Econ Lesson: The Rationing of Medical Care

 Like most things, the use of medical services must be
rationed. But who should do the rationing?

All things that are desired and cannot be provided without
cost (as we used to say about air) must be rationed. This is exactly what
markets do by discovering the price at which buyers are not willing to pay more
for more and producers/sellers are not willing to provide more at that price.
This market-clearing price has the interesting property of maximizing the value
(utility) of each person’s income because a reallocation of that person’s
spending would result in having more of things less valued and less of things
more valued. If you spend more on one thing you will have less income with
which to buy other things (what economists call the budget constraint). Each
person’s tastes and choices are different but each person can satisfy this
utility maximization goal in a free market by tailoring the mix of her
purchases to her own tastes. In short, the market-clearing (equilibrium) price
maximizes the value of each person’s income for each person. Why in the world
do they call this the dismal science?

While I know very little about the health industry, it is
obvious that the necessary rationing of medical services if we are to get the
best value from our incomes faces some challenges. The share of GDP going to
medical care in the U.S. has reached over 16% and is still climbing. This is at
least twice the level of spending of other developed countries, but the result
is not healthier Americans on average. For example, infant mortality rates in
the U.S. are about 40% higher than those in other high-income OECD countries
(World Bank data).

If medical care is provided to users free of charge (i.e. if
someone else pays the actual cost of producing it), those users will consume
medical services until the marginal value of an additional amount is zero (even
though the actual cost is far from zero).
Such users have no need and thus no incentive to restrict (ration) the
medical services they consume in order to save the income for something else
they value more. If insurance pays the full cost of all medical services, the
consumer, at the margin, is getting them free. This is why co-payments are now
usually required and serve the useful purpose of returning some incentive to
the consumer to ration services more carefully (e.g., should you ask for a
simple blood test or a much more expensive comprehensive one?).

If consumers don’t pay, other mechanisms for rationing are
required if gross over provision of medical services is to be avoided and it is
obvious that the escalating costs of such services (without a commensurate
increase in benefits) arise in part for this reason. Insurance companies
themselves ration by establishing what they will pay for and how much they will
pay for it. Ideally consumers would choose insurance plans that ration in ways
that match their own preferences as closely as possible. However, competition
among insurance providers over such cost/benefit decisions is limited by the
fact that since World War II employers have generally provided health insurance
to their employees (because the government subsidizes employer provided
insurance by exempting that form of employee remuneration from taxation). Thus
the employers rather than the actual consumers of medical services decide which
insurance plans to provide. This restricts competition among insurance
companies to provide the mix desired by consumers. Employer provided health
insurance also makes it harder for workers to change jobs and increases the
hardship of unemployment because it also result results in the loss of
insurance coverage.[1]  A national Insurance Exchange through
which everyone could chose competing insurance programs, as is now being
considered, would also increase competition for insurance plans.[2]

One problem with insurance (including Medicare) deciding how
to ration services is that they often do not know as well as trained and
experienced doctors which services (treatments, medications, and technology)
are most cost effective for each situation. So if consumers have little
incentive to ration, maybe doctors should make such decisions for them. Indeed
they are surely the most knowledgeable for making good judgments about the medical
services that are most appropriate and cost effective and in fact we rely
heavily on their judgments in this area. Unfortunately, doctors have several
strong incentives to over supply expensive services. Most doctors in the United
States are paid on the basis of the tasks performed (fee for service) rather
than on the basis of the services rendered (treating pneumonia, or setting a
broken bone) or the results of their efforts (curing a back pain). The more
they do the more they are paid whether they make the best choices or not. Some
medical practices, such as the Mayo Clinic have obtained good cost containment
with high quality service by making their doctors employees rather than paying
them fees for services. If the Mayo Clinic, or Doctors Inc. charge a fixed fee
for treating a particular ailment, they have an incentive to find the most cost
effective ways of doing so for each patient. But then they might have an
incentive to cut too many corners to save money.  HMO’s are another approach to rationing in an effort to deliver
good service at a reasonable cost. They have been unpopular with many people,
but might be the best choose for some if offered as one of many options.

