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The Nature of Technological Change:
Incentives Matter!
BURTON A. WElSBRODi
Technological change involves two dimensions-invention and adoption.
Much of the recent attention to cost containment in health care has focused on
whether newly available technologies should be adopted, that is, whether they
pass some form of cost-effectiveness test. It is clearly important to examine the
question of whether a new health care procedure, diagnostic test, or drug is worth
its cost relative to alternatives. Yet, by concentrating on the assessment of tech-
nologies that already exist, one implicitly assumes that inventions of new tech-
nologies are generated by exogenous factors over which society has no control.
Are social choices limited to deciding when and whether to utilize newly
developed medical advances? Or can society influence what kinds of advances
are produced by the research and development process?
In the economy generally, each year brings many new inventions that are
simply ignored, temporarily or even permanently. Knowledge about how to
produce new or improved products is not tantamount to actual provision; the cost
may exceed what buyers are willing to pay. Does this separation of invention
from adoption hold in the health care sector?
Probably not! When life itself is at stake, society finds it excruciatingly
difficult to withhold access to effective new technologies even when they are
extremely costly, as is the case with organ transplants and mechanisms for sus-
taining life for very low birthweight babies. Having to choose between making
~ Most of this paper was previously published as "The health care quadrilemma: An essay on
technological change, insurance, quality of care, and cost containment" in the Journal of Economic
Literature, 29:523-552, 1991.
8
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THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER!
i
9
such technologies available to all who can benefit from them, with enormous cost
consequences, and restricting availability to persons with the ability to pray, or
otherwise rationing access, poses choices with powerfully divisive social and
political consequences.
Society needs to recognize that to control these divisive forces society needs
to intervene earlier in the process of technological change at the stage of re-
search and development (R&D). This chapter highlights the means by which the
health care insurance system sends signals to the R&D sector and how those
signals affect incentives that generate tomorrow's new technologies. Those in-
centives will determine whether the new technologies drive health care costs
upward or downward.
Incentives matter! Public policy can and does provide the R&D sector,
where new technologies are developed, with incentives to pay more attention
either to enhancing quality or to reducing costs. Depending on which of those is
emphasized, tomorrow's health care technology arsenal will provide society with
expanded opportunities either to extend life expectancy and enhance quality of
life or to reduce costs. Public policy can choose the degree to which society
concentrates on each of these social goals; unfortunately, they conflict.
Throughout most of the post-World War II era the incentive signal sent from
the health care finance system to the R&D sector has been to enhance quality of
care regardless of costs. Over the past decade the incentive signal has been
changing, shifting toward an emphasis on costs. It is not my purpose to deter-
mine the socially appropriate balance between quality and cost. Rather, it is to
emphasize the inevitability of such a choice and the instruments through which
the choice can be made.
One of the mechanisms currently being utilized to contain costs in hospitals
.s the Medicare diagnosis-related group (DRG) system. The effectiveness of
such a price control mechanism in a dynamic context of technological change has
received little attention; it deserves more, however, since the mechanism, de-
pending on how it is administered, can have a profound effect on the R&D
sector.
To see this, consider two alternative scenarios that differ dramatically in
their response to technological change; they are polar opposites, and intermediate
positions are possible, but they help to clarify social policy alternatives. In one,
the DRG classification system is permanent and impervious to technological
change; any new technology must fit into one of the existing DRG classes at
prices that are not affected by the new technologies. In this case, an invention
that would enhance quality of care but at an extremely high cost relative to the
DRG price that a hospital would receive would have a weak market; a hospital
considering adoption of such a quality-improving innovation would not be able
to cover its costs unless it could supplement its resources with revenue from
other sources such as gifts. Thus, it would be likely to reject utilization of the
quality-enhancing invention. The rigid DRG system would discourage the R&D
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10
BURTONA. WEISBROD
sector from developing anything that raised costs, regardless of its effects on
quality.
An alternative scenario would posit a quite resilient DRG system. In this
case every new invention that enhanced quality would result in either (1) estab-
lishment of a new DRG class with an associated price that is high enough to
make hospital utilization of the new invention profitable, or (2) a reinterpretation
of an existing DRG class to encompass the new invention, together with an
increase in the associated price. In this situation the R&D sector would see that
anything that raised quality would be greeted with an effective price high enough
to make it profitable for hospitals to adopt it. The cost-containment goal of the
DRG system would be entirely undermined with respect to new technologies.
Which of these scenanos, or which position between them, is likely to
emerge from the political-regulatory process is unclear. The outcome, however,
matters a great deal whether one's concerns are largely with cost containment
or with the advance of medicine.
