November 2006

On February 4th, I wrote on the American Medical Association’s (AMA) role in modern medicine. Today I will give further commentary regarding the AMA by reviewing a seminal paper by Reuben Kessel (1958). The paper describing the AMA’s development in the first half of the twentieth century.

The AMA has two main goals: 1) a “suitable preliminary education” for all physicians and 2) “uniform elevated standard of requirements for degree of M.D. should be adopted by all medical schools in the United States” (Flexner Report). These goals amounted to the licensure of physicians and the accreditation of medical schools. The first goal of physician licensure was achieve gradually over time at the turn of the nineteenth century. The second goal took longest to achieve.

In 1904, the Council on Medical Education was founded. The group was dedicated to improving the quality of medical education. In 1906 the council inspected 160 medical schools in existence at the time and found that only 82 complied with their standards. Since this study was commissioned by physicians and preformed by physicians, it was not deemed to be unbiased. Thus the AMA looked to the Carnegie Foundation to repeat the study. In 1910, Abraham Flexner concluded his similar study and published what was later to be known as the Flexner report. This report “…convinced legislators that only the graduates of first class medical schools ought to be permitted to practice medicine and led to the delegation to the AMA of the task of determining what was and what was not a first class medical school.” Over the next 35 years, the United States saw a drastic decrease in the number of accredited medical schools.

Creating a cartel

According to the Kessel paper, the aim of the two goals was to establish a cartel. Cartels usually function best when there are a small number of producers; the physician market is made up of many small producers. The question remains how one would enforce a cartel to maintain artificially high prices with so many individuals who could defect.

Kessel claims that a combination of 1) severe threats 2) restriction of consumer access to information and 3) informal associations led to the permanence of this cartel. Individuals who tried to cuts prices (e.g.: those who used a prepaid model of medicine) were often banned from using hospital facilities in the area.

The Farmers Union Hospital Association in Oklahoma, the Kaiser Foundation of San Francisco and Oakland, Group Health of Washington, Group Health Cooperative of Puget Sound, Civic Medical Center of Chicago, and the Complete Service Bureau of San Diego all attempted to charge fees independent of patient income to create a more competitive environment. Physicians participating in these organizations were often banned from practicing in local hospitals or attending professional conferences. The banning of hospital privileges severely crippled many of these organizations who did not have their own comprehensive hospital facilities.

The second means to enforce the cartel was to restrict the information given to consumer. Advertising promoting the medical profession as a whole was allowed, but advertising promoting a specific doctor was prohibited as this would likely increase competition.

The third manner in which the cartel was enforced was the creation of an in-group mentality. Few minorities (especially Jews and African Americans) were allowed into medical schools in the first half of the twentieth century. Finally, free medical care was provided to fellow physicians and their families, and criticism of one’s peers was not tolerated.

Remarks

Since the time of the Kessel paper was published, much has changed in medicine. Large organizations such as HMOs are able to negotiate price discounts from physicians and thus reduce the market power of physicians. Members from nearly all races and religions are represented in the ranks of medical professionals. Nevertheless, it is important to review the history of the development of modern medicine in order to better comprehend its roots and find new avenues through which health care can be improved.

• Kessel (1958) “Price Discrimination in Medicine” J Law Econ, vol 1, pp. 20-53.

During the past few days, I have written extensively on the reasoning behind why society would wish to create a licensing arrangement for some professions. Today, I will review Hayne Leland’s 1979 paper which develops a mathematical model which explicitly describes the welfare implications of licensure.

Model

Leland uses a Akerlof style set-up where the seller knows the quality of their product, but the buyer does not. Thus, low-quality physicians have no incentive to lower their prices since lowering their price will signal to the buyers that they are low quality. Sellers can disguise their quality level simply by pricing at the average quality price. High quality physicians will not be able to charge a higher price since buyers cannot differentiate between high and low quality doctors. Thus, all physicians in the market must charge the same fees in equilibrium and this price will reflect the average quality of all medical services provided [see Akerlof 1970)]. The ideal remedy to this problem is to eliminate the informational asymmetry either through repeated interaction, certification, labeling, or a caveat venditor device. Leland assumes that these solutions prove too expensive in the case of physicians market and thus we are left with a classic Akerlofian framework.

Let us assume that f(q) is a function representing the potential supply of physicians at quality level q. Leland normalizes physician quality (‘q’) to a uniform distribution between 0 and 1 and thus f(q)=1. F(q) is equal to ∫_{q to 1} f(q’)dq which is equal to q in the uniform distribution case presented here. Finally we have R(q) which is an increasing, convex function of the opportunity costs to supply a unit of service of quality level q. The opportunity cost of quality must equal the supply price ‘p_s‘.

Market supply (y) and average quality (q_bar) will thus be:

• [1] y = ∫_{0 to q’} f(q) dq = F(q’)=q’
• [2] q_bar = ∫_{0 to q’} qf(q)dq/F(q’) = q’/2

Consumers’ willingness to pay p_d is a function of average quality (since it is impossible to distinguish between low and high quality doctors) as well as the market supply. So p_d = p(q_bar,y). Substituting equations [1] and [2] into our demand equation we have p_d=p(q’/2,q’). In equilibrium p_d=p_s so we have an equilibrium condition of:

• [3] R(q*)=p(q*/2,q*)

Welfare implications

Now we must determine how social welfare would change if we would change the quality level. Net benefits are measured using the Dupuit model and are calculated as follows:

• [4] W= ∫_{0 to y} p(q_bar,y’) dy’ – ∫_{0 to q’} R(q)dq

Leland shows that

• [5] dW/dq|_q=q*= .5*∫_{0 to q} p_q(q_bar,y’)dy’ > 0

Thus, in the case of asymmetric information, welfare would be enhanced by increasing quality.

