"Joe Nocera and Bethany McLean’s The Big Fail: What the Pandemic Revealed About Who America Protects and Who It Leaves Behind has a lot of criticisms of how medical institutions operated during the pandemic (and also generally). One occasionally hears that the United States shows why a free market in health care can’t work. (I confess, this is a pet peeve of mine, because the health care system we have in the United States isn’t within a light year of a free market. Even if you’re convinced a free market in health care would genuinely be a terrible idea, it’s still wildly dishonest to claim that’s what the United States has.) Respectably, Nocera and McLean never quite describe the health care system in the United States as an example of free-market capitalism. The closest they come is referring it the system that exists as “a perverted version of free-market economics” or “a bastardization of capitalism.”

Here’s one such example they give of this in action:

The second reason the poor and the uninsured wind up in safety net hospitals is a series of public policy decisions that sound logical in theory but are both callous and misguided in practice. Take, for instance, the decision by many states to reduce the number of hospital beds. They did so believing that fewer beds would help control spiraling Medicare and Medicaid costs. Theoretically, that makes sense. But the game was rigged: the closure of hospitals was determined by their profitability, which had already been determined by government reimbursement policies.

So, notes Alan Sager, the Boston University health-care management expert, the primary consequence of eliminating beds by closing entire hospitals was to further separate the wealthy hospitals, which were rarely affected, from the poor hospitals, which bore the brunt of the reductions. It was a classic example of a policy being handed down by elites who would never be affected by it and imposed on people who had no say in the decision.

The result of this policy? “In fact, Medicare spending actually increased.” Why did this public policy aimed at reducing spending actually result in a spending increase? Here’s what the authors have to say:

The answer was pretty simple: the kind of hospital that could be closed easily – the one with little or no power and prestige – was not the kind of hospital that was likely to save the government money. The same number of people were still going to need to visit a hospital; they would just have to visit one that was still open…

…The same pattern played out across the country; hundreds of hospitals in disadvantaged neighborhoods were closed, ostensibly to save money, yet neither hospital costs nor overall health costs went down. All that was really accomplished was a massive reduction in hospital beds in neighborhoods that needed them.

While a casual reader might breeze through the book and come away with the idea that it demonstrates markets don’t work in health care, a more careful reading of Nocera and McLean shows the problems they point to occur precisely because the peculiar ways government regulations structure the health care market. An entire book length treatment of that issue can be found in Christy Ford Chapin’s book Ensuring America’s Health: The Public Creation of the Corporate Health Care System. As Chapin puts it,

Insurance companies occupy a central position in medical care. Insurers decide which services and procedures qualify for policy coverage, influence physician pay and hospital revenues by setting reimbursement fees, and shape medical practices by requires that health care providers follow treatment blueprints to obtain compensation. Many scholars have taken this authority for granted, assuming that insurance companies are filling an intrinsic role in private medical care. Yet the insurance company model was only one option among an array of organizational possibilities that might have structured the private market. And in comparison with alternative arrangements, the insurance company model has delivered medical services less efficiently and more expensively.

So how did insurance companies acquire such a dominant role in health care? Politics – not the logic of the market – positioned insurance companies at the heart of American health care.

Chapin shows how the health care system we have in America didn’t develop into its current form because that’s how a market in health care naturally organizes itself. It was structured, step by step, from the top down by an endless series of policies and policy reforms that created a system with the worst possible combination of incentives for all parties involved.

Nocera and McLean are aware of this – they approvingly cite the book Overcharged: Why Americans Pay Too Much for Health Care, written by Charles Silver and David Hyman and published by the Cato Institute, arguing that the way the government has regulated and structured health care payments has resulted in an incredibly dysfunctional system. Nocera and McLean write:

Indeed, the flaws in the payment system – and the government’s failure to fix them – essentially encouraged hospitals to extort the government. The foundational issue was that hospitals were historically paid by performing procedures and the more procedures they performed, the more money they made. The 1965 law that created Medicare and Medicaid did nothing to change that; on the contrary, instead of capping what it would pay for a procedure, the government agreed to pay hospitals on a cost-plus basis.