At the Institute of Medicine conference on coverage and adoption decision-
making about medical technologies, the principal focus was on the rapidly grow-
ing area of technology assessment. This chapter, however, concentrates attention
on the process that produces the new technologies requiring assessment. It high-
lights some consequences of attempts by society to gain control over the health
care system to achieve multiple goals encouraging technological change, ex-
panding access to new technologies through insurance, sustaining or improving
the quality of health care services, and controlling costs.
INTRODUCTION
Dunng the roughly four decades since the end of World War II, the health
care system in the United States has experienced historically unprecedented
changes in three dimensions. First, new technologies have revolutionized the
ways in which health care is capable of being practiced. Almost all of today's
armarnentarium of disease diagnosis and treatment devices and techniques were
unknown 40 years ago. In the case of prescription drugs, for example, about 10
percent of the 200 top-selling drugs are new each year, and only 25 percent of the
200 top-selling drugs in 1972 remained in the group 15 years later (Cleeton et al.,
1988~.
Second, the role of health care insurance-private and public has expand-
ed dramatically. By 1980, 82.5 percent of the U.S. population had some health
care insurance, compared with fewer than 10 percent in 1940.2
2 Throughout the postwar period the expansion of private health care insurance has been spurred by
federal tax policy. By making employer-financed health insurance nontaxable income to employees,
federal policy distorted worker choice between health insurance and cash wages, encouraging excess
health insurance (Feldstein and Allison, 1974; Pauly, 1974; Mitchell and Vogel, 1975; Mitchell and
Phelps, 1976; Taylor and Wilensky, 1983; Chernick et al., 1987).
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THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER!
7
il
Third, personal health expenditures have soared. From $300 per capita in
1950, they leaped to $1,493 in 1987 (all in 1982 dollars). The percentage-of the
gross national product (GNP) devoted to medical care almost tripled over that
period-from 4 to 11 percent (U.S. Bureau of the Census, 1979, p. 97; U.S.
Bureau of the Census, 1989, p. 90; Letsch et al., 1988~.
This chapter explains how the expansion of health care insurance has paid
for the development of cost-increasing technologies and how the new technolo-
gies have expanded demand for insurance. My goal is less to review the vast
literature on the health care system and the rising level of real expenditures on it
than to reflect on the dynamic interplay of incentives for the R&D sector to
develop particular kinds of new technologies, the role of the insurance system in
that process and, reciprocally, the long-run effects of new technologies (any new
knowledge about health care) on the character of the health care insurance sys-
tem. The broad model outlined here highlights the ways in which the quality of
health care that can be supplied in a technically feasible manner at any point in
time and the breadth of access to that care influence each other and the aggregate
level of health care expenditures; but the model is not fully specified, nor is it
tested rigorously. Thus, this chapter should be seen as a personal interpreta-
tion largely positive, rather than normative, in character-of a period of enor-
mous growth and massive change in both the practice and finance of health care.
The central focus on technological change as an independent variable caus-
ing changes in the form and extent of insurance coverage, and as a dependent
variable, being influenced by incentives operating through the health insurance
system highlights the impact of incentives; both the pace and types of research
and development are functions of rewards that are endogenously variable, as are
the comprehensiveness of insurance coverage and the breadth of access to it.3
The following propositions are set forward: (1) The amount of resources going
into the R&D process and its direction during some time interval depend in part
on the mechanisms expected to be used to finance the provision of health care in
future periods, when the fruits of the research process become marketable. This
is simply to say that R&D is influenced by expected utilization, which depends
on the insurance system. Reciprocally, (2) the demand for health care insurance
depends, in part, on the state of technology, which reflects R&D in prior periods.
These relationships help to explain why (3) long-run growth of health care ex-
penditures is a by-product of the interaction of the R&D process with the health
care insurance system.4 I also examine briefly some effects of alternative forms
of health care insurance on the quality of care, as distinguished from its quantity,
3 Other effects of health insurance, particularly on incentives for utilization of health services, have
received considerable attention. For a recent and valuable review, see Pauly (1986).
4 Other forces also affect health care expenditures. Rising real income appears to have a positive
effect on demand for health care; an income elasticity of +0.2 (or less) has been estimated from the
RAND health insurance experiment (Manning et al., 1987).
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BURTON A. WEISBROD
and long-run changes in the definition of "health care" under insurance, as en-
dogenous R&D alters the menu of technically feasible measures.
