A Critique of the Medicare Payment Advisory Commission

The Medicare Payment Advisory Commission released its second annual report to Congress in June 2008. Titled “Reforming the Delivery System”1, the report outlines the change in direction that the Medicare program is likely to take in the coming years. The Commission recognizes that without change, “the Medicare program is fiscally unsustainable over the long run”2 and it believes that under the current Fee For Service (FFS) payment method, in which Medicare reimburses hospitals and physicians for individual units of service, incentives for reform under are limited for two reasons. One, paying for individual units results in a strong incentive to providers to increase volume of services, and two, separate physician fee schedule and hospital prospective payment systems discourage coordination between physicians and hospitals that might result in efficiencies or better outcomes. 3 As a result, the Commission makes a series of recommendations to move Medicare away from FFS payment method toward one that promotes better coordination and accountability.

While these goals are laudable, their fundamental error is that the Commission’s assessment fails to understand the cause of the symptoms it attempts to diagnose and treat. The tell-tale sign of this methodological mistake is encapsulated in one of their reform ideas: the creation of an independent entity to produce information about the relative value of the services for which Medicare pays. By “value”, the Commission means “the clinical effectiveness of a healthcare service compared to its alternatives,”4 which will include cost effectiveness. The report states that while “cost effectiveness is not the primary mission, the Commission does not rule it out,”5 obviously because it recognizes that questions of value cannot be divorced from questions of economic calculation.

However, under Medicare’s central planning authority any rational economic calculation about the relative value of different health services is practically and theoretically impossible. This is the root cause of the inevitable long term collapse of the Medicare program and as we shall explore later the root cause of the inevitable collapse of our entire health care system. Any health care system resulting from central planning is not just of higher cost, lower quality, reduced innovation, uncoordinated, inefficient and ineffective, but literally and truly impossible. Austrian economist Ludwig von Mises in his 1920 treatise “Economic Calculation in the Socialist Commonwealth” developed this fundamental insight about the nature of all central planning.6 I rely heavily on his analysis of the impossibility of economic calculation under socialism to understand the inherent problems in the healthcare system created by the Federal government under the auspices of Medicare.

From a practical perspective, one can imagine a central planner judging the value of health care goods which require very simple production process, such as picking and consuming an orange from a tree in order to replenish the body of needed antioxidants that may aid in the prevention of certain cancers. One can also imagine this central planner valuing goods that are required in a slightly longer production process such as using lumber, a saw, a hammer and nails, to build a ladder to be used to climb a tree to pick fruit more efficiently. This is because in these simple examples, the planner can measure income and expense across the relatively short period of time it takes to build a ladder and pick fruit. But matters get very complicated very quickly when the central planner needs to decide on the level of reimbursement for a chemotherapy agent that took a pharmaceutical company years and millions of dollars to discover, test and manufacture, for the oncologist who supervises the delivery of the drug and who invested thousands of dollars and years of his life to understand the cancer disease process and for the hospital that invested millions of dollars and decades to build the infrastructure within which to deliver the drug.

This type of valuation is quantitatively more complicated because chemotherapy agents, physicians’ intellectual development and hospitals require very long and wide production processes across time and geography and complex interconnections between people, producers, quality, revenue and cost. In addition, to this one particular health product at one particular point in time and geography, the Medicare planner must consider hundreds of thousands of other health care goods and services, tens of thousands of hospitals, pharmacies, nursing homes, surgery centers, diagnostic centers, laboratories, home health agencies, hospices, long term acute care hospitals, ambulances, and millions of patients physicians, nurses, therapists and clinicians, across time and space. The central planner must therefore consider a practically infinite number of permutations in order to correctly allocate half of the healthcare dollar spent in the US.

