Irrational Markets

March 20, 2011 § Leave a comment

Since Arvind is currently working on a  series on health care policy in the United States, I would like to provide some background on Capitalism and markets and to show how they can lend to inefficiencies in our health care system. Strangely enough, international reactions to the nuclear crisis in Japan provide just such an opportunity.

There have been some curious reactions to the nuclear meltdown in Japan in neighboring countries. In China, consumers have been buying up large quantities of salt out of fear that radiation from the collapsing nuclear facilities in Japan will carry across the Sea of Japan, the Korean Peninsula and the Yellow Sea and make them ill. The belief in China is that, since their salt is iodized, consumption of a large amount of salt will offer protection from radiation poisoning. Similarly, individuals in California have been purchasing potassium iodide pills for the exact same reason. Why iodine you ask? Nuclear radiation contains cancer-causing chemical isotopes, including iodine-131. For this reason, taking unpolluted iodine will saturate the thyroid gland with safe iodine, thus preventing the body from absorbing any radioactive iodine that could be unknowingly ingested.

The results of these reactions have been shortages of salt in China and of potassium iodide pills in California. The process leading up to these shortages could be summarized as the following: Japan has a nuclear meltdown, speculation occurs about what amount of area the meltdown will negatively affect, individuals possess rudimentary knowledge about the effects of radiation and use this knowledge to speculate about the effect of that radiation on their health, individuals consume products that they believe will mitigate those effects.

All of this seems well and good, except there are a few glaring problems:

1) There is agreement among professionals that the radiation in Japan will not reach Korea, let alone China or the United States. The Chinese National Marine Environmental Forecasting Center released a statement saying that it would be “impossible” for radioactive substances to reach China.

2) Consuming iodized salt will not protect individuals from radiation poisoning. Consuming too many potassium iodide pills can be harmful to the body, as Marc Siegel explains:

“Potassium iodide can interfere with the body’s normal production of thyroid hormone, leading to hypothyroidism, or can provoke an already diseased thyroid gland to make too much of the hormone. The pills can also cause nausea and diarrhea, and you can develop an allergy to them, I said.”

3) Much of the salt buying spree in China is connected to the belief that China’s sea-salt supply will be corrupted. But the CNME Forecasting Center explained that this too would not happen, also in the statement referenced above. Additionally,  a large majority of China’s salt supplies are not even at a remote risk of exposure, as “Chinese authorities [explained] that the country has massive reserves and that 80% of its salt sources were on land.” (wording changed for grammatical purposes, quote found here)

The “invisible hand” in capitalism and markets is a widely known term, but in brief it refers to the processes which lead to individuals purchasing demands, corporations supply decisions and the prices of products. The shortages of salt in China and of potassium iodide in California are a result of the “invisible hand”: the economic pressures from reactions to Japan’s meltdown have pushed demand for these products through the roof.

But, as shown above, the increase in demand for these products is completely irrational. Chinese citizens cannot use salt to protect against radiation poisoning and do not need that protection anyway, and Californians similarly have no need to worry about this sickness. Thus, in this example, the “invisible hand” has pushed market forces in a direction that is harmful to individuals by unnecessarily driving up the prices of these goods, creating shortages in them and leading individuals to waste money. Furthermore, these shortages may also negatively affect the supply of potassium iodide available to the Japanese, who are actually at risk of radiation poisoning.

This situation is, of course, not the only instance of irrationalities in capitalist markets. Because individuals possess limited information about the world around them, they will have errors in judgment. Indeed, this is precisely what Arvind is referring to when he notes the following:

“Among the most important drivers of cost in the American health care system is our fee-for-service model of care. Under this model, doctors and hospitals are paid not for outcomes, but for each procedure they perform. As a result, they have little incentive to provide efficient care and, instead, have every incentive to perform unnecessary services. This bias for increasingly expensive procedures affects many aspects of America’s health care system, making us, for example, the world leader in number of CT scans and MRIs administered per capita.”

In this scenario, CT scans and MRIs are taking the place of salt and potassium iodide. The irrationality results because patients do not have perfect knowledge of what treatments they need. Because of this limited knowledge, patients follow their doctor’s judgment, and doctors err on the side that enriches them. Markets will be only as rational as the individuals participating in them, and so we would only see a perfectly “rational” cost of health care if patients were purely rational actors and possessed perfect information of their world.*

And now to my final point. As Arvind continues his series on Accountable Care Organizations and health care reform, and as we debate these ideas, and economies more generally, through politics and media, it is important to remember that the “invisible hand” of our economy will not correct our mistakes for us. We are fortunate to have an economic system that allows for the recognition of such mistakes, but we must then use this information to reform and improve that system. For this reason alone, the Democrats’ effort to improve health care in America makes sense, and maintaining the status quo does not.

*Arvind was a contributor to this paragraph

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Accountable Care Organizations: An Introduction

March 16, 2011 § 2 Comments

Among the most important drivers of cost in the American health care system is our fee-for-service model of care. Under this model, doctors and hospitals are paid not for outcomes, but for each procedure they perform. As a result, they have little incentive to provide efficient care and, instead, have every incentive to perform unnecessary services. This bias for increasingly expensive procedures affects many aspects of America’s health care system, making us, for example, the world leader in number of CT scans and MRIs administered per capita.

The health care reform bill (PPACA) doesn’t attempt to solve the problems in our system with a single approach. Instead, it launches a wide variety of pilot programs and delivery reforms coupled with mechanisms for evaluating what works. A number of these provisions are targeted at encouraging Accountable Care Organizations (ACOs) in the hope that we can reduce costs by changing incentives. In this, the first part of a 3 part series, I am going to explain what an Accountable Care Organization is and how it functions to reduce costs. In later posts I will describe the incentives PPACA provides, both for ACO formation and for cost reduction, and the challenges facing ACOs as these incentives take effect.

At its simplest an Accountable Care Organization is a group of providers who organize together to take responsibility for a patient population across the entire continuum of care. This means that they work together to distribute payments, coordinate the care the patient receives, and reward quality care by implementing performance measures and payment structure reforms. In practice, most ACOs will come to resemble something like Kaiser Permanente – an integrated delivery system in which one organization acts as both insurer and care provider. Under the Kaiser Permanente model, health plan members pay into the non-profit Kaiser Permanent Health Plan which provides investment and infrastructure development for Kaiser hospitals, and directs payments to physician-owned Permanente medical groups. At the end of each year, doctors and hospitals split the excess revenue provided by the health plan.

In an ideal implementation, the distinction between health plan and medical group would be blurred further, essentially combining the two into a single entity. This model has numerous advantages from a cost perspective. Since the insurers and care providers are part of a unified organization, all premiums not spent on care can go towards profit and the lowering of premiums. This incentivizes, for example, providing primary care early in order to prevent costly health problems later on. Furthermore, integration can eliminate many of the overhead costs associated with providers billing insurance companies and with insurance companies deciding whether these bills ought to be paid. This model can also improve quality by allowing doctors to more easily coordinate care among different specialties.

In part two, I will discuss the incentives PPACA provides for the creation of these ACOs and how it envisions ensuring quality, affordable care.

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