To understand the markets in which health care is provided and financed, it
is useful to consider ways in which health care differs from most other commodi-
ties. First, it sometimes involves the preservation of life or, at least, major effects
on the quality of life. Second, it is a technically complex commodity that
abounds with informational asymmetries that are adverse to consumers (Arrow,
1963; Akerlof, 1970; Titmuss, 1971~. Third, and as a result of these two charac-
teristics, "nonmarket" (government and private nonprofit) suppliers in the health
care sector, especially among hospitals, nursing homes, and blood banks, play a
large role in influencing the interaction between insurance and R&D.s
Because health care affects the length and quality of life, many societies
have come to accept the normative proposition that "high-quality" care ought to
be made available widely, regardless of an individual's ability to pay. This
assignment of property right the breadth of which is under continuing debate-
results in pressure on government to finance access to some health care redistrib-
utively. In the United States, private market financing of health care, by individ-
uals and employers, has been supplemented by governmental resources-
particularly through the Medicare and Medicaid programs and, to a smaller
extent, through private charitable activities.
Another reason in addition to providing widespread access-for society's
willingness to intervene in private health care markets is the substantial informa-
tional asymmetries, which give rise to economic and political demands for con-
sumer protection (Arrow, 1963; Weisbrod, 1978, 1989; Hansmann, 19801. The
claims that physicians "induce" demand (Arrow, 1963; Evans, 1974; Wilensky
and Rossiter, 1983; Rossiter and Wilensky, 1984; Reinhardt, 1985; Cromwell
and Mitchell, 1986; Stano, 1987), that they engage in "defensive" medicine-
diagnostic testing and other practices that have no expected benefits for patient
health but are defenses in "malpractice" suits (Gary et al., 1978; Zuckerman,
1984; Danzon, 1985)-and that they perform "unnecessary" surgery6 may or
may not be valid; they are plausible, however, only if physicians are better in-
formed than their patients (Pauly, 1979) and do not act as perfect agents.7 The
importance of health care to life and well-being, combined with the limited abili-
ty of consumers to make well-informed judgments about quality of care and with
5 Some readers may prefer the term nonprofit to nonmarket. Whatever term is used, the point is to
distinguish private, profit-oriented organizations from the institutions of either government or the
private nonprofit sector. To be sure, government and private nonprofit organizations operate in
"markets," in the sense that exchange occurs.
6 A congressional subcommittee estimated that in 1977 there were 2 million unnecessary opera-
tions, at a cost of $4 billion and with a loss of 10,000 lives ("Elective surgery: Cut it out," 1979).
7 Operationalizing the concepts of "induced" demand, "defensive" medicine, and "unnecessary"
surgery-each of which reflects a market failure to the extent that it occurs-poses serious problems.
These issues, however, are beyond the scope of this chapter.
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THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER!
13
imperfect agency relationships with physicians, may help to explain why con-
sumers of health care rely upon public and private nonprofit institutions~to an
unusual degree.
The remainder of the chapter proceeds as follows: The next section contains
a brief outline of the recent history of the health care sector in the United States-
its evolving technology, changing insurance/finance system, increasing level of
real health care expenditures, and the advent of cost-control measures. Then I
show how the constellation of services included in "health care" is endogenous,
being affected by the interaction of the insurance system and the R&D process.
The subsequent sections focus on the effects of R&D (technological change) on
the health care insurance system, the reciprocal effects of the insurance system
on the R&D sector, and the effects of alternative insurance systems on quality of
care, with the state of technology fixed. I then summarize and point out some
possible generalizations beyond health care.
Finally, examining these interdependent relationships may help to explain
some of the differences across countries in financing of health care and their
roles in health care R&D, for the forces at work are not uniquely North American
and the policy implications can be generalized. The United States is unusual,
however, in the extent to which its actions as a producing and a consuming
country influence the rate and direction of health care R&D. No other country is
so major an actor in both the R&D (producing) sector and the health care (con-
suming) sector. For most other countries, outputs of the R&D sector are essen-
tially exogenous to their methods of financing health care, and their systems of
health care finance are also essentially exogenous to their own R&D activities.
Switzerland, for instance, is a substantial producer of health care R&D (especial-
ly pharmaceuticals), but it is a small consumer; the United Kingdom and Japan,
although they are not trivial elements in the R&D sector, are larger consumers of
the outputs of that sector.8 It is the enormous size and, therefore, impact of both
the producing and consuming elements in the United States that make it such a
fine subject for study.
A BRIEF RECENT HISTORY OF HEALTH CARE IN
THE UNITED STATES: TECHNOLOGICAL CHANGE AND THE
GROWTH OF INSURANCE COVERAGE
One striking aspect of change in the U.S. health care system since World
War II has been the dramatic increase in knowledge of means for diagnosing and
treating illness. Fifty years ago, physicians were little more than diagnosticians,
their activities being essentially "limited to identification of . . . illness, the pre-
diction of the likely outcome, and then the guidance of the patient and his family
8 For a broader, European perspective on health care systems, see Organization for Economic
Cooperation and Development (1990).
