeons 47,070 $ 206,770 $ 9,732,663,900
Psychiatrists 22,140 $ 154,050 $ 3,410,667,000
Physicians and surgeons, all other 262,850 $ 165,000 $ 43,370,250,000
Total Doctors 568,400 $ 170,677 $ 97,013,016,070

Total Registered Nurses 2,542,760 $ 65,130 $ 165,609,958,800

While the above data can be interpreted differently based on one’s bias, a strong argument can be
made that the $170,677 average annual compensation for a medical doctor is not overly excessive,
especially in light of the multi-million dollar compensation packages of Wall Street operatives that have
come to light in recent years. In addition, the total compensation for all doctors of nearly $97 billion is
only around 5% of total healthcare spending, even if we add to it related compensation benefits.
Furthermore, in comparison to other member countries of the Organization for Economic Cooperation
and Development (OECD), we have fewer practicing physicians per 1,000 people than most others.
(OECD, 2009) And while we spend nearly twice as much for nurses as we spend for doctors, it would be
hard to argue that the average nurse, even while making above average salary, is price gouging us.

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Finally, according to the US Bureau of Labor Statistics (www.bls.gov), of the 13.6 million people
employed by the health care industry (in 2006, a number which likely did not change substantially for
2007) 3.4% were physicians and surgeons, and 4.2% were managerial and executive staff. Even if we
supposed that each and every one of these doctors and executives was a millionaire, their total number
of 1.04 million individuals was just over 11% of the total number of millionaire households in the United
Sates at that time. (Krudy, 2009) Thus an industry that is 16% of the US economy likely supports less
than 11% of the millionaires in the US. (The BLS describes the other 92.4% of health workers as middle-
class Americans whose job requires certain skills and training but less than a 4-year college education.)

So having considered research and data on medical malpractice liability, the health insurance industry,
the hospital industry, and doctors and nurses compensation, it becomes quite apparent that neither of
these major players in the health care system enjoys excessive profits at the expense of patients.
Unfortunately, the vilification of various participants in the industry is so pervasive that it distracts us
from seeking and understanding the true reasons for high health care costs.

So where DOES the money actually go?

The analysis so far considered the three most common hypotheses of where our health care dollars go
(in the form of excessive profits), which covered 54% of the health care dollars. Certainly, there are the
other 46% of the $2.2 trillion. However, if we dig some more we will find somewhat higher profits but in
exceedingly small niches of the health care business. For example, pharmaceutical companies earn
19.3% profit (Fortune, 2009) but prescription drugs account for 10% of our health care expenses. (The
Henry J Kaiser Family Foundation, 2009) If pharmaceutical companies did not generate any profit, and
instead passed on the savings to the patients, this would reduce overall healthcare costs by only 1.9%.

Similarly, the medical products and equipment industry generates a profit margin of 16.3%, (Fortune,
2009) but its share of health care costs is even smaller than pharmaceutical.

The December 2009 PriceWaterhouse Coopers study cited earlier discusses a variety of factors, each
contributing ever so slightly to the increase in health care costs and to total healthcare spending. Among
these factors are increased utilization of services by insured individual, increased costs of new
technologies, increased charges by doctors and hospitals. (PWC, 2008) Ultimately, however, there
appears to be no smoking gun, no single major factor that drives total cost or explains cost increases.

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The visible and the invisible – who drives the Lamborghini?

Judging by our increasing health insurance premiums and by the frequent discussion of the subject in
the media, it is easy to see that the cost of health care is large and growing quickly. What appears
counter-intuitive to realize is that health care costs are high not because someone takes advantage of
us. They are high and rising fast because of a very inefficient system of delivering medical care.