Adding Licensing to the model

If minimum quality standards ‘L‘ were imposed, than it is easy to show that y=(q’-L) and q_bar=.5(q’+L). Our new equilibrium condition becomes:

• [3]‘ p[.5(q*+L),(q*-L)]=R(q*)

What are the welfare effects? Are new social welfare equation becomes:

• [4]‘ W= ∫_{0 to (q’-L)} p(q_bar,y’) dy’ – ∫_{L to q’} R(q)dq

When we calculate dW/dL, the sign is uncertain. Licensure will create some benefits at first, but too much licensure will cause society to incur unnecessary costs from restricted physician supply. Leland shows that in the general case dW/dL|_L=0>0. That is some licensure is always welfare improving in the case of fully asymmetric information.

Conclusion

The major qualitative points derived from this math are that licensure is most beneficial when: 1) markets are more sensitive to quality variation, 2) there is a low demand elasticity, and 3) the market has a low marginal cost of providing quality. In the case of medicine, it is likely that demand is sensitive to quality and there is a demand elasticity below 1 in magnitude, but it is unlikely that the cost of providing quality is inexpensive. Leland also extends his model to include when the level of licensure ‘L’ is chosen endogenously by the a professional group who is attempting to maximize profits of the group. When the level of licensure is chosen by a professional group, the level of ‘L’ is most often set to high or too low.

This model is elegant and shows that licensure can be beneficial. Leland acknowledges, however, that even if licensure is welfare improving, other options such as certification would likely be Pareto superior. What this paper concludes is that licensure can be beneficial, but is not necessarily optimal in light of other policy options available to society.

• Leland (1979) “Quacks, lemons and licensing: A theory of minimum quality standards” JPE, vol 87(6), pp. 1328-1346.

What is the purpose for licensing physicians?  For the general public, the answer seems obvious: society must prevent individuals from consuming low-quality health care.  From the economist’s point of view, this reasoning is not very compelling.  If individuals are looking out for their own best interests, it would be illogical for them to consume low-quality medical care if this is this is not in their best interests.  A seminal paper by Thomas Moore (1961) claims that there are three major classes of justifications for licensing. 

I. Lack of information or misinformation.  

One possibility for why licensing is needed is that individuals do not have complete information of the quality of their doctor.  From my experience, this seems entirely reasonable.  Did my health improve because of my doctor’s adroitness or did my body heal itself?  Am I getting since because I am getting old or because my physician is not caring for my health adequately?  The question remains, however, whether licensure is the proper means through which to cure this informational problem. 

I agree with Moore who claims that licensure is sub-optimal.  Licensure only “establishes minimum qualifications for entrants” and does not “give any information concerning the difference between practitioners above the minimum entrance requirements.  Further, licensure restricts the supply of medical care, thus increasing the price.  Certification would allow the consumers to see which doctors are high and low quality, without restricting the individual’s choice of physician.  On the positive side, in modern medicine certification may be more of a de facto quality control than licensure.  A family practice doctor is not legally prohibited from performing cardiac surgery, but most consumers and insurance companies will only pay for cardiac surgery performed by a board-certified cardiologist. 

Moore claims that certification should be used in industries with the following characteristics: 1) greater variation in service quality, 2) greater possibility of harm from poor service, 3) more training needed to evaluate the quality of the service rendered, and 4) fewer frequency of contact between the consumer and the provider.

II. Paternalism

Moore divides the paternalistic argument into two groups.  The first claims that “the individual, if he had perfect knowledge…would know what is best for himself” but the individual does not have perfect foresight; the second claims that even if the individual had perfect information they “would still not be the best judge of his own welfare.”  One can make a compelling case for licensure based on the first scenario.  If I believe that alternative medicine gives me the best chance of improving my health, but in reality traditional medicine offers me the greatest likelihood of health gains, it may be welfare improving for the government to outlaw alternative medicine (i.e.: license medical providers only of the traditional variety).  This is of course predicated on the fact that the government actually know best and acts altruistically.  If alternative medicine provides a superior quality of care to traditional medicine, however, outlawing alternative medicine would be welfare destroying.  The argument Moore makes in his paper is similar to mine, but he claims that “individuals are overly optimistic in evaluating the expected results of their actions” and thus may not be acting optimally.  By licensing, the government may eliminate choices which short-sighted individuals may elect, but which are not welfare maximizing.  [For an example how to model myopic behavior, see the hyperbolic preferences model developed by Laibson]

I would reject the second class of paternalistic arguments (‘big brother knows best always’) as coercive.  As Moore states, “If the individual is not the best judge of what is best for him, then what is best and who is to decide?”

III. Externalities

One common reasoning cited for the imposition of licensure is externalities.  In particular, many people claim that if an individual receives poor medical care and they become very sick, the state may begin to pay for this person’s medical treatment.  This is a fiscal externality which could have been avoided had the individual received higher quality care in the first place. 

Two issues would make a careful observer tentative to accept this reasoning.  First, if one assumes an individual wants to improve their health, than they would have an incentive to seek better quality care; it would be perverse to purposefully seek low-quality care in the effort to later receive government assistance.  More compelling is the author’s argument that “it is therefore necessary to argue as well that the harm done through purchasing from ‘incompetent’ practitioners is greater than the possible harm done through not purchasing the service at all.”  In a more contemporary setting, this is analogous to requiring a such a high level of care that insurance becomes unaffordable to many people. 

A true externality argument could be made in the case of contagious diseases, but in the West treating these diseases make up a relatively small portion of total healthcare spending. 

• Moore, Thomas (1961) “The Purpose of Licensing” Journal of Law and Economics, vol 4, pp. 93-117.