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14
BURTON A. WEISBROD
while the illness ran its full, natural course" (Report of the President's Biomedi-
cal Research Panel, 1976, Appendix A, p. 3~. Today, the scope~of effective
interventions includes kidney dialysis, organ transplants, polio vaccines, arthro-
scopic surgical techniques, computed tomography scanners, nuclear magnetic
resonators, and in vitro fertilization. As recently as a decade ago, heart and liver
transplants were virtually unknown, but their numbers have soared, from 62 and
26, respectively, in 1981 to 1,441 and 1,182, respectively, in 1987 (U.S. Bureau
of the Census, 1989, table 166~.
At the same time that the technology of health care has been changing so
dramatically, the system for financing health care has also been revolutionized.
In the quarter century between 1950 and 1973 alone, the share of health care
expenditures that was met by insurance more than tripled, from 12 to 41 percent
(U.S. Bureau of the Census, 1975, table 105~. The mix of insurance between
private and government insurance also changed during that period; while total
private expenditures on health and medical services were growing almost six-
fold, from $8.7 billion to $59.8 billion (current dollars), government expendi-
tures (Medicare and, to some extent, Medicaid) were leaping fourteen-fold, from
$2.5 billion to over $37 billion (U.S. Bureau of the Census, 1975, table 100~.
Insurance coverage for "major" or "catastrophic" health care costs has also risen
sharply, from 22 percent of the population in 1960 to 73 percent by 1984 (U.S.
Bureau of the Census, 1987, tables 1, 2, and 137~.
Initially, most health insurance was of one particular type-covering a limit-
ed menu of only hospital services, perhaps after a small deductible and paying
("reimbursing") the hospital for the particular services provided to a patient, the
payment being equal to the "actual" average cost of treating that patient with
whatever technology was used (Stevens, 1989~. Included was an approximation
of the average variable cost of any diagnostic or therapeutic procedures per-
formed on the patient's behalf, plus a per diem payment for room, board, and
basic nursing services and, in the case of for-profit hospitals, a markup. Thus,
the payment received by the hospital was determined retrospectively and was a
function of endogenous decisions by the hospital and physician as to the length
of stay and the resources deployed in treating each specific patient. With hospital
revenue being a function of the cost of services provided, there was little incen-
tive to weigh costs against patient benefits. Any diagnostic or therapeutic re-
source that had a positive expected value of benefits could be provided in a
financially feasible manner, and even when there was great uncertainty about the
probability distribution of benefits from a new, more costly technology, the ab-
sence of a budget constraint encouraged its adoption.
By the 1970s, however, the growth of real expenditures on medical care-
reflected in rising private insurance premiums, Medicare budgets, and the share
of GNP devoted to health care had become matters of growing public concern.
Some attributed this "health care cost inflation" to the insurance system and its
effect on demand; retrospective payment arrangements, operating through the
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THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER!
1 J
insurance system, were encouraging "overuse" of medical resources (Feldstein
and Friedman, 1977; Pauly, 1986~. The result was a spate of reforms designed to
force health care providers to consider the cost consequences of their decisions.
This was done by making more of providers' revenue "prospective." Health
maintenance organizations (HMOs) and, beginning in October 1983, the Medi-
care DRG system for pricing hospital services are the preeminent examples of
this type of reform.
Both HMOs and the Medicare DRG prospective payment system confront
suppliers with the incentive to be more cost-conscious, but they differ in the
comprehensiveness of that incentive. Under the current DRG system for paying
hospitals, the "fixed" payment for a particular patient is supplemented by addi-
tional payments to cover capital costs; thus, there is some incentive for hospitals
to substitute capital for labor.9 In addition, under the DRG system, as under the
previous retrospective pricing system, a hospital's revenue is a function of its
admissions of patients; this produces an incentive to hospitalize rather than to
utilize approaches that involve nonhospital inputs such as drugs, broad medical
management approaches, and instruction of patients in ways to prevent and alle-
viate problems through lifestyle and dietary measures. HMOs, which have a
contractual responsibility to provide medical services, not simply hospital treat-
ment, and receive a flat annual fee per member, maintain a greater financial
incentive to utilize alternatives to hospitalization.
