Cost - Supply Side Options

In previous posts, I discussed some of the demand-side options that could be used to reduce healthcare costs.  There are also supply-side options for cost reduction.  In general, the following changes can shift the supply of a product or service in a way that will result in lower costs:

• Increased number of suppliers
• Increased production efficiency via technology or process change
• Decreased price of inputs
• Increased profitability of the supplier's other products or services
• Increased expected future price

Let's look at the first option which is to increase the number of suppliers...


In healthcare, the number of suppliers/providers of healthcare services has become a hot topic in debates surrounding healthcare reform.  As I mentioned in a previous post, a shortage of primary care physicians is expected well into the future with predictions of a 40,000 doctor shortage within a decade.  In addition, the supply of nurses is expected to fall short of demand with a projected shortage of 260,000 nurses by 2025.  


Title V, Subtitle C of the healthcare reform bill (PPACA) focuses on the healthcare workforce.  It seeks to increase the supply via a combination of student loans and loan repayment programs, reallocation of existing residency slots, nurse-managed clinics, and grants specifically aimed at getting more primary care physicians into the work force. At HHS.gov, a recent news release states that $290 million in new funding will "support more than 16,000 new primary care professionals” by 2015.  However, I see a few problems with the plan:

1. Congress has yet to appropriate the funds for this.
2. There no focus on specialty training and no real consideration that there could be shortages in non-primary care specialty areas.  This has already become a big problem in Massachusetts.
3. It takes roughly 7 years to train a new physician and get them into the workforce.  I wouldn't expect this to have much impact prior to 2017 or later.
4. Congress capped funding for medical residencies in the late 90s leading to a shortage of residency positions today.  The PPACA redistributes existing residency slots to under-served areas, but it does nothing to lift the cap and create the necessary new residency slots to support an increase in physician supply.

Even if the plan does manage to introduce 16,000 new primary care physicians by 2015, this still falls far short of addressing a predicted shortage of 40,000, and the additional demand created by the newly insured makes it even more likely that demand for care will outstrip the supply.

Given the current supply challenges and the many questions about the PPACA's ability to increase the number of providers, we would need to look at some of the other supply side options to try to meet the demand and reduce costs.  


Next, I will look at the possibilities of reducing healthcare costs through increased efficiency via technology and/or process change in a post soon to come.

Wait times, cost and demand

There was an interesting posting on John Goodman's Health Policy blog today with stats on the wait times for the ED and primary care physician offices vs. the wait times for other services.  Here's a link to my thoughts on the topic.

Follow-up on "Coverage <> Access" post

It appears that Massachusetts' physician shortage that I mentioned in my June 2010 post "Coverage <> Access" continues to worsen.  The Massachusetts Medical Society released a report today found 10 out of 18 specialties they studied to be in short supply.


Adding an additional 440,000 individuals to the insurance rolls in Massachusetts without a corresponding increase in the supply of providers seems to have really taken a toll on the ability of the state's residents to access the care their newfound coverage is supposed to have offered them.

Cost - Demand Side Options (Part 1)

As I discussed in my last post, there are options for controlling healthcare costs that focus on the demand side of the equation. My next posts will examine several of these options.

Demand could be shifted through options such as increasing the percentage of co-pays and other out-of-pocket expenses to increase the price sensitivity of consumers. This could shift the demand in a way that could lower prices somewhat as healthcare consumers become more cost-conscious.

Let's look at an example of how this works from an economics perspective. In Figure 1 below, we start with a scenario where there is no cost sharing by the consumer. In this scenario, there is very little price sensitivity because the consumer is not paying for any of the costs of service. This results in the demand curve labeled D1. Note that this results in a quantity demanded of Q1 and an equilibrium price of P1.

If we introduce a co-payment of $25, some interesting changes occur. The consumer is actually price sensitive up to the amount of $25. After that amount, the consumer is not paying any additional amount for additional services. This results in the new demand curve labeled D2. Two significant things happened with this change:

1. Demand for the services decreased to Q2
2. The price for the services decreased from P1 to P2

So, the addition of the co-pay or other cost-sharing mechanism shifts the demand curve and results in lower prices for services.

At least with private insurance, consumers are already sharing more in the cost of care through co-pays, deductibles, and through consumer-driven plans that use a high deductible plan in combination with a Health Savings Account (HSA). However, costs are still rising overall, and the future of consumer-driven plans is unclear at this point given that the health reform bill requires minimum benefit levels that may exclude high-deductible insurance plans that are required in order for consumers to qualify to use an HSA. In addition, the use of Flexible Spending Accounts (FSAs) to purchase over-the–counter medications will be severely limited, and the maximum amount of money that can be set aside in an FSA will be reduced to $2,500.

In addition, the health reform bill includes requirements that Medicare and new private insurer plans make preventive services available with no deductible or copayment. This is likely to increase demand for primary care services at a time when many expect a growing shortage of primary care physicians.

What is interesting is that cost sharing actually has the effect of reducing demand without significant negative effect on outcomes, and making healthcare services available with no cost sharing has actually been found to have little positive effect on patient outcomes. A report by The Kaiser Family Foundation examined the findings of the RAND Health Insurance Experiment and other more recent studies and actually found that "higher co-insurance rates, with an out-of-pocket limit, can significantly reduce health care use without sacrificing health outcomes for the typical person." They also found that "there are no “substantial benefits” from being on the free-care plan for the typical enrollee".

The health reform bill is actually moving us away from using these cost sharing options as a method for controlling costs by reducing demand. In fact, it will likely serve to increase demand rather than constraining it, ultimately resulting in increased costs.

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.

A Question of "Access" - Follow up on Adverse Selection

In a previous post on June 18th, I discussed the issue of "adverse selection" and how it could potentially lead to a collapse in insurance markets. It turns out that there has already been evidence of this occurring in Massachusetts. According to a report from the Massachusetts Division of Insurance, "the number of people who appear to be gaming the state's health insurance system by purchasing coverage only when they are sick quadrupled from 2006 to 2008." http://bit.ly/bin9mN

What is interesting is that the penalties for choosing not to purchase health insurance in Massachusetts are stiffer than those outlined in the national health reform bill. With relatively weak penalties and little ability to enforce the mandates in the national health reform bill, I would expect that we would see an even greater percentage of people "gaming" the system than we see in Massachusetts if the bill is implemented in its current state.

This really becomes both an access and cost concern as it will either make it more expensive for people to purchase insurance and/or drive insurance companies out of the market depending on how the government responds to people "gaming" the system.

A Question of “Access” Part 2: Coverage <> Access

As I mentioned in my last post, the healthcare reform bill has been touted as a way to increase “access” to healthcare for all Americans. I discussed the fact that the bill mainly serves to increase the coverage for healthcare expenditures through mandates. In today’s post, I will take a look at how ensuring coverage does not necessarily result in increasing access to the care itself. I will start by looking at the State of Massachusetts and the results of their efforts to increase access to healthcare.

In Massachusetts, one of the very first goals of their healthcare reform efforts was to ensure coverage for all citizens of the state through mandates. They have been very successful in their efforts. With over 97% of residents having some form of healthcare insurance, Massachusetts boasts one of the highest coverage rates in the entire country.

One of the first issues that Massachusetts began to see early in the process was that the supply of primary care physicians was not sufficient to meet the newly created demand for their services. Wait times to see primary care physicians increased, and many primary care physicians stopped taking on new patients.

This does not bode well for the newly insured who are seeking care in the primary care setting. In fact, there is recent evidence in Massachusetts to suggest that many have been driven to meet their care needs (including primary care) in the more costly, already crowded emergency room setting. While this does provide them with access to care, it is certainly not the most appropriate level of care for many of these cases, and it raises some major concerns about the cost of care to both the patients and the State of Massachusetts.

The shortages in Massachusetts are not limited to primary care either. Specialties such as neurosurgery and oncology are seeing shortages as well. Of particular interest is the fact that emergency medicine is one of the specialties identified as being in short supply in the state. At some point, you have to wonder whether even the combination of primary care providers and emergency care providers will be enough to meet the demand of the previously insured plus the 440,000 newly insured residents of the state.

