Posted by on April 28, 2017

One of the most successful propaganda efforts of the Left is the myth that we have a “free market” healthcare system in America.[1]  This is followed by the claim that the manifest defects of American healthcare prove that a free market cannot work in this sector.  Both are wrong.

John Cochrane, the libertarian economist from the Hoover Institute at Stanford, is primarily a macroeconomist and monetary theorist.  But he does seem to have a soft spot for healthcare reform.  His “After the ACA: Freeing the market for health care” is a great summary of his position.[2]

Cochrane begins by laying waste to the myth that America has anything like a free market in healthcare, pointing out how bad government policy is actually responsible for many of the problems commonly attributed to “market failure” in this sector.

He then describes what a free market (or, at least, what a much freer market) would look like.  On the demand side, there would be an end to the “moral hazard” and lack of portability that results from the tax-subsidized system of over-insurance through an employer.  Health insurance would become “catastrophic,” contracted directly and portably (like every other kind of insurance), and guaranteed renewable (thereby dealing with the pre-existing conditions problem[3]).

The supply side would be liberated from restrictions (such as Certificates of Need, restrictions on nurse practitioners, restrictions on clinics and special purpose providers, etc.), some of which arise from the usual crony capitalism and regulatory capture, but others of which arise from the cross-subsidies in the existing system (see below).

He finishes by demolishing many of the arguments for massively regulated healthcare, including the “straw man” that extrapolates from rare circumstances (such as the proverbial visit to the emergency room with a broken arm) and the conflating of charity (that is, how to handle those genuinely unable to pay for their own healthcare) with overall healthcare policy.

Cochrane draws an analogy between healthcare today and the airline industry back in the days before deregulation and the elimination of the Civil Aeronautics Board.  Except it’s worse.  Because it is the airlines operating under a CAB-enforced cartel where everyone is flying on an expense account.

Many of these arguments will already be familiar to readers of this blog.[4]  However, he makes two other points that I found particularly powerful.

The first is the prevalence of mandates and cross-subsidies in the healthcare industry, and the incompatibility of these with competition.   As this blog has done, Cochrane rails against the cowardice of politicians, especially Democratic ones, who hide the financial consequences of their policies by loading up the private sector with “mandates” to provide benefits to their preferred constituencies, rather than being honest enough to pay for them directly out of the budget.  Cochrane calls this “phoney accounting.”

But it is even worse than that.  Mandates and the cross-subsidies they create mean that it is not possible to expose healthcare companies to competitors, which would “peel away” the subsidizing clientele and bankrupt the providers that remain exposed to the loss-making beneficiaries of the mandates.  The inevitable response is for the government to restrict competition, thereby undermining the method whereby the free market delivers better products and cheaper prices in virtually every other field.  This problem is so large that Cochrane refers to it as “[t]he second original sin of healthcare regulation” in a recent blog post.[5]

The second telling point made by Cochrane is that it is necessary to reform both the demand side and the supply side simultaneously.  For example, a supply side reform that makes it easier for efficient specialty clinics to emerge might only have a limited impact if Americans remain over-insured and have limited cost consciousness.  Entrepreneurs won’t try to innovate and save costs if they know that consumers don’t care.  To get maximum bang for the buck, both sides of the price equation must be attacked.[6]

A recent podcast from the Cato Institute entitled “Can Healthcare Innovations Reduce Prices and Drive Cost-Effective Care?” picks up on many of the same points.  The podcast features James Robinson, an economist specializing in healthcare at the University of California, Berkeley.  He describes his recent research into changes that have been made by some large funds in California, including CalPERS, the monster that provides retirement and health insurance benefits to many government employees in the state.

The innovation works like this:  The insurer surveys local markets for different medical procedures, such as hip replacements or blood tests, and medicines.  The insurer then establishes a “reference price”[7] which is the amount it will reimburse for each product in each market.  The beneficiary of the insurance is then free to shop around, knowing that he will keep any savings below the reference price or pay any excess above it.[8]

This form of reimbursement is sometimes called a “reverse deductible” since it inverts the incentives the parties usually have.  With a standard deductible, the marginal cost (once the deductible is met) is predominately borne by the insurer, which means that the consumer has little motivation to contain costs.  With reference pricing, 100% of the marginal cost and benefit flows to the consumer, which creates a powerful incentive.

