Code Red: Two Economists Examine the U.S. Healthcare System

Barring a Republican landslide in 2016, it looks like the Affordable Care Act (ACA) is here to stay.  By and large, we think that is a good thing.  While there are many things in the ACA that we would like to see changed, the law has provided needed coverage for millions of Americans that found themselves (for a variety of reasons) shut out of the health insurance market.

That being said, since its passage the ACA has evolved and the rule makers in CMS continue to tinker around the edges.  We are especially encouraged by CMS’ willingness to relax some of the restrictions on insurance design, but remain concerned about some of the rules governing employers and the definition of what is “insurance.”  In the next few blogs we will examine some of the best, and worst, of the ongoing ACA saga.

We start with one of CMS’s best moves—encouraging reference pricing.  The term reference pricing was first used in conjunction with European central government pricing of pharmaceuticals.  Germany and other countries place drugs into therapeutic categories (such as statins or antipsychotics) and announce a “reference price” which insurers (either public or, in Germany, quasi-public) that insurers will reimburse for the drug.  Patients may purchase more expensive drugs, but they were financially responsible for all costs above the references price.  Research shows that reference pricing helps reduce drug spending both by encouraging price reductions (towards the reference price) and reducing purchases of higher priced drugs within a reference category.  Other research has found suggestive evidence of similar results for reference pricing for medical services.

While the ACA does little to govern pricing in the pharma market, the concept of reference pricing can and should be extended other medical products and services.  In particular, insurers can establish reference prices for bundled episodes of illness such as joint replacement surgery.  Under the original ACA rules set forth by CMS, insurers were free to establish a fixed price for bundled episodes.  They could even require enrollees to pay the full difference between the provider’s price and the reference price.  But there was a catch. It wasn’t clear if any spending above the reference price would count to the enrollees by enrollees out of pocket limits (currently $6,600 for individual plans and $13,200 for family plans).  Obviously, allowing the out of pocket limit to bind on reference pricing would limit the effectiveness of this cost control measure.

A simple example may help. Consider knee replacement surgery for a patient who already paid $2,000 in medical costs this year.  An insurer might set a reference price of $15,000.  Then providers can charge any amount over $19,600 and the out of pocket cost to the patient would be capped at $4,600.  And if the patient had any other medical expenses that year, the out of pocket cost would be capped even lower.  This would hardly discipline providers whose prices are well above $19.600.   Considering that one study suggests there will be substantial differences between prices charged by the top and median quintile providers of bundled services, such kind of market discipline is sorely needed.

Last year the Department of Labor (DOL) solved this problem, issuing a new rule so that payments above the reference price do not count towards the out of pocket limit in large group and self-insured plans.  So now the formula for reference pricing under the ACA resembles the successful formula for reference pricing in Europe.  We would actually prefer the that the regulators go a step forward and say that spending above the reference price also cannot be counted towards the individual’s annual deductible.

But even this new rule will only go so far to introduce market discipline.  Insurers must be willing to bundle payments and this won’t happen in any big way until there are more “bundlers” – organizations capable of accepting bundled payments.  Providers need not integrate to do this; indeed, the organizational problem of paying and incentivizing individual providers (be they doctors, technicians, nurses, or therapists) remains regardless of how the bundler is organized.  But someone has to be the bundler.

More pragmatically, there are only so many conditions that lend themselves to bundling.  The study of price variation that we mentioned earlier covered most of the high priced conditions for which bundling is popular – joint replacements, CABG surgery, and back surgery.  Unfortunately, these represent just a small fraction of total health spending.  It is difficult if not impossible to delineate the boundaries of chronic care for diabetes, cancer, asthma, and many other high cost conditions.  One solution is to capitate providers, but many providers and their patients will object to this complete reversal of economics.  Shared savings under ACA is the half-hearted version of capitation.   But there is a way to incentivize patients to be more cost conscious.

The key is to recognize that deductibles might be a good way to get healthy people to pay attention to prices, but the U.S. health spending crisis is not driven by profligate healthy people. It is driven by the 18 percent of us, mainly with chronic conditions, who spend 80 percent of our health dollars. But patients with chronic conditions routinely blow through their deductibles.  So the increased reliance on first dollar deductibles seems woefully misplaced. CMS can and should allow insurers to creatively redesign cost sharing so as to increase the price sensitivity of chronically ill patients, without increasing overall financial risk.

For example, consider a typical plan with, say, a first dollar deductible of $5000, and a coinsurance rate of 10%. A diabetes patient will spend $5000 in just a few months, and the savvy diabetes patient will realize that the marginal price of all spending throughout the year is just 10 percent of the full price. This hardly encourages price sensitivity. Here is an alternative plan that the ACA should allow. Insurance covers the first $20,000 of medical bills.  Beyond that, the patient pays 33 percent of the next $20,000, up to their $6600 out of pocket limit.   (Of course, the exact thresholds would depend on the predicted medical needs of the patient.)  The patient faces less financial risk than previously, yet is faces higher marginal prices. It is a win-win. The point is that it is always possible in this way to encourage patients to be more responsible without increasing their total out of pocket burden.

Admittedly, this plan may force CMS to redouble its efforts to limit insurer cream skimming.  For certain this plan won’t do such a good job of encouraging price sensitivity among the healthy. But that is a feature and not a bug of our proposal. Instead of imposing costs on the low spending individuals who are not causing the run-up in health spending, we prefer to follow the advice of great sage Willie Sutton and concentrate our efforts on “where the money is” not where it isn’t.

To date, we’ve consciously chosen not to blog about the recent controversy surrounding our colleague Jon Gruber.  This is not because we lack opinions on the issue, but mainly because as economists we didn’t think we had anything of value to contribute to the discussion, which was largely about scoring political points.  However, recent attempts to stop grant support for Jon’s academic research have drawn our attention and we think it is important to highlight some important issues.  Beyond being the “architect of the ACA,” Jon is one of the most prolific and influential economists in academia.  His academic research is exactly what we should be supporting with grants regardless of any regrettable comments he made.