Consider the following illustration of two groups of car companies: A and B. All of them sell comparable
(in terms of function, features, safety, and quality) automobiles for approximately $22,000. It costs the
companies in Group A around $20,000 to manufacture their models, and leaves them with $2,000 profit
per vehicle. At the same time, it costs the companies in Group B $21,950 to manufacture their models,
which leaves them with little to no profit. Why does it take some companies only $20,000 to produce
essentially the same product that cost the other manufacturers $21,950? The difference is efficiency.
The companies in Group B are simply more wasteful while the companies in Group A are more efficient
at producing the same final output. What happened to the $1,950 additional dollars that it takes
someone from Group B to make their car? It is simply lost as a result of inefficiency. It is very difficult to
see that it is a wasteful expenditure that benefits nobody. In the real world, the results of such
inefficiency are the bankruptcies of manufacturers such as Chrysler and GM (sustained as going
concerns only through huge bailouts) and the precarious survival of Ford in the face of the more
efficient competitors from Europe and Asia.

Our health care providers are in Group B – they spend more money to get us essentially the same (and
in some cases inferior) service as other countries’ health care industries. In other words, doctors and
hospitals charge us a lot (or overcharge us), but they do so because their operations are so inefficient,
not because they make outsized profit margins. If the hard data seem unconvincing, consider evidence
from popular culture—of all the surgeons in the three most popular TV medical series: House, Grey’s
Anatomy, and Nip/Tuck the wealthiest appear to be the plastic surgeons on Nip/Tuck. Only they get to
drive a Lamborghini.

What drives efficiency?

There are only two forces that drive improvements in efficiency. One is the pride of a lone inventor or a
small group of engineers to see the results of some innovative idea in practice. This is what drove
improvements in efficiency in the Soviet Union’s command economy. However, this is an unsustainable
and unreliable motive, since the same sense of pride by the potential inventor can lead to projects and
processes that decrease efficiency. The only other and the only sustainable driver of efficiency
improvement is the discipline imposed by a competitive marketplace.

Whether motivated by profits or simply by the desire to stay in business, suppliers of products and
services try to maximize the difference between the price and cost of their service. To maximize the

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price, suppliers are driven to bring to market products and services that are ever more beneficial, and
also to communicate the benefits of their offerings to the potential buyers. At the same time, suppliers
also seek out and conducting research and development for new materials, processes, and technologies
that would lower the cost of their offerings. In the absence of competitive pressure such efforts and the
resulting efficiency improvements never take place.

For example, the US retail industry has used bar codes to keep an accurate track of its inventories for
over a third of a century. Many others have followed over the years. In June of 2009 The New York
Times commemorated the 35th anniversary of the commercial use of barcodes writing:

Now they [bar codes] are used to board airplanes and track packages.
Bar codes help people with diabetes calibrate glucose meters and researchers
study the pollination habits of bees. They inspired a hand-held video game,
Barcode Battler, in 1991. They even played a role in the 1992 presidential race,
when then-President George H. W. Bush, at a campaign stop, seemed surprised
by what had already become a technological staple of everyday life.
Today, bar codes are scanned more than 10 billion times a day around
the world. And after 35 years, they are both the mundane minutiae of modern
life and cultural icons of cold efficiency, identification and control. “It was cheap
and it was needed,” said George J. Laurer, who was already a veteran engineer
at I.B.M. in 1970 when he was asked to lead a team assigned to devise a
checkout system for grocery stores. “And it is reliable. Those three things
probably contributed more than anything else.” (Shih, 2009)

At the same time, in June of 2009, The Detroit Medical Center was running billboard and television ads
(DMC, 2009) touting its status as the first hospital in Michigan and one of the first hospitals in the
country to use barcodes to track the medications it administers to its patients. Competition had created
an incentive for grocery stores to find a more efficient way to track their sales of Juicy Fruit gum (Shih,
2009), but the lack of competition had made it unnecessary for the Detroit Medical Center to use the
same inexpensive technology to improve the quality and lower the cost of its services until three-and-a-
half decades later.

Lack of efficiency results from the lack of competition and lack of prices

Fundamentally, our health care costs so much because our doctors and hospitals are inefficient due to
the lack of competition, due to the lack of price information. There is simply no market for health care.

One exception in the industry is the existence of a market for cosmetic procedures that are typically not
covered by medical insurance (neither private nor government), and are paid directly by the patients out
of pocket. These procedures include liposuctions, breast augmentations, and lasik eye surgery. Doctors
compete for patients’ business by offering information about their own qualifications, experience,

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technology used, and prices. A market is thus created. Market prices for these procedures are easy to
find just by doing a web search. Plastic and eye surgeons advertise their services, including prices and
discounts, on television. Some even put them on billboards.