The oversupply of services by doctors has another cause as
well. American malpractice liability laws encourage lawsuits by offering very
large damages, sometimes in cases of reasonable judgments that proved wrong.
Malpractice insurance, often costing individual doctors several hundred
thousand dollars per year, has added considerably to medical costs directly. But
the threat of such suits has also added considerably to such costs indirectly
(with no real benefit) through the defensive, over use of extensive diagnostic
tests by doctors to ensure that they are protected from nuisance lawsuits. Most
professional practitioners (lawyers, engineers, directors, etc.) are protected
from such suits if they have adhered to established norms (protocols) of
decision making even if in retrospect their decision was wrong or not the best.
Reform of malpractice law for medicine along similar lines is needed.

Individual doctors rely on medical boards to establish
protocols for what is best practice in treating each disease and condition.
President Obama wants to establish professional boards to set such standards
for insurance coverage and to evaluate and propose the most cost effective
treatments. It is clear that individual doctors do not have the time and
resources with which to do so and still practice medicine. The American Medical
Association develops such protocols, but it also restricts medical practice in
ways that limit competition among doctors and techniques (e.g., phone or
internet consultations across state lines). As with other services, progress
comes from competition and experimentation. If doctors can never try new
techniques or technologies because they are dealing with human beings, medicine
would be frozen where it is (or where it was).

All of the above reflect failures or weaknesses in
traditional market rationing of medical services. They have contributed to the
high cost of these services in the United States in relation to the quality of
these services. In some cases services are expensive but produce superior
results (new medicines and machines) but in many cases they are wastefully
expensive without providing better results. As in other areas of providing
goods and services, financial and other incentives need to be properly aligned
to provide the best serve at the least cost, which is the level of service and
related cost desired by each consumer from the offered options. And all
services need to be competitively provided (insurance, doctors, labs,
hospitals, etc.). Currently medical services are not being properly rationed. I
wish I knew the answer to the best way forward. Generally the best approaches
result for experimentation and the survival of the best in the market place.
Medical care to too regulated for this traditional approach to work well, but
keeping in mind the importance of getting the incentives right will be part of
improving our system of delivering medical services in the U.S.


[1] Ruth Marcus,
Bipartisan Plan on Health Care? Try Two”
, The Washington Post, July 29, 2009, page A17.

[2] Ezra Klein, “A
Market for Health Reform”
, The
Washington Post
, July 29, 2009, page A17.

Las Vegas

For the second year in a row I participated in Mark Skousen’s FreedomFest here in Las Vegas. This year I spoke on “Inflation, Hyperinflation, and Will We Have One” and I debated “Fed up with the Fed: Should We Abolish it?” (John Fund and I vs Gene Epstein and Tom Woods) televised on C-SPAN.

Las Vegas itself deserves some comment. Its airport (the second busiest destination airport in the U.S.) has 16 baggage carousels (Dulles has 8) and can load 21 cabs at a time. The so called Strip (on the edge of town and seen in the picture) has 5 of the worlds 7 largest hotels. They are enormous. People still smoke inside here. Outside it gets to 110 plus degrees every day during the summer but the air is dry and you can see forever. We took a day trip to Hoover Dam about an hour away.


The image of Vegas as a dessert oasis of bright lights and ever clanging slot machines is well deserved. You have to walk through the gigantic, cavernous, gaming rooms to go anywhere and the bells and whistles and whirling never stop. But Vegas is also THE CITY of SHOWS. It puts Broadway, with its cramped West End London like theaters, to absolute shame. The performance spaces are stunning and the productions spectacular. On this trip I took my daughter and two grand kids to see “LOVE,” the Cirque du Soleils’ tribute to the Beatles as only it could do it. It was just breath taking. Cirque du Soleil has at least five different shows permanently housed along the Strip. The Strip is lined with spectacular shows (not just the usual Jerry Seinfeld, Bette Midler, and magic shows that you would expect). Every Paris and Broadway shop of note is here as well (not that I would care). You can walk for blocks down the streets of Paris, Venice, the Village, etc without going outside (which is usually a good thing).

Now on to Bakersfield to help move my parents into an assisted living unit in their retirement complex (another painful downsizing).