Since these videos emerged online, Jon has been subject to a wide range of attacks on both his personal character and his intellect (though we note that in a battle of the brains between David Axelrod and Jon Gruber, we’re taking Gruber every day and twice on Sunday).  We are not naïve, and understand that some of this is just part of the overly political nature of the debate over the ACA, in which the videos of Jon’s various comments are just another pawn.  Academics who choose to become involved in the political process must play by a different set of rules – and in the age of social media these rules are different even from what they were 10 years ago.  Though we would also note that the clutching of pearls by various members of each political party about the content of Jon’s statements does make use think we are watching the audition tapes for Casablanca’s Captain Renault.

We should note from the outset, that any casual reader of this blog realizes that we sincerely disagree with Jon on many political issues, particularly those related to the design and implementation of the ACA.  In addition, neither of us was pleased with the manner in which the ACA was debated, designed, or passed.  That being said, in the past couple of days, Republican lawmakers sent a letter to the National Institutes of Health asking them to review one of Gruber’s recent grants.  This is simply a bridge too far, going well beyond the bounds of reasonable and fair outcomes from this kerfuffle.

Perhaps a little context will make clear why this is the case.

Throughout his career Jon has written on a wide variety of topics ranging from the crowd-out of public health insurance, supplier induced demand and the effect of health insurance as precautionary savings (and these are just his health care papers).  In more recent years, Jon has focused a lot of his work on understanding the decision making of enrollees in Medicare Part D (i.e. the prescription drug benefit available to seniors as of 2005).

As we all know, choosing the right health insurance plan is really hard.  Consumers have to consider premiums, deductibles, copayments, coverage limits, networks…it is extremely challenging.  (To be fair, making the right choice for purchasing a variety of good is hard but insurance is just far more complicated).   We know from personal experience how hard this can be.  A few years ago, our employer offered a menu of health plans and learned, after the fact, that the cost sharing provisions assured that one of the options was worse for all employees, regardless of their health needs.  Even so, this was one of the most popular choices, and one of us made the mistake of choosing this plan!  I don’t think we are being presumptuous to say that if consumers with PhDs have a hard time making sense of plan options, others are also likely to struggle.  Indeed, Jon’s research (with various coauthors) confirms that seniors have potentially been making systematic errors with their initial plan selections.  For example, in peer reviewed work he has shown that seniors appear to use premiums rather than out of pocket costs when choosing their insurance plans, even though this decision rule often leads to worse financial decisions.

Jon’s  work is important for understanding how to shape the options available to seniors under Medicare Part D.  But it also suggests that all consumers may face challenges when choosing plans in the ACA exchanges and helps explain some of the rules governing plan offerings, such as the classification into “medal” categories that greatly facilitate comparison shopping.  In addition, several private companies are now providing information to consumers trying to sort through their plan offerings.  Jon’s research, which has been instrumental in these important developments, represents the very type of work that the NIH should be funding.  Thanks to his work, we have made important progress in designing exchanges that promote efficient choices of insurance plans.

Beyond this particular topic it’s important that we avoid the blatant politicization of the grant making process.  While we understand how some people could be offended by the comments that Jon made, and we remain unimpressed with the debate over the ACA, this shouldn’t spill over to the academic side of this conversation. Even throughout this entire process, no one has questioned the quality of Jon’s work or analysis.  He is one of the best economists of his generation and someone whose research should be supported. Ultimately, we all need to realize that stopping support for Jon’s research in order to score political points is, well, just plain stupid.

In the classic 1972 film The Candidate, Robert Redford portrays Senate candidate Bill McKay, who wins a surprising victory over the incumbent Crocker Jarmon. In the final scene, a stunned McKay escapes the victory party with his campaign adviser Marvin Lucas  in tow.   The movie ends with McKay asking “Marvin…What do we do now?”

Buoyed by their recent election gains, Congressional Republicans must be asking themselves the same question. Part of their answer is sure to be a renewed attack on the Affordable Care Act (ACA). Understanding that outright repeal is impossible for the foreseeable future, Republicans appear to be targeting (at least) two perceived flaws of the ACA: individuals cannot always keep their doctors, and individuals cannot always keep their health plans. We are hardly the biggest supporters of the ACA, as many prior blogs will show. But we think choosing these targets is not just a waste of effort but actually counterproductive to good health policy.

For the past three decades, Americans with private health insurance have gotten used to the idea that they do not have unfettered choice of doctors. In fact, Americans have time and again voted with their wallets for plans with networks. The majority is enrolled in PPOs, and most of the rest are in even more restrictive HMOs. Even in the exchanges, where individuals are not bound by their employers’ offerings, the plans with the broadest networks have lost out to narrower network plans that offer lower premiums in exchange for less choice. Like all goods, access is costly, and most Americans would rather sacrifice some access to save money. This doesn’t mean they won’t complain about it after the fact! In economics we call this a “revealed preference” and we believe that these revealed preferences are far more accurate than what people say they want. Put simply, if Americans prized access as much as Republicans seem to believe then why do they continually opt to save money by enrolling in limited access plans?

Given we know that Americans prefer money in their pocket over choice, any Republican effort to force all plans to broaden their networks will only serve to drive up health spending without a commensurate benefit. Republican lawmakers should keep in mind that we already have one prominent plan that promises nearly unfettered access – fee-for-service Medicare – which is a close as this country has to a single payer model. Is this what the Republicans really want?

Turning to the issue of plan turnover, we suppose this started when President Obama promised Americans that they could keep their health plans. We suppose Republicans were right to turn this into a campaign issue, but as a practical matter, it is not worth fighting. Yes, the ACA imposes minimum benefits standards and has encouraged some employers to drop coverage. In addition, some of the insurance plans offered in individual markets before didn’t meet these minimum standards and can no longer be sold. As a result, some individuals have been forced to switch plans.