To the extent that cost-based insurance has been at the root of the rising
expenditures on health care, however, the causal mechanism is less clear than it
seems. The "moral hazard" effect of insurance could cause patients and their
physician-agents to utilize more health care resources, and therefore aggregate
health care expenditures to be greater than they would otherwise be; yet it does
not follow that insurance would cause expenditures on health care to grow more
rapidly. Something had to be changing. That "something" could have been the
state of technology that, as we will see, was expanding in a systematic direction
as a consequence, at least in part, of the particular form of insurance that had
been adopted. An expanding health care insurance system more widespread
coverage of people and broader coverage of health care resources such as phar-
maceuticals and chiropractic services- might also account for the growth of
health care expenditures, but this explanation would pose the question of why
insurance coverage would be expanding.l°
The major theme of this chapter is that the demand for health care insurance
and the process of technological change are interdependent. A shift away from
insurance that paid hospitals and physicians on the basis of endogenously deter
9 I owe this point to an anonymous reviewer.
10 Even with constant technology, real costs of health care could increase if input prices rose for
example, because of increased unionization of hospital labor and this could increase the demand for
insurance, ceteris paribus (that is, other things being equal).
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BURTON A. WEISBROD
mined "costs incurred" and office visits to insurance that paid amounts that were
largely independent of costs incurred on behalf of any particular patient repre-
sented a major change. It altered incentives to use existing health care resources
(that is, their rate of diffusion and utilization), and it altered earlier incentives for
the R&D sector to invest in developing medical care techniques that were of
higher quality but more costly.
As noted above, the shift in the nature of health insurance has occurred in
two principal forms-expansion of HMOs and adoption of the DRG system of
hospital pricing. In the decade of the 1980s alone, enrollments in HMOs more
than tripled, from 9.1 million in 1980 to 28.6 million in 1987 (U.S. Bureau of the
Census, 1989, table 148~. Under the DRG prospective payment system, a hospi-
tal receives payment (prices) for treatment (e.g., of appendicitis) based on indus-
try-wide costs for each of the 468 DRG categories. Thus, conditional on admis-
sion of a patient with a particular diagnosis, what a hospital faces is a price for
treatment that is essentially independent of the actual resource cost it incurs
(Hogan, 1988.
Both HMOs and the DRG system of pricing hospital services are potentially
revolutionary in their incentive effects on R&D. The fact that the principal
objective of each of these forms of prospective pricing was fiscal control is not in
doubt (Pauly, 1986~. Several related matters, however, are far from clear and
deserve more research: Why did the shift in insurance mechanisms, from retro-
spective to prospective, occur when it did? Why did the United States ever start
with insurance based on retrospective and fee-for-service pricing; after all, the
incentives that cost-based pricing generated were, or at least should have been,
apparent long ago, and the fiscal problem, as manifested in the rising share of
GNP devoted to health care, has been growing for decades.
In some current research, Paul Boben (1989) presents a model in which
retrospective pricing of hospital services and physician services (through fee-for-
service payments to physicians on the basis of "usual and customary" fees) is
allocatively efficient when there is little insurance coverage and health care pric-
es are determined in relatively competitive markets, but diminishes as that cover-
age spreads. In this model the discipline of prices on patient and provider behav-
ior that prevails when few people have insurance gives way to growing price
insensitivity (inelasticity) with the expansion of insurance. Thus, a "tipping
point" is reached, at which the usefulness of market-determined prices as signals
of opportunity costs becomes less than its cost in terms of distorted resource
il The pricing system is not entirely rigid. For example, a hospital may collect from Medicare
more than the DRG price for a limited number of unusually high-cost "outliers."
12 The DRG system of hospital service pricing initially applied only to Medicare patients. It has
subsequently been expanded, however, through private arrangements, to a growing number of other
patients who are not covered by the Social Security Medicare law.
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THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER!
17
allocations (the moral hazard problem). Such modeling of the social choice of
the insurance system is in its infancy.
Many of the issues raised above have received scant attention in the litera-
ture. The effect of advancing technology on health care financing arrangements,
the incentives for R&D inherent in those financial arrangements, and the implica-
tions of those arrangements for the quality of the care provided are each the
subject of later sections, where I will also consider the inevitability that health
care expenditures would soar in the post-World War II era. But, first, how do I
define "health care"? How is it affected by technological change and how does
its definition affect insurance coverage?
DEFINING "HEALTH CARE"
Up to this point I have been discussing the market for "health care" without
defining that market carefully. The endogeneity of the definition of health care
under insurance contracts has received some attention (Goddeeris, 1984a,b).
Consider two nonmutually exclusive hypotheses concerning the causes and con-
sequences of the definition of health care under insurance: (1) the operational
definition of health care, under insurance contracts, is a function of the state of
medical technology; (2) the state of medical technology today is a function of
economic and political responses to prior definitions of health care coverage
under insurance contracts.
