Pricing and imperfections in the medical care marketplace

To summarize: Some economic literature treats price determination in the medical marketplace as if it were similar to that of a standard marketplace. It seems more realistic to treat it as an outcome of one or more administered price systems. Such systems, may be formula-based, as is common in the United States (for example, the Prospective Payment System), or not (for example, a negotiated budget). In either case, however, the actual price is likely to deviate from the ideal price in part for lack of information. Plausible deviations can explain some observed phenomena. The inability to attain the ideal price, together with heterogeneity of patients, may also explain why in practice we observe several different bases of provider payment; for example, fee-for-service, capitation, and salary. All of these may be attempts to arrive at second best prices. Ignoring any welfare loss from raising revenue and assuming those with the largest marginal social valuation for the service are served first, errors in price setting lead to a welfare loss that is approximately proportional to the square of the deviation from the ideal price. If price setting is unbiased (i.e., errors have a mean of zero), the welfare loss is approximately proportional to the variance of the error in setting price. If price setting is biased, welfare loss is approximately proportional to the variance plus the square of the bias. Taking account of welfare loss from raising revenue may make monopsonistic pricing optimal. If one uses multiple bases of payment, for example both fee-for-service and capitation, one can average the errors that arise in each basis. This creates a gain from using a mixed system, in addition to those gains cited by other analysts, who focus on the method of reimbursement assuming what, in the present context, could be termed error-free price effects. The gains from averaging errors would appear available in any administered price system and are compatible with a wide variety of models of provider behavior.