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.

Why finance professionals earn so much...for knowing so little

About five years ago I applied for a job as a financial advisor with a large, reputable financial services firm. I have a strong aptitude for math and a strong background in customer service, so I thought this would be a good fit for me personally as well as highly lucrative. I made it through a couple rounds of the process, but was confused by one thing: nobody seemed the least bit interested that I had no background in finance. While I felt confident that I could learn this field quickly, I didn't understand why I was never asked to provide all the answers I had prepared to justify my suitability for this position without a finance background. I finally asked an interviewer how I was supposed to provide the services I was selling when I had little formal background and the training period was only about a month.

His response: you don't need to know anything. We'll provide you the basics to sound informed. You just have to project confidence and sell the product. Once you pick up clients and have money to play with, you'll figure it out as you go along.

I couldn't handle the ethical implications of selling myself as a "professional" or "expert" so I could get other people's money to play with and figure things out. It's too bad, I might have made a lot of money. Instead, I decided to take my interest in economic and financial issues and pursue a career that seemed more genuine. I chose accounting.

Interestingly, as I was recently reading Nassim Taleb's "Black Swan", I came across a chapter on the "expert problem". Basically, some fields have true experts and some don't. Some "experts" have a lot of facts, but don't have a genuine understanding that translates into better results than what a non-expert would get through simple chance. Other experts (think surgeons, farmers, engineers) are genuine experts who will consistently deliver results far more useful and accurate than a non-expert could produce. Taleb confirmed my impressions of financial advisors and accountants by putting financial advisors squarely in the "expert" category, and accountants in the expert category. There's plenty of empirical evidence to back this up, of course...80% of mutual fund managers aren't able to beat average market returns; in the years prior to the (now obvious) meltdown of securities, most advisors were recommending buy-and-hold for stocks, and buying as much home as you can finance; just to name a couple of the more obvious examples.

So the question is, why are financial advisors and analysts and others in the "expert" category compensated so much better than accountants and others in the expert category? Why do the people who are unable to demonstrate any level of skill beyond what's easily explainable by pure chance demand so much more compensation than the people who can actually explain what they're doing and why and how it works?

And recently I realized why there is a disparity. And it's precisely because accountants practice a consistent method while financial advisors practice alchemy.

One of the pitfalls of the human brain (Taleb, among many others, discusses this at length) is our weakness for the narrative fallacy. We want a theory, a story, a narrative to explain every phenomenon. Even when the best theories are proven wrong over and over again, if nobody suggests anything better, we will assume the best narratives are accurate (even when proven wrong) until something better comes along. We are unable to simply accept that sometimes the only correct answer is, "Nobody knows."

In accounting, the best practices are known and have been understood and refined for many centuries. As a result, these practices have become broadly taught and can be practiced very systematically. Therefore, many people have been trained to be accountants, and they nearly all deliver consistent results.

In finance, the best practices are unknown. There is no proven strategy that has consistently been proven to perform better than average (of course, such a strategy is impossible, but that's another discussion). As a result, everybody comes in with their various ideas and narratives about how the market works. Through sheer luck, some will wind up doing much better than average. However, because of our human tendency to see order where there is none, we will attribute this success not to luck of the draw, but the accuracy of the person's methods and ideas. Over time, most will experience runs of bad luck as well as good, but a small number, by sheer luck, will have a long run of success. If humans were rational, we would see these "successful" stockbrokers, advisors, and analysts for what they are: lucky. But instead, we believe there must be an explanation behind their string of luck, it must be because they are extremely talented. And because this "talent" is so rare (runs of good luck are rare things, after all), the market is willing to pay extraordinary prices for this rare "talent".

Of course, to somebody considering whether to go into accounting or finance, the decision is easy if you only look at top salaries (or even average salaries for those who've been in the field for many years since, after all, only those who remain relatively lucky overall stay in the field). However, if you average in all of those who have "failed" at finance by being unlucky, and therefore left the field altogether, the picture might be very different. Either way, the wisdom of entering one field or the other ultimately boils down to one characteristic more than any other: luck.

Just goes to prove the old adage: It's better to be lucky than good.