Medical care and economywide price indexes.

• Author: Newhouse, Joseph P.

Joseph P. Newhouse (*)

It is well known that price indexes for service industries are subject to considerable error. However, errors in medical care price indexes are particularly significant because of that sector's share of the economy. Although the United States is an outlier with more than 13 percent of its GDP devoted to medical care in recent years, the share for other developed countries--typically between 7 and 11 percent--generally has been rising. The accuracy--or inaccuracy--of medical care price indexes has become sufficiently important that Alan Greenspan has taken note of it publicly. (1)

A group of NBER researchers have been working for several years both to quantify biases and to suggest technical improvements to medical care price indexes. (2) In a recent paper, I attempt to synthesize our results with those of other investigators and to put the work in a larger context. (3)

I make two principal points: First, although it is difficult to be precise about the amount of bias in the medical care price index, a number of studies have quantified the effects of its various problems. The results suggest that the bias may be large enough to have a nontrivial effect on the overall index. On the basis of some of the early studies, the Boskin Commission estimates that the medical care component of the consumer price index (CPI) was biased upward by 3 percentage points annually. (4) Second, the amount of bias may change from year to year. This possibility has important implications for monetary policy.

Some Causes of Bias in the Indexes

There are many reasons why the official medical care indexes may overstate the change in a cost-of-living index. Fortunately, some of the historical reasons have been corrected. For example, the CPI has measured the price of a hospital stay rather than the price of a hospital day since 1997. Between 1980 and 1995, the average length of a patient's stay fell 27 percent. Ignoring any effect on outcomes, this change clearly reduced the cost of treatment. Nevertheless, that reduction in cost was not proportional to the reduction in length of stay because marginal cost falls throughout a stay and care outside the hospital is frequently substituted for the marginal day. Before 1997, the CPI did not register the decrease in cost that resulted from shorter stays because it was pricing the cost of a day in the hospital. Indeed, pricing the cost of a day probably sent a perverse signal: because marginal costs rose as stays shortened, the average cost of a day rose with the fall in length of stay. (When the producer pr ice index for hospitals was introduced in December 1991, it priced the cost of a stay.)

Another improvement that was introduced into the medical care CPI in 1997 was the grouping of inpatient and outpatient surgical procedures in a single category. Prior to that time, a given procedure conducted in the hospital was treated as a different...