While we have taken issue with some aspects of the benefits standards, we see no virtue in some sort of stasis in private insurance plan enrollments. Americans may value their relationships with their health care providers, but it seems unlikely that they would be equally loyal to their insurers. More to the point, it is high time that we weaned ourselves away from employer-sponsored coverage and therefore we should seize the opportunity provided by the ACA. By tweaking exchanges and the Medicaid program, as we describe below, Americans can take control of their insurance purchases, find coverage that better meets their needs, in a competitive market that encourages innovation without excessive regulatory oversight. Indeed, any new legislation that promises Americans can keep their existing coverage is likely to limit market competition; this hardly seems in keeping with the best of what Republicans claim to offer.

So if the Republicans’ current attacks on the ACA are misguided, what should they try to do? In the rest of this blog we summarize a few areas for reform. In subsequent blogs we will provide a more detailed blueprint for ACA reform.

Eliminate the employer mandate. There is no need to perpetuate employer sponsored coverage, which is an artifact of World War II wage controls and has persisted primarily because we lacked a well-functioning individual insurance market. One of the greatest benefits of the ACA is that it has created a well-functioning individual market, eliminating the primary reason the employer provided market has survived for so long.

Permit and encourage greater flexibility in health plan design. One of the greatest problems with the ACA is that it greatly limits innovation in plan design. For example, we would like to see a greater use of the lessons from the Value Based Insurance Design initiative. We understand that some of this is already being considered by CMS rule makers – a sharp push from Congress could make this a reality.

Encourage greater innovation in Medicaid. An exceptionally large number of the individuals who gained coverage through the ACA are enrolled in Medicaid. As a result, nearly 70 million Americans are now covered through this program. While many states have used managed care programs to serve this population, these systems have so far shown limited innovation. In exchange for agreeing to the ACA Medicaid expansion some states such as Arkansas and Indiana have implemented unique expansions that leverage the private market. We think that Republican lawmakers should encourage additional waivers that allow states that have not yet expanded Medicaid (or even those who already have) to adopt similar systems.

Last Thursday was a watershed day for the Kellogg School of Management and Northwestern University.  For the first time in 60 years, a sitting President spoke at NU, as President Obama spoke before an audience packed largely with Kellogg students and faculty.  As this is election season, it was no surprise that he spoke at length on a variety of issues and defended the Democratic record.  We are not experts on every matter of public policy and therefore will not examine every aspect of the speech.  But we have more than passing knowledge of health policy, and the President did spend some time discussing the ACA. He also mentioned many times that he was simply giving the audience “the facts” and that they could not be disputed. Given this speech occurred at our University, we feel obligated to take a look at what he said and do some basic “fact” checking.

Here is the relevant excerpt from his speech:

“Today, we’ve seen a dramatic slowdown in the rising cost of health care. If your family gets your health care through your employer, premiums are rising at a rate tied for the lowest on record. What this means for the economy is staggering. If we hadn’t taken this on, and premiums had kept growing at the rate they did in the last decade, the average premium for family coverage today would be $1,800 higher than they are. That’s $1,800 you don’t have to pay out of our pocket or see vanish from your paycheck. That’s like a $1,800 tax cut. And because the insurance marketplaces we created encourage insurers to compete for your business, in many of the cities that have announced next year’s premiums, something important is happening – premiums are actually falling. One expert said it’s like ‘defying the law of physics.’ But we’re getting it done. That’s progress we can be proud of.”

There is no reasonable interpretation of this section other than the President is claiming that 100 percent of the recent slowdown in private sector health spending is attributable to the ACA.  Unfortunately, this claim does not stand up to basic scrutiny.  This issue has been extensively researched by both ourselves and a number of other economists. Conclusions drawn from studies of prior recessions suggest that the ACA could be responsible for more than half of the current slowdown in health spending.  More significantly, the most recent published work, which focused on differences across geographic areas during the most recent recession, suggests that the ACA is responsible for at most a small fraction of the slowdown in private health spending.  We happen to know a lot about this research because we (along with colleague Chris Ody) are the authors of the aforementioned study.   We blogged about it last month, and you can find the full study here, in the policy journal Health Affairs.  We have also shared this evidence with staff in several Federal agencies, so our findings are not unknown in DC.

We will be generous to the President and assume that these findings somehow did not make it onto his radar screen, or that of his speechwriters, or even more unlikely even his economic advisers.*  As a result, the President has, at best, grossly exaggerated the impact of the ACA when the best available evidence is that the ACA may not have had any impact at all!  We find it at least a little ironic that the President has (perhaps unknowingly) misrepresented the facts on a subject that was extensively researched by faculty at his host institution.

While we are on the subject of the accomplishments of the ACA, the President has in other venues reminded his audiences that the ACA has reduced the ranks of the uninsured by 10 million.  What he fails to mention is that a very large portion of those individuals (perhaps even a large majority) were simply added to the Medicaid rolls of various states. Considering that roughly half of the states chose to sit out the expansion, this is a remarkable figure.  While it is a good thing that we are able to provide these people with health coverage, the ACA was billed as a way to utilize the marketplace to expand private health insurance coverage by bringing some order to the individual marketplace. This is a policy goal that dates back to Stanford Professor Alain Enthoven’s 1978 Consumer Choice Health Plan, and was shared by President Clinton as well as many Republicans.  We may ultimately get to this point, but we certainly are not there today. Given this fact, why not call the ACA what it is – a massive expansion of the Medicaid entitlement, coupled with an as yet modest program to help some individuals find subsidized private health insurance?   We are rather partial to Professor Enthoven’s plan and hope the exchanges grow, but we are a long way from fulfilling his vision.  Let’s not pretend otherwise.

*We are reminded of an episode of the great British comedy, Yes Minister, where the Minister for Administrative Affairs Jim Hacker learns, to his chagrin, that he would have been better off politically if he had remained unaware of the facts.  Perhaps it is best for the President if he can continue, with conviction, to spin this tale about the ACA.

We have all seen the doomsday predictions.  Health expenditures in the United States are a large and ever growing component of GDP.  Nothing can seem to stop this perpetual growth, and eventually these expenditures could account for over 20 percent of government spending and have ruinous effects on both state and federal budgets. This was part of the motivation for the 2009 Affordable Care Act (ACA).

