Six Things Economists Know

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1 Six Things Economists Know About Inefficiency in Health Benefits Markets Wendy Lynch, PhD Harold H. Gardner, MD Truman Brizee 415 W. 17th St., Suite 250 Cheyenne, WY T 307/ /

2 A Different Perspective Individuals, in general, will behave in ways that maximize personal benefit and minimize potential loss. Each of us approaches new challenges from our own frame of reference. Our backgrounds, experiences and, yes, financial interests influence the solutions we design. Opinions about how to improve the health care system are no different. As one would expect, proposed solutions vary widely among (and within) groups of patients, clinicians, lawyers, politicians, employers and public health professionals. Given the inherently different motives of each group (or individual), it is unlikely that any single group will design a universally satisfactory solution. Broader perspectives are required. This paper uses economic principles to provide an over-arching perspective about current inefficiencies in health care, as well as natural tensions resulting from competing or misaligned interests. Why Economics? Economists have well over one hundred years of experience describing the effects of incentives on individual consumption behavior. Although many people think of economics as primarily a financial or mathematical field, it is primarily a behavioral science. The field provides a logical framework for understanding decision-making. Underlying economics is the basic premise that individuals, in general, will behave in ways that maximize personal benefit and minimize potential loss. Their choices are influenced by personal incentives and preferences. Economists have well over one hundred years of experience describing the effects of incentives on individual consumption behavior. This is an appropriate scientific framework to use in understanding health benefits utilization because incentives and preferences apply not only to patients and doctors, but also to all levels of decision-makers and stakeholders throughout the system. People will consider, naturally, their own potential for gain and loss in every choice they make. Another underlying principle in economics is that while the goods and services wanted by humans (consumers) are virtually unlimited, resources to supply those wants are finite and therefore scarce and valuable. This principle is critical in debates about services, because it demands an acknowledged upper limit to the amount of available resources. It also encourages consideration of choices about what can and cannot be included within the constraints of that limit. Economics applies the concept of markets (transactions between buyers and sellers) to describe how resources are allocated and priced. In a market economy, buyers and sellers come together, make their interests known by negotiating a transaction, and make exchanges that benefit both demanders and suppliers. The equilibrium price is the final result of the bargaining between demanders and suppliers, and represents the value of the product to the demanders and the cost of the product to the suppliers. This equilibrium is critical to efficient markets. In a mixed economy, there is some government regulation of price and supply. In the U.S., public 1

3 education and health care are examples of a mixed economy these services are not bought and sold by individual sellers and purchasers. As one can imagine, outside interference may prevent the market from achieving an equilibrium price. Market Efficiency In an efficient market, consumers are very aware of price and expect to get more when they pay more. For anyone interested in improving health care, economic principles are fundamental to achieving significant change. When a market does not result in a particular service being exchanged for the equilibrium price (the price where sellers would sell and purchasers would buy in a direct transaction, without interference), it is considered inefficient. Inefficiencies prevent a market from achieving the natural advances and innovations that should come from true demand and supply forces. In an efficient market, consumers are familiar with a product and expect to get more when they pay more. For example, a consumer may be willing to pay almost four dollars for a non-fat-double-shot-mocha at his favorite coffee house because he values the service and the product. Yet the same consumer would expect to pay much less for plain, black coffee at a late-night convenience store. Another consumer may not value coffee enough to pay more than $1.00. If you want fancy coffee, you pay more. In an efficient market, the combined interests of buyers and sellers pushes the price of fancy or black coffee to an equilibrium. The following discussion presents economic principles related to inefficiencies in health care benefits markets. The basic economic principles discussed here are well documented and widely accepted by economists, but are often overlooked in general discussions about health benefits. For anyone interested in improving health care, these principles are fundamental to achieving significant change. 2