(Photo by the author, March 2009,

Oakland County, MI).

Another interesting feature of elective cosmetic procedures is their ever declining prices. For example,
the prices reflected on the above billboard in 2009 are all lower than the 2007 national average prices
for the same procedures, as shown in the table below. (Nordenberg, 2009)

2007 National Average 2009 Dr. Rifai Billboard Difference

Physician Fees Advertised Fees
Breast augmentation $ 3,816 $ 3,400 -11%
Tummy tuck $ 5,264 $4,900 -7%
Liposuction $ 2,982 $ 2,000 -33%

While the above price comparison would only be valid and relevant for a potential client of Dr. Rifai’s
practice, the main point here is that pricing information for non-covered cosmetic surgery procedures is
publicly available, quite easy to access, and may indicate declining prices for these medical services over
time, likely the result of competition and innovation in the field.

Unlike prices for plastic and eye surgery, prices for covered medical services and procedures are next to
impossible to find. Web searches are futile and in many cases even direct requests for price information
from health services providers yield no clear price information. (Stossel, 2009)

A December 2008 report titled “Hospital & Physician Cost Shift – Payment Level Comparison of
Medicare, Medicaid, and Commercial Payers” prepared by the actuarial firm Milliman on behalf of the
America’s Health Insurance Plans and the American Hospital Association illustrates the lack of pricing
information for physicians’ services:

To estimate typical commercial physician fee levels relative to Medicare, we relied

on three proprietary databases which contain commercial physician claims,
nationwide. Physician fee levels vary among commercial payers. (Milliman, 2008)

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In addition, one of the US Department of Health and Human Services’ 12 agencies, the Agency for
Health Care Research and Quality (AHRQ, www.ahrq.gov) spends around $330 million a year (AHRQ
Budget FY 2010, 2009) for the Health Care Cost and Utilization Project (HCUP) and the Medical
Expenditure Panel Survey (MEPS). Aspects of each project are the collection of payment information for
physician and hospital services, but these cost data are a small component of data-gathering projects
that are intended for much broader research. Furthermore, as with the databases used by the Milliman
research, there is only information for the amounts paid upon discharging a patient. After all, some
amount of money is usually exchanged between the government or a health insurer and a service
provider for the total service rendered. But these historical data can be of use and is accessible
primarily to researchers, not to patients or others seeking to learn prices and make health services
purchasing decisions.

In 2006 Health Care Strategic Management summarized research efforts to obtain pricing information:

… at the individual level, patients have a difficult time determining the

actual prices they are being charged, especially before treatment.
In a survey limited to California hospitals, the California HealthCare
Foundation sent 622 "mystery shoppers" to 64 hospitals during a period of three
months.
The shoppers posed as uninsured patients seeking a price for one of 25
elective procedures and information about available financial assistance. They
contacted each hospital by phone and in person.
Nearly a quarter (24%) of the shoppers were unable to obtain the price
for the procedure they asked about. Among the 76% who did receive answers,
more than one-third had to make three calls or more.
Some were quoted several different prices from the same hospital,
according to the foundation report, because most hospitals did not appear to
have a designated person or department to provide pricing information.
(Anonymous, Feb 2006)

The Milliman study mentioned earlier also demonstrates something curious that goes on in the decision
on how much money will be transferred between the government agencies, private insurers, and
medical service providers. Put simply, the government decides, through an act of Congress and/or a
government agency, how much money it will transfer to health services providers for various treatments
through the Medicare, Medicaid, and CHIPS programs. Logically, these amounts are driven by several
factors: level of government revenues appropriated for these programs, priorities of the Congress men
and women, and lobbying efforts by the health services providers. In any case, for the last decade,
Medicare and Medicaid payments have NOT been sufficient to cover the costs of hospitals that provide
services through these two programs.

