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January 05, 2006

It Costs Less, Therefore We Spend

Several blogs -- EconLog, Prestopundit, and Club for Growth among them -- give us the heads up on Robert Kuttner's interview with Milton Friedman in the online edition of the American Prospect.  It is indeed a joy to read, but this passage -- also noticed at Mediated -- caught my attention:

RK: Another question: In my own work I have argued that in most sectors of the economy markets work as advertised, but there are some sectors such as healthcare where for a variety of structural reasons, if you let the free market operate you will have socially unpleasant consequences and maybe even inefficient consequences...

MF: Wherever government is largely involved, inefficiencies result. Now let me ask you a question. Dentistry does not come under Medicare. Dentistry is operating well. You never had any of the problems in dentistry that you have in medicine. If markets work in dentistry why wouldn’t they work in medicine? They did work in medicine for many years. In 1945-46, total spending on medical care was about four of five percent. Now it’s gone up to 13 or 14. Something happened.

RK:  Well, but part of that surely is because medicine has figured out more ways to treat people.

MF: Every other technological improvement lowers costs. What technological improvement raises costs? Government is now paying at least half the costs of medical care. Obviously, that’s why, whatever the technological improvement, it’s generating higher and higher costs.

Gee.  It seems to me that Professor Friedman has it -- gulp! -- not quite right.  It is certainly my impression that technological progress in medical care has lowered costs.  My favorite example is the repair of torn knee cartilage.  When my brother was a high school football player in the 1970s, he had the unfortunate need for such a procedure. It cost him several days in the hospital, and several weeks in a cast.  A few years back, I had a similar need (occasioned by my demonstration that overweight, out-of-shape guys in their forties really shouldn't be playing basketball.)  It cost me a morning in an outpatient clinic, and a couple of days on my couch.

The problem with the statement above is that is confounds cost -- the resources expended in delivering a product like "fixing a knee" -- with expenditure -- how many knees we choose to fix.  One of the lessons many of you may remember from microeconomics is that total expenditure on a good can rise even as the price falls, if the demand for the product in question is "price-elastic". (For those who may be a little rusty, total expenditure equals price times quantity sold.  If lowering the price of a good by 1% increases the demand for that good by more than 1%, total spending rises.) There is no inherent contradiction between falling costs of production and increasing expenditure.

It may indeed be the case, as Professor Friedman suggests, that government involvement in health care has resulted in inefficiencies that shouldn't be.  And it may be that third-party payer systems have lowered the incremental price of health care services to levels that result in socially suboptimal levels of spending.  But I don't think we have a case where technological improvement raises costs. 

January 5, 2006 in This, That, and the Other | Permalink


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I agree that there have been many technological improvements. However, with the improvements, you have had to retrain labor. What tech improvements have there been that cut labor? Medicine is not manufacturing, so I am not sure if the same conclusions can be drawn. There also have been technological improvements in dentistry. As pointed out, its costs haven't risen as much as medical costs. I think that insurance, legal and government have led to gross differences in the cost for medicine.

Tort and insurance reform are needed. Savings, similar to savings that non-smokers get, should be given for preventive medicine (physicals, health club participation, not membership etc) because it saves larger dollars down the line.

I tend to agree with Friedman because every time govt gets involved with something, distortions occur.

Posted by: jeff | January 05, 2006 at 06:11 PM

forgot to mention a personal story, i inadvertantly stabbed myself with a knife unloading the dishwasher. (a tip: put them in points down) I drove to the emergency room, thought "is it more expensive here or at my doctor", drove to the doc, called my wife who knew the correct answer. Drove myself back to the emergency room to save money.

Another time, I cut myself with a knife. Did not go to the hospital for stitches because of al the peperwork I would have had to do for the insurance.

This is the state of American health care. (moral for me, stay away from knives!)

Posted by: jeff | January 05, 2006 at 06:15 PM

Every LASIK should be running 24x7 until every corrective procedure that should be done has been done. The marginal cost for the "other" 22 hours per day of operation are less than the billing costs. The billions in eyeglass and optometrist and contact lense and such saved make this a public health priority orders of magnitude more serious than fast food workers washing thier hands but. But what? We'd destroy several "vital" industries that depend on extending human misery? Bausch & Lome will miss their earnings? We MANDATE measles and subsidize the process. Where is the moral or economic distinction here?

Posted by: Robert Cote | January 05, 2006 at 07:00 PM

Milton Friedman -- "What technological improvement raises costs?"

Can't believe he said that.

Sounds like Milton is still having them use x-rays instead of more costly methods of body/body part scans.