Robinson found that reference pricing reduced actual payments – not the phoney “quoted prices” which prevail in healthcare – by 20%, which is an extraordinary savings in a field where these have been very difficult to achieve.  Robinson also found that these savings were not made on the back of the insured: out-of-pocket costs also fell.

The reason for this is simple.  Robinson presented evidence that the dispersion in prices is huge, even for very simple procedures such as blood tests.  Reference pricing gave the insured the motivation to seek out low-cost providers, including sometimes not the most convenient ones, as they would with any other product.  A personal anecdote is useful here:  My girlfriend was recently prescribed an MRI.  If she did this at the local provider, it would cost about £600.  If she took a 30-minute train ride to a specialist MRI clinic, and went at an off-peak time, it would be about £200.  Since we now have a policy with a high deductible – which costs about 85% less than the full coverage policy we used to have – the choice is pretty simple.

Reference pricing also gives suppliers a strong incentive to reduce their prices.  Robinson gave an anecdote in the podcast.  When he presented his research to a group of hospital CEOs, one of them grabbed the list of reference prices and placed a call to his CFO demanding that he come up with a strategy to get all of their prices at or below the reference levels.  He also described how some providers cut their prices substantially when CalPERS started the program, something he had never seen before.

This research shows that consumer choice, combined with competition, is a much more powerful tool than negotiation by insurers (or negotiation by the government, as many advocates of a single-payer system claim).  The insurers theoretically had the same motivation to achieve cost savings.  But, as Robinson points out, no party is as well positioned as the end consumer to judge and enforce the trade-off between cost and service.  He also points out that the politics of healthcare and health insurance often make it very difficult for insurers to override the uneconomical decisions of unmotivated beneficiaries.  You can imagine the headlines.

Reference pricing is not a panacea.  It only works where there are multiple suppliers and the product is reasonably homogeneous.  The creation and maintenance of reference prices is also administratively costly (although it is pretty obvious that specialized companies would arise to provide this service cheaply due to economies of scale).  But Robinson estimates that it is applicable to roughly 33% of healthcare expenditures.  If these can be reduced by 20%, we are talking about an annual savings of roughly 1.2% of GDP.  In an $18 trillion economy, this is not chump change: almost $220 billion a year.  And it starts to show what can be achieved with the right incentives.

Another myth of the Left about healthcare is that America is a holdout, with all other advanced countries having gone to a single-payer system heavily controlled by the government.  This is also not true.  Singapore has a system that is noticeably more free-market than America’s.  Yet it produces health outcomes markedly superior to America’s[9] and it costs, although there is some debate about the reliability of this figure, about 4% of GDP versus America’s 18%.  That difference translates to $2.5 trillion per year.

I won’t attempt a full description of the Singapore system, which is, in any event, not a completely free market.  I will simply point out that the system relies heavily on forced savings into accounts that function similarly to Health Savings Accounts in the USA (with government help for the poor) and insurance against catastrophic risks.  In other words, self-insurance (through savings) for the routine vicissitudes of health and the unavoidable costs of old age[10], combined with a pooling of major risks for the unlucky.  This is exactly the direction that the US system should be taking.

One interesting phenomenon is the impact that Singapore’s system has on end-of-life care.  These expenditures are very large: one study found, for example, that 30% of all Medicare costs relate to the 5% of patients who die each year, with 1/3 of these occurring in the last month of life.  There are also plenty of horror stories that these expenditures buy absolutely no quality of life.  It is not surprising, therefore, that many Singaporeans, who have the right to pass on the balances in the health accounts to their heirs, chose to die peaceably at home instead of pursuing a costly agony in the hospital.

Finally, I leave you with this.  A recent Washington Post/ABC poll found that 62% of Americans favor Obamacare’s requirement that health insurance covers a minimum set of services.  The poll also found that 70% of Americans favor the requirement that pre-existing conditions are covered.