As a result, the services providers collect from private insurers sufficient amount to cover all of their
existing costs, including making up the shortfall from the government programs. The practice is called

13
cost shifting. (Milliman, 2008) Two conclusions follow from cost-shifting: First, under the existing
circumstances, doctors and hospitals prefer to, and are able to, shift costs from government buyers to
private buyers in order to cover their expenses instead of seeking and developing more cost-effective
solutions. Second, health services providers appear more focused on lobbying the government for
increased payments rather than figuring out ways to cut costs. The Milliman report was requested by,
and is an excellent bit of evidence for, the health services providers to lobby government for increased
payments. Interestingly enough, the report does not mention cost reduction or cost cutting at all.

It is noteworthy also that in public discussion of health care spending, the term used is practically always
cost and never price. The distinction is more than semantics. Hospitals and physicians speak of
payment levels and payment rates but not of prices. Those who pay (health insurance companies and
government Medicare, Medicaid, and state CHIPS programs) are referred to as payers and never as
clients or customers, or buyers. The differing amounts paid by the private insurers and the various
government programs for the same procedure are referred to as provider payment rates, not as
different prices. (Milliman, 2008)

While governments and insurance companies are capable of acquiring services through competitive
bidding (think stealth bombers and collision repair services), there is no competitive bidding in the
provision of health care. Competitive bidding requires prices, it requires a market.

Consequence of the lack of prices

The lack of pricing information contributes to the absence of competition. The absence of competition
leads to the absence of incentives to increase productivity. There are no incentives to increase
productivity because neither the ultimate users (patients), nor the proximate payers (insurers and the
government) have pricing information on which to base their health services purchasing decisions.

Behaving rationally under these circumstances, patients tend to choose the largest number of the most
expensive treatments they can. Two factors motivate this behavior: first, it’s the perception that more
and more expensive treatments would be better than fewer and cheaper ones; second, it’s the vicious
logic that “if I’m paying this much for health insurance anyway, I should take advantage of all the
benefits I can.” The net result—health care costs go up.

Behaving rationally under these circumstances, Congress uses its legal power to force providers to both
provide health care and to accept as payments in full funds that are insufficient to cover the cost of the
service rendered. The net result—lobbying and political jockeying goes up.

Behaving rationally under these circumstances, health services providers do two things—they shift costs
to private insurers (contributing to ever higher premium rates) and they seek to attract ever more
patients with private insurance by providing ever more advanced treatments (without consideration of

14
marginal benefit vs marginal cost). In this current situation there is no incentive to reduce costs.
Doctors and hospitals do not lose patients because other doctors and hospitals offer comparable
services for a lower price.3 The net result—health care costs go up but health providers fail to capture
proportionately grater profits.

Behaving rationally under these circumstances, health insurers make efforts to contain their costs. To
that end, health insurers prefer to write policies for large pools of individuals who have come together
for purposes other than to buy health insurance, such as employees of large employers. This provides
some degree of protection from adverse selection (the possibility of a group having a greater-than-
average number of people needing expensive treatments). Coupled with favorable tax treatment for
employer-sponsored health plans, this has all but eliminated the individual market for health insurance
(and explains why you don’t see an Aetna gecko and only a Geico gecko on TV). Insurers also try to
negotiate lower payments for services from health care providers, which results in the unnecessary
complication of physicians’ networks, in-network and out-of network charge differences, concerns by
insured individuals whether their personal doctor is a member of their new insurance company’s
network, etc. And in some cases when a legal justification can be found, insurance companies may drop
patients requiring very expensive treatments. (The Henry J Kaiser Family Foundation, 2008) The net
result—health care costs keep going up, the complexity of using the health care system goes up, some
individuals lose coverage; health insurers suffer public disgrace, and fail to capture proportionately
greater profits.

