Late last night I was reading my post "Cutting "Costs"" and I noticed an apparent contradiction between this post and "Government Efficiency", as well as "High Cost of Medical Care". In both, I wrote that it was the high prices charged to the wealthy that fueled the technological innovation that made computers, air travel, cars and other former luxuries into everyday items within the reach of the common man and even most of the poor. However, in "Cutting "Costs"", I wrote that one problem was that our reliance on insurance as our first resort for payment of medical costs allowed us all to live as if we were rich men, with everyone getting top notch care, without a thought to cost. By the logic of what I wrote, this should fuel even faster technological innovation, and should be bringing down prices more quickly. However, as we all know, medical prices do not show the downward trend other prices do¹.

The problem here is not that there is a contradiction, just that I failed to spell out all the factors, most specifically, price elasticity.

It is a concept in every economics book, and one which is usually behind at least one test question, but one which gets short shrift for the most part, and with good reason. You see, there is a lot of talk about "inelastic demand" or "inverse elasticity", but in reality, they are very uncommon, if not non-existent. Oh, over certain price ranges they may exist. For example, while Mercedes are very expensive, making them cheaper may reduce their "snob appeal" and harm sales, or while it is very cheap, a few cents change in the price of salt may have very little impact on demand, but over a whole range of prices it is almost impossible to find inelastic prices.

Let me start with a definition, a very general one. Price elasticity is the amount by which demand changes when prices change². If demand falls by the same percentage as prices rise, that is considered to have an elasticity of 1. When demand drops more swiftly, then prices are said to be very elastic. On the other hand, if prices can rise very high before demand shows any impact, then prices are considered inelastic³.  Many examples are offered in texts, food, water, salt, sugar, and so on, but all of them are only really inelastic over a limited range of prices. However, even those examples only hold for a limited range of prices. Salt is today subject to inelastic demand as the cost is trivial, and doubling it still leaves it trivial. Were it to rise to historical levels, say approximating the ancient Roman prices at around $500 a pound⁴, then demand would clearly become much more elastic. The free market, excluding a few cases where price is trivial, simply argues against inelastic prices, as the availability of substitutes and alternatives, and capital which can quickly flow into funding such goods, makes it too easy for consumers to find something cheaper, even when price changes are relatively small.

But when the government gets involved, distorting the market, then we find inelastic prices. And that is precisely what explains the seeming contradiction above.

You see, consumers have no interest in price competition when they are covered by insurance. Admittedly, insurers try to encourage economizing by adding co-pays and covering only a fixed percentage, but as most medical practices then forgive a large part of the uncovered amount, in reality the amount the consumer pays is effectively trivial, at least within the category of medical services. And as tax policy makes insurance the single most common way to pay for medical procedures, this effectively means there is no consumer interest in cutting prices.

Of course insurers would normally be interested in reducing costs, but they are somewhat hampered int his by both statutes which require specific coverage and liability lawyers who threaten to sue overly restrictive insurers. Thus, insurers tend to look to managed care, "personal medical plans"⁵, and other comprehensive schemes to cut costs, and largely leave individual prices alone. Due to the unusual conditions of the market, mainly caused by government factors, it is not in the interest of insurers or customers to worry about the prices of individual services.

And that explains the seeming contradiction. Under normal circumstances, an influx of massive payments would inspire innovation, as the ability to lower prices would increase the number of sales greatly, more than making up in volume for the loss of per-unit profit. And, even if an individual provider did not do so, a competitor⁶ would do so, as his lower prices would steal away market share. But, due to inelastic prices, that simply does not work. No one has an incentive to reduce prices, as it will not improve market share. Instead market share is gained through non-price competition, such as all the freebies pharmaceutical companies give away, convention presentations, and other "brand recognition" strategies. Thanks to the defective market caused by insurance and medical laws, there is no incentive to reduce prices.

Of course, some companies might want to invest in technology to reduce costs, as they would see these savings as additional profits. And, prior to the birth of imaging centers (as described in "Government Efficiency"), we did see that in the field of imagining. However, even here it may not be a strong incentive, as the benefits of R&D are speculative, and the profits are already adequate. So, unless the chance of technological improvement is certain or nearly so, improvements in process or technology, and thus cost cutting, is likely only to come from outside, from related fields, as there simply is little incentive to economize, when prices are essentially fixed, and market share more dependent on word of mouth than either price or quality⁷.