4 Principle 1: Your own time and money matter more to you than someone else s. Moral hazard refers to the excess amount of a product or service that a person would consume when someone else pays, compared to what he would consume if paying with his own money. When someone else pays for goods or services, there is a tendency for people to consume more. This tendency applies for both inexpensive (a dinner allowance for business travel) and expensive items (insurance coverage for emergency room visits). The economic term for this phenomenon is moral hazard, and it refers to the excess amount a person demands or consumes (e.g. steak instead of a burger) when someone else pays the bill, compared to what they would consume if paying with their own money. Essentially, when someone else pays, the price (paid by the individual) becomes artificially low. As a result, demand increases beyond the efficient level. Further, the consumer perceives it to have a lower value than when paid for directly. Most excess spending falls into a category of discretionary spending, rather than intentional abuse, and it occurs because there are minimal market forces (costs) to discourage consuming more. For example, one might add dessert to a meal paid for by a business account, partly because cost is not a concern. Similarly, if there is no (or little) extra cost to a patient, he or she may not question adding more tests or services, just to be safe. This source of market inefficiency extra consumption that occurs because the consumer doesn t pay contributes to higher overall costs in the system. Neither the dessert nor the extra test would constitute inappropriate or fraudulent consumption, but, in both cases, discretionary consumption was higher. Moral hazard is often difficult to quantify because it falls into discretionary categories of consumption. However, the magnitude of moral hazard in health insurance has been estimated. The RAND health insurance experiment in the 1980 s showed that individuals who had free care consumed about 30 to 45 percent more health care services than those who paid 95% of the cost, yet there was little indication that those consuming less care experienced negative health effects. 1 The same phenomenon applies to paid time-off benefits. When there is no obvious cost to an employee, he or she will have few barriers to being absent. Economists have estimated a 13% increase in the number of employees who use sick days for minor illness when those days are paid days. Interestingly, adding paid sick days also increases the number of doctor s 3

5 Paid time-off (someone else s money) increases likelihood of illness absences. Paying cash for unused sick time (employee s money) reduces illness absence. visits by 5% for those who also had full insurance coverage.7 Again, compared to paying full costs, when the individual can acquire services at low or no cost, some level of excess consumption of time-off or services will occur. The same phenomenon applies to paid time-off benefits. When there is no obvious cost to an employee, he or she will have few barriers to being absent. Economists have estimated a 13% increase in the number of employees who use sick days for minor illness when those days are paid days. Interestingly, adding paid sick days also increases the number of doctor s visits by 5% for those who also had full insurance coverage.7 Again, compared to paying full costs, when the individual can acquire services at low or no cost, some level of excess consumption of time-off or services will occur. Individuals who had free care consumed 30 to 45 percent more than those who paid 95% of the cost with little indication of negative health effects. Amount of health care consumed by individuals paying zero, fifty, or ninety-five percent of the cost of health care in the RAND Health Insurance Experiment. 4

6 Principle 2: Nothing is free. Employees may experience the cost of health insurance through opportunity cost. Employees may not pay for insurance directly, but instead will have fewer total dollars available for raises, training, bonuses and other benefits. Consumption that occurs at little or no cost to the consumer must be paid for by someone. Wasted items in the allyou-can-eat-buffet must be covered in the overall price of the meal, spread across all big and small eaters. When a person can see a doctor for $5, the remaining costs are paid for through other business arrangements. Part of the cost of services may be paid for through a prepaid insurance premium, which has similarities to the all-youcan-eat prepaid buffet. Although the consumer may perceive that the services are covered by insurance, all costs will be paid one way or another. Insurance premiums may be paid or subsidized by an employer. Although this eliminates a direct cost to the consumer, indirectly the employer cost of the premium must be covered in other ways. Because the amount of resources an employer can devote to compensating employees is finite, employees may experience the cost of health insurance through opportunity cost. Employees may not pay for insurance directly, but instead will have fewer total dollars available for salaries, training, bonuses and other benefits. If health care is subsidized by the government, taxpayers consciously or not pay directly and also experience the opportunity loss of having to use dollars for health care that could be applied to other services. When a consumer receives products or services for free, either because someone else pays or through a prepaid insurance arrangement, it results in other consequences in addition to excess consumption. One is a lack of awareness of the real cost of specific health care services. Another is a lack of engagement in usual consumerism behaviors such as shopping for better quality and price, or asking for performance guarantees. Further, when consumers anticipate that future needs will be met at low cost to them, there is less incentive to take proactive steps to avoid future health problems. Similar to the opportunity cost of insurance premiums, costs for paid time -off benefits affect employees in numerous ways. As with health insurance premiums, employer spending on paid time-off reduces available funds for other sorts of compensation and benefits. Additionally, when employees are absent from work especially for extended periods there may be personal opportunity costs of missing opportunities for training, advancement and bonuses. 5

