This is not a problem unique to the United States. Every country faces increases in health care costs, the differences are in degree and in how each country responds to those cost pressures. The first place to look for cost pressures is what is known in economics as Baumol & Bowen’s Cost Disease.

Baumol & Bowen’s Cost Disease

This insight comes from understanding how prices of some things can decrease over time. For instance, many people are familiar with Moore’s Law in the computer industry, which talks about continual decreases in the price of semiconductors even as performance increases. This is marvelous, but what is the underlying cause? If we look into it, almost all of the decreases in prices of products over time are due to the increasing application of capital, i.e., increased automation. Factories that once employed thousands of workers can now employ hundreds, and can as a result reduce prices while increasing employee pay (True in theory. Notably pay increases decoupled from productivity increases in the 1980s in the U.S., but that is a topic for another day).

That is fine in industries such as manufacturing where automation is comparatively easy to implement. But Baumol (and his co-author Bowen) noted that the service sector is not that type of industry. Services tend to be “people-to-people” interactions. When you go to a concert you want to hear real live musicians. If you are going to college you want contact with a real live professor. And when you want health care you want to deal with a real live doctor. Our notions of quality all depend on this. But these are all cases where automation is either not feasible or would notably reduce quality.

Everyone working in the service sector has to earn money for doing so, and even though they are in a sector that does not raise productivity very much they are looking at a wage scale determined by the overall labor market. So, for instance, if you work in a good job and your pay increases due to productivity improvements, you will shortly find that your children’s teacher is also looking for a pay increase. But teachers find it difficult to actually improve productivity. One way they could in theory increase productivity is by increasing the size of the class, but that would be seen (rightly) as a decrease in quality. And in health care this productivity puzzle is equally difficult to reconcile. We sometimes talk about how good our doctor is (or isn’t) by discussing their “bedside manner”, which is simply a way to say we value the person-to-person interaction that cannot be automated. Indeed, that is one of the few metrics most consumers have available to them to evaluate quality in this sector. Chances are we don’t ask the doctor “Where did you go to medical school? What were your grades like? How well do you keep up on the latest trends?” And would an average consumer even know how to evaluate the answers to those questions?

Just today (as I write this) I saw an article on CNet with the headline “Cancer-fighting robots still need human touch: Robots can improve breast cancer diagnoses but shouldn’t diminish the patient experience.”

The basic point is that the robot can do the job as well as a human, but that it affects your experience as a patient. To have the robot do it would “diminish the patient experience”.

Quality Improvements

The other factor to keep in mind is that there can be quality improvements that have impact on costs. As we discussed previously, we don’t do “Exploratory Surgery” any more, and that is all to the good. But that quality improvement came from increasing capital investment in very expensive imaging technologies like CAT scans, PET Scans, and MRIs. This is a particular case of the more general problem economists deal with in trying to create price indexes to measure inflation. Price is not the only thing that changes over time, the technology employed also changes, so a straightforward comparison of prices in two different times is very tricky. A late-model automobile costs more than one purchased 20 or 30 years ago, but also incorporates a lot of safety features that were not available back then.

And health care also brings in quality improvements due to changes in our scientific understanding of medical and health problems. We are using new technologies, such as CRISPR (gene editing) to address diseases, which may let us cure or ameliorate diseases against which we were previously helpless, but which can add costs to the equation as well. Just in the last generation we have seen organ transplants save many lives, but that has a cost. Now we are looking at being able to 3D print and grow organs from our own stem cells, which would be even better, but that costs money too.

Market Forces

There are several market forces that are driving costs up. First is the entirely natural (and rational) move on the part of companies to find profitable niches. For instance, drug companies have largely abandoned the search for new antibiotics because there is not enough profit there. Instead, they look for market niches where they can charge a high price and for a drug that people will take daily for many years. In a profit-oriented market economy you should not be surprised at this. Examples of this include cholesterol-reducing drugs, impotence drugs, and so on. There is a ready market of people who will pay for these medications, and in many cases it will be covered by health insurance. Of course, that drives up insurance premiums, but that is not a problem the drug companies are interested in.

Hospitals look to improve their appeal to patients by purchasing all of the latest technology and that means their costs rise. Once you have an MRI machine, you tend to start using MRIs more, after all. Doctors tend to specialize in niches where they can earn more, leading to a situation where have plenty of cardiologists but a shortage of primary physicians

Another market force is consolidation. If we look at the landscape of the healthcare market we see Hospital chains growing through mergers and buyouts. Larger hospital chains gain market power to negotiate better reimbursements from health insurance companies. And on the lower level, there are fewer individual practices by doctors. Instead, they are consolidating into larger groups, and often those groups are merged into or allied with hospital groups. At the same time, health insurers are merging and consolidating to improve their market power.

Market power matters in all of these cases because different layers are competing to get a larger share of the healthcare money available. But in the course of their competition prices inexorably rise.

And what is clear that is that spending in the U.S. is higher and is rising more rapidly than in other countries.

I recall that I was working in the Finance department of a major university hospital back when Obamacare was being discussed, and the changes that might happen disturbed some of my co-workers. The CFO of the hospital said “Remember, the present system is unsustainable. So it will have to change.” And indeed it did. That is our next topic.

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