Posted by: Movie Guy | January 05, 2006 at 07:01 PM

I have little sympathy with Old Milt. I think the issue isn't that improvements in medical technology raise costs, but that they raise life expectancy, which in turn indirectly raises costs. Doctors never definitively cure a patient, since as long as the patient is alive, they come back for more. Where there is life, there is business, as they say. That is why smokers may be a net gain for a health system, they tend not to stay around so long.

But increasing life expectancy should also raise the number of years during which you should be able to have peak earnings, so the equations should balance.

What I mean is, as a society we should be paying more incrementally for medical care as the years pass, but we should be able to discount the cost over more years.

Of course, if the proportion of your population in the oldest-old age groups is rising, then so will the share of your GDP which goes to medical care (isn't this what Greenspan keeps going on about).

The government/private issue is a red herring here. Only a tired old ideologue would want to twist round a really interesting situation into a hakneyed one-liner.

Posted by: edward | January 06, 2006 at 05:57 AM

Milt is absolutely right. Federal market forces are corrupting and wasteful.

But why only look at Medicaid and medicare?

The federal government has hugely over paid for national security.

If they went back to the "common defense" and relied on local militias...................

Costs would be much less.

The best aircraft of WW II the P-51 mustang cost $ 50K per airplane. It flew all the way to Berlin swept away everything the Japanese and Germans put in the sky and worked in a copmprehensive strategy.

Today, we get an F-22 for 123 million a copy, it is broke most of the time, has no one to shoot from the skies and was built to keep Lockheed Martin solvent and profitable.

All with federal tax dollars that could be given back to the citizen and the engineers building the trash allowed to work on something that will benefit society as determioned by market force not a PAC funded by Lockheed.

Posted by: ilsm | January 06, 2006 at 07:33 AM

The problem with free enterprise in medicine is the objectives of the companies and the consumers can be at odds.
The company objective is to maximize profits, a highly expensive drug to manufacture that cures you might be far less profitable than a less effective treatment that requires repeated doses. If you are a company with patents on both compounds, you develop the treatment that maximizes your bottom line. The best treatment or health care outcome isn't necessarily an issue.
Development of an AIDS vaccine is a good example, only small profits in selling vaccines in comparison to the drugs, so this isn't a very active area of research for the major pharmaceutical firms.

MF's comparison with 1945 medicine is similar to comparing horse and buggy costs to space travel. The state of the art in 1945, penicillin, was purifed from mold. Numerous diseases that were essentially death sentences in 1945 can now be cured. The current developments in biotech/medicine are largely offshoots of government (NIH/NSF) funded basic research in the 60's, 70's and 80's. It is highly unlikely that industry would have pored billions in seed money into basic research on the noninfectious disease organisms to simply understand how they work, the payoff date is simply too far out. Yet this early basic research lead to the discoveries need to develop the biotech industry.

Posted by: cb | January 06, 2006 at 09:23 AM

Friedman’s contention that the price of health care (as opposed to the quantity) is rising is certainly supported by the path of the CPI for Medical Care, which has been rising more quickly than the overall CPI for the past 20 years. The big issue is quality adjustment. Your knee example suggests that the current quality adjustments are missing a huge part of the picture. The cost of a day in the hospital has clearly risen, but if newer procedures require fewer hospital days to realize the same result, then hospital time has become more cost-effective in a way which the CPI would have a hard time capturing. Moreover, if earlier procedures had higher non-pecuniary costs (incapacitation), then the total cost has fallen in ways that are not measured. I think you may have stumbled onto a serious upward bias in the reported inflation rate (and, in this case, a bias that has probably increased over time, so that the decline in the inflation rate over time may have been understated).

Posted by: knzn | January 06, 2006 at 10:58 AM

Even if he is less liberal than I am, I have always enjoyed reading Milton Friedman on this topic (as well as every other topic he writes about). But I agree with you - as insightful as he can be, his diagnosis of the health care market in the U.S. is not 100% right. But then who does get it correct? Still looking.

Posted by: pgl | January 06, 2006 at 02:55 PM

As someone who is not an ideologue I have trouble getting my mind around the notion that the the government involvement in health care is the source of the ineffeciency. Output per unit of input. The US which has the least governmment involvement in the industry, spends by far the most in relative and absolute term per person on healthcare yet we are at best in the middle of the pack of developed nations in terms of life expectancy. I am far from a socialist but it takes a big act of faith or intellectual slight of hand reconcile the these facts with the libertarian manta that "the government is ALWAYS the most ineffcient".

Posted by: centrist | January 07, 2006 at 12:52 PM

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