San José State University
Department of Economics

applet-magic.com
Thayer Watkins
Silicon Valley
& Tornado Alley
USA

Higher Medical Costs in the United States as a Result of the
Artificial Restriction on Training of Physicians and
the Impact of the Subsidization of Prices
for the Effectively Cartelized
Medical Service Industry

The expenditures of Americans for health care are enormous, as the statistics below indicate. Not only are they high, they are increasing.

>
Medical Care in the U.S. 2001 to 2006
in billions of dollars at 2000 Prices
 Category20022003200420052006
Total Cost of
Medical Care
 1,353.2 1,411.0 1,457.0 1,504.6 1,556.1
  Drug preparations
and sundries1
195.5 208.6 218.3 223.8 232.2
  Ophthalmic products and orthopedic
appliances
21.1 21.5 22.0 22.3 23.3
  Physicians2 269.8 288.1 302.2 317.7 334.7
  Dentists 66.4 65.9 67.5 68.0 68.5
  Other professional services3 178.1 187.2 196.6 204.4 213.7
  Hospitals and nursing homes 529.3 541.5 549.8 564.5 578.3
Hospitals4Total 440.9 452.2 461.1 473.5 484.6
Nonprofit 288.1 297.0 305.7 315.3 322.7
Proprietary 54.7 57.2 57.0 58.9 61.7
Government 98.2 98.0 98.5 99.4 100.4
  Nursing homes 88.4 89.5 88.8 91.0 93.8
Health insuranceTotal Costs 93.3 98.8 101.9 105.8108.4
Medical care and hospitalization5 74.8 79.2 81.8 84.7 87.9
Income loss6 1.9 2.0 2.1 2.3 2.4
Workers'
Compensation7
16.7 17.7 17.9 19.0 18.0
Source: U.S. Department of Commerce, Bureau of Economic Analysis

Notes:

Caution on the use of chained-dollar NIPA estimates

The amount now spent on medical care by Americans is about twenty percent more than they spend on food and about ten percent more than they spend on housing. Some portion of the increased costs comes from the development of new and expensive procedures, but that is only part of the story. The rise in the cost of medical care is said to be out of control and somewhat of a mystery. However there is really no mystery involved. It is due to the subsidization of an industry in which effectively there is a cartel operating to restrict the supply of medical practitioners.

Around 1900 there was a concerted effort on the part of physicians in the U.S. to restrict the supply of doctors; as they termed it, "To practice professional birth control." First campaigns were conducted in every state to require doctors to pass an examination in order to practice medicine in that state. That was easy for everyone to accept as reasonable. However it is one thing for the government to create a program of certification and yet another thing to create licensing. Certification provides consumers with information whereas licensing is always a vehicle for restricting supply. In the case of physicians it was then specified that in order to take the examination a candidate had to be a graduate of an accredited medical school. Somehow that deviated from the goal of requiring competency for medical practitioners. But most would accept that as probably basically wise. Then came the clincher. Who was to be the accrediting agency for the medical schools? The task was given to a committee of the American Medical Association (AMA). The AMA is basically the union for doctors, or perhaps more accurately the guild for the doctors.

A survey was made of the American medical schools and the results published in 1910 and known as The Flexner Report after Abraham Flexner the principal figure in its creation. Flexner himself visited all 155 medical schools in existence at that time. He recommended closing of all medical schools which were not affiliated with a university.

Representatives of the state AMA committees with the power to lift the accreditation of medical schools went around to those medical schools telling them that it did not think they could not do an adequate job of training the number of doctors they were training and that half that number was more suitable. The medical schools had no choice. The lifting of their accreditation would eliminate all demand for their services.

The impact on the production of doctors was dramatic. In 1904 there were about 160 medical schools in the U.S. training more than twenty eight thousand students. In 1920 the number of medical schools was reduced to 85. Some of this reduction was due to the merging of different schools and this would not necessarily have been detrimental to the supply of doctors. However in 1920 the number of students in American medical schools was reduced to 13,800. A reduction from 1904 levels of somewhat more than 50 percent. In 1935 the number of medical schools in the U.S. was down to 66 and all but nine were part of a university. It was said that Flexner wanted the number of medical schools reduced to 31 and the annual number of graduates reduced from 4400 to 2000. With the reduction in admissions the enrollment returned to a more nearly all white male student population.

So the admissions to medical schools in the U.S. was reduced about fifty percent. There was now a quota. There were thousands and thousands of Americans with the abilities and the motivation to become doctors who were denied the opportunity simply because of this quota. In Canada while more than 50 percent of the medical schools were eliminated and the enrollment cut also by more than 50 percent there was no elimination of medical schools. This suggests that what was happening to medical education was not entirely or even mostly about improving the quality of medical education.

