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Saturday, June 27, 2009
Inefficiency, Transaction Costs Plague Health Care
By Allen M. Parkman
Management Professor
Every day we read about new efforts in Washington to reform the health care industry. The most common concerns are controlling costs and expanding coverage to those who do not currently have insurance. President Obama has recently proposed $313 billion in cuts in costs while expanding coverage to 46 million currently uninsured individuals at a cost of $1 trillion over the next decade. History suggests that any cost reductions will be hard to obtain and expanded coverage will be very expensive.
On closer scrutiny, the problems with this industry should be viewed differently, as purchases of health care are often inefficient with unnecessary transaction costs. Let me explain. They can be inefficient because consumers are not exposed to the true cost of the services they are receiving and, consequently, the benefits may not justify the costs. In addition, there are unnecessary costs associated with each transaction. In contrast to a simple credit card purchase at a grocery store, health care expenses covered by insurance require additional paperwork for the provider and then administrative scrutiny from the insurance company.
Both of these problems exist because of the inappropriate use of insurance with regard to health care. Normally, we buy insurance to convert uncertainty into certainty. For example, we pay a predictable premium for fire insurance with the understanding that we will be reimbursed if our house burns down. We have converted an uncertain event (the burning of our house) into a predictable event (a premium and reimbursement if there is a fire). Fire insurance is fairly inexpensive — because it is seldom used.
The need for many health care services are predictable — annual checkups and routine doctor visits, for example; so under normal conditions we would not expect people to buy insurance to compensate them for these expenses. Any insurance would just increase the cost of those services due to the administrative cost associated with reimbursement. Just as with fire insurance, we would expect people to buy health insurance to cover unexpected, high priced medical expenses.
However, most people have much broader health care insurance than I just described. They have insurance that provides compensation for part of essentially all health care purchases. Approximately 60 percent of Americans have that type of insurance through their employer and another 25 percent have it through government programs such as Medicaid and Medicare.
Employer-provided heath care insurance has an interesting history. Changes in the Internal Revenue Code during World War II permitted employers to provide this insurance to its workers without the benefit being treated as income to the employee. Paying for health insurance in before-tax dollars makes it particularly attractive. So, people want health insurance with broad coverage to reduce their expenditures from after tax dollars. They want low co-payments and deductibles that isolate them from the true cost of the health care that they are obtaining. If each dollar of health insurance was costing the worker a dollar that could be spent on something else, many would reject the current insurance plans and look for lower cost alternatives.
A proposal circulating in Washington that is not intended to address my concerns about inefficiency and high transaction costs has the potential for dealing with those concerns. Proposals to treat employer provided health insurance as income to the employee are based on concerns about fairness and the desire to increase government revenues.
The proponents have not recognized the expected change in behavior. If the employees are taxed on the value of their health insurance, they will have an incentive to encourage their employer to find a lower cost alternative — and give them the difference as income. An obvious way to reduce their premium is to avoid the transaction costs associated with predictable services by buying insurance with a higher deductible. When more consumers are confronted with paying for these predictable services, it will put pressure on doctors and hospitals to adjust prices. Prices currently are high — often resulting in disasters for the uninsured — so the hospitals and doctors can offer "discounts" to insurance companies. Currently, the insured do not care about those prices — because they do not pay them. They will care if they are paying them. Then the providers will have incentives to innovate with less skilled professionals being used when that is practical, for example.
With more realistic prices, some of the problems facing the working uninsured will be reduced. There still may be a role for the government providing catastrophic coverage for those individuals and families.
In conclusion, real health care reform does not come from promising cost reductions and expanding coverage. It comes from making processes more efficient.
Dr. Parkman is regents' professor emeritus of management at the University of New Mexico's Anderson Schools of Management.
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