7 Principle 3: What gets paid for gets done. Similarly, what is not paid for is not done. When a higher fee is applied to a prescription medication, patients will refill the prescription less often.... Higher paid practices DID more, but it is questionable whether they provided more value for the price. How we structure payments also dictates what gets accomplished. In other words, finance leads to form, and form leads to function. In medicine, payments are based on transactions, not outcomes or satisfaction. Providers are not usually compensated for the functional status of patients, short waiting times in their offices, or good rates of preventive care. In fee-forservice arrangements, compensation is based on the number of visits and transactions achieved. Consequently, it is hardly surprising that visits will be tightly booked, supported by technicians (to draw blood or do tests) with little unpaid time devoted to patient follow-up by phone. In end-of-life circumstances, insurance covers highly technical interventions that may prolong life, but may not cover comfortbased or counseling services. This financial structure leads to an end-oflife experience that is more technical and less connected to people. In any service arrangement, we can predict the emphasis of the function by knowing the payment structure. If someone is compensated for quantity of services only, there will be a tendency to provide more, lower-quality services than if someone is compensated for both quantity and quality. If someone is compensated for hours spent rather than tasks completed, they will maximize time over outcomes. Similarly, what is not paid for is not done. For example, when a higher fee is applied to a prescription medication, patients will refill the prescription less often. If providers were paid for having constructive conversations and compensated for measurable health outcomes, the form of medicine would change. Recent analysis of high and low cost practices providing care to Medicare patients illustrates this concept well. The highest paid practices provided MORE of almost every type of service (practices are paid by volume of claims for services rendered). However, more services did NOT result in better adherence to quality guidelines, better patient functionality, higher patient satisfaction, or lower mortality. Higher paid practices DID more, but it is questionable whether they provided more value for the price. More services did NOT result in better adherence to quality guidelines, better patient functionality, higher patient satisfaction, or lower mortality. Higher paid practices DID more, but it is questionable whether they provided more value for the price. 6

8 Principle 4: Incentives and disincentives always exist, influencing the general direction of behavior. In any contract for services, it is natural that the two parties may have different objectives.... Underlying incentives always affect the likelihood of a particular behavior seeking care, using benefits, or performing one job task versus another. In any contract for services, it is natural that the two contracting parties may have different objectives. When one person hires another to perform tasks and responsibilities in behalf of the former, we have what is known as the principal-agent problem. For example, in a medical transaction the patient (principal) hires a physician (agent) to perform certain tasks that are expected to enhance the health status of the patient. Likewise, an employer (principal) hires a worker (agent) to perform tasks in the interest of the employer. The principalagent arrangement naturally involves several levels of uncertainty the principal does not know if the agent has the skills to perform the activities, if the agent is giving a high level of effort, or whether he or she will act only in the best interests of the principal. On the other side of the transaction, the agent may have incomplete information about what the principal really wants and expects him or her to do. This uncertainty is sometimes referred to as information asymmetry, where one party has knowledge or takes actions that are hidden from the other party. Information asymmetry is problematic because the two parties rarely have the exact same objectives. When considering the many principal-agent relationships in an organization shareholders with executives; supervisors with workers; managers with consultants it is easy to imagine a large number of different objectives. Shareholders want returns on their investments; workers want rewarding work for a fair salary; consultants want to be paid well for their expertise. Because there is information asymmetry in each of these relationships, there is significant potential for inefficient and ineffective efforts. While information asymmetry may not lead the agent to behave in ways that intentionally harm the principal (i.e., doctors causing intentional harm to the patient), there is still a tendency for the agent to behave in ways that benefit himself. For example, the doctor would like to earn more money for his or her services, while the patient wants to feel better and pay less to do so. Medical reimbursement, except in strict managed care, is based on visits and procedures. Thus, the tendency is for providers to induce demand for more visits and services. The patient is not equipped with the technical and medical knowledge to question the need for these services. And, since he or she is not paying directly for services because of his or her health insurance, he or she is unlikely to question whether such services could be provided over the phone or through less expensive means. 7