As a result of this restriction the income of doctors went up. In the long run the gains of the restricted supply of doctors did not all accrue to doctors. The restriction generated economic rents which others found ways to garner. The medical schools, with their quotas on admission, could charge higher tuitions. Consequently now many doctors graduate from medical school with enormous debts for their educations. So now it appears that doctors need to receive high incomes to pay for their expensive education.

In terms of economic analysis, what was involved was the creation of a cartel of doctors. A cartel functions as a protected monopoly. If a monopoly is created in an industry that was previously competitive, the first thing the monopolist does is raise the price and reduce production. The same thing is accomplished by reducing production and allowing the price to be bid up. This is the procedure in the case of a cartel.

In the simplified case of constant unit cost (average and marginal) and straight line demand functions the monopoly output is one half of what the competitive output would be. The price rises to a level that is half way between the competitive price and the maximum price for the market; the maximum price is the price that would reduce the quantity demanded to zero. This is shown in the following diagram.

In the diagram the upper red line is the demand function. The demand line extends from the quantity demanded if the price were zero, qmax, to the price at which the quantity demanded is reduced to zero, pmax. The quantities pc and qc are the price and output that would prevail under competition. In the absence of externalities in the production and consumption of the product, qc and pc, would be the socially optimum levels of production and price.

The lower red line is the marginal revenue line which represents the benefit to the monopolist of a unit increase in production. The monopolist chooses a level of output where marginal revenue is equal to marginal cost. That output is labeled qmon in the diagram and the price charged is pmon. The monopoly price is only partially tied to cost. The other consideration is what the traffic will bear. The monopolist does not charge all the traffic will bear because that would reduce the quantity demanded to one unit. Instead the monopolist sets price and output to maximize profit. In the simple model being considered above that price is half way between pc and pmax. Since pmax is the maximum price that anyone will pay for one unit of the product the monopoly price may well be far above the marginal cost. For example in the medical field the cost of setting a broken arm considering the cost of training and employing someone competent in setting broken bones might be $200. The maximum price anyone might be willing and able to pay for having a broken arm set might be $60,000. The price set by a medical cartel would then be $30,100. Thus the price is dominated by pmax, the price of all the traffic will bear.

The medical cartel does not involve a centrally directing organization. Each doctor knows what policies are in the interests of the doctors as guild. All that needed to be done to was limit the production of doctors. The market itself drove up the price of medical services and the severe limitation on the number of doctors dictated that doctors had all the business they could handle. However, if some doctor was tempted to offer medical services at below the prevailing rate there was a mechanism to bring the maverick back into line. The maverick was simply threatened with the withdrawal of hospital privileges. Without being able to sent patients to a hospital a doctor generally cannot effectively practice medicine.

So the monopolization of an industry brings about a higher price. The consumers may petition the government to alleviate their suffering by helping them pay the higher price. The economic analysis of the impact on price of a subsidy can be carried out in two forms. One version focuses on the price received by the cartelists; the other on the price paid by the customers. The diagrams for the two analyses are shown below. The end result is the same for both approaches; i.e., the price paid by consumers goes down, consumption of the product increases and the price received by the cartelists increases.

If the government pays a subsidy s in a cartelized market where the price without the subsidy is pmon, the price paid by consumers does not fall to (pmon-s). Instead the monopoly price rises to pmon+½s so the price to consumers falls to pmon−½s. Thus the higher the subsidy the higher the cartel price and the more consumers feel they must have a subsidy. The consumers do benefit from the subsidy but only to an extent equal to half of the subsidy. The other half of the subsidy goes to the cartel. Of course the consumers ultimately pay for the government subsidy in terms of taxes. Thus the consumer/taxpayers have a net increase in costs equal to the one half of the subsidy that goes to the cartelists.

In the general case the effect of the subsidy may not be divided equally between the consumers and the monopolist. The division would depend upon the shape of the demand function and the slope of the marginal cost function. For the details of the general case see Impacts of taxes and subsidies in monopolized markets. However, the essential thing is that one effect of a subsidy is to raise the price set by the monopolist.

Now suppose the government want to cover the entire cost of the service. Then the subsidy is set so s=pmon. Then the price rises to pmon+½pmon=(3/2)pmon. Now the subsidy has to be (3/2)pmon. The price would then rise to (3/2)pmon+(3/4)pmon =(9/4)pmon. The next subsidy has to be (9/4)pmon and the price would rise to (27/8)pmon. The pattern is that after n increases in the subsidy the price would be (3/2)n and with this exponential growth the price of the service is soon astronomical. The price paid by consumers would never get to zero but the attempt to reduce it to zero would result in astronomical prices and astronomical gains to the cartelists.

