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The difference between cost and waste

1/12/2015 10:45:00 AM
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Healthcare journalism has been flooded with anecdotes of outrageous hospital charges for mundane things. Here's a $1,206 toenail clipping. Here's $9,000 to put a band aid on a cut finger. I could fill several blog posts just with links to these kinds of anecdotes, but I will stop there.

One criticism I have of these posts is that they don't distinguish between cost and efficiency. Consider the toenail guy. Here's his enumerated charges:
  • Office Visit -- $248.00
  • Biopsy -- $182.00
  • Treatment Room -- $328.00
  • AMB Clinic -- $117.00
  • Pathology Lab -- $165.00
  • Laboratory Services -- $166.00
  • Total -- $1206.
The vast majority of the charges here--the office visit, most of the biopsy, the treatment room, and AMB clinic--are charges for hospital time rather than goods. But we already know that they didn't waste a significant amount of hospital time, because the whole thing took "about 15 minutes." The main source of actual waste here is the running of what turned out to be unnecessary lab tests on the sample, but my guess is that even here the vast majority of that $165 was for lab time, and that these particular tests did not actually take that much time. This is to say that an obviously outrageous price tag needn't be indicative of an outrageous quantity of resources wasted.

The way I think about hospital prices is this: they don't really calculate charges on a patient-individual basis. Instead, patients are standardized into surprisingly broad sets of codes, and the hospital charges it's average cost per each code applied to the patient. So while this particular individual had only a tiny toenail clipping, the hospital needs to charge a high enough price for all biopsies to be able to cover the biopsies that actually are expensive to administer. The guy in this anecdote wasn't paying just for his own biopsy, but also cross-subsidizing a more expensive, trickier case somewhere else in the hospital. When averaged across all patients, this hospital could be running an extraordinarily lean and efficient operation. Or it could be scamming people out of billions. Anecdotes of individual experiences do not provide any evidence on this at all.

To make the point more general, we tend to talk about US healthcare spending as if more spending for the same outcomes is necessarily inefficient, when in reality much of this is actually a matter of distribution rather than efficiency. As a society, we may decide that doctors deserve to be paid more because they perform a great service to society. Or we may decide they don't deserve as much money as they already get. These are social choices and can neither be right or wrong. But regardless of how much we choose to pay doctors, if the quantity supplied and quantity demanded do not change, then neither does the level of efficiency.

Outrageous prices necessarily involve redistribution from consumers to producers. Whether that is inefficient depends on what happens to supply and demand. There are ways in which high prices cause inefficiency: first, they incentivize unnecessary procedures that doctors would not otherwise have done. Was this the case in the toenail clipping story? Doesn't look like it to me--they took a biopsy, ran a test, and discharged the guy within 15 minutes. Maybe the test was not necessary, maybe it was. But it doesn't look like they did a lot here that wasn't justified. So, the supply side does not actually look terribly wasteful to me.

The other way high prices can cause inefficiency is if consumers opt not to buy because the price is higher than it needs to be. The healthcare not administered to patients who can't afford outrageously high hospital prices is inefficiency. But I'm somewhat skeptical that this particular factor causes much inefficiency in our system. As I mentioned above, outrageous prices are usually a sign of extensive within-code redistribution from easy to complex patients. One reason hospitals do this is to avoid losing complex patients who can't afford to pay their true individual-level cost of care, and to the extent this is the case, then the outrageous prices actually increase rather than decrease overall access to care.* Moreover, most people have insurance, which like the hospital, averages costs across patients so that within-code price variation matters little.

That's not to say that outrageous prices never cause inefficiencies, but I think this is a substantially smaller problem than it is made out to be. The much bigger issues are:
  • the fairness of the distribution of income between hospitals, insurers, and patients, and
  • medical overuse.

*Aside: a common dictum in economics is that agents must internalize their own marginal costs. A less well known result is that fixed costs should be divied up according to willingness-to-pay. Hence, easy patients pay to keep the roof over the OR, so complex surgeries can happen at marginal cost. I'm really making the standard price-discrimination-as-welfare-improving argument here.