The medical care cost ratchet.

• Author: Foy, Andrew

Since 1970, the annual growth in U.S. health care spending per capita has been more than double the real growth in GDP per capita: 4.3 percent versus 2 percent. Over that same time period countries belonging to the Organization for Economic Cooperation and Development (OECD) averaged an annual growth rate of 3.8 percent in health care spending per capita compared to only a 2.1 percent annual growth in GDP per capita. Eight of 20 countries had higher average annual growth rates in health care spending per capita than the United States (White 2007). In light of the pronounced institutional differences among these countries in medical financing arrangements, the similarity in the rate of health care spending growth is striking. Therefore, any explanation that seeks to account for the tremendous cost growth in health care over the last several decades must hold true across all OECD countries.

This article describes a construct for health care cost growth associated with social welfare loss that we refer to as the medical care cost ratchet (MCCR). In this model, health care spending increases over time as new technologies are incorporated into the traditional standard of care that confer only modest clinical benefits. We explain how the current medical insurance model perpetuates the MCCB. We then explain how medical cost analyses are performed before presenting several clinical vignettes that validate our model. The article concludes by arguing that market-based approaches to health care reform would be effective at bending the cost curve over time by encouraging individuals to economize nonemergent health care decisions--doing so would upset the MCCR and reduce spending growth.

Technological Change and the MCCR

In the 1980s, the conventional explanation of health care cost growth emphasized the moral hazard from health insurance and particularly the tax treatment of health insurance (Newhouse 1992). According to this view, traditional health insurance reimburses as a function of expenditure or use. Because insurance drives the marginal price of medical care at the point of use to near zero, consumers--or physicians acting as their agents--demand care until the marginal product of additional care is nearly zero. Empirical evidence exists in support of the conventional view. Studies have found that a fully insured population spends about 40-50 percent more than a population with a large deductible and their status is not measurably improved by the additional services (Manning et al. 1987). This has been referred to by Enthoven (1980) as "flat-of-the-curve medicine," where spending on medical care increases even though additional gains from such spending are very low or nonexistent. This idea has been recently reaffirmed by a landmark analysis of the Oregon Experiment where Baicker et al. (2013) found that Medicaid coverage generated no significant improvements in health outcomes in the first two years, despite increased use of prescription drugs, office visits, preventive care services including mammograms, and annual spending per individual (by insurance plan) in excess of $1,100.

The conventional view was challenged by Newhouse (1992: 11) who argued that the bulk of health care cost growth "is attributable to technological change, or what might loosely be called the march of science and the increased capabilities of medicine." According to this view, increased medical spending is welfare enhancing. To support this view, he offered that "patients are not going to the hospital more frequently ... nor are patients staying longer. But the real cost of a day in the hospital rose by nearly a factor of 4 from 1965 to 1986. Thus, what is being done to and for people who are in the hospital is affecting hospital costs."

While Newhouse acknowledged that there was some validity to the conventional view when looked at over a single period, he argued that it was insufficient to explain health care cost growth over time: "To explain increasing expenditure, one needs to point to something that is changing, indeed to factors that have been changing for 50 years" (Newhouse 1999: 5). He reasoned that the factor-of-five increase in real expenditure per person over the period 1950 to 1980 was more than eight times as large as one could predict from the effect of increased insurance on demand in the context of the one-period model.

Newhouse (1992) dismissed the idea that increased insurance could lead to too much technological change that was not welfare enhancing. If technological change diminished welfare, he reasoned, then countries that make centralized decisions about how much to spend on medical care would not adopt certain changes. Hence, their health care cost growth would be less than the United States. But since cost growth is similar, technological change must enhance welfare.

In our opinion, Newhouse was incorrect to dismiss the argument that too much insurance could lead to too much technological change that does not enhance welfare. In this article, we demonstrate that technological change has indeed increased health care costs in many cases without significantly improving health outcomes. This has occurred because medical insurance in its current state discourages individuals from economizing health care decisions and incentivizes the adoption and overconsumption of services with progressively diminishing returns on investment. Through this process health care costs increase as each technological advance is added to the medical repertoire. We refer to this construct as the "medical care cost ratchet" because a ratchet is a mechanical device that allows continuous linear or rotary motion in only one direction while preventing motion in the opposite direction.

Despite differences in health care financing across OECD countries, medical insurance is basically the same; its goal is to make medical care free at the point of delivery. This is achieved in several ways. The Bismarck system, which originated in Germany, is dominated by private insurers that are created by or connected with employers, financed by employees and employers, and heavily regulated by the government. In the Beveridge system, conceived in Great Britain, the state provides comprehensive health care insurance and services to all citizens with no intermediaries (Colombatto 2012). In many countries today, including the United States, health care delivery reflects a hybrid of these two systems. Over the years, the main principle underlying them has not been challenged--that health care is a social right rather than a service to be purchased. The consequence of this attitude is that people demand the standard of medical care be made available despite the cost. Unfortunately, the general public has no conception of how valuable (or beneficial to them) the standard of care actually is and how it is determined. In many cases, providing the standard of care to a patient at the expense of a third party or the public could reasonably be considered a social welfare loss.

Before building our case we would like to clarify several points. We do not believe that our concept of the medical-care-cost-ratchet and Newhouse's concept of technological change are mutually exclusive. Instead, they should be viewed as a continuum. For example, it is common for a new drug, diagnostic test, or procedure that significantly benefits a small subgroup of patients to be...