The way health care is defined under insurance contracts is important for a
number of reasons, positive and normative. It affects the level of insured expen-
ditures, the incentives to utilize resources that are covered relative to those that
are not (Feldstein, 1988), and the incentives for the R&D sector to explore vari-
ous potential health-promoting technologies. At the operational level, the defini-
tion of health care is at issue when coverage for chiropractic care or for "experi-
mental" drugs or other "new" technologies is debated.
The effect of health care insurance on incentives for R&D depends on the
operational definition of health care that is, on the boundaries of the insurance
contract. Health insurance contracts do not offer the option of coverage only for
particular subsets of technologies, such as those already available at a given point
in time (Goddeeris, 1984b; Goddeeris and Weisbrod, 1985; Baumgardner, 1989~.
A reasonable conjecture, however, is that health care expenditures today would
be substantially lower than they would be if health care were being defined, for
insurance purposes, as limited to the use of medical technologies available at the
time the policy took effect or at some other fixed date. The more broadly health
care is interpreted under the contract, and the more responsive it is to changes in
technology, the broader the range of activities over which insurance will encour-
age R&D.
What determines how health care is defined? I suggest that the R&D pro-
cess causes the definition of what is covered by health insurance to change in
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BURTON A. WEISBROD
systematic ways. Technological advances are not only expanding the range of
medical capabilities for extending life and enhancing health status, as the latter
term is customarily understood, they are also presenting opportunities to deal
with problems not conventionally considered to be "illnesses," in ways not con-
ventionally considered "health care."~3
An illustration of this causal process is the current debate over whether
health insurance should necessarily cover in vitro fertilization. This has become
an issue only in the past few years, when advances in medical capabilities made
such fertilization technically feasible. An advance in medical technology has led
to pressure to expand the traditional definition of insurance coverage, pressure
being felt now through the political system; by 1988 such insurance coverage had
been mandated in five states (U.S. Congress, 1988),14 and by the end of 1989,
laws requiring insurers to cover such "advanced" treatments for infertility had
been enacted in nine states and bills had been introduced in eighteen others
(Nazario, 1989~.
The effect of technological change on the health insurance market can also
be seen with "experimental" drugs. The decision to term a drug experimental is
often seen as a statement of the degree of professional knowledge about its safety
and efficacy. It is, however, also a statement of whether the drug will or will not
be deemed "health care" for insurance purposes, since insurance typically does
not cover "experimental" technologies. For example, as long as the AIDS drug,
zidovudine (AZT), was termed experimental, its exclusion from coverage under
health insurance involved each patient with costs that, until 1990, were in excess
of $8,000 per year, even though conventional hospital-based treatment was cov-
ered in the traditional fashion.
The hypothesis that the definition of health care is endogenous to the eco-
nomic-political system in which health care insurance is defined, provided, and
financed has important implications, to the extent that it is valid. If insurance
coverage is defined, as it has been, to encompass new technologies regardless of
the costs involved and to encompass an ever-widening concept of health care that
is, itself, responsive to the development of new technologies, the R&D sector
will continue to face incentives that reward costly new measures relative to cost-
reducing innovations. Such a reward system may not be incentive compatible;
13 Another example of the need to decide, as a matter of public policy, how to define operationally
what is health care involves people with physical disabilities. Surgery and physical therapy illustrate
"traditional" health care resources employed to reduce the disabilities. City buses that are wheelchair
accessible are unquestionably valuable to the disabled; whether their cost should be regarded as
health care expenditures and covered by health care insurance is another matter.
14 As of May 1988, Arkansas, Hawaii, Maryland, Massachusetts, and Texas had enacted legislation
requiring private insurers to provide some coverage for in vitro fertilization procedures. Delaware
Blue Cross/Blue Shield began offering coverage voluntarily in response to legislative activity (U.S.
Congress, 1988).
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BURTON A. WEISBROD
Finding the answers to these questions requires modeling the behavior of
each form of organization and the process of competition among them. There
has been some attention to the conditions of equilibrium in institutionally mixed
industries (Schiff, 1986; Marmor et al., 1986; Phelps and Sened, 1989), but strong
conclusions have not been reached.
