AS THE ECONOMY TURNS

EVEN THE DEUS EX MACHINA DIDN’T MAKE HOUSE CALLS

Dr. William Shingleton

November 27, 2005

In the classical Greek theater impossible situations were sometimes resolved by having a god descend upon the stage to set events on the playwright’s intended course. They literally brought the god onto the stage with some combination of pulleys and lifts and this part of the story came to be known as the deus ex machina, which translates into the “god from the machine” if I remember my Latin. The Greek god could do anything and was a convenient tool that could right any wrong or destroy any fortress. We would assert that basic problem with American medicine today is that too many people are looking for somebody to play the role of the Greek god in the tragedy of attempting to pay for our medical services.

Americans spent 1.52 trillion dollars on health care in the last 12 month reporting period, October 2004 to September 2005 and that represented 12.1 percent of our 12.6 trillion dollar economy [SOURCE: www.bea.doc.gov/bea/newsrelarchive/2005/gdp305a.xls]. And while the increasing cost of health care is often in the news, the BUREAU OF LABOR STATISTICS (BLS) reported that the price of health care only increased 4.1 percent over the last 12 months, compared to the average inflation rate in the economy of 4.3 percent, as measured by changes in the Consumer Price Index (CPI). Somehow I suspect that the fact that health care costs ran below the average in the past year is a bit of an aberration, especially since every aspect of health care costs has run well ahead of the CPI when we look at what has happened over the last 22 years. On the average, since the 1982-84 BASE YEAR period, over-all prices as measured by the CPI have almost doubled (from 100 to 199.2), while most medical care prices have about tripled (MEDICAL CARE from 100 to 326.2; MEDICAL CARE COMMODITIES from 100 to 278.9; MEDICAL CARE SERVICES from 100 to 339.7; PROFESSIONAL SERVICES from 100 to 284.0;) and HOSPITAL AND RELATED SERVICES have more than quadrupled. from 100 to 443.6 [SOURCE: <http://www.bls.gov/news.release/cpi.t01.htm>].

With the increase in the prices has come the usual impatient American demand that the government “do something” about the rising costs, as if the government had the ability to roll back the laws of supply and demand, the laws that determine most of the prices in our capitalist system. If we look more closely at the evidence we’ll see that these price increases are probably caused by increases in the DEMAND for health care. The logic is simple. There are only two events that can cause prices to rise in a competitive market, either we have a DECREASE IN SUPPLY or we have an INCREASE IN DEMAND. If we consider the cause of the higher prices to be a decrease in supply, what we are saying is that health care suppliers would have been reducing the quantity of health care they offer to consumers even if the price had stayed the same. This would be consistent with some of the media stories about the big bad drug companies holding back their supplies in order to raise their prices and increase their profits. However, a reduction in supply assumes that consumers would continue to want the same amount of the product until the price begins to change. This would give us a short-term situation in which suppliers were supplying less than they were earlier and consumers were continuing to want the same old quantity. Economists would call this a SHORTAGE, where the quantity that consumers wanted to buy was more than the quantity that sellers were willing to sell at the old price. If we had had a shortage develop in this manner, then either the price would have risen or health care providers would have had to ration their products. While the higher prices are certainly consistent with what we have seen in health care prices there is another problem. In this scenario we would also be seeing consumers buying less, because of the higher prices or rationing, and that is not consistent with the world that we know, since the volume of health care we consume today is greater than at any time in the past. These conclusions are inconsistent with the facts, so the hypothesis that the higher prices over the last twenty odd years have been caused by any kind of supply reduction is logically false...