But before the ACA was even drafted, something important was happening to the rate of growth medical spending – it was slowing!  From 2000 – 2007, health spending grew at 6.6 percent per year, well above inflation and a source of concern.  However, over the next four years this rate of growth slowed to an annual rate of “just” 3.3 percent.  We should note that even slower growth of a large number is a cause for concern.

The source of this slower growth has caused great debate.  Theories have ranged from a slower adoption and development of new costly technologies, to a number of blockbuster drugs coming off patent, to early effects of the ACA, and finally the effects of the “Great Recession.”

In a new study published in Health Affairs, we (along with our co-author Christopher Ody) examine the role of the economy in the slowdown in health spending.  In a research partnership with the newly established Health Care Cost Institute (HCCI) we obtained data on the health expenditures of a large sample of privately insured individuals.  We aggregate these data to the CBSA level and then examine how the effect of the 2008 economic downturn affects health spending in these areas.  We find that absent the recession, the rate of growth in health expenditures would have been 70 percent higher.  This is similar to some previous studies, and quite higher than others.

An advantage of our study over the existing literature is our ability to exploit regional variation during this downturn.  Previous efforts have primarily used evidence from past recessions on the relationship between aggregate economic activity and health spending to predict the role of the recession in the past few years.  However, there are many reasons to think that this recession might be different.  For example, it has been a longer and deeper recession than those in recent decades.  In addition, it was caused primarily by a shock to the financial system and results in large losses in housing wealth.  A second advantage of our study is that we examine individuals that retain private insurance. Therefore, our results show that the downturn in spending from the economy was not caused simply by individual losing employer provided health insurance.

Exploiting regional variation also allows us to control for other coterminous factors that might be affected health spending.  A fair question is what is the appropriate measure of economic activity in this setting?  The generally used measure in this literature is Gross Domestic Product (GDP).  For two reasons, this measure won’t work for our research question. The first is practical.  We don’t have good measures of this type of economic activity at the local (i.e. CBSA) level.  The second is more conceptual.  It is not clear that GDP reflects the economic conditions facing the average American.  This is particular true following the most recent recessions which have been marked by “jobless” recoveries where employment growth lags aggregate economic activity.

For these reasons, we measure the impact of the 2008 economic downturn using the change in the CBSAs employment-population ratio.  Looking just at the raw correlations, we find that every one percentage point decrease in the employment to population ratio resulted in a 0.84 percentage point decrease in medical spending in that CBSA.

While it is important to understand the past, the obvious question is: What does this mean for the future of health spending.  Our results suggest that if all other things remain equal, as the economy improves we should see a return to the previous rate of growth in health spending.  But are all things remaining equal?  Of course not!

First, we have implemented the ACA.  While we think it is naively optimistic to think this caused an immediate change in health spending in 2009, it is quite possible that in the future the incentives and programs created by this law could coordinate care in a way that leads to lower spending.  On the other hand, it is also fair to note that an increase in the number of insured individuals might actually raise health spending.  Just today, the Wall Street Journal reports large increases in utilization by the newly insured – including an increased used of the emergency room.  This utilization increase might offset the benefits of more coordination.

Second, one mechanism that likely drives a portion of our main results is a decrease in the generosity of cost-sharing for employer provided plans.  It is possible that this shift was greater in areas the suffered a larger macroeconomic shock as employers used less generous health insurance as a means of lowering compensation and absorbing the financial shock.  However, if this were the case it is quite possible that future employment negotiations may increase the cost sharing in these plans in the future.  Such a shift may take some time as these contracts are typically negotiated on at least at most an annual basis.  Therefore, we are not sure whether this will remain a permanent feature of the market.

Our results show that attempts to claim the slowdown in health spending primarily resulted from changes in government policy have little merit.  Importantly, we find this change among a group of insured individuals. This means that we are not simply finding that individuals losing insurance following job loss spend less on health services.  Instead, our results show that the depth and breadth of the downturn (and likely the decline in housing wealth) affected even the health spending of those who retained insurance.

However, it is also important to note that we find that among our sample of privately insured individuals approximately 30 percent of the decline in the growth in health spending resulted from factors other than the local economy. Given what we spend on health care services each year, this point is nothing to gloss over.  It is important to think carefully about what might or might not be in that 30 percent.  For example, this could result from factors such as a lower rate of technology adoption or the lack of new blockbuster drugs (though if this was the cause it seems like Sovaldi alone might end this channel).  But it also could be that economic trends that were not well correlated with the local economy, such as changes in the stock market, could explain a large portion of this effect.  Given this fact, we might want to keep our proverbial champagne on ice for even the 30 percent decline going forward.

The Affordable Care Act is premised, at least in part, on the notion that competition can be harnessed to reduce healthcare costs and improve quality. This explains why insurance in the individual market has not been nationalized. Instead, consumers go to an online exchange where they customers can easily (at least in theory) compare plans offered by different firms. Unleashing competitive forces should result in lower premiums for these plans. And why not? Over the past two decades, competition has been one of the few success stories in the U.S. health economy. For example, when competition intensified in the 1990s, healthcare costs moderated. When competition weakened in the wake of provider mergers and the backlash to the narrow networks that were essential to cost containment, healthcare costs rose.

When most people think about the benefits of competition, they tend to think about prices. Monopolies charge high prices; competitors charge low prices. There is nothing wrong with this perspective, but it misses a more fundamental point. In the long run, the greatest benefit of competition is that it has the potential to fuel innovation. This is as true, in theory, for health insurers as it is for telecommunications and consumer electronics. It hasn’t always been true in practice; for several decades after the IRS made employer-sponsored health insurance tax deductible, insurers tended to offer the same costly indemnity products. But consumers eventually demanded lower premiums, and insurers responded with managed care. After the backlash, insurers developed high deductible health plans and value based insurance design. Insurers are now moving towards reference pricing. These plans offer consumers reimbursement up to a pre-specified level for treatments that can be easily broken into a treatment episode such as hip replacements or MRIs. Patients have the choice of any provider, but they bear the cost of choosing a more expensive facility.

