Health Care from first principles -- long

The fundamental issue facing health care is how to pay for it, given that the amount we spend on health care continues to rise not just in absolute terms, but as a percentage of income.

In order, then, to address the health care puzzle, we need to understand a few items.

1.  What is the health care cost problem?
2.  Where do health care costs come from?
3.  Why are health care costs rising faster than other costs?
4.  What other major issues do we see?

Once those items are understood, then one can address the topic of holding down costs.

The cost problem.

Very simply, the cost problem has two parts.

1.  Health care costs are increasing faster than GDP.  The absolute expenditures (17% here, 9-12% in single payer systems, 4-5% in Singapore's HSA-approach) is 98% irrelevant to the solvency of the system.  The important issue is that Health care costs are increasing at a rate much faster than other prices.

2.  The government pays for a lot of our health care.  If the government didn't pay for a lot of health care, people would simply opt for cheaper services over time.  However, since the government pays for a lot of health care (government insurance + Medicare + Medicaid + ? = 80%??), this makes the issue one of governmental solvency, which is a much bigger deal.

Health care costs.

Health care costs come from the same place as roughly all other costs.  Some human beings spend time, money, effort, and perhaps use prior knowledge in order to create a product or learn to perform a service in order to exchange this service with others.  The demand for the service, as compared with the real costs (opportunity, $ and sweat) of preparation/production creates the cost.

In detail, there are roughly five factors involved with health care costs:
1.  Labor fees for practitioners (Doctor, Nurse)
2.  Device fees (EKG machines have to be built)
3.  Drug costs (It costs something to create a drug)
4.  Facility costs (Hospitals are expensive)
5.  Support costs ( cleaning, administration, insurance administration, IT, etc.)


Rising health care costs.

There are three major reasons why costs might be rising at a faster rate than other costs.
1.  labor-intensive activities get comparatively more expensive as societies get richer.  This is true whether it be massage, health-care, or education.
2.  our detailed knowledge of the effectiveness (and cost-effectiveness) of new procedures (and drugs) substantially lags the introduction of the procedure or drug.
3.  there is no effective incentive for cost-reduction in place for doctor, patient, or insurer.  Perverse incentives make everyone support more procedures.  Doctors don't worry about payment, they just do what is "best" for the patient.  Patients don't pay directly, nor do they truly pay for the cost of their own procedures, even over time.  Rather everyone pays for everyone's procedures...the classic case of the tragedy of the commons. Finally, insurers are incented (and legally required) to support ever-increasing numbers of procedures, and are happy to as they then make slightly more money.  In any case, the cost of the procedures is entirely passed on to customers.
4.  Older people consume more medical care, and the portion of our population which is old is increasing, both in size and in average age.
5.  Government involvement in paying.  Note that the ONLY other sector of the economy growing at similar rates to insurance/government covered health care spending is education, which is financed by government loans.  Also...for a while...Housing as financed by Fannie and Freddie.   Note also that non-covered procedures (lasik, plastic surgery) are getting cheaper.

People don't know what works, and so try everything, because no one directly bears the burden of trying more stuff.  Furthermore, even with perfect incentives, and better knowledge, health care should be consuming an increasing portion of the budget, as it's labor-intensive, and people are getting older.  Since the government pays, it's worse.

Other major issues:

1.  We don't know what works, and when we do know, we don't do much of it.  Seth Roberts and Robin Hanson are the standard bearers for this position, but the recent "does insurance work" topic spearheaded by Megan McArdle is in the same direction.

2.  Innovation is essential.  Our health now is a lot better than our parents' was, and we have reason to believe that our kids' health should be better than ours, if the status quo continues.

3.  American health insurance is not, properly speaking "insurance".  It's more like prepaid all-you can-eat care.  Insurance says...I don't expect anything super-bad to happen, but if it does, you hold the risk.  Health "insurance" says...I pay now, and when I go to the doctor (which I expect to do), the "insurer" pays.  Buffet, not insurance.

4.  Americans don't want health insurance at market prices.  American health insurance in its current state was created by an act of congress in WWII, allowing health benefits to rise untaxed, while wages were frozen.  It remains true that people whose companies do not have health insurance do not find the cost/benefit of said "insurance" persuasive: more than half of self-/un-/small-business-  employed people are uninsured.

Cost management.

The health care cost problem could be addressed in the following ways:

1.  Get the government out of health care.  Moving to some system wherein the government has no financial skin in the health care game would solve a major portion of the problem, as consumers, insurers and providers would be forced to deal with the cost issue.  Not gonna happen.  Also hugely destabilizing, as right now our system is ~80% socialized medicine.

2.  Limit procedures by administrative rules.  This is what European/Canadian/etc. single payer systems do.  If you have a procedure (or test) that works one time in 50, costs $100K, and whose only benefit is to give an elderly person an extra six months of life....the procedure won't be done offered.  This has a low success rate  politically.  First, it does not hold growth rates of medical costs down: European costs are rising as fast as ours.  Second, in democracies, people just vote themselves more medical care, especially since the most-voting group in any established democracy is the elderly.  This path is well known to lead to decrease in innovation.  There is a reason that the US does an obscene percentages of all medical/drug research.  It's 'cuz people can make profits.  Single payer: Cure of diabetes/cancer/AIDS/Alzheimers?  Not gonna happen.

3.  Incent against rising costs in other fashions.  A tax on cadillac plans would do this, if not now then eventually, provided that there were no cost-of-living increases along the way.  Caps on what Quality of Life Year (QOLY) benefits could be covered by cheap insurance.  Highly unlikely to work...though it might be politically feasible to do.  Dropping the tax-benefits of health insurance would do this as well, but is no more politically believable.  This sounds like a step in the right direction...mostly because of consumer-incentives towards cost-effective procedures

4.  Force market discipline on consumers by banning (or making more expensive) first-dollar third-party payment (or making cheaper other choices).  The simplest version of this is HSAs as implemented in America, or the highly equivalent choice implemented in Singapore.  Singapore's system: something like 5% of each person's paycheck goes into a personalized, individual health savings account each year.  This is used to pay all medical bills.  Further, 1% goes to insurance.  If your medical bills exceed 15-20% of your annual income, the government covers the excessive part.  This is really the only thing we've seen work in practice that decreases health care cost increases.  In Singapore, where this is the system, the rate of cost increase is actually being held down.  Also, John McCain's health care plan included expansions of HSAs, which was perhaps the only sane position on any topic held by either presidential candidate in the 2008 elections.  If nothing is passed on the health care front soon, it would not surprise me if the rate of adoption of HSA and other high-deductible plans may took the US almost to this system in the next 10-15 years.  Medicare will still need to be handled.  This should lead to almost lasik-like cost reductions and quality improvements in other medical areas.

5.  Decrease supply restrictions.

• Labor fees are massively increased by laws mandating that only doctors do certain procedures.  These laws are guild-style supply restrictions that massively inflate the costs of doctor activity.  
• Limitations on the number of doctors graduating in a given year by means of school accreditation does the same thing.
• Other countries permit Bachelor of Medicine to do significant amounts of medical work.  
• The FDA massively increases the cost and decreases the speed-to-market of new drugs via their "effectiveness" requirement, and also (but less controversially) with their safety requirement.  Decreasing even the "effectiveness" component of FDA review would be huge for real costs
• The FDA also significantly increases the cost of new medical devices, by largely the same procedures. 
• Simply, between the FDA and the AMA, the supply restrictions on medical care cost enormous amounts.  
• This is so politically impossible as to be laughable.  If you want to find something that would make abolishing medicare look easy...consider taking on the AMA lobby. 

6.  Increase age of eligibility.  This is actually what will happen, and what will save our (and other countries') government's bacon on the health care front.  Essentially, if you push Medicare eligibility slowly upward as average lifespan increases, then the pressure on Medicare falls off, and there's massively less pressure for the government to do anything.

7.  Massively increase economic growth.  If the economy grows at 9%, but health care costs increase at 8%...so what.  The problem is that the economy tends to grow at 2%, but health care costs at 8%.  This is not liable to happen either...partly due to lack of knowledge of how, and partly due to lack of interest in economic growth differences between 2 and 3%, when compared to other political goals.

UPDATE:
8.  You can theoretically buy between 2-5 years of solvency by twiddling administrative costs, cutting middleman profits, etc.  However, since the rate of cost growth is unimpacted by this..it doesn't matter much in the larger scheme of things.  Also, in reality, these support costs are there for a reason...and it would be difficult to extract too much from that.

I am strongly in favor of #1, 4, 5, and 7.  Of course, neither 1 nor 5 nor 7 has a snowball's chance in Houston.  #3 is massively unlikely, but I am in favor, as that tilts towards #4.  #6 is going to happen, or else medicare will fall apart.  Hence, it will happen.  #2 is a horrible choice on the innovation front, and it has not been shown to hold down the rate of increase any more so than our current system.  But it might, in theory work, (and even more likely, might appear to work) even though it has yet to in practice manage increasing costs.