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The Economics of Healthcare


The Economics of Healthcare
A Brief Memorandum from the Virginia Institute for Public Policy

Caleb Taylor

An extremely brief history of American healthcare

Over the last 10 years, the healthcare market has been among the most important issues for Americans, almost singular in it’s significance. The public’s obsession can largely be attributed to the considerable increase in health insurance costs which have followed the implementation of the Affordable Care Act (ACA) in 2010. Public memory is short, however, as the ACA was itself a response to the increasing costs of medical services, much of which has stemmed from the Medicaid/Medicare programs of 1965.

The issue with both Medicaid and the ACA has always been a fundamental misunderstanding of the Laws of Supply and Demand. Robert Graboyes, Senior Research Fellow with the Mercatus Center and co-creator of the Healthcare Openness and Access Project, has said that the biggest issue with the ACA and Medicaid has been that it inadvertently increased demand for healthcare without providing any mechanism by which to increase supply. In fact, with the added regulatory burdens of Medicaid alongside further ill-advised measures such as the Certificate of Public Need policy, it might be reasoned that the growth in the supply of medical services was obstructed over the same period. The effect according to the Centers for Medicare and Medicaid Services (CMS): healthcare spending has increased an average of 9.16% annually from 1965 to 2015; a substantial growth rate considering that GDP has advanced an average of only 3% per annum over the same period.

Economics 101 and Medicaid

As designed, Medicaid has redistributed a considerable percentage of each American’s wages into the healthcare system. Currently, in Virginia an estimated 30% of the state budget, approximately $34.5 billion, will be spent on healthcare alone. As this money makes its way into the market, demand for medical services increases. Whether an increase in demand is natural or policy driven means little to the market; without a coinciding increase in supply, prices must also increase.1 Unlike consumer monies, however, Medicaid funds have always come with considerable strings attached and cannot (easily) be used for any substitute or complimentary treatments, and, most significantly, cannot be entirely removed from the healthcare market (i.e. to be spent on food, housing, or entertainment). Market actors on both sides of the equation (service providers, and Medicaid recipients) see this inflexibility and find ways to engage the system to their benefit. This additionally introduces two costly problems for the Medicaid system: the open access problem, often called the tragedy of the commons, and moral hazard. These problems, among others, create ancillary costs by effectively decreasing the total welfare benefit received in the Medicaid system, currently estimated at 20 to 50 cents per dollar spent, according to a 2016 study out of MIT.2

Further unintended consequences of Medicaid

Increased costs are not where the effects of Medicaid, and its reforms end. Each new spending-based reform supplies new ripples, leading to new and different “market mutations” which themselves must be reformed. Below is a short list of ripples with a brief explanation.

  • Service rationing (wait listing): Over the last 4 years alone, there has been a measured 30% increase in wait times for new patient physician appointments. From an economic standpoint this is a shortage, which can nearly always be attributed to a price ceiling. Price controls are a common occurrence in the formula driven Medicaid system. Prices and price changes signal producers and consumers to appropriate economic action within the market; as such it is impossible, and usually harmful, to attempt to efficiently regulate these economic triggers through statutory means.
  • Restricting or obstructing the growth of supply: Several attempts have been made historically to fix the increasing costs associated with Medicaid and Medicaid expansion. The earliest attempt was Certificate of Public Need (COPN), which was adopted nationally in 1974 and repealed in 1987 but is currently codified in 34 states, including Virginia. James Bailey, Assistant Professor of Economics at Creighton University, expresses that because of the relative inelasticity of demand in the healthcare market COPN laws actually decrease supply exacerbating the problem and leading to even higher consumer prices. In similar fashion, some states have recently attempted to offset costs using taxes on service suppliers such as hospitals. These efforts bear little difference to corporate taxes, and thus will likely have the same effect. According to a 2005 study by Young Lee and Roger Gordon,3 corporate taxes decrease a business’s profit margin and thus diminish the owner’s incentive to invest further in the venture. In the same way that corporate tax rates have a significant negative correlation to economic growth, new taxes may lead to decreases in supply and increases in consumer prices.
  • Effectiveness of alternative care options: Since the 1950s, charity giving has increased by a factor of 3.5 when measured on a per capita basis. When calculated as a proportion of GDP, the growth in charitable giving almost mirrors growth in GDP at about 2% per year. Unfortunately, the increase in healthcare costs over the same period far outstrips that of total charitable giving, utterly eliminating the ability of the most charitable people in the world (Americans) from helping to serve those most in need in their own country.

Expansion as a solution for Medicaid: Seriously?

As marginal service costs increase, some states have taken advantage of the option to expand Medicaid eligibility through the ACA. It should be noted that the negative economic effects of Medicaid will expand alongside eligibility. As Brian Blase has noted, state expenditures have increased dramatically due to a woodwork effect which sees Medicaid roles expand far more dramatically than program projections have expected. By 2016, initial CBO enrollment projections were adjusted 50% higher than their 2010 counterparts, and health officials from states which have already expanded Medicaid have warned some advocates and legislators in Virginia to realistically expect double the current estimates. The breakdown: whereas current public/private estimates run from 400,000 to 506,000 new enrollees, the Commonwealth might be better served to expect between 800,000 and 1.12 million newly eligible Medicaid recipients. This would roughly increase the current number of Medicaid recipients twofold in the state, and Virginia has already experienced complications with wait-listing, consistent increases in service costs, budget short-falls, and deaths attributable to inadequate availability of services. More money does not necessarily equate to better outcomes; a sentiment which is particularly true of Medicaid. However, the expansion of consumer choice and responsibility in healthcare will create the kind of outcomes that Virginia really needs.

1 The use of the word “prices” is important as opposed to the word “costs.” I use this word to specifically indicate marginal costs borne by the consumer (i.e. cost per service or good). It is important to also note that due to the design of Medicaid the government has also become a consumer in the healthcare market and must bear these increasing marginal costs as well.

2 Dependent on analytical methodology.

3 Cut and paste link: