November 18, 2004
Competition and Incentives May Help Control Health Care Costs
EALTH care just keeps getting more expensive. According to the Stanford economist Victor R. Fuchs, health care expenditures by the elderly are growing 2 to 3 percent more rapidly than their spending on other goods. If this trend continues, by 2020 health spending by or on behalf of the elderly will exceed their spending on all other goods and services.
As the economist Herbert Stein cogently put it, "If something cannot go on forever, it will stop." What can be done to stop, or at least slow, the rapid growth in health care spending?
It has been argued, with considerable justification, that a significant part of the increase in health care expense is a result of improved quality. The real issue is not simply reducing spending on health care, but reducing it while still maintaining an appropriate quality.
Economists have two magic potions to control prices and improve quality: competition and incentives. How can these elixirs be best administered to the health care industry?
This question has preoccupied the Stanford economist Alain C. Enthoven for decades. In a recent book that he edited with Laura A. Tollen, "Toward a 21st Century Health System" (Jossey-Bass, 2004), he provides an outline of an answer.
Start with competition. For better or worse, most Americans receive health care benefits through their employers. The problem is that employers do not have much incentive to offer their employees choice in health care plans.
Offering three or four health care plans imposes administrative burdens on employers. A large employer might be able to handle these extra administrative costs, but small employers find it more economical to offer a single plan. In 1997, only 23 percent of insured employees were offered a choice of plans.
But competition cannot be effective unless there is choice of competing providers. What policies could be used to offer more choice?
What is needed is experimentation with, and competition among, different ways of delivering health care: prepaid group practices, health maintenance organizations, traditional preferred providers, and other ways not yet thought of. The key is to give consumers a choice among different delivery systems, not just minor variations on a single theme.
Mr. Enthoven argues that the most promising solution is a health care "exchange" like the California Public Employees' Retirement System, or Calpers. Calpers arranges coverage for over 1.3 million public employees, retirees and dependents for 2,400 different employers in California.
Such exchanges standardize business rules, facilitate comparisons among plans, and expedite enrollment decisions, billings and payments. BENU Washington is a new exchange aimed at companies with 100 to 1,000 employees, allowing these relatively small companies to offer a much wider range of plans.
Such exchanges could help businesses control the administrative costs of offering a number of health care plans. But there is still the issue of providing appropriate incentives to the individuals who must choose the plan most suited to their needs.
To provide the right incentives, individuals who choose the low-cost plans should be able to capture most of the benefits from such choices. Otherwise, they would have no incentive to economize.
Current practices offer perverse incentives. Employers often cover some fixed fraction of the cost of each plan. As Mr. Enthoven points out, "If the employer pays 80 percent of the premium, no matter the cost, the employee only keeps 20 percent of the possible savings from choosing an economical plan."
Mr. Enthoven argues that it would be better to have the employer cover the entire cost of the low-price plan, and let the employees who choose higher-priced plans cover the additional costs themselves.
Now that it is possible for employees to pay health care costs using pretax dollars, there are no adverse tax consequences to such an arrangement.
Plans of this sort are offered by Calpers, Stanford University and other employers. In many cases employees choose the less-costly options and capture the savings from doing so. But nationwide fewer than 5 percent of insured workers are offered both choice and the ability to retain savings from economical choices.
More choice and better incentives should help control health care expenses. But offering more choice in plans is not entirely risk-free.
One problem that providers face is what economists call "adverse selection." This means that workers who need more-expensive health care because of existing conditions will want to choose more comprehensive plans. This leads to higher costs for such plans, making the premiums even more expensive.
Mr. Enthoven advocates "risk adjustment" to control for adverse selection. This is a type of statistical procedure that estimates the likely cost of subscribers based on age, location, sex and so on, allowing insurers to predict the cost of those who sign up. Premiums can then be adjusted to reflect actual costs related to different health risks associated with different populations.
Such a system is not perfect - there are certainly incentives for insurers to exaggerate the likely costs. Presumably some oversight would be required to make such a system work. The current system certainly has its share of such problems as well, so this should not be a decisive factor.
Mr. Enthoven is a big fan of prepaid group practices like Kaiser Permanente. Such organizations offer both health care services (doctors, clinicians, labs and hospitals) and insurance services (financing, benefit plans and customer services) in one package. Prepaid group practices are well established on the West Coast, and in certain other areas, but there are many regions of the country where they are simply not available.
One attraction of providing more choice, and better incentives, is that it would reduce entry costs for new providers like prepaid practices.
The start-up costs for such plans easily exceed $100 million. It can take years to develop a strong reputation among doctors and potential subscribers. Yet once such reputations have been developed in a region, prepaid group practices have created large and loyal followings. Indeed, many health economists view such plans as providing models for cost-effective health care.
But regardless of how one feels about these plans, it seems clear that more choice, more competition and stronger incentives would be good medicine for the health care industry.
Hal R. Varian is a professor of business, economics and information management at the University of California, Berkeley.