There absence of a market with prices and competition for health care services ultimately leads to
never-ending increase in costs, without corresponding increase in the benefit. In Senate Finance
Committee hearings in February 2009, the director of the Congressional Budget Office testified that,

“The available evidence also suggests that substantial share of spending on

health care contributes little if anything to the overall health of the nation… the
current system does not create incentives for doctors, hospital, and other
providers of health care—or their patients—to control costs.” (Elmendorf, 2009)

There are no economies of scale, no experience curve effects, and the discoveries of new conditions and
new methods, pharmaceuticals, and technologies to treat these new conditions simply add to the total
expenditures without any limit. If the current system and cost increase trends continue unchanged, the
Congressional Budget Office estimates that by the time this year’s newborns retire healthcare would
consume 100% of our Gross Domestic Product. (CBO, Nov 2007)

3
Procedures that are preformed both in hospitals and in clinics subject to competition provide an interesting
comparison. One such procedure is abortion. In 2001 women, using mostly low-cost abortion clinics, paid on
average of $372 for the procedure. In the same year the average hospital bill for abortion was 14 times greater -
$5,217. Sources: Guttmacher Institute (http://www.guttmacher.org/in-the-know/cost.html) and HCUP data
(http://www.hcup-us.ahrq.gov/)

15
Missing the forest for the trees – the misdirected attempts at solutions

Current health care reform efforts undoubtedly deal with great many issues, given the two-thousand
page bill passed by the US Senate. As reflected in the media, the emphasis has been on increasing
coverage so that many of the 45 million or so Americans who currently have no health insurance.

While universal, or at least increased, access to health care is preferable to the status quo, simply
mandating increased coverage without changing how the system works would only increase the total
amount we spend on health care. (Elmendorf, 2009) The additional costs will manifest themselves as
increased health insurance premiums, increased taxes of various types, and legal mandates for some
currently uninsured individuals to purchase health coverage (which has the same effect as an additional
tax). This is not to say that, as a matter of public policy, we should not change the system to enable
practically universal access to health care. But mandating universal access (whether through private
insurance or some form of public option is practically irrelevant) under the current cost structure would
only hasten our march along the unsustainable path of ever greater health care costs.

The current reform efforts do practically nothing to deal with the real cause of high health care costs
and the resulting limited access to it. As this analysis suggests, the costs are high and growing not
because of price gouging by insurers or health care providers, but because of the lack of incentives to
increase efficiency resulting from the lack of price information and competition. The Congressional
Budget Office director, Douglas Elmendorf, testified before Congress that the health care cost reduction
proposals being considered now might not yield substantial savings within 10 years, and some might
actually increase total health care costs, and further states that both patients and providers need
incentives to control costs. (Elmendorf, 2009) What other mechanism do we have, as consumers, to
control our costs other than the consideration of various prices before we make a purchase? And what
other mechanism exists there for companies to control their costs other than the threat of losing
customers to competitors who offer lower prices or greater values for comparable price?

Politicians speak of cutting waste in the Medicare and Medicaid systems. But even if the government
administers its programs more efficiently (clearly a desirable outcome), most of the inefficiency in the
health care system comes from the inefficient providers (doctors and hospitals). If government tries to
play hardball by underpaying providers, this will not motivate cost savings, rather induce more cost
shifting. It is what happens now. Cost savings do not come from government programs; they come
from discipline imposed by competitive markets and price pressures.

Tweaking the details of the current system would not solve the fundamental cause of high and rising
health care costs. Only making price information publicly available would naturally lead to reforms
throughout the health care system, which will lower cost, increase efficiency, increase access, and save
the US economy from going bankrupt. When, in the early 1990s, the Soviet Union collapsed and its
member countries moved from planned toward market economies the United States applauded. It is
time to do our own perestroika and move toward markets for health care services. It appears, however,
that the current reform effort moves us in the opposite direction.

16
The right direction for reform

Health care economist Jonathan Gruber in a 2008 talk at MIT (Gruber, 2008) makes an argument for
considering cost and access to health care as two separate issues to be addressed in separate reform
efforts. Vast disagreements over the cost control methods block reform that could solve the access
issue, on which there is a much greater consensus. This clearly seems to be the challenge facing the
current health reform effort in Congress. Gruber’s preference is for addressing the access issue first and
then focusing exclusively on the cost problem. His arguments are both logical and practical, especially
since covering the remaining uninsured in the US under the current cost structure would increase total
healthcare spending by only about 8%4, a one-time increase that is equivalent to roughly two years of
intrinsic health care cost increases. While in my assessment the cost issue has a greater priority, both
Gruber and I appear in agreement that the current reform efforts are not likely to lead to either
universal or increased coverage, nor to lower health care costs. And since the focus of this paper is on
the fundamental problem of high costs, here are a couple of possible cost reform directions:

As discussed above, tort reform and competition among insurance companies would not reduce medical
costs significantly. (This is not to say that there is no room for improvement in these areas, rather the
improvements are desirable but would not significantly lower overall health care costs.) Only the
discipline of competition among doctors and hospitals, however, would force innovation and efficiency
as it does in almost every other industry and may lead to reduced costs.