The alternative hypothesis is that the higher prices have been caused by an increase in demand. When a market experiences an increase in demand we have a situation in which consumers want to buy more even if the price does not change but, in the absence of a price change, suppliers are content to continue to deliver the same volume of services to the marketplace. Since we would normally assume that we were starting out with a market in balance between demand and supply, the change would again cause a shortage just like we discussed a moment ago, only this time it was the change in buyer behavior that was the cause. One remarkable feature of markets is that it usually does not matter whether a shortage was caused by a change in supply or by a change in demand; the effect of a shortage is either for the price to rise or for some sort of rationing to develop. However, now the higher prices would cause the sellers to increase their production from whatever it was earlier to whatever is most profitable at the new higher prices. If we have a procedure that a hospital can perform at a cost of $500,000 and the market price is only $100,000 the hospital may not be able to provide the procedure, even if it is life-saving. If the market price changes to $700,000 the hospital will not only provide the procedure, it will promote it. An increase in demand leads to both higher prices and higher quantities and this is consistent with the data from the world that we know.

A final, technical point here is that it is quite possible that both supply and demand have been changing over the last 22 years. As a matter of fact, it would be a surprise if that were not true. What we have shown above is that the dominant force behind the price increases has been rising demand rather than falling supply. Actually, once we have shown that rising demand is the dominant factor we have to allow that we know nothing at all about the direction of supply change without much more sophisticated analysis. Changes in both demand and supply have had some role in getting us to the point we are right now in health care.

So where has the increase in demand come from? The first logical cause has been our higher incomes. Health care is a NORMAL GOOD, which means that the demand for health care has increased, and will continue to increase as long as incomes continue to increase. As incomes go up, people often try to buy more and better health care with some of their increases in income. And just like the market for stringbeans, once you get an increase in demand, the price goes up too. If we really wanted to put a lid on health care costs the most obvious solution would be to stop our increases in incomes but I doubt that anyone, other than a handful of Luddites, would want to use this approach. Since we are fortunate enough to live in a society in which increases in income are so common as to be expected, we should recognize that the demand for health care, and health care prices, will continue to rise.

Of course, there are many other causes for this rising demand. Many of the ailments that our parents and grandparents were expected to “put up with” or worse, die because of, are treatable or even curable in today’s medical environment. These advances in medicine result in a two-pronged increase in demand. Consider something as simple as the flu shot. The great flu epidemic of 1918 killed over 20 million world-wide, including 675,000 Americans [SOURCE: < http://www.stanford.edu/group/virus/uda/ >]. While the specter of Bird Flu looms on today’s horizon, modern medicine has the ability to reduce most flu epidemics to mere inconveniences to most people. Today we have demand for some products that did not exist in earlier times, even if the earlier time was just a year or two back in the distant medical past.

So we have a market for medical services in which we have a rising demand and consumers upset about rising prices. Is it time to bring in the deus ex govenmenta to descend upon the stage to set events on our intended course? That depends, to a very large extent, on what you think the government is capable of doing. Most economists recognize that there are two necessary conditions that must be met before the government can play a constructive role. There has to be a problem and the government has to have the ability to alleviate the problem. Unless both conditions are met there is no logical basis for the government to be on the stage of health care.

High prices play a dual role in this drama. They are the villain when they ascend to “unfair” levels. And they provide the profits which draw more resources to the industry. Unfortunately, the two roles are opposed to one another. If we allow the prices to continue to rise at recent rates, more and more of our fellow Americans will be priced out of the medical care market. On the other hand, if we don’t allow the prices to rise, then the profits will not be there to attract new resources, including new medicines and new people. We can’t have it both ways, so we must say that one is the OPPORTUNITY COST of the other.

Of course, we could have the government produce our medical care. Imagine that, the people who brought us FEMA in charge of your life or death. That’s pretty scary. Any takers?

Alternatively, some people would say we should have some sort of national health care like they do in all of the other modern economies in the world. What people do not realize is that you cannot repeal the laws of supply and demand. Even if I walk into a drugstore and get my medicine for “free” somebody paid for it, and in the other countries it is the taxpayer, sometimes on a Medicare type assessment and sometimes out of total tax revenue. We could do that, but that kind of program raises costs for everyone on everything as the taxes impact the other markets. All we would need is about a trillion dollar tax increase to pay for it. Anyone interested? I didn’t think so. Sometimes there are not any simple solutions. Just don’t wait for the deus ex machina to come and help. He never did make house calls, even for the Greeks.

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