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The Health Czar Can't Calculate

Mises Daily: Thursday, April 30, 2009 by

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Experts agree that our healthcare system is unsustainable and in need of reform to promote better coordination, accountability, outcomes, and cost effectiveness.[1] Regrettably, they also seem to agree that we need a robust central-planning authority — a health czar — to make this coordination happen.

But as economist Ludwig von Mises proved in his 1920 treatise "Economic Calculation in the Socialist Commonwealth,"[2] under central planning any rational economic calculation, that is, any method to efficiently allocate resources, is practically and theoretically impossible — not just of higher cost, lower quality, and reduced innovation; not just uncoordinated, inefficient, and ineffective; but literally impossible.

In practice, a health czar would have to evaluate the quality, revenue, and cost of complex production processes, and billions of healthcare goods, services, hospitals, pharmacies, nursing homes, surgery centers, diagnostic centers, laboratories, outpatient clinics, home health agencies, hospices, long-term-acute-care hospitals, ambulances, patients, physicians, nurses, therapists, and clinicians, all across geography and across time. The health czar must therefore consider an almost infinite number of permutations in order to correctly allocate trillions of dollars.

Reformers argue that computers and an electronic medical record will help resolve this practical calculation problem. However, even if the health czar possessed the most advanced computer systems, hospitals, physicians, and producers of healthcare services will possess similar electronic systems to manage their own operations. Together, they would be capable of generating more data than the health czar can absorb and process meaningfully. Paradoxically, computers actually make economic calculation more complex and difficult.[3]

The health czar must also consider two additional exacerbating factors.[4] First, like all goods, healthcare resources by their very nature are substitutable for one another. For some cancers, chemotherapy, radiation therapy and surgery may be substituted or complemented with one another. The health czar has to discover the natural substitutability of millions of healthcare services in accordance with the exchange relations that in a free-healthcare-market economy take place automatically, permanently, and instantaneously.[5]

Second, capital can be invested to improve the efficiency and quality of any healthcare service. Hospitals may decide between investing in robots for pharmacy or the operating room to improve the productivity and accuracy of pharmacists and surgeons; or they may hire additional pharmacists or more experienced surgeons, or varying combinations of them. Simultaneously, the manufacturer of robots would need to decide to invest capital to develop either pharmacy, operating-room, radiation-therapy, or industrial robots and varying combinations of them and direct the production chain of all the inputs necessary to develop robots, such as software, research, labor, parts, raw materials, financial services, marketing, etc. This investment in production at both provider and manufacturer levels multiplies infinitely the permutations the health czar would have to evaluate.

In addition to facing the practical economic calculation problem outlined above, health reformers misunderstand pricing theory. Unlike the weather forecaster who faces a practical problem that can be resolved by the use of better satellites, faster supercomputers, and better equations and models, the health czar faces an unsolvable theoretical problem. He cannot forecast the price for health services because, by definition, prices can only be calculated by the free and unencumbered interaction between producers and consumers.

"Health reformers misunderstand pricing theory."

There are two reasons why it is theoretically impossible for the health czar to arrive at meaningful prices. First, contrary to popular belief, costs of production do not determine prices of goods. Prices are determined by the instantaneous valuations made by consumers and producers bidding against one another. By a process of imputation that flows from the consumer to the producer, prices of goods impute value to the factors of production necessary to make the goods that consumers demand. This imputation of value occurs when producers and entrepreneurs bid for the factors of production (labor and materials) in response to expected future profits, which sets wages for labor and prices for materials. Prices of goods, therefore, determine costs of production.

"Costs of production do not determine prices of goods. Prices of goods determine costs of production."

Since its inception, Medicare planners have come up with alternative valuation methods that unsuccessfully attempt to arrive at a rational price structure for health services. Medicare recognizes that "cost-based payment methods" (in which reimbursement is determined by allowable costs supplied by providers) are complex, result in unpredictable payments and spending for providers and government, and weaken providers' incentives for efficiency.[6] Medicare claims that these methods are being substituted for "prospective payment" (in which an initial operating and capital-payment base rate is adjusted by wage indexes, medical education costs, charity burden, long lengths of stay, etc.).

