Everyone agrees that the US healthcare system is not working so great. Compared to the rest of the world, our healthcare is extremely expensive and yet we suffer worse health by many measures. And we can’t seem to agree on what’s to blame, or what we should do about it. Do we have too much, or not enough, competition? Should the government intervene in health care markets more or less?
Basic economics can help us better understand what’s happening.
As with any exchange of goods and services, the standard competitive market model has the familiar upward sloping supply curve and downward sloping demand curve, illustrating that when prices are higher, demand decreases and supply increases as sellers are incentivized to produce more of that good or service at its higher price. Sellers and buyers arrive at what quantity to produce and consume and at what price based on where these two lines intersect, called the equilibrium. Both buyer and seller are happy with the deal they’ve struck!
But not every market works this way. There are actually standards that need to be met in order for a market to fit this model and for it to work efficiently for both the buyer and seller.
First, there must exist multiple sellers competing to sell the same goods or services and new sellers must be able to easily enter the market.
There must be a sufficient open exchange of information between buyer and seller about price, availability, and value of a service or good.
And buyers must make, or be in a position to make, rational decisions using the information they possess about the market.
Healthcare does not meet these standards and when these standards are not met, the equilibrium cannot be reached or accurately known. Any price and quantity that falls outside of the equilibrium is considered a market failure. Using only this model, we can see how healthcare’s market failures contribute to high prices.
To start, it’s true that healthcare is failing the market standards when it comes to competition. The number of sellers in the market is decreasing due to both an increase in barriers to entry and due to consolidation, including hospital mergers. This causes an imbalance in power of the seller over the buyer that can begin to reflect what economists call monopolistic competition where sellers can charge a price above the perfect competition equilibrium. In the extreme, when there is only one seller, the market is a monopoly.
So then, don’t we just need more competition? Unfortunately, a lack of competition isn’t the only reason that healthcare fails the market standards.
Another failure is that consumers in healthcare, patients, do not have all the information that providers, like doctors and hospitals, do. This is known as asymmetric information. Patients often have no idea before getting care how much it will cost, what the prices available to them elsewhere are, or what the quality will be. When consumers are in the dark about these basic features, the true demand and supply will be different than the model. The true demand may be lower if patients knew ahead of time how much it cost or how much less valuable the service is compared to how it is promoted. This means prices can be set higher than they likely would be if the true demand was known.
Even if patients had full information, they are not always in a position to act as rational consumers. A patient’s decision may be influenced by their concern for their health, or their ability to think rationally may itself be affected by their condition.
So, as you can see, the problem is that a lack of competition only accounts for part of the reason why healthcare doesn’t meet the market standards. No matter how much the government either steps back to allow for more competition or invests to foster competition, the market will never fix ALL of these failures on its own. Healthcare is not and can never be a free market. It simply does not fit this model.
In 1963, economist and later Nobel prize winner, Kenneth Arrow, warned us about this looming healthcare crisis. He explains that “If the actual market differs significantly from the competitive model […] coordination of purchases and sales must take place”
That coordination he is referring to is government intervention.
Dr. Mike Chernew, Health Economist and Professor of Health Policy at Harvard Medical School agrees…“an unregulated health care market is unlikely to lead to desired outcomes.”
In reality, health care always has, and always will, involve a combination of both government intervention and market forces to control prices and increase quality. The debate isn’t really whether or not the government should intervene, but by how much and in what way.