High deductibles and reference pricing are fine, but do not always work in practice. Chronically ill patients quickly exhaust their deductibles, and reference pricing does not work well for chronic diseases. In order to complement these tactics, some insurers are once again offering narrow network plans. We commented in earlier blog posts that the ACA would catalyze the return of these narrow networks and also warned that this might fuel another backlash. Unfortunately, a recent New York Times article shows, the backlash is well underway.

Make no mistake, restrictive networks are essential to cost containment. Through narrow networks, insurers can negotiate lower prices. More importantly, they can direct enrollees to providers who have lower overall costs and higher quality. Dranove has written two books about this. Don’t take his word for it. The independent Robert Wood Johnson Foundation has published two comprehensive studies showing that the competition triggered by networks has been successful in reducing costs and improving quality.

By definition, some providers are excluded from narrow networks, and this is where the trouble begins. Excluded providers who have lost out in the cauldron of competition always complain the loudest. In sports, there are pejoratives to describe such complaining losers, and it is the rare referee who is moved by their complaints. In healthcare, they are called an interest group, and when providers complain they have the ear of legislators. We should have no sympathy for them.

What about patients? Some patients knowingly choose health plans with narrow networks in order to save money, and should not be surprised to find that some of their favorite providers are excluded. Others may be in the dark about their networks. The solution isn’t to regulate narrow networks out of existence; it is to shine some light on network structure.

Another concern may be that low income enrollees who cannot afford broader networks might be at a disadvantage. But if we want to provide big enough subsidies so that all enrollees have broad networks, we will have to either (a) raise taxes further, or (b) limit the number of uninsured we can enroll. Neither choice seems better than the status quo.

Now, this does not mean that we think there is no place for regulation of narrow network plans. We don’t think that the newly formed ACA exchanges, or any market, should be the proverbial Wild West. For example, if we want consumers to make educated choices across insurance plans, then they require timely and accurate information about which providers are in which networks. We would think this would be more than feasible, though healthcare.gov was somehow unable to provide this information to many of the initial enrollees. We understand that providers go in and out of networks all the time and it would be burdensome for insurers to inform enrollees of all network changes in real time. But insurers could provide regular updates. We also wonder if insurers have the capability of identifying, through billing records, when a particular patient’s provider has gone out of network, and sending that patient an immediate update. In these situations, patients should be allowed to change their choice of plans outside of the open enrolment period in the same way they might be able to if they had another qualifying event such as the birth of a child. These small steps should prevent some of the worst case scenarios described in the New York Times article.

In addition, narrow network plans are only effective if there are multiple high quality providers offering services in an area. Given the recent wave of provider consolidations, it is critical that anti-trust authorities carefully monitor these mergers. After all, competition can only work in truly competitive markets.

But what we must avoid is mandating broader access. This would spell the end of market-based health reform. If insurers cannot exclude some providers, then providers have little incentive to lower prices and become more efficient. In the wake of the last managed care backlash, patients equated access to quality and virtually all insurers decided they needed to include in their networks virtually all providers. The result was double digit price growth that ended a decade of pricing tranquility. In the new post Great Recession economic reality, enrollees must have a low price alternative to high cost, broad network plans.

Many states have already attempted to mandate minimum access through Any Willing Provider laws. These laws require insurers who have come to terms with a specific provider to accept all providers who agree to those same terms. This may sound fair, but the economic implications of AWP for patients are anything but fair. Under AWP, no providers need negotiate with insurers or accede to an insurer’s request for discounts. Providers can bide their time, knowing that they can always force their way into the network. Having lost all their leverage, insurers can no longer demand discounts, and prices invariably rise. Research confirms this dim dynamic.

The push for broad access seems to be especially strong in sparsely populated states such as Montana. But proposals to assure access, which often take the form “At least X% of enrollees must live within Y miles of a provider” do more to drive up costs than any other rules we can imagine, because they grant effective monopoly rights to rural providers. Insurers facing such rules have two options (a) accede to the pricing demands of the local monopolies, or (b) drop coverage in areas where providers have been granted local monopolies. Montanans may as well have nationalized healthcare.

Health policy makers love to talk about the need to reduce costs, improve quality, and expand access – and like to talk themselves into believing that through government intervention they can achieve all three. They would do well to heed the economist’s “golden rule”: There is no free lunch.

There is a broad consensus (and a strong economic argument) that Americans should be protected against the potential financial catastrophe that can result from unexpected costly illnesses. This is the essence of health insurance. We count ourselves among those that broadly agree with this consensus opinion. Put plainly, unexpected medical bills should not be a source of financial insecurity. The Affordable Care Act represents President Obama’s best effort to provide this protection. But the ACA does far more than simply provide financial security in the form of health insurance to a large number of previously uninsured Americans. When the ACA reaches beyond this goal, it tends to get into the most trouble.

Americans like having health insurance, so to serve its broad political goals, the Obama administration has tried to label all aspects of the ACA as elements of health insurance. But the labels do not always fit. Recall that the administration was placed into the awkward position of defending the individual mandate as a tax in court, despite clear statements by various supporters of the ACA that it did not involve new taxes on those earning under $250,000 a year. In some people’s minds this continues to bring into question the legitimacy of the entire legislation.

This week, the debate has been about the mandate that employers include contraception in the basic insurance benefit that they are mandated to provide as part of employee compensation. Plans that do not offer this coverage do not meet the minimum requirements of the ACA and therefore employers would be required to pay steep fines per employee. In the “Hobby Lobby” decision, the Supreme Court ruled that owners of closely held corporations could not be compelled to provide certain types of birth control as part of their employee health insurance plans if they objected. The court then followed this up by granting a temporary injunction that allows Wheaton College to avoid filing a form facilitating the provision of contraceptives to its employees by a third party insurer. A final ruling from the Supreme Court on that issue will come in the future.

This is a fight that the Administration frankly didn’t need to and shouldn’t have picked. Recall that we got in this situation when the HHS (now perhaps our nation’s most powerful agency) decided to include contraception as part of the “essential health benefit that must be offered as part of all qualifying insurance plans.” And with that relatively simple decision, we’re off! Since that point the administration has been attempting to tailor its contraceptive mandate to avoid infringing on the religious beliefs of different groups. First, explicitly religious organizations were exempted. Then religious non-profit organizations were given the accommodation that serves as the center of the recent Wheaton College decision. Finally, as a part of the Hobby Lobby decision, closely held for-profit corporations have access to this potentially problematic non-profit workaround.