9 The simplest employment arrangement self-employment (with no disability insurance) has perfectly aligned incentives. One has to work to be paid. Employment agreements have similar degrees of information asymmetry, especially in jobs where the actual work activity is difficult to track or observe. Naturally, the employer (principal) would like the employee (agent) to behave in ways that maximize profit for the principal s organization. While most employees understand that their job involves advancing the goals (profits, products) of the organization, economics tell us that an individual will serve his or her own best interests which will be a balance of achievement, leisure, earnings and other personal objectives. If work is paid on a straight salary, with no bonus, the employee experiences little penalty for lapses in effort. The risk from low effort is borne by the employer, who cannot easily verify level of effort. Further, if an employee has paid sick leave, there is little penalty to him or her for periods of no work. Incentive Theory2 in economics provides models for aligning incentives that mitigate the principal-agent and information asymmetry circumstances. In general, the goal is to align the incentives of both principal and agent such that there is a win-win when the principal s objectives are met. In addition, to whatever degree is possible, agents should bear some cost from periods of low or no output. Of course, these incentives and disincentives must be measurable, fair and transparent to both parties. Incentive Theory acknowledges the influence of other incentives approval, community, learning, positive culture, etc. but focuses on the underlying tendency for individuals to maximize their own gains. One way to think about aligned incentives is in noting that a partnership is a mutually beneficial financial relationship. Do both (all) parties gain when goals are achieved? The simplest form of employment arrangement, selfemployment (with no disability insurance), has perfectly aligned incentives. One has to work to be paid. There are more earnings for more work output, and a strong incentive to increase one s earning power and remain healthy. 8

10 Principle 5: There is a reason the term rational has the word ration in it. Whether obvious or not, every group or society has limits or constraints on what can be produced (health care, education, transportation) with scarce resources. Whether obvious or not, every society has limits or constraints on what can be produced (health care, education, transportation) with scarce resources. Underlying these limits are the market forces that require consumers and suppliers to make choices. Although mainstream U.S. culture places great value on this country s offering of superior medical services, few realize the cost burden of producing such a system. Clearly, not every citizen can have excess to unlimited amounts of all medical, technical and pharmaceutical advancements. Although not a popular political viewpoint, most policy experts agree that difficult choices will be required.3 As the cost of health care continues to increase in the U.S., and concerns grow about the ability to fund government and private coverage in the future, discussions about rationing will inevitably occur. In thirty years, health care costs have risen from 5% of GDP to over 14% of GDP.4 Economics tells us that unless production of services becomes much more efficient (less waste, lower prices, less moral hazard), either overall spending will continue to rise or supply will have to be limited. Some studies calculate that one-half to three-quarters of the increase in health care costs have been driven by scientific advances in medical technology.5 Further, we spend a significant portion of resources in the last year of life (where four percent of the U.S. GDP, and 30% of all Medicare expense occur).5 As costs rise, it will become increasingly important to make conscious decisions about where and how dollars are spent. If having the most expensive health care system in the world resulted in the best outcomes in the world, there would be reason to argue for continued high spending. And some economists believe that increased spending on health care would not necessarily be a bad investment.6 However, recent research tell us that 1) increases in spending are not strongly associated with increases in life expectancy/reduction in death rates; 2) more spending in the last six months of life does not result in improved outcomes, quality, or satisfaction; 3) the U.S. system is not necessarily superior to systems in other countries in many respects, even though we spend more. Economics tells us that value is equal to performance over price. We expect more when we pay more and it is not clear 9

