The Cost of Healthcare Isn't the Price Tag, It's the Resources Used To Produce It

The cost of something isn't the nominal price.

Suppose we all set aside half of our nominal earnings and threw them into a black hole, then called it "health spending." I'm assuming away all the deadweight losses due to taxation and transaction costs associated with monitoring and accounting for this tribute: we all just spontaneously give up half our dollar incomes, perhaps burning them at the Altar of Health Care. (Or, to make it nearly costless, deleting digital currency at the Altar of Health Care.) If this ritual were strictly observed, it would not affect the real economy at all. It wouldn't mean Americans had less command over goods and services. The dollar would deflate, because we'd each have exactly half as many dollars chasing the same amount of goods and services. But some careless analyst who added up all expenditures on health care would wrongly conclude that health care consumes over half our income (the half of our income sacrificed to the Health Care Gods, plus any real spending on health care). I think that something similar is happening in the American economy. I think the very high spending on health care is something of an accounting illusion. (I'll say at the end why this might not be the case.) 

I recently came across this excellent article on healthcare costs (hat tip to Scott Alexander). I initially found the title off-putting, because I thought it implied a different argument from the one that the authors ultimately made. But then I was pleasantly surprised by the actual content.

After doing a review of the literature, the piece concludes that Americans spend fewer real resources on healthcare than their OECD counterparts:

In 2000 the US had fewer physicians per 1,000 population, physician visits per capita, and acute care beds per capita, as well as fewer hospital admissions per 1,000 population and acute care days per capita (data not shown), compared to the median OECD country. The US was still not devoting more real resources to health care than most other OECD countries in 2015 or 2016. At that time, the US had 26 percent fewer hospital beds per capita, 20 percent fewer practicing nurses, and 19 percent fewer  practicing physicians per capita, compared to the OECD median country. Because the US is still not devoting more real resources to medical care than the typical OECD country, we believe that the conclusion that “it’s the prices, stupid,” remains valid.

I don't know how clearly this comes across to most readers of the article, but let me say it clearly. If the United States is spending fewer real resources on healthcare, that means healthcare costs per GDP are lower in the US than in other OECD countries That's because the cost of something is the real resources used to produce it. The high prices are likely some kind of accounting illusion. 

I'm reminded of some work Robert Higgs did on the Great Depression. (This Econtalk gives a good discussion of his arguments.) It's widely believed that the wartime economy pulled us out of the depression, and some economists use aggregate economic data from that period to make this point. Higgs says, Hold up! This is an economy with price controls and other command-and-control features. The accounting numbers don't represent the true costs in this society. A binding price ceiling usually means the "cost" in dollars understates the true cost of producing it. What is the contribution to GDP of a tank, paid for with tax dollars, made with price-controlled labor and steel? You certainly couldn't estimate that by simply adding up accounting entries on purchased steel and wages paid. In calculating GDP, economists are careful not to "double-count". Something with a long production chain, where the intermediates change hands many times, can produce several accounting entries. If the intermediate goods get sold several times to several different entities in a supply chain, simply adding up all these transactions overstates the value of the final thing that gets produced. My understanding is that this problem get handled well when economists compute GDP. But what if all the prices are completely phony? What if none of those prices even remotely reflect the cost of resources used? A war-time economy, with high deadweight loss due to very high rates of taxation and rampant wage and price controls and other command-and-control features, does not have real prices. The sticker prices and accounting entries don't reflect the true value of resources used. 

In healthcare, prices are phony because the industry is dominated by third-party payments. Almost everyone pays the bulk of their health expenses through their insurer. We end up with a lot of nonsense prices. Hospitals set their list prices (when they even have them) very high, knowing they will negotiate them down when dealing with insurers or when treating a patient who is not able to pay. (Health care providers usually engage in price discrimination, charging lower prices to those with a lower ability to pay. Low-income people are typically not shut out by the high prices. Rather, providers treat them and charge a lower, more reasonable price, or charge them nothing at all. It's something of a myth that these people simply go without care and die in Dickensian poverty.) I don't think it's valid to simply add up the accounting entries and call it "health spending." If some of these prices are phony, not reflecting the actual cost of resources used, then adding them up gets a phony total. Some fraction of that total reflects real resources used, but some other (probably large) proportion of that total reflects a (purely nominal) sacrifice to the Health Care Gods. 

There is one obvious way that high prices combined with low real resource use still implies gross inefficiency. Suppose the high prices are largely due to supply-side limitations. There are too few doctors, because the AMA only accredits so many schools and creates positions for only so many new residents each year. Or the law mandates that only doctors can do certain procedures, even though a nurse or simply a trained technician could do he same procedure. (I was told by an EMT that ER staff sometimes ask them to intubate patients for them, because they do it all the time and they're very good at it. Surely there are other areas where a trained technician with a specialized skill could do something that would otherwise be done by a highly trained professional.) "Certificate of Need" laws allow hospitals to block competition. Surely it has to be admitted that there are supply restrictions and that these restrictions increase the price of healthcare. It's worse than just the higher prices, actually. Supply restrictions can lead to fighting about who gets to be a supplier, because those higher prices are so enticing. Society wastes resources fighting over who gets to be one of the chosen producers, rather than using those same resources on actual production. (E.g. doctors study harder to show how smart they are so they can get into med school and claim one of those coveted resident slots, rather than training to actually be doctors. Hospitals employ teams of lawyers to sue would-be competitors rather than spending those resources on actually producing better health outcomes.)  See the last three paragraphs of this article on the minimum wage for an explanation of deadweight loss. (The minimum wage article is describing a price floor rather than a supply restriction, but the principal is similar.)

If supply restrictions are important, it could mean that the United States spends too little on health care, even while the inflated prices imply we're spending too much. Part of the cost to society is the foregone value of resources that should be spend on health care but aren't, but this isn't even reflected in typical measures of health care costs that simply add up spending. But I don't know how important this story is. Someone should be getting really rich, according to this story. I believe American doctors earn modestly more than doctors in other nations, but my understanding is that it's hardly a notable difference. There doesn't seem to be any one group who is getting super rich at the expense of their fellow Americans. If you could identify such a group, it would revive the story that Americans spend more real resources on health care. The people who make enormous salaries and the companies who make abnormally high profits have larger command over goods and services in the real economy. So those phony-baloney high prices could imply a truly higher cost; those dollars are ultimately buying mansions and yachts and corporate jets and fancy cars for highly-paid healthcare providers. If this story is important, then it revives the "we spend too much on health care" story. (Those dollars sacrificed to the Health Care God don't simply evaporate; they end up being spent on real resources, which means a real cost is incurred.) The high prices represent monopoly power and economic rents, and the real resource cost shows up in the consumption of people earning those rents. But someone should be able to put their finger on exactly who is earning these rents.

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Resist the urge to think, "The sacrifice to the Health Care God is a real cost, because if I didn't have to pay it I'd have more money to spend on other things." That would be the fallacy of composition. If we're all paying the same inflated phony health care prices, there shouldn't be an effect on the real economy. Then again, if some people have a special privilege by which they manage to escape paying tribute to the Health Care God, real resources might be spent fighting over who gets to join the ranks of this elite group of rent-takers. Even if some of this is going on, it's probably still the case that phony prices overstate the true cost of healthcare in that economy.

If you haven't read it, Random Critical Analysis has a great post arguing that American health spending isn't unusual, and that GDP is a poor proxy for spending power. Using a different measure (AIC) America fits the trend of other OECD nations. It's a compelling argument, but I still think there are bad policies that make the health sector grossly inefficient. America isn't unique here, but I don't quite buy that American health spending is inevitably high due to some immutable law of social science.