A Cure for Our Health Care Ills: The Supply Side

We often hear that governments in the United States should regulate health care more because free markets have made it more expensive than in other countries. It’s true that medical care in the United States is usually more expensive than in other countries, even after accounting for differences in wealth. But the cause is not the free market. For more than half a century, there hasn’t been a free market in health care because governments at both the federal and state levels have heavily regulated doctors, hospitals, and drugs. We propose abolishing virtually all of this regulation so that doctors’ and hospitals’ services and drugs would be more plentiful and cheaper.

Further, governments and commercial third-party payers often make payments for health care, thus encouraging the ultimate consumers—patients—to spend “other people’s money.” This spawns restrictions, opaque prices, queues, and distortionary behavior that negatively affect both the demand and supply sides. Segments of the health care market in which customers pay suppliers directly have largely avoided these problems.

The Supply of Doctors

In a free market, if one person desires another’s services and the two parties reach mutually agreeable terms, they make an exchange. That’s not the system we have in medicine, as willing providers are often not allowed to sell to willing buyers. The outward rationale for governmental and quasi-governmental control of physicians’ services is consumers’ supposed incompetence: how can we know what good care is? The result is reduced competition, which leads to higher prices for doctors’ services.

To provide medical services as a doctor, one must be licensed, and to be licensed, one must have completed a four-year undergraduate degree and a four-year medical degree, plus four to six years of residency training.2 There are only 141 accredited medical schools in the United States, and Congress anchors the number of residency positions to the level of Medicare funding, resulting in 110,000 residency positions currently filled.3, 4 Want to unlock more residency positions? Talk to Congress. Want to start a new medical school? It would cost an estimated $150 million, due to the necessity of linking medical education with medical research, and would take eight years for the Liaison Committee on Medical Education, under the authority of the U.S. Department of Education, to accredit your school.5 That’s a daunting prospect. One small bright spot is that, despite these challenges, new medical schools are, in fact, cutting ribbons.6

While the majority of physicians are not members of the American Medical Association, the AMA has successfully persuaded the government to limit the freedom of nurse practitioners, midwifes, chiropractors, foreign doctors, and retail clinics to provide economical medical care.7 Foreign medical graduates fill about 15 percent of residency positions. Many more trained foreigners would prefer to practice medicine in this country but are not allowed to under laws that have little or nothing to do with professional competence.8 Even if foreign physicians are allowed to immigrate here, to scale the imposing wall of rules facing them—verifying their credentials, proving English proficiency, passing the United States Medical Licensing Examination, working or volunteering with the purpose of acquiring letters of recommendation, and winning a coveted residency position—takes about a decade. Many simply give up.

The resulting reduction in the supply of medical services has rewarded American physicians with incomes that are, relative to per capita GDP, fifty percent higher than those of their OECD contemporaries.9, 10 By implicitly assuming an elasticity of demand of zero, McKinsey estimated this “extra” cost of physician compensation at $64 billion in 2008.11

While customers certainly benefit from knowing beforehand the quality of the services and products they may purchase, occupational licensing is merely one way to address that objective. Private rating organizations can also achieve the same goal, usually with fewer untoward consequences. There are other ways to ensure quality. Kaiser Permanente and your local hospital certify that the physician helping you is, indeed, qualified to treat you. In addition, the medical school that the doctor attended, self-policing actions by professional medical societies, peer review procedures, and the use of second opinions can help us ascertain and ensure physician quality.

The Supply of Hospitals

Public health professor Milton Roemer, while teaching at Cornell University in 1961, wrote an article laying out what has been termed Roemer’s Law: whenever hospitals add beds, those beds fill up. Or, in Field of Dreams terms, “if you build it, they will come.”12 Roemer’s Law caused people to question whether doctors had a financial incentive to fill hospital beds, which led to the hypothesis that a limitation on hospital expansions would limit overall health care expenditures.