The first condition for competition is the existence of price. It is the ultimate reference. Federally
driven reform would be more beneficial if it requires publicly listing prices by all health service providers
for all services they offer. This would be no different than going into a grocery store and seeing the
price of every item posted next to it, or going to the gym and being able to find out what the price of
membership is, or going to an attorney, or to an auto mechanic, or to an architect and being able to ask
for both the hourly rate and the estimated total cost. Price would be a measure by which we can
compare doctors and hospitals. When we can compare two providers, this creates competition among
them and incentives to improve both efficiency and quality. The experience of Pennsylvania, which
started rating its hospitals on some measurable outcomes, resulted in competition among the providers
and led to lower costs and higher quality of health care. (Burton, 2009) Price is the easiest to see and
easiest to evaluate characteristic by which we can compare providers. The rest follows. Even the
Congressional Research Office, after considering the complexities of the healthcare industry and the
available empirical evidence, agrees that price transparency would increase efficiency and lower prices.
(Austin & Gravelle, Does Price Transparency Improve Market Efficiency? Implications of Empirical
Evidence in Other markets for the Health Sector, 2008)

If everyone has health insurance, people won’t care how much their procedure cost with one doctor vs.
another. This poses the challenge of getting people to become shoppers of health services. Effecting
such reform is beyond the scope of this paper, though a starting point may be to remove from health

4
Own calculations based on data from sources cited elsewhere in this paper.

17
insurance coverage procedures that are standard and predictable, such as annual exams. Predictable
risks are non-insurable events. We don’t insure ourselves against the possibility that an annual exam
might happen to us. We simply prepay the health insurance company the cost of the exam plus the
administrative costs and the profit margin. Our total health care spending would be cheaper if we
simply excluded the extra step of prepaying the cost of the annual medical exam to our health insurer,
and paid the doctor directly, and thus became more conscious of costs and choices in medical services.
Again, though, this is meant a direction for consideration, not a full-fledged policy solution.

Making pricing information available and making us shoppers for at least a few medical services offers
an opportunity for us to begin to form a market for health care. With markets comes competition—
lower prices, higher quality, greater innovation, and more value.

Some express concern that in emergency care situations hospitals and doctors will still be able to price
gouge us, even if we had a market for health services. This may be true to some degree in rural
environments, where there are no reasonable alternative to the one accessible ER. In most urban and
suburban areas individuals are in proximity to a number of different emergency rooms, and can as easily
go to, or request to be taken to, one over the others. Competition creates lower prices and better
service not by the individual customer bargaining with the supplier (clearly hard to while waiting for
medical attention in the ER) but by the threat each provider of service experiences of a customer
(patient) who has the option and a reason to choose an alternative provider. This only happens in an
environment of market competition.

18
 Appendix A

$1.56 Trillion – World’s total defense spending in 2007

$36 $12 US defense spending, incl. Iraq &

$47 Afghanistan
Europe defense spending
$85
China's defense spending
$95
East Asia/Australia defense
$660 spending
$135
Middle East / N. Africa defense
spending
$145 Russia defense spending

Latin America defense spending

$350 Central/South Asia defense

spending
Sub-Saharan Africa defense
spending

$2.20 Trillion – USA’s total health care spending in 2007

$48 $20
$20 US spending on Medicare,
$56
Medicaid, CHIPS

Out of pocket & other private

funds

US health insurers' (except the

four largest) benefits payments
$626
$1,012
United Health Group benefits
payments

WellPoint benefits payments

Aetna benefits payments

$418
Humana benefits payments

19
Sources: The Center For Arms Control and Non-Proliferation & The Henry J. Kaiser Family Foundation
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