Economic behavior may differ across ownership forms because of differenc-
es in objective functions, constraints, or both. Profit maximization is typically
assumed for the pry ate enterprise components of the health care sector, but a
variety of objective functions have been suggested for the nonprofit sector (New-
house, 1970; Davis, 1973; Pauly and Redisch, 1973; James, 1983; Young, 1983),
as have venous constraints on the distribution of profit44 and access to public
subsidies and private donations of money and time (lIansmann, 1980; Rose-
Ackerman, 1982; Easley and O'Hara, 1983; Holtmann, 1983; Clotfelter, 1985;
Steinberg, 1986; Weisbrod and Dominguez, 1986~.45
DRG pricing provides the same financial incentive for all hospitals to dis-
charge patients earlier than would a retrospective pricing system, but because of
differences in objective functions and constraints, the behavioral responses may
differ among institutional forms. There have been studies, for example, of the
effect of prospective payment on the condition, at discharge, of elderly patients
with hip fractures (Palmer et al., 1989; Fitzgerald et al., 1988) in two nonprofit
hospitals, but they have not examined differences across ownership forms.46
More generally, neither theory nor empirical tests have resolved the question
of whether there are systematic differences among institutional forms. Econo-
metnc evidence, while mixed, is growing that when for-profit, nonprofit, and
government organizations coexist in a given industry as they do in hospitals
and nursing homes, for example-they do behave differently. Differences have
44 Nonprofit organizations are not legally restricted from engaging in profitable activities; they are,
however, restricted in what they may do with the profits. Little explicit attention has been devoted,
however, to the enforceability of this constraint (Weisbrod, 1988). This is relevant to the "managerial
discretion" models of Williamson (1967), Alchian and Demsetz (1972), and Migue and Belanger
(1974).
4s All organizations, regardless of ownership, confront the same technological constraints, but they
face different financial constraints in such forms as nonprofits' exemptions from property and sales
taxes and eligibility for postal subsidies. Charitable contributions of time and money to a nonprofit
hospital (but not to a proprietary hospital) might respond positively to the amount of unprofitable
services it provides to low-income, uninsured, or other "deserving" people. The relationship between
donations to nonprofit organizations and the tax and expenditure behaviors of government" the
"crowding out" effect has also received attention in the public finance literature. At the theoretical
level, see Warr (1982); Roberts (1984), Bergstrom et al. (1986), and Andreoni (1988); for empirical
studies, see Abrams and Schmitz (1978, 1984) and Schiff (1985).
46 Palmer and colleagues (1989) found no change in ambulation status, comparing patients dis-
charged from one nonprofit hospital in the several years before and after the change in price incen-
tives. Fitzgerald and colleagues (1988), studying a single "community" hospital (presumably also a
nonprofit), found significantly reduced mobility.
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THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER!
39
been examined in four principal dimensions: (1) access to care, as reflected by
admission of uninsured patients (e.g., provision of "uncompensated" care) and
the use of waiting lists rather than prices, (2) quality of care, (3) cost-efficiency,
and (4) extent of opportunistic behavior toward asymmetrically underinformed
consumers.
Systematic behavioral differences between private firms and nonprofit orga-
nizations have been found in some studies (Gray, 1986 twhich summarizes a
number of studies]; Herzlinger and Krasker, 1987; Lewin et al., 1988; Weisbrod,
1988; Selden, 1989), but not in others (Clark, 1980; Sloan and Vraciu, 1983;
Gaumer, 1986~. Nonprofit providers of health care, especially the church-affili-
ated nonprofits, appear to utilize a somewhat greater proportion of their resources
to care for the indigent; they provide a wider range of services (and in this sense,
higher quality); and they take less advantage of their informational advantages
over patients.
Neither the underlying theory nor the available, nonexperimental data, how-
ever, are yet strong enough to justify confident generalizations about differences
in institutional behavior. Measuring quality of service in a hospital (Shortell and
Hughes, 1988), controlling for differences in patient conditions, and distinguish-
ing care of the indigent from "bad debts" associated with poor management all
remain subjects for future research, as does any differential responsiveness to the
development of new technologies.47 There is also a question of the appropriate
estimation modeling; many econometric efforts to detect differential behavior
across institutional forms may have misspecified their models, controlling erro-
neously for variables such as organization size, which are endogenous to the
choice of institutional form (Weisbrod and Mauser, 1990~.
CONCLUDING REMARKS
Economists' concerns about skyrocketing health care expenditures have fo-
cused heavily on insurance and its encouragement of inefficiently great utiliza-
tion. Yet it is clear that much of the growth in health care expenditures during
the post-World War II period has resulted not from increased prices for existing
technologies but from the price for new technologies. Newly developed technol-
ogies have driven up both costs of care and the demand for insurance, while also
expanding the range of services for which consumers demanded insurance. At
the same time, expanding insurance coverage, which includes more people as
well as a growing array of health care inputs, has provided an increased incentive
to the R&D sector to develop new technologies and a growing incentive for
subsets of consumers, who could benefit from particular new technologies, to
47 In a related study of rapidity of introduction of new technologies in HMOs relative to fee-for-
service providers, the RAND Corporation health insurance experiment found an apparently slower
rate of introduction in HMOs (Newhouse et al., 1985).