Pretty compelling, eh?  I am sure that Paul Krugman thinks so.

The Cato Institute and YouGov also did a recent poll on basically the same issues.  The only difference is they asked whether, in order to have these Obamacare provisions, the respondents would be willing to pay higher premiums.  Or more taxes.  Or have their access to procedures, medicines or facilities/doctors restricted.  Or have to wait for an appointment.  In other words, they were asked their opinion on the assumption that there truly isn’t any such thing as a free lunch.

Under these conditions, the majorities flipped the other way.  Which just goes to show that, if you ask a stupid question, you’ll probably get a leftwing answer.

Roger Barris

Weybridge, United Kingdom


[1] This is probably rivalled only by the myth that the rich don’t pay their “fair share” of taxes.

[2] For those who prefer to listen, Cochrane discusses this paper in an Econtalk podcast.

[3] A full discussion of Cochrane’s views on renewability and pre-existing conditions would take an entire blog on its own.  In brief, he thinks that, without regulatory barriers, the private market would offer policies that guarantee the right to renew at premiums that do not consider pre-existing conditions; he cites, for example, these efforts by UnitedHealth, which charged 20% more for policies with a guaranteed renewable feature, until Obamacare killed the market for this by forcing insurers to provide coverage for pre-existing conditions at no extra cost.

This line of reasoning requires additional review, particularly issues relating to transferability and the risk of stranded insurance pools.  However, since the standard argument for market failure in this area relies on information asymmetries between the insurer and the insured, and since these are no different than the ones that arise in the clearly functioning life insurance and annuity markets, I suspect that Cochrane is right.

[4] See, for example, here, the answer to the first question in the fantasy debate here, and the discussion of the Surgery Center in Oklahoma here.

[5] The first original sin? This is the tax preference granted to employee-provided health insurance which creates the moral hazard of over-insurance.

[6] An interesting article about Silicon Valley’s attempts to disrupt healthcare also makes this point.  The article highlighted two startups.  Their biggest problem?  Questions about whether their cost-effective services would be covered by conventional insurance.  They noted, however, that the rise of high-deductible insurance created an opening for their products.

[7] Where the reference price is set within the range of surveyed prices is a variable.  One of the programs described in the podcast set it systematically at the lowest cost provider.  Another set it at about the median point.

[8] Very often the insurer/employer will provide market information, and sometimes pre-negotiated deals, to help beneficiaries make this choice.

[9] Longer life expectancy (4 more years) and lower infant mortality (less than half), for example.  I quote these figures purely because they are commonly cited, not because I think they are meaningful.  Health outcomes are so heavily influenced by life-style choices (eg, diet, exercise, high risk behavior, etc.), which differ tremendously between countries, that I consider these comparisons to be nearly useless.

[10] To give you an idea of the possibilities, Robinson quotes an annual figure of $13,000 for the average company payment for an employee’s family health insurance.  If this were paid out to the employee in a tax-efficient way, this would quickly build up a substantial HSA kitty.

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5 Comments on "Healthcare and Free Markets"

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Gerard MacDonell
I enjoyed reading this post and found it compelling. As a practical matter, for your average Joe who basically only gets to vote for the politicians that will decide this stuff, what is s/he to do? Maybe Singapore is not on offer, so we need to choose the path to second or third best? I remember Douglas Holtz Eakin came into our shop and made a lot of very sensible points that got me quite enthused. Then a pal pointed out, yeah but the GOP ain’t the vehicle to get your THERE. So what do you do? I know not… Read more »

[…] of the best things about Cochrane is that he thinks from first principles.  (I have already covered his views on America’s broken healthcare system, which he attributes to the “original sins” of tax subsidies, which promote over-insurance, and […]

Dave Anderson

Roger, great article. The question it raises is why no politician chooses to ride this type of analysis to glory. Kamala Harris is smart enough, but we haven’t heard a peep! I would even vote for Trump if he asked by we don’t come close to doing as well as Singapore (or Germany) in $ per patient health care.

So, what would you recommend as a slogan to get this started, something on the level of MAGA?

Dave Anderson