This is a transcription of the Economics of Health Care Policy podcast:

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Rising health care cost. Problem of the budget deficit is related to rising health care costs. You probably already know that the single biggest concern about our American health care system is its cost. In 2011, the U.S. spent $2.7 trillion dollars on health care, which was just under 18 percent of the gross domestic product. Or one in every six dollars going to health care. This equates to eight thousand six hundred eighty dollars for every person. By comparison, we spent less than a trillion dollars on food and about a third of a trillion dollars on motor vehicles. How does our health care spending compare to that of other countries? During that same year, 2011, the UK spent nine point six percent of its GDP in health care, which was about thirty-four hundred dollars per capita. Canada spent 11 point 4 percent of its GDP on health care, or about forty-four hundred dollars per capita. Health care is and will remain the single biggest fiscal issue facing the federal government over all of our lifetimes. By 2075, when I’m not around anymore, most of you will probably be, if health care costs continue to rise at the same rate, health care will consume about 40 percent of our national product. Continuing at the same rate for 100 years, it will reach 100 percent, which obviously is not sustainable.

[radio: There’s too much government control. Radio of a politician speaking.]

Some propose that one answer is to get the government out of the health care business so that its budget for health care drops. Well, as your reading suggests, the health care market is far from perfect because of market asymmetry, moral hazards and information gaps and most health care economists believe that some degree of government regulation is therefore needed. This course is focused on the legal aspects of health care, but it’s helpful to have at least a basic grasp of health care economics to be able to fully understand and appreciate the legal issues. So I want to provide some basic tenets of health care economics based on general principles that are supported by most economists. The first principle is one that some call the law of large numbers, meaning that as the number of people in a cohort or market gets large enough, the mean or average becomes more predictable. And this is the basic way that insurance companies and health plans work. The larger the number of lives insured, the easier it is to predict what the company has to spend. So the company merely figures out that average, adds a bit in for profit and divides it up by the number of lives. But once the company figures out those numbers and sets its premiums, if anything happens to cause the population to become sicker, the company starts losing money. This is why insurance companies have historically imposed restrictions on covering pre-existing conditions, which in turn, led to millions of people being uninsured. Either they can’t get insurance at all, the company wants to charge so much because of the pre-existing condition that the individual just cannot afford a policy. Or sometimes the insurance company simply decides to drop the beneficiary from coverage because they became sick during the term of the policy and the company simply chose to stop paying for the treatment.

Prior to the ACA in 2011, approximately 18 percent of our non-elderly population, about 50 million people were uninsured. The elderly, of course, are all insured under Medicare. In the U.S. system, most people get coverage through their employers and through large insurance companies, and in those arrangements the insurance company has a large enough pool of lives that it can better cope without having to exclude people with pre-existing conditions. So when you get a job, you get insurance and you aren’t asked about whether you smoke or whether you’ve had cancer. You just get the coverage.

So what can the government do to increase the number of people who are insured? One way may be to subsidize it to make it free for everyone for example, like they did in Canada and in many other countries. Canada has one of the largest single-payer government-run insurance companies in the world. It wouldn’t have to be just one, though; the government could simply contract private companies to manage the coverage and the beneficiaries in return for cash. But where would the money come from? Two trillion in dollars is a lot. Not enough to get by raising taxes, right? Well this is the big reason why many experts think that we wouldn’t be able to turn immediately to a single-payor system in one fell swoop.

Another solution might be to require everyone to buy insurance, which is what is happening now with the advent of the ACA. There are lots of exceptions to the mandate, but let’s put those aside for now.

The government can’t really require people to get insurance unless it also prohibits insurance companies from cherry-picking; that is from discriminating based on risk, including pre-existing conditions. So, under the ACA, the insurance companies must take everyone and they cannot reject a bad beneficiary or kick them out later because of illness. And in return they get a large number of new customers, which helps under the law of large numbers to reduce the risk.

So there’s a trade-off: The government forces the insurance companies to take everyone but the government also ensures that they have more lives over which to spread the risk. But even if the insurance companies can’t theoretically continue coverage for a larger population without increasing their costs, insurance is still expensive. In response, the ACA includes a lot of subsidies, including expanding Medicaid and through other measures that we will talk about in our section on the ACA so as to make it more affordable.

So we now see two things the government can do to address some of the market imperfection issues that prevent health care from being provided in an unregulated free market. First, it can subsidize it; second it can mandate it. The ACA does both. Certainly where the money comes from for the subsidies is another issue.

[singing: Where does the money come from? Where does the money come from? Don’t know where they get it but I gotta get me some. Where does the money come from?]

The answer is typically through higher taxes. The ACA has added numerous provisions to tax or increase tax rates for certain participants in the new system.

Now that we’ve set the background with the basic fundamentals of health care economics, let’s look at some more factors that play roles in health care costs. Back in the 70s, the Rand Company performed a randomized perspective study of people’s financial behavior around purchasing and using health care. The upshot of their findings was that when people were charged more for health care, they use less of it. No surprise, right? But the converse is also true: The cheaper the care, or insurance policy, the more the patient will use the system. Indeed, Americans overuse the health care system, which is a significant factor in why the costs have gotten so great. You go to your doctor with a headache that you’ve had for three days. The doctor says the chance that you have a tumor, stroke, bleed or other life-threatening condition is very low; let’s say one in 100 million. But you have insurance and the CT Scan won’t cost your or the doctor a dime and perhaps only a $10 copay. So you and your doctor say, “Let’s just be sure” and the doctor orders the scan. And what if the doctor has a CT Scanner in his office or is part owner of one? He makes more money if the machine gets used more.

We will talk about the restraints on setting up such arrangements under the Fraud and Abuse sections, but an arrangement like that further incentivizes the doctor to order the scan.

Another example is the Medicare program, which is essentially national health insurance for older Americans. Medicare used to simply pay hospitals for however long the patient was hospitalized. Then the program switched its approach and started to pay a fixed amount for the diagnosis, a so-called diagnosis-related group, or DRG. In the first year after DRGs were implemented, lengths of stay in hospitals dropped by 20 percent and there was no change in the rate of mortality and morbidity. The elder population was no worse off. In short, the authors of the ACA took all these factors into account when drafting the bill. The law tries to set up incentives for patients and providers to behave more economically by recognizing the common factors that increase cost, particularly when they do not improve care.

I’d like to leave you with this. Our understanding of health care costs has led to efforts to incentivize patients, doctors, hospitals and third-party payors to behave more economically. And we will take a closer look later on in the course at how health care reform aims to do that and whether it’s been successful. For now, let’s just say that we still have a long way to go. I think we’re still quite a way off from really putting those incentives in place in a major way. But change has begun and I see us all now as being observers and scholars in the big laboratory of health care as the elements of health care reforms slowly start impacting the triple aim of cost, quality and access, a topic we’ll explore further.
[singing: Where does the money come from? Where does the money come from?]