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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.
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