Had the administration thought more clearly about the underlying economics, and demonstrated a bit more political boldness (after all, wasn’t boldness one of the reasons America supported the President in 2008), it could have avoided this Rube Goldbergeseque solution. For the sake of argument, we will accept that affordable contraception is an underprovided public good requiring a government subsidy (a point that has a good deal of validity). But contraception is predictable and does not involve substantial expense – compared to say a new child. As such, it is by definition not an insurable product, and tying its provision to insurance is asking for trouble…the type of trouble that the Supreme Court has provided. Besides, tying contraception to insurance all but guarantees that millions of women will not receive the subsidy; witness the millions of Americans who still lack health insurance.

There are better ways to subsidize public goods than tying them to health insurance, especially when the goods in question are not insurable. If the administration believes that contraception is an underprovided public good, then why not carve this troublesome feature out of the ACA and offer contraception stamps? Like food stamps, they could be exchanged at the pharmacy for the purchase of qualified contraception products. This would eliminate the employer middleman and better target the subsidies to the low income individuals who need it the most.

We will tell you why the administration didn’t pursue this path. While we have no qualms about it, we suspect that most Americans would not accept this notion of directly subsidized contraception. By labeling contraception a healthcare service that requires insurance coverage, and rolling the subsidy into the ACA, political acceptance is all but assured. Unfortunately, the rules of the ACA effectively lock most Americans into their employer-sponsored insurance (another problematic provision of the law), so this approach ties contraception to employment, ties the hands of employers, and guarantees legal challenges along the lines of Hobby Lobby. This only serves to further politicize the ACA and assure that far more important reforms to the ACA will be delayed even further into the future.

Contraception is not the only uninsurable good or service that CMS has added to the minimum benefits package, which includes far less controversial preventive health measures that are routine and expected. But, as we previously discussed, it is only a matter of time before lobbyists and weigh in on other benefits that are not cloaked in the legitimacy of prevention. Judging by the experiences of the states, which collectively impose over 2000 “insurance” mandates, most of these mandates will actually be subsidies for uninsurable services. Lobbyists have long known that by labeling these subsidies “health insurance,” political hurdles melt away. In the case of contraception, the Obama administration has learned this lesson well.

Given that this Supreme Court felt confident enough in their economic logic to call the mandate a tax, we are surprised that they did not take this opportunity to question the entire notion of “insuring” contraception. So we are glad to have had this opportunity to do it for them.

This week we offer a brief interlude from the world of healthcare to kick off a new intermittent series: “Business Strategy in Unlikely Places.” On semi-regular basis we will talk about various topics in business strategy, which is the “other half” of our job here at Kellogg.

In addition to being economists and strategy professors, we are both big fans of sports in general and basketball in particular. Therefore, we couldn’t help but notice the recent tiff between Kobe Bryant (one of the best basketball players in the world over the last two decades) and Jurgen Klinsman (the coach of the United States national soccer team).

It all stems back to an interview in the New York Times magazine where Klinsman said many controversial things. First, he admitted that he thought the United States couldn’t win the World Cup this year, which may be accurate (although for a few minutes yesterday we felt irrationally exhuberant about our chances) but was strange to hear from that source. More interestingly, Klinsman said the following in response to people who were critical of him leaving veteran Landon Donovan off of the 2014 World Cup Roster:

“This always happens in America … Kobe Bryant, for example—why does he get a two-year contract extension for $50 million? Because of what he is going to do in the next two years for the Lakers? Of course not. Of course not. He gets it because of what he has done before. It makes no sense. Why do you pay for what has already happened?”

Perhaps unsurprisingly, Bryant was none too pleased about this comment and had the following response to ESPN Magazine:

“I thought it was pretty comical, actually. I see his perspective. But the one perspective that he’s missing from an ownership point of view is that you want to be part of an ownership group that is rewarding its players for what they’ve done, while balancing the team going forward. If you’re another player in the future and you’re looking at the Lakers organization, you want to be a part of an organization that takes care of its players while at the same time, planning for the future.”

While we could write this off to sour grapes from Bryant, in reality he is sketching out an important strategic point. To understand this point requires a bit of context. Under the collective bargaining agreement of the NBA, teams are constrained in how much they can pay in salary each year and the maximum amount that can be paid to any player in a year. As a result, star athletes such as Bryant are likely paid less than their actual value to the team. When Bryant led the Lakers to five titles, he brought in hundreds of millions of dollars in additional revenue for the team owners. But his salary has been capped at a bit over $20 million, and he could not receive more than a token bonus for his superlative effort.

The upshot of this is that, as a result of the salary cap, the Lakers could not pay Kobe Bryant his true value during his prime years. Without getting lost in the intricacies of the salary cap, the same is more or less true for all teams trying to hire superstars. The superstars are always paid less than they are worth and they are paid pretty much the same at each team. How then can the Lakers and other teams compete to land top talent?

Unable to up the ante on salary for current superstars, teams engage in elaborate courtships where they sell other attributes. The Miami Heat offer the twin attractions of South Beach and no state income tax. Los Angeles offers its glamorous life style, Boston has tradition, while New York offers, well, New York. Dranove thinks Chicago has much to attract star athletes, including a strong shot at winning a title (Are you reading this Carmelo? No? Why not?). Garthwaite thinks star free agents should be intrigued by the possibility of bringing the Pistons back to their “Bad Boys” glory.

But what if a team could “promise” a current superstar an increase in salary above the cap? League rules prohibit offering this in writing; even verbally committing to pay more would bring down the long arm of the NBA law. However, a team could credibly commit to pay current superstars more than they are worth after their stars have faded (sorry Kobe, we are talking about you). This circumvents the salary cap and effectively allows teams to pay current superstars what they are worth. The question is how can a team do this? Well at least one way is by demonstrating they have done so in the past. This costly signal helps convince future players that they also could ultimately earn more by signing with this team.

