Dr. Martin Regalia's Econ 101 will return next month.

By Merrill Matthews, Ph.D., Executive Director, Council for Affordable Health Insurance

Rising health care costs and-consequently-the large number of uninsured have become two of the most prominent public policy issues in the presidential campaign. Before politicians attempt to "solve" the problem, they should first understand what is driving it.

Occasionally, scholarly studies emerge that try to explain the explosion of health care costs by identifying the various component parts of the health care system-e.g., technology, prescription drugs, hospitals, physicians, and administrative costs-in order to assess (or blame) which component is ultimately driving the increase and by how much. For example, the bipartisan Congressional Budget Office (CBO), the federal agency that estimates the fiscal impact of proposed legislation, recently published a study estimating that "about half of all growth in health care spending in the past several decades was associated with changes in medical care made possible by advances in technology" (see Congressional Budget Office, Technological Change and the Growth of Health Care Spending, January 2008, www.cbo.gov/).

Of course, there is certainly some truth in the notion that technological innovation, prescription drugs, new medical devices, and other innovations play a role in the rising costs. For one thing, modern medicine can do more today than it has ever done in the past. And because medicine can do more, it costs more. No one is surprised that a car in 2008 costs more than a comparable model did in 1978-even the term "comparable model" is misleading because cars today are so much better and have so many more functions, capabilities, and amenities. Nor do people seem to complain much about the fact that the new flat-screen televisions are more expensive than the older picture-tube models. Consumers know that they are getting more for their money.

We see technology and innovation affecting most areas of our lives. Yet those costs seem
reasonable. Indeed, the costs usually decline shortly after a new product is bought by the
"first adopters." 

But maybe health care is different-something we hear often these days. Except when it isn't. Take LASIK eye surgery, for example. Doctors providing this service are constantly upgrading their expensive machines, looking for ways to attract customers and providing additional services. Still, the prices have fallen significantly since these procedures first became available. Why? The primary reason is that patients are paying out of their own pockets and demand value for their dollars.

Herein lies the fundamental economic principle that explains why health care costs are growing much faster than the rate of inflation: cost insulation. In the vast majority of cases, when a patient goes to the doctor, hospital, or pharmacy, someone else-i.e., the employer, health insurer, or government-is paying the bill. And when someone else is paying the bill, consumers have little reason to care about the costs.

While patients are complaining that they are spending more out of pocket on health care than ever before, the numbers tell a different story. According to the CBO study, consumers in 1965 were spending 52 cents out of pocket for every dollar spent on health care. That number has fallen every year, so that by 2005 they were spending only 15 cents out of every dollar.

When we as consumers are insulated from the cost of our purchasing decisions, we tend to consume more. How much more is the subject of scholarly discussion. But many health economists think that with regard to health care, we could easily cut total spending by 20% to 30% with no ill-effects on health outcomes. Outcomes may even be better.

Employers probably know this economic fact of life better than any other segment of the population. Take business travel, for instance. When employees are traveling at company expense, they tend to be less circumspect about the price of hotel rooms, dinners, and airfares than they would if they were paying those bills themselves.

As a result, managers study travel expense forms as a check and balance to make sure that expenses are reasonable. Does anyone doubt that if employees were spending their own money on travel, they would find ways to spend less?

Similarly, employers and insurers tried to implement a checks and balances system with regard to health care expenses; managed care imposed a "manager" looking over the receipts of the patients and doctors to ensure that expenses were necessary and reasonable. And in the late 1980s through most of the 1990s, health care cost increases began to moderate. From 1994 to 1999, annual growth never exceeded 2.8%, according to the CBO study.

But there was enormous pushback from both patients and physicians, and eventually from politicians, in the form of patients' bill of rights legislation, which limited what managed care could do. As a result, the cost increases began to escalate again, leaving employers in a quandary: What should they do now?

We will never get health care costs under control until consumers have a reason to seek value-just as they do in every other sector of the economy. And the only way we're going to do that is to remove some of the cost insulation that pervades the health care system.

Consumers in most markets can compare and contrast the costs and benefits between products and services and determine for themselves whether one is providing additional value. And since they are paying for the product or service themselves, they have an economic incentive to get value for their dollars.

But in most medical care there are no prices. And for good reason: Consumers don't really care about prices because they aren't paying the bill! As a result, most medical providers have no idea what it costs them to provide a particular service, and patients who want to know can't find out. 

How many businesses could operate like that?

But you ask: Don't other countries with government-run health care systems control their costs? Don't they spend much less than we do in the United States? Yes, but there's a reason for that: The government simply imposes from the top down how much it will spend on care. These countries aren't more efficient; the government just sets a budget. And if there isn't enough money to cover everyone's health care needs-and there never is-someone just goes without. It's called rationing, and it's rampant in those countries with government-run systems. 

So how do we move to a system where patients are seeking value for their health care dollars but are still protected from the financial devastation that could come from a major accident or illness? Actually, many employers have already discovered the answer. They are shifting away from traditional health insurance to a high deductible health insurance policy, in conjunction with a Health Savings Account (HSA) or a Health Reimbursement Arrangement (HRA). 

The high deductible policy costs less-often significantly less-than a traditional policy, allowing the employer to give part or all of those savings to the employee. With the HSA, for example, employers might provide a policy with a $5,000 deductible for a family, but they put $3,000 or $3,500 into a tax-free personal account that belongs to the employee. Money left over in the HSA at year's end rolls over and grows with tax-free interest. Because that money belongs to the employee, he or she has an economic incentive to ask the question that is seldom asked today: Doctor, how much will that cost? Should a major accident or illness occur, health insurance kicks in to cover those costs and protect the employee's assets.

And this approach appears to be working. Employers offering so-called consumer driven policies are seeing annual premium increases in the low single-digit range; those with traditional policies have seen average increases of 8% to 14% over the past several years.

With regard to the presidential campaign, Republican candidates have generally been supportive of removing the cost insulation by transitioning to a consumer driven model that relies on options such as HSAs or HRAs. Democrats, by contrast, have generally supported increasing the level of cost insulation, promising to ensure that everyone has comprehensive health coverage while holding down costs by imposing top-down price controls.

If health care consumers have an economic incentive to get value for their health care dollars, spending will go down. If not, then health care spending will continue growing at double-digit rates until the politicians take over and tell us how much we can spend.