Sunday, November 29, 2009

Entitlement Programs Drive Health Care Innovation

America's health system is a world leader in innovating new treatments for many diseases. This is often attributed to competition in the delivery of health services. What is generally overlooked, however, is the way entitlement programs contribute to innovation.

When I say "entitlement programs", I'm referring specifically to Medicare, Medicaid, and any program in which government at any level pays for medical services, generally for those who would be otherwise unable to afford these services. Such programs account for around half of the health care spending in America. They are frequently blamed for the high cost of health care in America. The reality, however, is far more complex.

Entitlement programs do undoubtedly increase demand for health care services. By their very nature, they generally provide payment for services for individuals who would not have the financial means to demand these services otherwise. And increasing demand, according to basic economics, does indeed drive up prices for a scarce good.

But the history of economies since at least the Industrial Revolution shows that there are far more factors at work. Indeed, the success of economies of scale in driving down prices for countless products (think computers, as an obvious example) has led to a widespread belief that the fundamental economics principle is that increasing demand actually lowers prices. While this is not true in the case of a scarce resource, what is true is that increasing demand creates incentives to produce more of a product, and do it more efficiently (aka cheaply), which causes an increase in supply that actually drives down the cost. Increases in supply actually do decrease prices, according to fundamental economic theory. So increases in demand frequently are countered by larger increases in supply, which has a net effect of driving down prices.

Entitlement programs are typically designed to accommodate people who have no reasonable means of paying for their own treatment (i.e. they are unable to generate "demand" for services). They primarily are for the elderly and the disabled. The disabled, obviously, are unable to work and therefore unable to provide economic incentives for health care providers to meet their needs. And the elderly, while they may have access to significant financial resources after a lifetime of working, will frequently find that their medical costs will generally exceed what a lifetime of aggressive saving and investing could have accumulated for all but the wealthiest. Simply put, without entitlement programs there would be little economic incentive for health care providers to increase the amount of services they deliver. Without these incentives, it is likely supplies of medical services would be far lower and it is quite possible that prices for these services would be even higher than they are now.

Even more interesting is considering what medical services would simply not be available were it not for entitlement programs. Consider that most new medical innovations cost billions of dollars to develop. Then consider that most new innovations are only useful to a small percentage of the population afflicted with an ailment that might actually benefit from the specific innovation. You're now talking about an item that costs many billions to develop, but might only be useful to a few million people. Now, consider that if we took away entitlement programs, only a small percentage of the people who could benefit from an expensive new innovation will actually be able to afford it. That changes the economics of product development considerably. Now, rather than a new innovation potentially delivering treatment to a few million people, it might only deliver treatment to a few hundred thousand people (or less!). The cost-benefit analysis for seeking new medical innovations changes significantly as the number of people who could potentially afford to use the innovation goes down...and that is precisely what would happen if we ended entitlement programs.

Right now in America, about 80% of the population is covered by either a government program, or by health insurance through their employer which is heavily regulated by the government to prevent companies from denying payment in all but the rarest of circumstances. When developing a new medical treatment, companies can essentially count on the fact that at least 80% of the people needing their treatment will be able to pay for it. (In reality, it's probably much higher because people with serious diseases often become eligible for government benefits.) In a truly market-based system, government would not get involved to provide services for the severely ill. Further, private insurers would be free to eliminate the seriously ill from their plans. Ultimately, only the seriously ill who are also extremely wealthy would be able to afford to pay for treatments of serious diseases. The net effect is the financial demand for medical innovations would drop by roughly an order of magnitude (aka ten-fold) as we go from a system where close to 90% of the people needing serious medical treatment have a way to pay for it, to a system where probably fewer than 10% of people needing serious medical treatment have a way to pay for it.

What do you think will happen to the pace of medical innovation in our country if demand drops by around 90%?

It's true that a "socialized" way of paying for medical services will drive up the cost for healthy people. But what is also true is that when a healthy person becomes an unhealthy person, as nearly all of us do at some point in our lives, a "socialized" method of paying for medical services not only guarantees we will be able to afford treatment when we need it, it also means we will have far more medical treatments and innovations available to us than we would in a purely free-market system of paying for health care.


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