(As an aside, Nocera and McLean find the “fee-for-service” model, where “the more procedures they performed, the more money they made” to be a serious cause of dysfunction in health care. And they’re on to something – as Johnathan Gruber aptly put it, “This issue is best summarized in the saying that having a doctor tell you how much medical care to get is kind of like having a butcher tell you how much red meat to eat. What we face in the United States is a broken fee-for-service health care system where physicians and providers are paid based on how much care they deliver, not on how healthy they make you.” But this fee-for-service system was, itself, created as a result of government regulation, as Chapin documents in her book.)

Simplified, a cost-plus basis worked something like the following. The government would pay hospitals whatever it “cost” to perform some procedure, plus an extra percentage. Let’s just say 10% to make the  numbers easy. So if a hospital performed a procedure for $100, the government would pay the hospital $110, with the hospital gaining $10 for that procedure. But if the hospital instead spent $1,000 to perform the procedure, the government would pay the hospital $1,100 – a $100 gain rather than $10 gain. This method of payment gave hospitals a very strong incentive to inflate costs as much as they possibly could – which is exactly what happened.

A similar issue was pointed out in an EconTalk episode where Russ Roberts interviewed Keith Smith of the Surgery Center of Oklahoma. As Michael Huemer summarized the problem:

Later in the podcast, he describes some of the scams that go on in the industry. When hospitals claim that they were underpaid (the patient didn’t pay the full cost of treatment), they get money from the government. That sounds reasonable, right? They should be compensated for their good work.

This has caused hospitals to jack up prices to absurd levels, so they can regularly claim they were paid only a tiny fraction of the costs, so they can get more money from the government.

The hospitals make agreements with insurance companies whereby the insurance company only pays a fraction of the absurdly inflated price. This is all cool with the insurance companies too, because it enables them to claim that they negotiated unbelievable discounts (like an 80% or 90% discount) for their customers. It also makes it cost-prohibitive for a patient to get medical care without insurance, which is also fine with the insurance companies.

Now, you may look at the way hospitals or insurance companies behave in response to these regulations and feel like they are deserving of condemnation. And you may also read what Nocera and McLean and feel the same way about the actions of the various medical organizations they describe. But I would suggest this is the wrong reaction. To quote an old adage I often heard in my younger years – don’t hate the player, hate the game. If the government writes a rulebook heavily incentivizing businesses to inflate costs, and then businesses responds to that incentive by inflating costs, the best response isn’t to yell at the business for responding to the incentives they are given. You should instead be upset with the people who wrote the rulebook and created those incentives."

Corcoran adds this in the comments:

"If you don’t want to take the time to read Chapin’s entire book, she does provide a few highlights in this article. Some key points:

Nor were doctors passive participants in the health care sector’s wave of organizational innovation. By the early 1930s, they had founded hundreds of prepaid physician groups, which delivered high-quality care in a cost-effective manner…

The second distinctive feature of these doctor groups was that they were “prepaid.”…Individuals and families paid a set monthly fee in exchange for unlimited services. Physicians who worked for prepaid groups typically earned a salary plus a portion of the group’s quarterly profits. These financing arrangements motivated physicians to both hold down costs and provide high-caliber care.

Examining how present-day financing systems incentivize physicians to behave illuminates the elegance of prepaid group arrangements. Rather than directly financing care themselves, today’s doctors are usually compensated by third parties, either governments or outside insurers…

In contrast to current financing arrangements, prepaid physician groups aligned the doctor’s pecuniary self-interest with the patient’s desire for quality care. They carefully balanced resource expenditures between rationing and overutilization…

On one hand, if group doctors delivered poor-quality care or rationed services, they earned less. Patients who became sicker would consume additional resources, and dissatisfied customers would discourage new subscribers from joining. On the other hand, if group physicians supplied unnecessary services and procedures, they reduced their pay by frittering away group resources…Because they offered reasonably priced insurance and excellent care, prepaid physician groups were popular with consumers…

So what happened to prepaid doctor groups and the health care models sponsored by mutual aid societies, unions, businesses, and consumer cooperatives? In sum, AMA leaders captured and reconfigured the market to serve their own ends."