Think about it this way. Kevin Durant, the best young player in the NBA, will become a free agent in 2016, exactly when Bryant’s latest contract will expire. The Lakers would love to land Durant. So would every other team. Durant is worth much more than the maximum allowable salary, so no team can outbid any other in the traditional way, and whichever team lands him will pay him less than he is worth. But the Lakers can “outbid” other teams for Durant’s services by demonstrating that they will eventually pay him more than he is worth. How can they assure Durant that statements about “taking care of him” in the future are not just some elaborate cheap talk? By doing the same thing, right now, for Kobe Bryant.

It may appear to Klinsman that the Lakers are paying Bryant for his “past performance.” In reality, they are simply structuring their compensation differently to avoid regulations. Of course, this is most effective in leagues with strict salary caps – something that is not true for European soccer leagues. In an uncapped league, you can just pay players their market value in the current year.

Economists call these types of arrangements implicit or relational contracts. We happen to know a bit about them because our strategy department here at Kellogg has some of the best people in the world who consider these arrangements (Niko Matouschek, Jin Li, and Michael Powell). In situations where firms cannot explicitly write out all provisions of a wage and bonus structure, these types of contracts can be powerful strategic tools. In the NBA, relational contracts might allow a team to effectively attract players who otherwise would view them as interchangeable with their competitors.

Starbucks, which taught America to love lattes, made news this week with the announcement of a new tuition benefit for its partners (Starbucks-speak for employees).  At first glance this move seems like simply another benefit in Starbucks relatively (for its industry) generous compensation package.  In particular, Starbucks has long been heralded for providing health insurance for all partners working more than 20 hours per week.  It is this connection to health insurance that we wish to explore.  While Howard Schulz the founder and current CEO of Starbucks has long said the firm offers health insurance because it is the “right thing to do” for their employees, we have always suspected a more profit maximizing goal for this compensation decision.  If we put on our strategy hats (we are both members of Kellogg’s Strategy Department), we can deduce that as a profit-maximizing firm, what Starbucks giveth with tuition benefits it may soon taketh away from health insurance benefits.  In the process, Starbucks may be heralding the demise of employer sponsored health insurance, something we have predicted in previous blogs.

While Starbucks is nominally a fast food firm, it seeks to hire a different kind of employee than its competitors.  Starbucks employees are more productive (i.e. they generate more revenue per employee) and they are expected/required to contribute to the warm environment Starbucks offers its customer.  From its creation, Starbucks has positioned itself as the “third place” in American society, i.e. a place to gather that was neither home nor work. This is why chatty and productive employees (think, college educated individuals looking for full-time employment or a struggling actor waiting for his big break) are worth more to Starbucks than they would be to one of its competitors such as McDonalds.  While McDonalds may now offer a competitive latte, no one would mistake it for a third place.  

Starbucks must, on a daily basis, find ways to attract and retain its employees.  Rather than simply pay them more (an expensive proposition), Starbucks has long exploited a unique feature of the American employment and health insurance markets.  Private firms are generally able to offer health insurance for rates that are far less than their employees can obtain in the individual insurance market.  As a result, Starbucks can attract workers with a package of wages and health benefits that is worth more to the employee than a similar amount of compensation paid entirely in wages.  Given that many of their competitors are not seeking to hire the same kinds of employees, Starbucks can retain part of this spread within the firm.  Workers who highly desire health insurance, whom more often than not are the types of workers Starbucks would like to hire, are delighted by this wage/benefit package. 

The Affordable Care Act changes this calculus.  Workers who opt into exchanges can now obtain health insurance at an actuarially fair price. That wage/benefit package from Starbucks doesn’t seem so attractive any longer.  Many would rather take an all-wage package elsewhere – a package that featured higher wages, albeit without health benefits – and apply some of those higher wages towards the price of a cheap silver or bronze plan on the exchange.  This is particularly true when we consider that Starbucks offering health insurance benefits makes their employees ineligible for the large subsidies on the exchanges. 

Facing this situation, Starbucks needs to look to a different fringe benefit with the same two characteristics as health insurance:  (1) that Starbucks can obtain the benefit at a discount, and (2) that the benefit is attractive to the kind of employee that Starbucks wishes to hire.   Enter the tuition benefit.  Starbucks has apparently used its purchasing clout to obtain a discounted tuition from Arizona State University for its online undergraduate degree program, and is passing on the discount to its workers.  Because this program does not make strategic sense unless Starbucks has a purchasing advantage, we expect more details about the discount to emerge in the fullness of time.  

As in the case of health insurance, do not believe for a moment that Starbucks is offering tuition benefits as a public service.  Indeed, the language that CEO Schulz used to describe the tuition benefit is strikingly similar to his description of why the firm offers health insurance benefits: “I feel so strongly this is the right thing to do and Starbucks as a company is going to benefit in ways that probably we cannot identify today.”  We suspect that Schulz knows full well how the company will benefit. We also suspect that, despite its protests the contrary, Starbucks will eventually announce that it is dropping insurance coverage in favor of higher wages.  The company is too savvy about its benefits to miss this obvious move. 

We should also note that this is not a question of “right” and “wrong” or a greedy corporation slashing benefits.  Instead, it is about Starbucks (and likely other firms) realizing its employees are better off getting their wages from their employer and their insurance from and insurance company.  That is why, beyond being an interesting business strategy example, Starbucks’ recent moves offers a glimpse into the future (or lack thereof) of employer health insurance.  Ultimately, what we are seeing is the not so gradual erosion of one of the primary benefits of employer health insurance, i.e. the pricing benefits of group coverage.  With the creation of individual insurance exchanges, Americans no longer need their employer to provide their health insurance.  In fact, given the nature of the fairly generous tax subsidies they may no longer want their insurer to offer them insurance.  As a result, as we have previously predicted, many employers and particularly those with a large number of low-income employees will stop offering health insurance.  To borrow a phrase from Schulz, in this new economic environment this choice will be the “right thing to do” for their employees.

