Healthcare Price Control Shuffle…

Romney and Ryan have incorrectly characterized Obamacare as a “Raid on Medicare” and news organizations and the Obama campaign have fired back that is it actually a program to reduce healthcare costs — an important achievement of the administration. This whole discussion misses the fundamental point that $716 billion in savings would be the result of mandated price controls. Given that this is a major intervention, it is important to understand how these altered incentives will affect the U.S. healthcare system.

Medicare currently pays providers 30% less than private insurers and Obamacare will further reduce that to save $716 billion in payments to providers (hospitals, doctors, etc.). At the same time, broader coverage (another goal of the new law) will undoubtedly increase demand for services. How will these effects play out?

We already know that some providers are less willing to accept Medicare patients. Of course, these patients tend to be less profitable and providers risk losing money given their strained margins. While some will continue to accept Medicare, supply of services to Medicare patients is bound to drop. Putting this together, we expect to see decreased supply concurrent with increased demand and price controls. This should raise some red flags.

We can anticipate a major squeeze on suppliers who continue to accept Medicare and, ultimately, on legislators to respond if supply is over constrained. Legislators may lift or ease the price controls — in which case the savings will naturally not be realized. They may also mandate that providers accept Medicare (and the associated lower payments). Such mandates would put an even bigger squeeze on healthcare providers. How might they respond?

Actually, the early signs are already visible. Jay Greene (Crane’s Detroit) reports on some interviews he conducted with hospital officials on how they are planning to respond. An array of cost cutting measures are apparently already under way. Some are clearly sensible such as efforts to curb the use of unnecessary tests (if you can figure out which ones those are…). However, some of this effort involves cutting staff or reducing services. For example, Mark Kelley, the CEO of Henry Ford health systems anticipates layoffs, reduced hours and an increase in physicians taking early retirement.

This is consistent with findings in a recent NBER working paper by Wu and Shen. They found that previous Medicare payment reductions resulted in reduced staffing and cost cutting measures. This, in turn, increased mortality rates.

So the new legislation may ultimately foster increased demand, reduced supply, and perhaps lower the quality of care. This is probably no surprise since price controls are typically considered a dubious solution. Milton Friedman said “We economists don’t know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers can’t sell tomatoes for more than two cents per pound. Instantly you’ll have a tomato shortage.”

That said, the U.S. healthcare system is among the highest cost systems and the outcomes are not at all commensurate with the costs incurred. Something must clearly be done to lower the costs. Unfortunately, “Medicare raid” rhetoric obscures any serious debate on alternatives that may reduce costs while improving patient outcomes. The Ryan plan is not as different as it might seem. It would give patients vouchers that increase at a slower rate than costs. Some people would be able to purchase supplementary insurance so that patients may bear more of the costs of the price controls. However, as described above, the costs of price controls are borne by virtually everyone — whether directly or indirectly.

That does not seem like a recipe for solving the problems. However, all I’ve done here is call fouls. What better solutions might there be than price controls or other forms of shock treatment?

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