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40
BURTON A. WEISBROD
seek a wider definition of what would be covered by insurance. Both the re-
source costs of health care and the technical ability to prolong life and enhance
its quality have risen sharply. The interactive process involving insurance and
R&D is still evolving. It is increasingly being influenced by the recent change in
incentives associated with the shift from retrospective, cost-based insurance cov-
erage to prospective, exogenously determined pricing.
Although this chapter has focused on the health care sector, the kinds of
incentive effects it has examined are quite general. As an example of the poten-
tial effect of insurance on incentives facing the R&D sector, consider another
major area of public policy and expenditure education. Unlike health care,
which has been financed for decades by a retrospective, cost-based finance sys-
tem, elementary and secondary education has been financed traditionally through
what amounts to a prospective payment system; roughly speaking, state and local
governments have given the schools a fixed grant per child. This is roughly
analogous to a DRG system with a single DRG, so that every patient (child)
entering a hospital (school) brings a fixed sum of revenue to the provider. A
school district can also be thought of as, like an HMO, providing "comprehen-
sive" services to all "members" (students) in return for a fixed annual fee. By
examining how the interaction of finance mechanisms and R&D incentives have
operated in the health and education areas, one can gain insight into what the
health care system would be like today, had the country taken an alternate route
for financing it, as well as how a change in school finance would be likely to
have an impact on the education system.
Assume that public schools had been financed differently in the way hos-
pitals have been financed until recently: (1) school revenue was determined
through a retrospective (cost-based) pricing system, in which (2) teachers were
empowered to decide what resources should be used (a) to diagnose a particular
child's educational "needs" and (b) to meet those needs, and (3) a bill for the cost
of the resources used for each child was sent to government or a private insurer
and subsequently paid to the school district.
Two questions arise: If such a system had been adopted after World War II
for schools, what would have happened over the subsequent 40 years to the level
of education expenditures? What would have happened to the pace of technolog-
ical change in education? The lessons from health care suggest conjectures: if
schooling had been "insured" on the basis of retrospective costs, expenditures
would have increased far more rapidly than they did and the pace of technologi-
cal innovation in schools would have been far greater than it was.
Since education actually utilized a prospective pricing system, while health
care utilized a retrospective pricing system, it is interesting to compare the two
programs in terms of expenditure growth and technological change. First, with
respect to expenditures, the share of GNP devoted to public elementary and
secondary education has changed little over several decades (in which enroll-
ments have remained relatively constant); between 1960 and 1985, for example,
OCR for page 41
THE NATURE OF TECHNOLOGICAL CHANGE: INCENTIVES MATTER! 41
years of virtually identical school enrollments (36.7 million and 36.6 million,
respectively) public school expenditures increased from 3.03 percent of GNP to
3.42 percent (U.S. Bureau of the Census, 1987, tables 186, 190 and 698~; mear~-
while, health care expenditures were rising from 4.6 to 10.7 percent of GNP
(U.S. Bureau of the Census, 1975 and 1987~.
Second, with respect to the pace and nature of technological change that
might have occurred in education had retrospective pricing prevailed, one can do
some informed speculating. To begin, compare, impressionistically, the techno-
logical change that has occulted in health care and in education. The typical
hospital, for example, is barely comparable to its counterpart several decades
ago, with entirely new techniques and facilities for diagnosis and treatment. The
typical school, however, differs far less from its post-World War II counterpart,
utilizing similar classrooms, teachers trained in similar ways, and instructional
techniques that, despite some computerization in recent years, employ capital-
labor ratios that have changed relatively little.
One can predict that if retrospective reimbursement had prevailed for
schools, the private sector would have devoted more resources to development of
"improved" educational diagnostic and reaming technologies; had that been the
case, society would probably find now that education, like health care, had im-
proved dramatically, but that society was paying a great deal more for it.
Today, the public policy "problems" in health care and education are per-
ceived to be sharply different, and in ways that correspond to the differences in
finance mechanisms (although other forces are doubtless also at work). In health
care, the central policy focus is on control of expenditures, with quality of care
not generally being seen as a problem.48 In education, it is the reverse the
policy focus is on "low" quality of education, with control of school expenditures
receiving relatively less attention.
The ideas presented above are a mixture of solid knowledge, soft knowl-
edge, and hypotheses requiring testing. In order to expand knowledge about
health care and provide financial access to it, society needs to understand more
fully the dynamic process through which the health insurance sector, private and
public, interacts with the R&D sector. This area offers a rich research agenda
with enormous potential, for the policy implications extend far beyond health
care and across geographical boundaries.
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Representative terms from entire chapter:
care insurance