Firms that previously took advantage of the inefficient individual insurance market will have to look to other strategies.  This week the firm that brought us the Frappuccino we have may have also brought us the first strategy for this new context.   

It seems that you can’t spend more than five minutes socializing with health economists these days without the topic of Sovaldi and the prices of new drugs coming up (we economists are a wild and crazy bunch).  As we blogged a couple of weeks ago, this new cure for hepatitis C is far more effective than existing treatments and has fewer side effects but is also quite expensive (though it should be noted that it is not actually more expensive than many of the previous treatments, it is just more expensive per day and the lower number of side effects has caused a greater number of patients to seek out treatment).  Calls are coming from all quarters to force lower prices on Sovaldi’s manufacturer Gilead.

As we discussed, constraints on the profitability of drugs once they are released, such as price controls, are concerning because they limit future innovation.  A host of previous economic studies have shown that increases in expected profits have caused greater research activity by pharmaceutical firms as measured by new products, clinical trials, or both. 

What has been generally absent from this existing literature is whether these increased investments result in products that are socially valuable or if they are simply rent seeking by firms.  In general, new products can increase welfare by offering more value than existing products or lowering prices and increasing the quantity sold.  However, if demand is relatively inelastic (as is the case with many pharmaceuticals) lower prices do little to change demand and just represent business stealing by firms. In this setting, new products are only welfare increasing if they are sufficiently differentiated from existing offerings.     

Critics of the pharmaceutical industry often claim that there is little true innovation and most new products are simple modifications of existing blockbusters.  If this were true, most research by pharmaceutical firms is just a very expensive form of business stealing.  We would be remiss not to note that these critics have been noticeably silent in the case of Solvadi, which represents real innovation. 

Previous studies examining the link between profits and research investments for pharmaceutical companies have not directly confronted the question of the social value of these investments. Ultimately the social value of innovation after changes in marginal profits is an open empirical question and one that we hope to help answer.  To that end, we (along with our co-author Manuel Hermosilla) just released a new NBER working paper [ungated] (yes we do something other than blogging or teaching Kellogg’s MBAs). 

In this new paper we examine the social value of changes in research investments by biotechnology firms into drugs targeting the elderly after the creation of Medicare Part D – the pharmaceutical insurance program for elderly Americans.  These biotechnology firms have traditionally been associated with innovative activity.  For example, they disproportionately produce biologic products and the firms in our sample have a history of focusing on products targeting unmet medical needs.  As a result, the products they develop are less likely to be simple modifications of existing products than those from traditional pharmaceutical firms.

Similar to the previous literature, we find a marked increase in clinical trial activity for drugs targeting conditions with a large share of patients that are on Medicare.  This appears to have been caused by the insurance expansion, i.e. prior to Part D there was no noticeable difference in the number of clinical trials based on the elderly patient share.

Given that the increase in clinical trials occurred among biotech firms, they are likely for products that represent a scientific advancement of some type. The question is the degree to which they provide an increase in treatment availability – a key indicator of their contribution to social value.  We therefore examine two indicators of this outcome:  (1) the number of existing treatments for the targeted condition and (2) regulatory indicators of the product targeting an unmet need. 

First, we categorize the conditions in our data based on the number of available pharmaceutical treatments.  We then estimate the response to Part D based on the number of treatments for the targeted conditions and find that the increase in clinical trial activity was primarily for diseases with five or more existing treatments.  Importantly, we find that there was no change in the number of clinical trials for conditions with one or fewer treatments.  While the products aimed at conditions with five or more treatments may be more effective than existing treatments, our results show that marginal changes in profits do not spur investments in products targeting conditions that currently lack treatments.

We recognize that products aimed at conditions with existing treatments may still improve welfare improving the standard of care.  So we next turn our attention to three FDA indicators of products that address an unmet need: priority review, fast track and orphan drug status.  We estimate no increase in the prevalence of products receiving these designations as a result of the creation of Part D.

To understand the mechanism driving our results, we should consider the investment decision facing biotechnology firms.  Regardless of firm size or origin, products make their way to market based on their profit potential.  Truly novel products earn large profits and are there pursued by firms in all time periods.  However, those products offering simply another treatment option in the arsenal or providing price competition for existing products might generate limited profits.  As a result, there may be a large number of products for these conditions which were not sufficiently profitable in expectation prior to an insurance expansion but become profitable after a small change in market size. If this were the case, we would expect a differential response to the creation of Part D based on the number of existing conditions.  This is what we observe.

So this brings us back to the question of price controls and more specifically the case of Sovaldi.  Our results demonstrate that marginal changes in profits do not appear to increase investments in products that serve an unmet need.  However, the question is how large of a change is required to see a change in the incentives to develop truly novel products?  Unfortunately, we (and by that we mean all economists) simply don’t know the answer to that question. What we do know, is that the easiest path is to ignore the negative dynamic incentives for innovation and impose strict price controls on new drugs offering valuable benefits, i.e. the very types of drugs we have been asking the pharmaceutical sector to develop for years.  For example, Doctors without Borders is pushing for Sovaldi to be made available for $250 in the developing world—which is their estimate of the marginal cost.  Certainly this policy would dampen incentives to develop more products that would be socially valuable.

While we must avoid the temptation of draconian price controls, our results provide more nuance to the argument against any action affecting the prices of blockbuster drugs.  Modest efforts at controlling expenditures on these new medications do not appear to dampen incentives to invest in socially valuable products.  Recently, struggling to afford the cost of this new medication, some state agencies are rationing access.  For example, the Oregon Medicaid System is limiting access to the treatment to only its sickest residents with hepatitis C.  The hope is that over time, new products from AbbVie and potentially Merck will emerge.  Importantly, these new drugs may be even better than Sovaldi – as we would expect from the incentives provided by the high prices.  At a minimum, these new products should lower prices and transfer resources from pharmaceutical firms to patients (either through lower future premiums or taxes).  Our results demonstrate that small changes such as the rationing of access based on the progression of the disease might be a reasonable way for health plans to adjust to the high cost of new treatments without foreclosing the development of new treatments.