Why the health sector is like a blocked drain, and how to unblock it

Technological progress is often held to be one of the main drivers of rising healthcare spending. Medical science advances, enabling us to manage or even cure more and more diseases, and great though that development is, we haven’t yet worked out a way of dealing with the financial consequences.

This description is not wrong, but it is incomplete. Technological progress is not per se a cost driver; on its own, it is neutral with regard to its impact on costs. What matters is the economic incentive structure within which it takes place.

The conventional textbook definition distinguishes between two different types of innovation. ‘Product innovations’ enable us to do things we were not previously able to do, ‘process innovations’ are efficiency improvements that subsequently slash the cost of doing them. The invention of the DVD player was a product innovation; process innovation then cut the typical retail price of a DVD player from initially over £200 to under £30. This is why, even though our homes are full of widgets that a time traveller from the 1990s would not recognise, our total spending on widgets would not seem unreasonably high to said time traveller. In the market for consumer electronics, product innovations and process innovations roughly balance each other out in terms of their impact on total spending. Process innovations make space in our budgets, which product innovations can then fill. If product innovations are a running water tap, then process innovations are the drain pipe which makes sure that the water level in the sink stays about the same.

Neither type of innovation just happens ‘naturally’. Both are the result of risky investment projects that will only be pursued if investors see a reasonable chance of them paying off. In the market for DVD players, process innovations clearly paid off: Consumers were price sensitive, so even a small price advantage over a competitor would lead to a large change in market shares. This is where healthcare differs from most other sectors. In Western countries, most healthcare is free, or nearly free, at the point of use, which means that consumers have no reason to be price-sensitive.[1] In a market without price-sensitive consumers, there is no demand for cost-cutting innovations, so very little of it will occur. To put it bluntly, there could never be an equivalent of Ryanair, Aldi or Wetherspoon’s (which can be seen as the extreme end of the process innovation spectrum) in the health sector. Under those conditions, healthcare spending is like a sink with the tap running, and the drain pipe clogged.

But this is a product of our financing arrangements; it is not an inherent feature of healthcare. In some emerging economies, where coverage of public insurance systems is patchy, process innovation does occur in the health sector. And there lies the dilemma: The cost-cutting innovations in these countries were born out of sheer necessity, and the alternative would have been for thousands of people to go untreated. So is there a way to combine the security and universality of First World health systems with the cost-consciousness that breeds process innovation?

There are two possible strategies, not mutually exclusive, to give process innovations at least a fighting chance. The first is the introduction of broad-based user charges, subject to caps, exemptions for preventive care, and support for low-income households. Proportional co-payments, i.e. patients paying, say, 10% of all treatment costs, up to an income-related cap, would fit the bill. So would deductibles, i.e. patients paying, say, the first £1,000 of all treatment costs themselves, coupled with a subsidy for low-earners. Co-payments and deductibles could also be combined, and anything related to early diagnosis and prevention could remain free at the point of use.

The second strategy would change incentives primarily at the provider level rather than the level of the individual patient. Let’s put it this way: From a member’s perspective, a gym is also free at the point of use, and yet we do not see an explosion in gym fees. The reason is that while consumers may have no reason to behave cost-effectively once inside the gym (i.e. don’t use fanciful bells-and-whistles equipment when you can just use a pair of dumbbells), they have good reason to do so at the point of choosing a gym. The healthcare equivalent of a low-budget gym would be a ‘managed care’ model of integrated providers, with those opting into such a model receiving a rebate. This would be easier to achieve within a social health insurance system, where people already choose between different insurers, among other things on the basis of cost. But it would not be impossible to integrate such options into the NHS.

Neither of these strategies would currently be politically feasible, let alone popular. But unless we want either brutal rationing through the back door, or substantial tax hikes, we have to find some way of hardwiring process innovation into the health system. Talking about how much we ‘love’ the NHS, which is the preferred option of the political class and much of the media, will not do that trick.

[1] This is true even in the US. Only about a tenth of US healthcare spending is out-of-pocket spending, with the remainder coming from various pre-paid sources, mostly private insurance, followed by Medicare and Medicaid.

Head of Political Economy

Dr Kristian Niemietz is the IEA's Editorial Director, and Head of Political Economy. Kristian studied Economics at the Humboldt Universität zu Berlin and the Universidad de Salamanca, graduating in 2007 as Diplom-Volkswirt (≈MSc in Economics). During his studies, he interned at the Central Bank of Bolivia (2004), the National Statistics Office of Paraguay (2005), and at the IEA (2006). He also studied Political Economy at King's College London, graduating in 2013 with a PhD. Kristian previously worked as a Research Fellow at the Berlin-based Institute for Free Enterprise (IUF), and taught Economics at King's College London. He is the author of the books "Socialism: The Failed Idea That Never Dies" (2019), "Universal Healthcare Without The NHS" (2016), "Redefining The Poverty Debate" (2012) and "A New Understanding of Poverty" (2011).

2 thoughts on “Why the health sector is like a blocked drain, and how to unblock it”

  1. Posted 10/08/2015 at 11:34 | Permalink

    What do you think of the current system where GP commissioners buy services, will that not increase innovation?

  2. Posted 13/08/2015 at 06:31 | Permalink

    Kris – A good example of this is the techniques used by the charity, SightSavers International, who perform cataract operations in mobile units on a near production line basis at an average cost of around £17 compared to the NHS tariff which is typically in the region of £800. The NHS simply has no incentive to reduce costs in this way.

Comments are closed.