Regardless of the veracity of Roemer’s Law—more a localized observation than a validated law—it inspired “certificate of need” (CON) rules that threatened serious penalties for hospitals that built without a CON in hand. CON requirements put facility planning firmly in the hands of central planners, and hospitals reacted accordingly by acting politically and gaming the system.

Consider Cedar Rapids physician Lee Birchansky, who, after performing cataract surgeries for six years at his clinic, was forced to stop because a change of ownership required him to get his own CON, independent of the local hospital under whose umbrella he had operated. That was 2004, and his expensive equipment sits unused today because the state government turned down his request—four times. “The established health care provider uses this as a way to keep out competition,” says Iowa governor Terry Branstad. And not just new competition—Birchansky had operated for six years without problems.13

In a review of the literature, Michael Morrisey concluded that “rather than controlling costs, if anything, CON programs tended to increase costs.”14 When President Ronald Reagan and Congress repealed the federal CON laws in 1986, about one third of the states followed suit. Not surprisingly, given Morrisey’s findings, economists found no subsequent increase in total health care spending as a result of the repeal.15

CON laws are anti-competitive, as they make it relatively easier to expand existing hospitals than to build new, competitive ones. We tend to find sprawling hospitals where people lived years ago, not necessarily new hospitals where they live today. Another result has been corruption. Some states haven’t followed the federal lead, and Illinois has some of the toughest CON laws in the nation. In one prominent case of corruption, a hospital CEO wore an FBI wire to record warnings from developers and bankers that the planning board would deny the hospital’s CON request if she didn’t use their services.16

Whether or not Roemer’s Law is actually a law, and whether or not filling hospital beds is truly a problem, CON rules aren’t a viable solution.

The Supply of Drugs

Pharmaceuticals are one of the most regulated products, and this regulation has limited their supply.

There have been two noteworthy pieces of legislation. The Food, Drug, and Cosmetic Act of 1938 required pharmaceutical companies to test their drugs for safety before marketing. After the Kefauver-Harris Amendments of 1962, pharmaceutical companies were required to test their drugs for both safety and efficacy. The net result, especially for the efficacy requirement, has been a steep increase in the time and cost of getting a new drug approved.

Capitalized drug development and approval costs have increased at 7.5 percent per year in real terms: $179 million in the 1970s, $413 million in the 1980s, $1,044 million in the 1990s through early 2000s, and $2,558 million in the 2000s through early 2010s (in 2013 dollars).17 If this 7.5 percent annual growth rate were to persist, costs would more than double every ten years.18 To get one new drug now, pony up $3 billion; in ten years, come up with $6 billion.

When the cost of developing a drug increases, we would expect the number of new drugs developed to decline. The empirical data show exactly that.

In 1973, economist Sam Peltzman analyzed the effect of the Kefauver-Harris Amendments by comparing the number of new chemical entities (i.e., not just reformulations) approved by the FDA before the law changed—from 1948 through 1962—with the number approved after the law changed—from 1963 to 1972—as well as econometrically projected values for that same 1963-1972 period.19

For the drug approvals from 1948 through 1962, Peltzman used actual, historical values. He then built a model to project the number of approved drugs from 1963 through 1972 to see how many approvals would have been expected had the law not changed. His model was based on three variables, most notably the size of the prescription drug market lagged by two years. Why two years? Prior to 1962, it took just two years to develop a new drug; it now takes 12 to 14 years.20, 21

That statistic alone should give us pause because it indicates how drastically things have changed since 1962. Using his projections, Peltzman looked at the actual number of new chemical entities approved and found that it was a shocking 60 percent below his model’s projections.22

According to his model, there should have been about 40 new approvals each year, but, instead, there were just 16, which is 60 percent lower than the predicted value. Multiple researchers have concluded that it wasn’t just inferior drugs that were weeded out by the FDA’s process. Two researchers wrote, “In sum, the hypothesis that the observed decline in new product introductions has largely been concentrated in marginal or ineffective drugs is not generally supported by empirical analyses.”23

Peltzman, himself, came to this same conclusion, seeing the culling “as… if an arbitrary marketing quota… had been placed on new drugs after 1962.”24 The Kefauver-Harris Amendments, designed to improve the safety and efficacy of new drugs, resulted in 60 percent fewer new drugs—a total of approximately 1,300 fewer since 1962—and no clear evidence that today’s drugs are safer or more efficacious than they would have been absent the new rule.

