Why Health Care Is Expensive

With the whole country talking about the crisis in health care and Congress debating massive new programs, I feel the need to speak out. I’ve thought a lot about this issue over the years and I don't think most people are analyzing the situation very well. For that reason I would like to share some insights that I don’t often hear expressed in the national debate. I’ve said much of this before, in a long comment on another blog last year. It seems timely today to repeat it.

Complaints about health care in the U.S. are frequent and loud. The two that figure most prominently in today’s debate are that it is too expensive and not everyone has access to it. I would quibble a bit on the second point and say that everyone in this country has equal access to health care; they just don't have equal ability to pay. So it boils down to one major complaint: health care is too expensive. What I want to ask then is, why? Popular opinion tends to blame corporate greed, but this is, at most, a minor contributor.

Let's take pharmaceutical companies, for instance. How can they possibly justify charging as much as $200 a dose for some new drugs? Surely it is due to rapacious profits! It turns out that's not the main driver. Now, there's no doubt that the pharmaceutical industry has much higher profit margins than many other industries. In recent years they have averaged a net profit margin of about 25%. That's pretty high. Many other industries average well under 10%.

But there’s nothing nefarious about these high profits. Profits naturally tend to be higher in industries that are driven by technological innovation. In fact, high profits are what drive the innovation. No investor will settle for low returns in a risky, capital-intensive industry. Fortunately, companies can charge more for products that are new, unique, and dramatically better than what was available previously. In contrast, profits are low in industries that produce commodities. Innovation is also slower. In a commodity market companies can only compete on price and service because the products they sell are no different than their competitors. In the modern world health care is definitely a high tech industry.

Now let's suppose the pharmaceutical companies decided to operate as non-profits. What would that do to drug prices? Take away the profit margin and the price of that $200 drug would decline by 25%, but I think we would all agree that $150 a dose is still extremely expensive. So where is all that money going? It turns out that new drugs are exceedingly expensive to develop and bring to market. These companies spend billions on R&D, and many of the drugs they develop never even make it to market because they fail to meet the FDA's safety and efficacy standards.

Now let's take a step back and try to look at the big picture. What is driving the health care cost spiral? It’s our collective demand for better health care. The bottom line is that everybody wants the best possible health care they can get. There's no such thing as "good enough" when it comes to me or my loved ones. This understandable desire has driven astonishing advances in medicine over the past few decades, and nowhere is that more true than in the United States. As a people we have gotten wealthier and healthier. There are so many more treatments available now than there were, say, when our grandparents were children. And many of those treatments involve sophisticated, high tech equipment or drugs that cost billions to develop. So if you look at the really big picture the reason health care costs so much more than it used to is that there is so much more of it. If everything your doctor could do for you would still fit in a little black bag he brought to your house, I can assure you there would be no crisis in health care costs.

The dilemma we face is that the total societal cost of providing the best available health care to all our citizens is growing at a pace that outstrips even the sizable growth in our societal wealth. Therefore health care accounts for a large and ever growing percentage of our GDP. At some point that trend is unsustainable. It doesn't matter how we structure the system, our society will simply not be able to afford to pay for the best available health care for everyone. Many of you probably think some form of government administered universal health care is the "answer". That will redistribute the cost, but it doesn't change the cost. Taxes and insurance premiums will need to rise dramatically to cover all the people who are not currently getting the best available treatment. And they will have to continue rising as the state of the art in health care advances.

Another alternative is to ration health care. This is effectively what other countries do with their universal health care systems. I am not familiar with every system, but I have talked to friends who are from Canada and the U.K. What they describe are ever lengthening waiting lists for non-emergency surgery and ever tightening requirements to qualify for expensive treatments. Some very expensive treatments are effectively unavailable in these countries. Even routine services are in short supply. A colleague of mine in the U.K. recently went to his doctor about a knee injury. He was told that he will have to wait months just to get an x-ray!

I know this sounds really depressing. I have thought about this a lot and personally I don't think there are any easy answers. There are some things we can do to help the situation, perhaps, but nothing that will satisfy everybody. I think the politicians are being egregiously deceptive on this topic. The easy sound bites are nothing more than lies. So what to do?

We should definitely try to improve the efficiency of the system, of course. The question is how. One thing I would definitely NOT do is give the government a bigger role. That's the last thing you should do if efficiency is your goal. Among the other proposals I’ve heard recently, tort reform stands out in my mind as one item with the potential for substantially reducing costs. I’m not sure how much interstate competition in health insurance would help, but it can’t hurt.

The most important thing, however, is figuring out how to incentivize the industry to focus more R&D on developing cheaper, as opposed to better, treatments. I’m not sure how you do that, but part of the answer is putting more of a price signal back into the health care market. One way to do that is to make sure everybody pays something for their health care, even if they can’t afford to pay much. Another way is to get rid of fixed co-pays and go back to having patients pay a fixed percentage of the cost. Yes, that would often force some painful, difficult choices. But as a society, that’s exactly what we’re facing. And I would rather make my own difficult choices than cede that role to a faceless bureaucrat.