The medical marketplace today is not a competitive market in which resources are allocated based on mutually beneficial exchanges between patients and physicians. It is instead a regulated, bureaucratized, institutionalized market, replete with perverse incentives for all who participate in it.

If the medical marketplace had developed the way other markets for goods and services developed, and if health insurance resembled insurance in other fields, the vast majority of the problems we are discussing would never have emerged. Our health care system is not the result of free choices exercised by consumers and producers in a competitive market, however. The American system of health care finance has been shaped and molded by unwise government policies.

The United States is not alone. In almost all Western industrial democracies, health care systems shaped by government policies have evolved through three stages.

The Cost-Plus System of Health Care Finance (Stage I). From the end of World War II through the mid-1980s, Americans paid for hospital care principally through a "cost­plus system" of health care finance. Cost-plus reimbursement worked like this: If Blue Cross patients accounted for 25 percent of a hospital's patient days, Blue Cross reimbursed the hospital for 25 percent of its total costs. If Medicare patients accounted for 30 percent of the hospital's patient days, then Medicare paid the hospital 30 percent of its total costs. Other insurers reimbursed in much the same way. [1]

In the cost-plus system, health insurance literally served the function of insuring that hospitals had enough income to cover their costs. In this role, health insurers were acting as agents not for their policyholders, but for the suppliers of medical services. Since the only way the suppliers could increase their incomes was to increase costs, the cost-plus system of health care finance invariably led to rising health care costs.

A cost-plus system could never exist if patients were spending their own money in a competitive marketplace. Therefore, the prerequisite for cost-plus medicine was a market in which the supply side was dominated by nonprofit institutions with limited ability to compete, and the demand side was dominated by large, third-party bureaucracies which were more responsive to the needs of sellers of medical services than to the needs of the people they insured. By the 1970s, these institutions were well in place. [2]

In a cost-plus system, the pressures to increase spending on health care are inexorable. Patients have no reason to show restraint, since the funds they spend belong not to them but to third-party institutions. When they enter the medical marketplace they are spending someone else's money, not their own money.

Physicians often believed that the "pure" practice of medicine could be free from the constraints of money. In prescribing tests and other medical treatments, physicians not only did not think about costs, they had no idea what those costs were. Guided by the sole consideration of patient health, physicians naturally were inclined to do anything and everything that might help the patient – restrained only by the ethical injunction to do no harm.

The system in its pure cost-plus phase rewards scientists, inventors and R & D personnel. The message of the medical marketplace is, "Invent it; show us it will improvehealth; and we will buy it, regardless of the cost." In no other market for any other type of technology does anything remotely similar take place.

The role of the hospital in such a world is to provide an environment in which cost-plus medicine can be practiced. A suitable environment is one in which all of the latest technology is available, preferably within easy reach and on demand. In such a world, hospital administrators do not manage doctors. To the contrary, they serve the physicians' interest in practicing medicine with as little interference as possible in the physicians' activities.

Such a hospital environment would be inconceivable were it not for a system that reimburses hospitals based on their costs. The role of third-party payers in the system, therefore, is to pay whatever bills are submitted with few questions asked. Cost increases are passed along to policyholders in the form of higher health insurance premiums.

The Cost-Plus System in its Cost-Control Phase (Stage II). Because there is a limit to how much any society will pay for health care, the cost-plus system is ultimately forced to limit the decisions of the suppliers of medical care in arbitrary ways. These limitations take the form of rules and restrictions written by impersonal bureaucracies, far removed from the doctor/patient relationships they seek to regulate. The extreme form of this approach is national health insurance (or socialized medicine), in which decisions concerning the allocation of health care resources are as far removed from patients as they can possibly be.

During the 1980s, the U.S. health care system evolved from a pure cost-plus system (Stage I) into a cost-plus system in its cost-control phase (Stage II). In this stage, there are many different third-party paying institutions, some public and some private. Each is engaged in a bureaucratic struggle – not merely to resist the cost-plus push of the medical care providers, but also to reduce its share of the total cost. Each separate third-party institution is free to initiate its own cost control strategy in random and uncoordinated ways. But since the basic structure of cost-plus finance has not been changed (that is, no real market has been created), Stage II only secondarily is about holding down total spending. Primarily, Stage II is the stage in which there is bureaucratic warfare over shifting costs. [3]

The central focus of third-party paying institutions is to eliminate what they perceive as "waste." Yet bureaucratic institutions (operating principally through reimbursement strategies chosen by people remote from actual patients and doctors) usually cannot eliminate waste without causing harm to patients. Third-party payers may seek to eliminate waste by controlling price, or quantity, or both. In the very act of trying to control prices, however, third-party institutions invariably focus on a normal price for a normal service, thus ignoring patients and institutional settings which are not normal. In the very act of trying to control quantity (e.g., by eliminating "unnecessary" surgery or "unnecessary" hospital admissions) third-party institutions again invariably set standards for what is normal – thus ignoring the unanticipated, abnormal circumstances in which medical care is often delivered.

On the supply side of the medical marketplace, institutions have great resources and considerable experience at resisting change. So in the face of a cost-control measure initiated by one institutional buyer, the suppliers attempt to shift costs to another institutional buyer, without changing their fundamental behavior. We expect the suppliers to be sufficiently adept at this so that, over the long haul, costs are not really controlled in Stage II. At best, the rate of increase is slowed at various intervals. Each new wave of buyer restrictions has an initial impact. But after suppliers adjust to the new restrictions, costs rise again. Precisely for this reason, a system in Stage II evolves into Stage III. It is in this final stage that institutional buyers acquire the ultimate weapon in the cost-control battle – the power of government.

Evolution to National Health Insurance (Stage III). In the final phase of the cost-plus system's evolution, the third-party payers directly or indirectly control the entire system. That is, third-party institutions begin to determine what technology can be used, what constitutes ethical behavior in the practice of medicine, what illnesses can be treated and how they are to be treated. Ultimately, these institutions determine who lives and who dies.

In most countries with national health insurance schemes, many of the perverse incentives that were present in Stage I are still in place. The appetite to spend is held in check, or misdirected, by rules and regulations enforced either directly by government or by insurance company proxies for government. In this stage, government not only controls the total amount of spending on health care, it also actively intervenes in the allocation of health care dollars. Stage III is pure special interest warfare, fought out in the political arena. Stage III takes all of the struggles present in Stage II, and elevates them to the realm of politics. [4]