Peltzman wrote, “The penalties imposed by the marketplace on sellers of ineffective drugs before 1962 seem to have been sufficient to have left little room for improvement by a regulatory agency.”25 Repealing the Kefauver-Harris Amendments would give us more drugs and cheaper drugs. Why cheaper? Because new drugs apply competitive pressures on existing drugs and help hold down prices.

Third-Party Payers

In our previous article,26 we noted the simultaneous technological improvements and cost reductions in eye surgery, a corner of the health care market largely free from governmental and commercial third-party interference.27 While third-party payment does offer some advantages, it tends to increase the cost of health care and reduce its availability. Canada’s socialized health care system and the advent of medical tourism provide two examples of this principle.

Consider Canada, whose single-payer system is called Medicare. In Canada, people must often wait many weeks for various procedures and doctors’ visits. The Fraser Institute, a think tank in Vancouver, has reported wait times since 1993, and, after years of increases, wait times between referral from a general practitioner and receipt of treatment hit a record 21.2 weeks in 2017.28

Canadian pets don’t wait. Veterinarian Danny Joffe explains the discrepancy between humans and animals receiving MRI scans. “For [humans] it might be a several-month process. We get it done [with pets] in a week or less.”29 While CT scans for pets are nearly identical to those done for humans,30 “[a] Canadian newspaper reported that in Toronto in 1991, dogs could get CT scans for $300 with less than 24 hours notice, whereas people had to wait up to three months for the same CT scanner. Why couldn’t people get scans as easily? Because, explained the news story, only the provincial health service could legally pay for a human CT scan.”31 This service is available immediately for pets because customers pay out-of-pocket. When the government pays and patients pay a zero price, patients have to queue. This causes some Canadian patients to travel across the border for scans.32, 33 According to Canadian Medical Association President Brian Day, “People can and do spend money on their pets—but if it’s their own body, they have to join a lineup and wait for that care unless they leave home and go to another province or country.”34

Medical tourism provides an example of how third-party payment makes medical care pricier. Medical tourism refers to patients traveling to other countries for medical care, especially when that care is so inexpensive that the amount saved covers all the medical and travel expenses. Look at American and overseas prices and you’ll notice a key difference between surgical procedures with substantial third-party coverage and those with substantial out-of-pocket payments: procedures for which patients pay a considerable portion of costs have smaller U.S. to ex-U.S. differentials.

Consider costs in the United States versus in Singapore. The costs for heart bypass and heart value replacement—both paid for largely by third parties in this country—are over 750 percent higher in the United States, while the costs for a tummy tuck and LASIK—both paid for largely out-of-pocket by patients in this country—are only about 40 percent higher in the United States.35 The same relationship largely holds for other countries compared, such as Colombia, India, Jordan, Thailand, and Turkey. American costs are closer to those in other countries when the final consumer pays than when a third party pays.

Conclusion

Freeing the supply of health care is beneficial due to enhanced price competition, improved access, and new technology.36

The solution in all the cases explored above is deregulation, such as removing anti-competitive licensure and CON laws. The way to improve the health care system—both the supply and demand sides—is to make health care more like other goods and services that we purchase directly, while still providing financial protection for those unlucky enough to need expensive care.