There are certainly concerns about access on a national scale as well. Similar to the healthcare reform in Massachusetts, the national healthcare reform bill also attempts to address access via mandated coverage. This, of course, will be on a much larger scale as tens of millions of people gain coverage.

In a detailed analysis of the estimated impact of the healthcare reform bill, the chief actuary of the Centers for Medicare and Medicaid Services expressed much concern that the combination of supply issues and unfavorable reimbursement rates would likely result in both higher prices and decreased access to care for Medicare and Medicaid patients:

“In practice, supply constraints might interfere with providing the services desired by the additional 34 million insured persons. Price reactions – that is, providers successfully negotiating higher fees in response to the greater demand – could result in higher total expenditures or in some of this demand being unsatisfied. Alternatively, providers might tend to accept more patients who have private insurance (with relatively attractive payment rates) and fewer Medicaid patients, exacerbating existing problems for the latter group. Either outcome (or a combination of both) should be considered plausible”

“[P]roviders for whom Medicare constitutes a substantive portion of their business could find it difficult to remain profitable and might end their participation in the program (possibly jeopardizing access to care for beneficiaries).”

Since it takes many years to educate and train new physicians and to have physicians from other markets move and enter underserved markets to meet the demand, it is unlikely in the short run that the supply of physicians will catch up to the newly created demands for care. In the long run, we will need to consider the possibility that the supply may never catch up to demand. In fact, an AAMC study estimates that the US will be short by more than 150,000 physicians by the year 2025 given current patterns of declining first-year medical school enrollment.

While the health reform bill is very likely to increase the coverage of the uninsured, it fails to truly increase access to actual healthcare services. It is apparent from what we have already seen in Massachusetts that coverage and access are not synonymous. Increasing access to healthcare services will require other solutions that include a re-examination of government reimbursement and funding and the use of solutions that improve the operational efficiency and effectiveness of the healthcare providers themselves (topics for a future post) to increase the available supply of those services.

A Question of "Access"

My first post in this series starts with the question of access. When it comes to the issue of access, the health reform bill has focused on access to insurance and government programs for paying for healthcare rather than on access to healthcare itself. Since so much of the reform effort has been in the area of insurance reform, it is important to understand how some of the changes called for by the bill in the name of improving access have ultimately led to government mandates that are likely to be ineffective in improving access and may actually drive up the cost of insurance for everyone.

We will start with a basic insurance concept known as “adverse selection”. The Insurance Information Institute defines adverse selection as “the tendency of those exposed to a higher risk to seek more insurance coverage than those at a lower risk.” Adverse selection in an insurance market has a tendency to drive insurance premiums higher since it results in a risk pool that tends to use more healthcare. In the most extreme scenarios, adverse selection could even lead to the collapse of insurance markets.

There are several ways to avoid adverse selection:
1) Waiting periods and exclusions for pre-existing conditions
2) Charging higher premiums for greater coverage
3) Adjusting premiums based on information about an individual or population of individuals
4) Mandating that everyone purchase health insurance

Let’s consider what happens when we take away the insurer’s ability to exclude based on pre-existing conditions. Without these exclusions, individuals may choose not to purchase insurance until they are actually sick and need it. If I am healthy and I know that I can purchase insurance when I happen to get sick, I am likely to determine that it does not make sense for me to purchase insurance until I do get sick. If I later find out that I have developed a heart condition, I am now more likely to consider purchasing insurance to protect myself from the risk posed by that condition.

An insurer can offset this to some extent by charging higher premiums for greater coverage or greater risk. The idea here is that there is a correlation between an individual’s health (or anticipated healthcare needs) and the amount of insurance he/she will purchase. Sicker people tend to want more coverage because they anticipate a need for it. Healthy people want to purchase less because they do not expect to benefit as much from having more insurance. They are more likely to choose a plan with a lower premium and higher out-of-pocket costs for care (high deductible plans, HSAs, etc…) since they do not expect to need as much healthcare or simply not purchase health insurance at all.

