WHY HEALTH ECONOMICS?
• Economics helps managers focus on key issues.
• Economics helps managers understand goal-oriented decision making.
• Economics helps managers understand strategic decision making.
• Economics gives managers a framework for understanding costs.
• Economics gives managers a framework for understanding market demand.
• Economics gives managers a framework for assessing profitability.
1.1 Why Health Economics?
Why should working healthcare managers study economics? This simple question is really two questions: Why is economics valuable for managers? What special challenges do healthcare managers face? These questions motivate this book.
Why is economics valuable for managers? In this chapter, we will briefly touch on the following six reasons why economics is valuable to highlight the themes that we will develop more fully in later chapters:
1. Economics helps managers focus on key issues. Economics helps managers
to wade through the deluge of information that they confront and to
identify the data that they really need.
2. Economics outlines strategies for realizing goals given the available
resources. We will explore carefully the implications of economics on
rational decision making.
3. Economics gives managers ground rules for decision making when their
rivals are not only competing against them, but watching what they do.
Later, we will explore how an understanding of economics can aid in
strategic planning and decision making.
4. Economics gives managers a framework for making sense of costs. A crucial
part of a manager's job is the need to understand how to manage costs.
5. Economics provides an explicit framework for thinking about how much
consumers value goods and services. Other disciplines may offer more
insight into what motivates consumers, but economics gives managers a
firm understanding of what consumers value.
6. More than anything, economics sensitizes managers to fundamental ideas
that affect the operations of every organization. Effective management
must begin with the recognition that consumers are sensitive to price differences, that organizations compete to advance the interests of their stakeholders, and that success comes from giving consumers value.
1.2 Economics as a Map for Decision Making
Economics provides a map for decision making. Maps do two things: They highlight key features and suppress unimportant features. If you drive from Des Moines, Iowa to Dallas, Texas, you need to know how the major highways connect. You do not need to know the name and location of each street in each town you pass through along the way. Of course, what is important and what is unimportant depends on the task at hand. If you drive from Burch Street and Ridgeview Road in Olathe, Kansas to the Truman homestead in Independence, Missouri, a map that describes only the interstate highway system will be of limited value to you. You need to know which map is the right tool for your particular situation.
Using a map takes both knowledge and skill. You must know what information you need, or else you may choose the wrong map and be swamped in extraneous data or be lost without key facts. But simply having the right map is no guarantee that you can use it. You must practice using maps to learn to use one quickly and effectively. In this sense as well, economics serves as a map for decision making.
Like a map, economics highlights some issues and suppresses others. For example, economics tells managers to focus on incremental costs, which makes understanding and managing costs much simpler. At the same time, however, economics has little or nothing to say about the health belief systems that motivate consumer behavior. If you are seeking to make therapeutic regimens easier to adhere to by making them more consistent with consumers' belief systems, economics is not a very helpful map. If, on the other hand, you want to decide whether it will be feasible to set up an urgent care clinic, economics helps you focus on how that will change revenues and costs. This sort of simplification can be very helpful to managers who are deluged with information.
Economics also gives managers a framework for understanding rational decision making. Rational decision making entails making choices that further one's goals given the available resources. Whether those goals include maximizing profits, securing the health of the indigent, or other objectives, the framework is much the same. It entails looking at both benefits and costs to realize the largest net benefit. (We will explore this question somewhat further in Section 1.5.)
Obviously, this framework for rational decision making requires a clear understanding of costs and benefits. Economics provides the basis for this understanding. Managers must understand costs and be able to explain them to others. Confusion about costs is common, so confused decision making is also common. Confusion about benefits is, if anything, more widespread than confusion about costs. As a result, management decisions in healthcare often leave much to be desired.
The enthusiasm of economists for "perfectly competitive markets" (which are, for the most part, mythical social structures) obscures the contribution of economics for managers who are competing in real-world markets. In reality, economics offers concrete guidance about pricing, contracting, and other quandaries that managers face in their "imperfect" worlds. Economics also offers a framework for evaluating the sorts of strategic choices that many managers must make. Many healthcare organizations compete with a small number of rivals. As a result, good decisions must take into account the actions of the competition. Will being the first to enter a market give your organization an advantage or will it give your rivals a low-cost way of observing what works and what does not? Will buying primary care practices bring you increased market share or "buyer's remorse"? A knowledge of economics will not make these choices easy, but it can give managers a plan for sorting through the issues.
Hospitals Learn About Incentives and Buyer's Remorse
In recent years, many hospitals have acquired physician practices. Nearly all of those hospitals are losing money on what were once profitable practices. Economics gives two important insights into the unhappiness of hospitals with their purchases.
First, most practice purchases were knee-jerk responses to what competitors were doing, rather than carefully considered business plans. Enamored by the fact that physicians typically generate large inpatient revenues for each dollar of outpatient revenue that they generate, hospitals typically did not ask two key questions, "How will buying these practices change the amount of inpatient revenues that physicians will bring us?" and "Why are physicians willing to sell?" We still do not know the answer to the first question. The answer to the second question is quite simple—-hospitals overpaid. Hospitals started buying just as practice valuations began dropping as a result of the growth of managed care and the increasing competition for patients.
Second, hospitals ignored incentives. Most hospitals converted from compensation based on billings to salaries after they acquired practices, which was a significant mistake. Economics reminds us that incentives matter. For physicians whose earnings depend on billings, the marginal patient, the patient squeezed in at the end of the day, or the patient booked in anticipation that someone will cancel, is highly profitable. For physicians whose earnings depend on salaries, in contrast, the marginal patient is financially unrewarding. Not surprisingly, Richard Haugh reports that physicians in independent practice produced 38 percent more procedures than those in practices owned by hospitals (1998). In recent years, hospitals have been rewriting compensation contracts, returning to incentive-based pay. Hospitals that have done so have seen productivity turn around, once again confirming economists emphasis on incentives.