And that is why my original posts seemed to contradict one another. There is no contradiction between the high profits of medical goods keeping prices high and the high profits of the early days of computers or autos driving prices down. The difference is the elasticity of the market, and the degree of government intervention.

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1. One thing to bear in mind is that the claims that medicine "costs too much" are somewhat exaggerated, as I wrote in "High Cost of Medical Care". In some ways, it is as if we all bought top of the line computers or cars and complained that prices keep going up. Medicine has undergone tremendous improvements, which would obviously drive up prices. However, if one compares the same service from 1945 and today, in real dollars, you will find that costs have held steady or dropped.  Actually, event hat is misleading, as the chance of infection, the additional safety measures, and other imperceptible changes which cannot be removed from the process, make even the "same service" today immeasurably better than in 1945. There are factors making medicine more expensive than it probably should be, but it is also expensive because we get a lot for our dollar. Just ask any foreign citizen who comes to the US for medical treatment what they get for the same price at home. (Before I get indignant emails form foreign readers,. let me argue that the number of medical tourists does suggest the US is offering something many cannot find at home. Either that or there are a lot of irrational people who choose to pay more for worse care than they can get locally.)

2. I argued in "The Limits of "Scientific" Management" and "The Limits of Econometrics" that supply and demand curves are fictions, and really cannot be determined. However, for our purposes even vague approximations using historical data are adequate. We are not trying to determine precise prices here, just get a general idea of how greatly prices effect demand, so even approximations drawn from historical data are adequate to get a general idea of the responsiveness of demand. Of course one should not rely too heavily on such approximations, but they can be a useful tool in some contexts.

3. I am ignoring those bizarre products which show inverse elasticity due to "snob appeal". In reality, that works only over limited ranges of prices. Yes, minks may be in higher demand due to their high prices and the status that implies, but were it possible to supply minks at the price of nylon, I still think at some point normal elasticity would be restored. It is only when we look at a very narrow range of prices that we can find this inverted elasticity. In any case, it is irrelevant for our current topic, so I will not go into it more here.

4. This number is guesswork, especially as "ancient Roman" covers a range of 1100-1200 years (circa 700 BC to 476 AD if we limit ourselves to the Western Empire), making any single prices a huge oversimplification. So, no need to tell me I am too high or low. I know both are true given various assumptions about period, inflation, and price equivalences.

5. I have a little first hand experience with this innovation. Some insurers have decided to start treating PPO customers in an HMO fashion, assigning those with "chronic problems" nurses to help develop "care plans", allowing the insurer to direct the patient away from more costly treatments and into less costly, nominally preventative measures. (In the interest of full disclosure, I should also reveal that as my current condition was revealed following some seemingly unrelated back problems, my insurer spent a year or more trying to force me into physical therapy for back pain, despite my repeated assurances that spasms, pain, numbness and skin changes were not caused by a bulging disk. It was eventually cleared up, or at least dropped, so I have no current complaints with this system, though I do still think it has more to do with cost cutting than providing adequate care. Of course, in a free market, that would inspire me to find a better insurer, but, given current policy tying insurance to employment through tax incentives, that is more difficult than it needs to be.)

6. That is another factor here, limited competition due to the onerous licensing requirements in any health care field. That acts as a bar to entry and keeps competition somewhat stifled. So the competitive forces int he medical field, be it among hospitals, doctors or providers of goods, is much less aggressive than in the market as a whole, meaning improvements are slower and prices less responsive. I did not mention this in "Medical Regulations" or "Medical Regulation II", but it is yet another argument against medical licensing, the negative impact on competition caused by entry barriers, and the effect that has on prices and innovations.

7. There is some competition in the area of quality, but again, regulation establishes a floor upon which doctors rely, making competiton less aggressive than in unregulated markets. As most good remain closer to the minimum requirement (see "When Help Hurts"), they really do have a "sameness" to them. And that allows for little competition on the basis of quality.

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POSTSCRIPT

I have a few things to do at work today, but I promise to get to the comments and my outstanding posts today. I would have done it last night, but I only got some free time very late, and I ended up reading the post which is the subject of this email and then going to bed. So, once work is finished today, I promise to get back to my normal pace of replying to comments.