To a more limited degree, insurers can also offset this by adjusting premiums based in information about the health of an individual or a group of individuals. Take insurance policies that protect against specific diseases (cancer) as an example. These plans tend to have much higher costs to purchase. It makes sense. If, for example, I have a strong family history of cancer, a cancer policy is much more appealing to me than if I am completely healthy and have no family history of the disease. My strong family history of cancer means that it is more likely that I will actually need to use the insurance. With these types of policies, the insurer has adjusted the price based on the increased risk associated with the population that is being covered.

The first three options I covered above for combating adverse selection are solutions that have come out of a free-market approach to insurance and healthcare. The current healthcare reform bill essentially takes most of these free-market solutions off the table as options for preventing adverse selection. It takes away the ability of insurers to exclude on pre-existing conditions, limits the ability of the health insurers to adjust premiums based on factors such as age and gender, and actually requires insurers to submit justification before any premium increases. In addition, it requires that insurers must accept every individual or employer that applies for coverage (guaranteed issue). http://bit.ly/b0UkCw

So, let’s think about what happens now. Without any significant mechanisms for preventing adverse selection, some of the healthiest individuals begin to make the decision to cancel or simply not purchase health insurance. The perceived benefit of insurance for these individuals is no longer worth the cost of the premiums. Now, the risk is spread over a smaller, sicker population of individuals. This will cause insurers to raise premiums. The higher premiums will cause yet more of the healthy, low-risk individuals to cancel or choose not to purchase health insurance. This leads the insurers to again raise premiums. Again, healthy people drop out of the risk pool. The cycle continues until healthy people no longer have any incentive to purchase insurance and the sick and unhealthy can no longer afford the premiums to purchase insurance.

The scenario I have described assumes that the insurer is actually able to increase premiums to adjust for the higher risk. If they are not able to adjust their premiums adequately based on reforms, the insurance market will still collapse as insurers determine they can no longer cover the risk of the covered population with their current premiums.

To fill the void left when the free-market solutions for avoiding adverse selection have been taken away or limited, the government has chosen to implement the fourth option I mentioned above for preventing adverse selection. The health reform bill mandates that all individuals obtain health insurance coverage or face a penalty. http://bit.ly/cvsWiP Assuming the mandate is enforceable, the healthy, low-risk individuals are now re-introduced into the risk pool, and the adverse selection spiral is prevented.

This assumes that compliance with the mandate is high. Some individuals could still decide that it is more cost effective to pay the penalty rather than purchase insurance. If this happens, we still could see adverse selection driving premiums up. Non-compliance rates for government mandates have historically been around 14 – 15%. Hawaii is an example of a state that actually has had mandated health insurance since the 1970s. While there are penalties for non-compliance, the state of Hawaii still experiences a non-compliance rate of roughly 10%. http://bit.ly/bnyQ7C

So, has the reform bill truly addressed the issue of “access”? Not really… If you think about it, the current healthcare reform bill only serves as a vehicle for increasing access to health insurance and government programs that pay for healthcare, not to the actual healthcare services themselves. In fact, we are introducing millions of new people into the system without a similar increase in the supply of providers and healthcare delivery organizations (a topic for a future post). While individuals could potentially have more access to insurance and government programs to pay for their care, it is likely that there will be less care to go around as the demand for care outstrips the supply. In addition, the expected success of a government mandate in increasing access to insurance itself is at best questionable given the historically high non-compliance rates with other mandates.

Should the reform bill move forward as-is, we may very well see a future where efforts to increase access to insurance and government programs have failed, and access to affordable, high-quality healthcare services has simply never been addressed.

Healthcare Reform

Healthcare reform discussions in our country initially suggested that the purpose of the reform was to deliver improvements in the following three major areas:

1. Access
2. Quality
3. Cost

Even the title of the bill “Patient Protection and Affordable Care Act” suggests that it will ultimately address the issues in these areas. In my first series of posts, I will look at each of these areas and provide thoughts on the ways healthcare reform does or does not address these areas and on some of the implications of reform for healthcare delivery organizations and providers.