In 2006 the cost of medical care in the U.S. reached the astronomical level of $1.59 trillion. This is up from $1.21 trillion in 2002. In 2006 the total amount American spent on food was $1.26 trillion. Thus Americans are spending about 26 percent more on medical care than on food. The total spending in 2006 on housing was $1.38 trillion, so the cost of medical care was 15 percent more than the cost of housing. The difference between medical care and housing and food, all of which are essential for life is that there is not an effective cartel limiting the supply of food and housing.

Medical insurance is a great boon to the public for dealing with catastrophic illnesses. However, the effect of insurance on medical care prices is much like that of a government subsidy. The price that a monopolist imposes is only limited by the effect of higher prices on the quantity demanded. If the government or insurance removes the effect of higher prices on the quantity demanded then there is no limit to the price the monopolist or the cartelists will impose. The combination of private insurance and public subsidies has driven the cost of medical services to the astronomical levels where consumers feel that they cannot survive without insurance or government subsidies or both. It makes only marginal differences in the price of medical services whether they are paid for out taxes or from the premiums on insurance that everyone has to have.

Suppose the government or the insurance does not attempt to pay the full amount of the price, but instead attempts to cover some fixed proportion of the price, say β. Then the cartel price rises to pmon(1+β/2) and the price paid by the consumers would fall to pmon(1−β/2). Thus the government subsidy would have failed to bring the price down to pmon(1−β). The next increase in the subsidy brings cartel price to pmon(1+β/2)(1+β/2)=pmon(1+β/2)². After the nth increase in the subsidy the cartel price would have risen to pmon(1+β/2)n.

The bottom line is that only a substantial decrease in the quantity demanded will limit the price set by a monopolist. If the quantity demanded is fixed over some range of prices the monopoly price will go to the top of that range. Government and insurance both try to make the demand for medical services independent of price. The price goes up to the limit of the range that government and insurance can make the quantity independent of price.


To put the matter in perspective, if a cartel actually did charge all the consumers can bear and a subsidy were given then the cartel would take the subsidy and continue to charge all the consumers will bear. As the above indicates the monopoly price incorporates only half the subsidy or insurance payment but that is enough for government subsidies or insurance coverage to drive monopoly prices to astronomical levels.

A backward bending supply curve for a labor service is a situation in which the providers of a service take the benefit of a higher rate of pay in the form of more leisure time. This may take the form of a reduced work-week or more vacation time each year. As is shown in Impacts of taxes and subsidies when there is a backward bending supply curve the subsidy raises the price to consumers rather than lowering it.

Conclusions

What the analysis reveals is that government subsidies and insurance are not the solution to the high cost of medical services, they are a major part of the problem when the medical services field is cartelized. The subsidies may even make the situation worse. When the incomes of doctors and other medical service providers reaches a level where they take the benefits of higher pay in term of increased leisure time then the restricted supply of medical service providers will be (or has already been) reduced. From that point on the effect of increased subsidy will be not only higher prices but also reduced quantities of medical care.



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Caution on the use of chained-dollar NIPA estimates:

Chain-type estimates provide the best available method for comparing the level of a given series at two points in time. Chained-dollar estimates are obtained by multiplying the chain-type quantity index for an aggregate by its value in current dollars in the reference year (currently 1996) and dividing by 100. For analysis of changes over time in an aggregate or in a component, the percentage changes calculated from the chained-dollar estimates and the chain-type quantity indexes are the same. Thus, chained-dollar estimates can be used to compute "real" (i.e., inflation-adjusted) rates of growth. However, comparisons of two or more different chained-dollar series must be made with caution, because the prices used as weights in the chained-dollar calculations usually differ from the prices in the reference period, and the resulting chained-dollar values for detailed GDP components usually do not sum to the chained-dollar estimate of GDP or to any intermediate aggregate. A measure of the extent of such differences is provided in most chained-dollar tables by a "residual" line, which indicates the difference between GDP (or another major aggregate) and the sum of the most detailed components in the table. It is usually best to make comparisons of aggregate series in current dollars or to use BEA's estimates of contributions to percent change. Measures of the contributions of components to the percentage change in real GDP and to the percentage change in other major aggregates are provided in NIPA tables S2 and 8.2-8.6. In general, the use of chained-dollar estimates to calculate component shares or component contributions may be misleading for periods away from the reference year.