Government corruption of our economy

I have noted on several occasions (most recently “State Ownership of Businesses) the growing threats to America’s economic productivity of ever greater government involvement in the economy. This productivity is the basis of our high standard of living and of our influence in the world. It is almost impossible for the government to get involved, especially as a shareholder without replacing commercial judgment and considerations with political considerations. Rather than better goods and services at lower prices we get more expensive goods that provide employment or profits for the benefit of a congresswoman’s constituents at tax payer expense. Today’s Washington Post has an article that so clearly illustrates this corrosive danger that I must pass it on: "Time to Click and Drag Car Sales into the 21 Century". The government’s involvement in the economy reduces its productivity but of equal if not greater importance it erodes the integrity of government.

On Friday in Las Vegas I debate whether we should get rid of the Federal Reserve as part of FreedomFest. If interested, you can see it on C-SPAN.

Best wishes,


Nairobi, Kenya

My latest two weeks in Nairobi are over. I am quite happy with the progress being made by the Central Bank of Kenya in developing its capacity to formulate and implement monetary policy. My advice in these areas has enjoyed the full and enthusiastic support of the Governor.

The sights and sounds of Africa included many memorable moments. Early on my first Sunday morning (about 6:00am), fifty or sixty singers passed on foot on the street below my window lead by a chanter. He would sing a phrase and the choir would respond. It was a lovely way to start the day.

My second Sunday, after two other members of the IMF team arrived, we drove to the home of Karen Blixen, authoress of Out of Africa. Much of the Meryl Streep and Robert Redford movie was filmed there. We also visited the orphan zoo on the edge of the Nairobi National Park. The zoo is unique and has a very different feel than any other zoo I have been to because all of its animals there have been rescued from certain death when they had been separated from their mothers (usually by her death) in the nearby jungles or bush. There I feed a giraffe from my hand and pet a cheetah. When I scratched the cheetah’s ears it purred loudly (reassuringly). You can see pictures on

Actually the highlights of my visit were the dinner discussions with fellow mission members Phil Bartholomew and Tom Lutton. Phil lead our IMF mission but earlier was Chief Economist of the Office of the Controller of the Currency ( the primary regulator of national banks) and staff economist of the former House Banking Committee (the Financial Services Committee now chaired by Barney Frank). Tom is now Principle Economist of Federal Housing Finance Agency, which regulates the bankrupt and now effectively nationalized Fannie Mae and Freddie Mac (the huge government sponsored mortgage financiers about which I have written much earlier). In 2003 Tom wrote a report on Fannie and Freddie for OFHEO as it was then called in which he concluded that they were not financially sound and should be broken up. He was asked to change the conclusion and refused. The report was not issued– an example of the corrupt relationship between industry, labor, and the government. Phil and Tom elaborated on why they consider the financial crisis of the last two years a major regulatory failure (not a failure to have enough regulations, but a failure to enforce existing ones) and why the government’s bailout response is a source of serious (moral hazard) problems for the future, and their disgust at the corrupting influence of Wall Street on American politics and government policy. I looked forward each day to another dinner discussion and wish I could share more of it with you but you have heard bits of it in my earlier notes on the crisis.

Our friend Denny Drabelle’s latest book is being published this month. He is also a traveler and has wonderful stories to tell. Information and reviews are attached.

There was sad news during my stay in Nairobi. Michael Jackson’s surprise death was announced. I received emails about it from all over the world. The next day the local newspaper delivered to my hotel room devoted its first full eight pages to Jackson.

The bodies of two of the Kroll PSDs (personal security details) assigned to my BearingPoint colleague Peter Moore, kidnapped in Baghdad two and half years ago, were turned over to the police. One of them, Jason Creswell, had an existing medical condition that may have caused his death, and we had been told a long time ago that the other Jason had committed suicide. Peter is the one that the kidnappers put on the Internet last year and may still be alive along with the other two Kroll PSDs kidnapped with him.

The two Jasons had actually been dead for some months. Their bodies were turned over to the police and then to the Ministry of Foreign Affairs. The bodies were released because one of the prisoners that were supposed to be exchanged for the hostages was released.  This was a "good faith" gesture on the part of the kidnappers. Such exchanges or payment of ransom keep kidnapping and piracy profitable, and guess what…

On the “lighter side” the joke (but all too true) of the week:

"Big Oil’s Answer to Carbon Law May be Fuel Imports"

By Joe Carroll and Edward Klump

June 26 (Bloomberg) — America’s biggest oil companies will probably cope with U.S. carbon legislation by closing fuel plants, cutting capital spending and increasing imports.