11 Whether one agrees that spending 13% (or more) of GDP on health care is a good investment or a bad investment, a more informed public discussion about value will be necessary in the future. that health care meets those expectations. Whether one agrees that spending 14% (or more) of GDP on health care is a good investment or a bad investment, a more informed public discussion about value will be necessary in the future. The country will inevitably reach a limit in desired spending, requiring choices and limits on care. Policy-makers will face wrenching choices about the relative value of various health services, or society will make choices about the relative value of health care compared to other needs, such as education or housing. On a smaller scale, corporate policy makers will continue to examine whether investments in health are valuable enough to sacrifice other investments in their people, products and services. Rationing Happens (whether we realize it or not): Formularies that cover some drugs but not others Limiting Medicare to certain ages Limiting Medicaid to certain incomes Flu shots for high risk patients only Decreasing one service (early childhood care) and increasing others (coverage of gastric bypass surgery). 10

12 Principle 6: Employment is a human capital marketplace. Because employees do not connect higher costs for health care and paid absence with lower salaries, they do not realize the association between health and career rewards. Although many employees do not recognize it, every job is a dynamic, perpetual business transaction. Employees exchange valuable resources for rewards; those resources are personal human capital. Individuals can influence their human capital value in three ways gaining skills/expertise, improving attitude, and maintaining good health. The first five principles listed above provide a framework for understanding why the typical employeeemployer relationship is burdened by misaligned incentives that have unproductive consequences for both the employer and the employee. A general lack of awareness about the human capital consequences of poor health for the employer and the employee has lead to a wide-spread misconception that there is little career or earnings risk to becoming ill. Because in most large companies medical costs and all of salary will be paid during a period of illness, there is little financial incentive to think proactively about health. Further, because employees do not connect higher costs for health care and paid absence with lower salaries, they do not realize the association between health and career rewards. Incentives (intentional or not) that eliminate any earnings risk for healthrelated lost time create an environment for increased moral hazard. While in the short-term an individual may gain from the ability to be paid while not working, a lack of incentives for a quick return to work and quick return to high performance inevitably harms both parties. The employee loses opportunities for greater earnings and training, and the employer loses work output. New solutions will evolve when employees and employers both understand how many of our current benefit designs jeopardize human capital value. As economists know, economic rather than medical solutions are required to improve the current cost situation. 11

13 Implications of the Six Things Economists Know Understanding these underlying incentives will help guide future policy and financing decisions. Incentives drive behavior. Aligned incentives lead to shared goals for success. Misaligned incentives lead to conflicting or incongruent effort. Many misaligned incentives are described in this report paying doctors for transactions rather than results, paying individuals as much for being absent as being present, adding costs to essential medications that reduce hospitalizations, and paying employees to show up rather than for what they accomplish. Understanding these underlying incentives will help guide future policy and financing decisions. Wherever possible, effective Human Capital Policy results from sharing rewards and sharing consequences for performance and health status. The goal is to align rewards and consequences among employers, employees and health care providers, such that there is mutual benefit from high achievement and good health. 12

14 References 1 Newhouse JP: Free for All? Lessons from the RAND Health Insurance Experiment. Cambridge, Mass.: Harvard University Press; Laffont J., Martimort D: The Theory of Incentives: The Principal-Agent Model. Princeton, N.J.: Princeton University Press; Lamm RD: The Brave New World of Health Care. Golden, CO.: Fulcrum Publishing; Levit K, et al.: Trends in U.S. health care spending, Health Aff (Millwood) Jan-Feb;22(1): Jones C: Why have health expenditures as a share of GDP risen so much.? Department of Economics, U.C. Berkeley and NBER. May 5, 2004, Version Dranove D: What s Your Life Worth?: Health Care Rationing Who Lives? Who Dies? And Who Decides? Upper Saddle River, NJ: Financial Times Prentice Hall; Gilleskie DB. A dynamic stochastic model of medical care use and work absence. Econometrics 1998;66: