Why Does the Free Market Fail to Control Costs in Health Care?

     In our national debate over health care and its rising cost, many health care economists say that one of the reasons why health care costs keep rising is that the free market does not work to control costs in health care. Why should that be true? Why should the free market work to control costs well in many areas of our economy, but not in health care?  The reasons are complex, but we must understand them if we are to create a health care system that does not bankrupt us. So, this post attempts to explain why the free market not work to control costs in health care when it works well in so many other areas of our economy. The main reasons are:

1. Health care suppliers have monopoly power to set prices.
2. Market prices do not exist in health care.
3. Buyers of health care services cannot evaluate the quality or necessity of what they buy.
4. The decision to buy a health care service is separated from the responsibility to pay for it.

In Health Care Markets, Suppliers Have Monopoly Power to Set Prices

A free market controls costs through competition. Sellers of a product in a free market are not free to raise its price above the market price because if they do, they will lose sales to other sellers who provide the same product at the market price. In this situation, sellers can maintain their profits only by keeping their costs under control, and sellers work to reduce their costs in order to increase their profits.

     This process works only if there are many sellers and they cannot collude to raise the price of a product or limit its supply. If there is only one supplier of a product, he/she can easily control the price at which it is sold and use that power to increase profits. If there are very few suppliers, they can work together to keep the price of a product above what a free market would establish.

     Health care markets do not have many sellers of health care services. Health care markets are local, and in each local market, there are very few health care providers.  In most communities, there is one medical center or perhaps two. Even in big cities, there are rarely more than half a dozen medical centers. Because there are so few of them, health care providers do have the power to set the prices of their products.[i] This power to set prices is known in economics as “monopoly power.”

Market Prices Do Not Exist in Health Care

     Competition in a free market controls cost by setting a market price for each product, but in health care, there is no such thing as a market price for any health care service. If you go to a medical center and ask the price of – say – a gall bladder removal, you will be told (if you can get an answer at all) that the price depends on the insurance that you have. There is a different price for every insurance company and still another price for those who are unlucky enough to be without insurance.  If you are covered by Medicare, there will be a yet another price.

     

     In fact, even among patients with the same health insurance, the “price” for a gall bladder removal will be different for every patient because the fee-for-service payment model allows a health care provider to charge for each, separate element of the service. How many bandages are used? How much blood is used? Was there a “facility charge?” And on and on.

     In short, the cost control function of the market price does not exist in health care because, in health care, there are no market prices.

     The lack of clear, market prices has yet another bad effect, which is that neither a patient nor a doctor can consider cost when deciding among alternative treatments. For example, a blockage in an artery may be treated by using stents or by using bypass surgery, and it is often difficult to know which of the treatments would be best in a specific situation. In some cases, it might be best to choose the least expensive procedure, but doctors are not trained to think that way, and patients cannot obtain the information to initiate the discussion. So, cost-effectiveness is rarely considered. 

Health Care Providers Are Experts While Patients Lack Technical Knowledge

     

     Most patients lack the technical knowledge to understand what they are buying. They have to trust their doctors, who are also the sellers of the services they are recommending. Even among health care providers, there are no accepted standards for health care services. When should arterial bypass surgery be recommended? When should a gall bladder be removed? These are matters of medical judgment, and doctors can and do differ.  In short, patients cannot judge the necessity or the quality of what is being offered to them.  If one procedure is more expensive that another, is the more expensive procedure really better? How can a patient have that discussion with a doctor?

The Decision to Buy is Separated from the Responsibility to Pay

     

     A market can control costs only if the buyers of a product are motivated to obtain it at the lowest cost. Their bargaining with the sellers sets the market price, and if they do not bargain, the whole process breaks down.  In the health care market, most buyers are not motivated to obtain care at the lowest cost because most people have health insurance. They do not have to think about cost. Thus, the fact that people have health insurance interferes with the cost-containment function of the market. We cannot do away with health insurance because modern health care is inherently so expensive that, without health insurance, most people would be unable to afford it. So, we must live with the fact that the buyers of a health care service are not motivated to seek it at the lowest cost.

     In theory, patients would become cost-conscious if they had to pay a part of the cost themselves.  However, in order for such “co-payments” to have the desired effect, they would have to be large, and large co-payments would create a hardship for most people. Indeed, if co-payments were large, most people would be unable to afford health care at all, and our inequitable health care system would become even more inequitable.

     For all of these reasons, we cannot expect the market to perform its function of controlling the cost of health care. The market cannot control costs because

1. In each local market there are very few sellers of health care services, and they have monopoly power to set prices.
2. The market price cannot serve a cost control function because in the health care system, market prices do not exist.
3. Patients lack the technical knowledge to evaluate the cost-effectiveness of alternative treatments.
4. Because most health care bills are paid by health insurance companies, the decision to buy a health care service is made by a patient who does not care about its cost.

Therefore, we will need non-market methods of controlling cost if we want to avoid being bankrupted by our health care system.

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[i] This power might be offset by the countervailing power of the health insurance companies, but they are prevented by the anti-trust laws from joining together to bargain collectively. So, they are weak compared to the health care providers, who are able to set their prices almost at will.[i]