Cost - The Role of Supply and Demand in Driving Healthcare Prices

In my last several posts, I focused on the question of what access means in healthcare and how the healthcare reform might affect access to care. In discussions of access, issues and questions related to cost inevitably arise. In my next series of posts, I will begin looking from an economic perspective at some of the cost dynamics in healthcare, how we might expect reform to impact cost, and some options for lowering the costs of healthcare.

First, let's start by looking at basic supply and demand for a service or good. In Figure 1, there is a demand curve (D) that shows the relationship between the price of the good or service and the quantity demanded by consumers. As price goes up, the quantity demanded typically will fall. As price goes down, the quantity demanded tends to go up.

There is also a supply curve (S) which shows the relationship between the price of the good or service and the quantity that the providers of that good or service are willing or able to provide that that particular price.

In an unimpeded market (free of price controls, over-regulation, etc...), prices for the good or service will naturally move toward the equilibrium price (P) at the intersection of the supply and demand curves. This is the basic mechanism that drives the price and quantity of a particular good or service in the market.

Both the supply and demand curves can shift or change based on changes in the market. This can indicate a change in price sensitivity. For example, factors such as the introduction of new technologies or an increase in income can change the amount of a good or service consumers demand at a given price and cause a shift in the demand curve. Figure 2 shows an example where the demand curve has shifted. Note the affect on price. Without a similar shift in supply, the price is driven up from P1 to P2 by the additional demand. As a good or service becomes more scarce through additional demand or decreased supply, prices are driven upward.

Next, let's look at how this applies to the healthcare market. Understanding basic supply and demand is important in understanding some of the reasons why the price of healthcare tends to rise so quickly. In the healthcare market, the demand curve tends to be more "price inelastic" than other goods and services. In economic terms, the term "price inelastic demand" refers to the insensitivity of demand to a change in price. Among the major reasons that healthcare demand tends to become inelastic or price insensitive are the following:

1. The Role of 3rd Party Payors - the greater the share that a 3rd party (the insurer or government) covers, the less price sensitive consumers tend to be. Imagine, for example, if services were 100% covered with no out-of-pocket from the consumer. There would little incentive for the consumer to choose services based on price.
2. Urgency of Need - many healthcare services are urgent in nature. Consider individuals who are in motor vehicle accidents and require immediate life saving intervention. They are very unlikely to and may not be in a state to be able to consider the price of care.
3. Life-Saving Treatment - consider individuals with life-threatening illnesses such as cancer that require expensive, resource-intensive treatments. In these situations, individuals are likely to be more insensitive to the price of the care and willing to do whatever it takes to receive treatment regardless of the cost.

The supply of healthcare also tends to be price inelastic at least in the short-run. It takes a long time to train new providers such as physicians and nurses, and the time involved in opening new a new physical location to provide additional care (hospitals, clinics and other treatment facilities) is not insignificant either. So, supply increases and a corresponding shift in the supply curve that could offset the increase in demand are unlikely in the short run.

Figure 3 shows an example of what happens when your supply is price inelastic and your demand shifts and becomes more price inelastic. D1 shows an initial demand curve where demand is relatively sensitive to changes in price. Let's say that demand increases and becomes less price sensitive, moving to the new demand curve (D2). Note that when demand increases and becomes less price sensitive (D1 to D2) in a market with price inelastic supply (S), the resulting increase in price (P1 to P2) is much more dramatic than what we see with goods and services that are more price sensitive (Figure 2 above).

I raised some of my concerns in previous posts about how the healthcare reform bill could increase overall demand for healthcare services without a corresponding increase in the supply. I expect the increase in the number of of individuals who have access to healthcare coverage will increase demand and shift the demand curve as they will have more money to purchase healthcare services. Demand remains relatively price inelastic and may become even more inelastic as minimum benefit levels required by the health reform bill increase the amount that will be covered by 3rd party payors and further decrease consumer sensitivity to price. Without a corresponding increase in the supply, this is likely to drive healthcare prices up further as the supply becomes less able to meet the demand for services.

So, how will we prevent the cost of healthcare from continuing to rise and and make sure that individuals have access to the care they need given that we expect a large increase in demand in a short period of time with a very limited ability to increase the supply to meet the additional demand? My next post will look at ways in which we could drive prices down through both demand and supply-side measures.