Footnotes

[1] Charles L. Hooper and David R. Henderson, “A Cure for Our Health Care Ills,” Library of Economics and Liberty, June 4, 2018.
[2] David Dranove, Code Red, An Economist Explains How to Revive the Healthcare System Without Destroying it, Princeton University Press, 2008.
[3] Logan Albright, “How Government Helped Create the Coming Doctor Shortage,” Mises Institute, 3 February 2015.
[4] Roger Stark, “The Looming Doctor Shortage,” Washington Policy Center, Policy Note, November 2011. PDF file.
[5] Stark, “Looming Doctor Shortage.”
[6] Anemona Hartocollis, “Expecting a Surge in U.S. Medical Schools,” The New York Times, 14 February 2010.
[7] Sue A. Blevins, Cato Institute Policy Analysis No. 246: “The Medical Monopoly: Protecting Consumers or Limiting Competition?,” 15 December 1995.
[8] Dean Baker, “The Post’s Protectionism Strikes Again: It Never Heard of Foreign Doctors,” The American Prospect, 5 December 2009.
[9] “Accounting for the cost of US health care: A new look at why Americans spend more,” Exhibit 14, McKinsey Global Institute, December 2008. PDF file.
[10] Carolyn McClanahan, “Physician Pay: A Big Driver of Health Care Costs?” Forbes, 19 January 2012.
[11] “Accounting for the cost of US health care: A new look at why Americans spend more,” Exhibit 15, McKinsey Global Institute, December 2008. PDF file.
[12] David Dranove, Code Red, An Economist Explains How to Revive the Healthcare System Without Destroying it, Princeton University Press, 2008, p. 32.
[13] Erin Jordan, “Iowa hospitals use state law to stifle competition, critics say,” The Gazette, 14 August 2016.
[14] Dranove, Code Red, p. 69.
[15] Dranove, Code Red, p. 70.
[16] Dranove, Code Red, p. 70.
[17] Joseph A. DiMasi, “R&D Cost Study Briefing,” Boston, MA, November 18, 2014. PDF file.
[18] Charles L. Hooper, “Hooper’s Law of Drug Development,” Library of Economics and Liberty, August 7, 2017.
[19] Sam Peltzman, Regulation of Pharmaceutical Innovation, University of Chicago, 1974.
[20] Gail Van Norman, “Drugs, Devices, and the FDA: Part 1: An Overview of Approval Processes for Drugs,” JACC: Back to Translational Science, Volume 1, Issue 3, April 2016.
[21] Deloitte’s Center for Health Solutions annual report, 2016.
[22] Peltzman, Regulation, University of Chicago, 1974.
[23] Grabowski, Henry G., and John M. Vernon, 1983. The Regulation of Pharmaceuticals: Balancing the Benefits and Risks. Washington D.C.: American Enterprise Institute for Public Policy Research.
[24] Peltzman, Regulation, 1974.
[25] Peltzman, 1974.
[26] Hooper and Henderson, “Cure for Health Care Ills.”
[27] Hooper and Henderson, “Cure for Health Care Ills.”
[28] “Waiting Your Turn: Wait Times for Health Care in Canada, 2017 Report,” The Fraser Institute, 7 December 2017.
[29] “Veterinary Care Faster Than Health Care for Humans,” by Barbara Righton and Nicholas Köhler. The Canadian Encyclopedia, May 25, 2008; edited December 16, 2013. Historica Canada, from Macleans, 12 May 2008.
[30] know” target=”new”>”CT Scans in Pets: Everything You Need to Know,” PetMD.com.
[31] David R. Henderson, The Joy of Freedom, An Economist’s Odyssey, Prentice Hall, 2002, p. 269.
[32] Canadian Patients. WindsongRadiology.com.
[33] “Leaving Canada for Medical Care, 2017,” The Fraser Institute, 29 June 2017.
[34] ““Veterinary Care Faster Than Health Care for Humans,” by Barbara Righton and Nicholas Köhler. The Canadian Encyclopedia, May 25, 2008; edited December 16, 2013. Historica Canada, from Macleans, 12 May 2008.
[35] Medical Tourism, Compare Prices for 2018.
[36] David Cutler and his colleagues have found that the benefits of new health care technology generally outweigh their costs by five to one. David Cutler, Your Money or Your Life: Strong Medicine for America’s Health Care System, Oxford University Press, 2005. Also see Dranove, Code Red, p. 231.