But despite these recognitions and claims, Medicare still uses cost information to determine prices. This is because the initial-operating and capital-payment base rate is always determined by the operating and capital costs that a set of "efficient" providers incur.[7] When Medicare uses cost information to arrive at pricing, it uses the wrong economic cause-and-effect relationship and therefore distorts prices.

The second reason why it is theoretically impossible for a health czar to price services is that prices in a market economy are continually, instantaneously, and simultaneously created, destroyed, and recreated by the individual subjective valuations of consumers and producers facing the passage of time.

This process takes into account change in expectations, economic conditions, wants, scientific knowledge, income, needs, technological advancements, etc. But note that information about valuations is not created until after consumers and producers act in the real world by placing their respective bids. These bids are impossible to transmit to a health czar before they exist, before they are made real through human action. Until then, a central health planner has a universe of infinite possibilities stored in the minds of each of hundreds of millions of economic participants. This universe does not and can never constitute meaningful economic information until patients and providers act in the marketplace. And once bids take place and pricing information is created, transmitted, processed, and analyzed by the health czar and returned to the market place in the form of reimbursement rates and rules and regulations, it is old, distorted, and useless information that cannot possibly have any rational guiding content for patients or providers. It is wasteful, non-value-added, false, and misleading information.

At the outset of the Medicare program, its central planners were able to set their prices as parasites of the then-existing competitive private-healthcare price structure, just as Soviet central planners were forced to copy the price structure of Western economies to direct Soviet production processes and meagerly subsist for eight decades.[8] This parasitic existence of copying the free-market pricing structures continues to be the theoretical edifice of Medicare central planners. But as the proportion of Medicare, Medicaid, Veterans Administration, and other state, county, and city health expenditures grow, and as the proportion of eligible population for these payors increases relative to the rest of the population, the private-sector pricing is crowded out of the market and is distorted; a health czar has fewer and fewer free market pricing signals to copy. Inevitably, our health system will continue to descend into further and further chaos, in which actors will be unable to rationally allocate capital. This is exactly what happened to the economy of the Soviet Union.

The health czar may know what final healthcare goods and services are required to meet the government-determined needs of the US population. Indeed, in their own words, "Medicare's primary goal is to ensure that its elderly and disabled beneficiaries have access to medically necessary acute care of high quality."[9]

But this is only the first of two simultaneous equations that are necessary to allocate health resources. The second equation is the pricing valuation of the means of production to ensure that those needed goods and services are produced within a rational production process. But without the bearings of economic calculation — that is, without pricing signals derived in a free market — all patients, hospitals, physicians, and producers of healthcare services (and the health czar himself) are left, to paraphrase Mises, groping in the dark.

Notes

[1] Medicare Payment Advisory Commission, "Report to Congress Reforming the Delivery System," June 2008, p. xi. Download PDF

[2] Ludwig von Mises, "Economic Calculation in the Socialist Commonwealth."

[3] Jesus Huerta de Soto, "Socialismo, Calculo Economico y Funcion Empresarial," p. 105.

[4] See Joseph T. Salerno, "Postcript: Why a Socialist Economy is 'Impossible'," p. 35. Download PDF

[5] Mises, p. 9.

[6] Medicare Payment Advisory Commission, "Report to Congress Medicare Payment Policy," March 1999, p. 4. Download PDF

[7] Medicare Payment Advisory Commission, "Hospital Acute Inpatient Services Payment System," October 2007, p. 3. Download PDF

[8] Medicare Payment Advisory Commission, "Report to Congress Medicare Payment Policy," March 1999, p. 5. Download PDF

[9] Medicare Payment Advisory Commission, "Hospital Acute Inpatient Services Payment System," October 2007, p. 4.