This blog continues my exploration of mysteries of health economics. The title of the blog may seem inane, but when a senior colleague asked me this question 25 years ago, it changed my life. And the answer helps us understand a lot about what is wrong with today’s healthcare system.
I was in my second or third year as an Assistant Professor at the University of Chicago when my brilliant senior (but still young) colleague Dennis Carlton asked me to explain how medical providers set their prices. I told him that we needed to throw the traditional textbook economics model of pricing out the window. This wasn’t a market where price sensitive consumers chose among homogeneous sellers, with the result that prices in competitive markets converged towards marginal cost. Instead, consumers had insurance that paid for all or nearly all medical bills. Moreover, patients were loyal to primary care physicians and their referral networks. As a result, patients rarely shopped around for the best price. This was when Dennis asked me why prices weren’t infinity. The question stumped me! I supposed that insurers would only pay usual, customary, and reasonable rates but that didn’t prevent providers from asking for infinity and occasionally getting it. Perhaps providers didn’t want to appear unseemly or were bound by ethical constraints. Or perhaps, as I ultimately responded, medical prices were inflating so rapidly that they would soon reach infinity.
The conversation ultimately led me to examine all sorts of pricing puzzles. Why did prices seem to be higher in more competitive markets (in violation of the traditional price/concentration relationship?) Why did specialists make so much more than generalists? Do any of the rules of pricing apply to medicine?
Economists have solved some of these puzzles. The seeming violation of the price/concentration relationship for hospitals was partly a statistical artifact resulting from a failure to control for quality and severity of illness. And once managed care took over, the traditional price/concentration relationship firmly established itself. The violation for physician pricing could be explained by simple economic forces in monopolistically competitive markets (i.e., markets with many slightly differentiated sellers each of whom has some loyal customers). If some factor causes prices to be higher in some areas than in others, physicians will tend to gravitate towards the high priced areas in order to share in the higher profits. It is not difficult to imagine what factors might cause prices to differ – socioeconomic conditions, culture, the willingness and ability of patients to shop around. Health services researchers offer an alternative hypothesis – that physicians in concentrated markets “induce demand” in order to drive up prices. But this hypothesis had little empirical support beyond some old studies with major statistical flaws. And even these old studies found modest inducement effects at best – not enough to explain the data. Besides, the inducement hypothesis fails to explain why some markets are more concentrated in the first place. The market forces explanation is consistent with the data with the added virtue of explaining the variation in concentration.
Economists will be hard pressed to explain the pricing data that was just reported in Health Affairs. Laugesen and Glied find that U.S. physicians earn far higher incomes and charge far higher prices than their counterparts in other developed nations. The pricing gap is larger for specialists than for generalists. These price differences cannot be explained by differences in costs, including the cost of medical education. Economists often suggest that entry barriers protect physicians against competition that might drive prices down. But it is more difficult to become a specialist in Europe and Canada than in the United States. Moreover, Laugesen and Glied provide further data suggesting that U.S. physicians are not working at capacity; excess capacity is one of the surest predictors of price competition in almost any market, even hospitals. So why not physicians? And the specialist/generalist pricing gap has not been explained to anyone’s satisfaction, especially when there is excess capacity.
Policy makers seem likely to use the Laugesen/Glied findings as an excuse to slash physician payments. But until we understand why physician fees are so high, we will never be able to accurately forecast the impact of fee reductions. Unfortunately, after 30 years of trying, we are no closer to explaining these pricing patterns. During this time, prices have climbed inexorably closer to infinity.