Some may argue that the advent of the information age will resolve this practical calculation problem. But even if the Medicare planner possessed the most advanced computer information systems, it is only logical to assume that hospitals, physicians and producers of healthcare goods and services will possess similar computer systems as aides in the management their own internal operations and that hence, together, they would be capable of generating more information than the Medicare planning computer could absorb and process meaningfully. So paradoxically, information technology actually makes the economic calculation problem for Medicare more difficult to resolve.7

The Medicare planner must also consider two additional exacerbating factors.8 The first one is that like all goods, healthcare resources by their very nature are to a greater or lesser degree substitutable for one another. This is the phenomenon that the Commission is attempting to resolve by creating another commission to study the relative value of different health care services. For some types of breast cancers, for example, chemotherapy, radiation therapy and surgery may be substituted or complemented with one another. The challenge for the Medicare planner is to discover and approximate the myriad of natural substitutability of all healthcare goods and services in accordance with the exchange relations that an unhampered healthcare market economy would take place automatically and instantaneously.9

The second factor exacerbating the calculation problem is that since time is a scarce resource, capital can be accumulated and invested in order to lengthen any process of production and improve the efficiencies and quality of any healthcare good or service. This further multiplies the permutations required to evaluate alternative plans for the allocation of capital for the production of not only health care goods and services that Medicare patients consume, but also of capital required to manufacture the goods and services used by producers to fabricate the goods and services that hospitals and physicians purchase. For example, hospitals may decide between investing their capital in robotics for pharmacy or the operating room in order to improve the productivity and accuracy of pharmacists and surgeons or they may hire additional pharmacists or more experienced surgeons, or varying combinations between all or none of the above. Simultaneously, the manufacturer of robots would need to decide to invest capital to develop either pharmacy, operating room, radiation therapy or automobile robots and varying combinations between all or none of the above, and so on and so forth up the production chain of producers of software, research, education, parts, raw materials, financial services, etc., etc. So another challenge for the Medicare planner is to discover and approximate the natural substitutability of all alternative production chain possibilities that an unhampered healthcare market economy would discover automatically and instantaneously.

The infinite complexity of actual and potential relationships among producers, suppliers, providers and patients require precise calculations of income, expense, assets and liabilities across time in terms of a medium of exchange, i.e., money. Monetary calculation under conditions of private property and freedom of exchange, allows all consumers and all producers in very complex and long production processes to simultaneously solve the economic calculation problem detailed above by what Mises calls an “intellectual division of labor.” 10 This process is twofold. On the one hand, each and every consumer makes monetary bids for goods and services based on his individual subjective valuation resulting in objective money exchange ratios for goods and services (i.e., market prices for goods and services). On the other hand, every producer seeking to engage in production and seeking to maximize profits, bids against one another for the factors of production (labor and materials) resulting in objective exchange ratios for labor and materials (i.e., wages and prices for materials). In this way, Mises points out, not only end products ready for consumption but all intermediate goods used in the production of those end products “receive a position in the scale of valuations in accordance with the immediate state of social conditions of production and social needs.”11

When prices in the health care market are not the result of unhampered exchanges between economic actors but are mandated by a central planning agent, the capital structure of health delivery systems is distorted. This is because the prices of goods and services set by Medicare create different profit expectations in the minds of hospitals, physicians and the rest of the producers of healthcare goods and services up and down the various chains of production than the prices that would have been created by the free market. For example for years Medicare has handsomely rewarded hospitals and physicians who set up ambulatory radiation oncology programs. This preferential pricing not only encourages the proliferation of radiation centers and the associated stimulation of demand by patients, but also affects each and every intermediate step in the entire production chain necessary to build and operate a radiation center. This includes, for example, the production, marketing and distribution of linear accelerators, the programming of software to design treatment plans and control the accelerator, the production of CT scanners that feed patient’s anatomical information into the treatment planning and accelerator navigation systems, education facilities to train radiation technologists, physicians, physicists and administrators to diagnose, plan, treat and manage the accelerator, the production of lead, aluminum, steel, plastics and other raw materials needed to build and produce all of the physical components of accelerators, facilities and supplies needed, etc., etc. The length and scope of this production process alone and hence the capital structure required to bring about thousands of radiation treatment centers across the nation is as deep as it is wide.

All of these intermediate industries are interrelated using hundreds of thousands pricing signals. By making pricing decisions on the reimbursement of radiation therapy services based on criteria other than the subjective valuation of patients and producers, the Medicare planner affects all the pricing signals throughout the production process of each intermediate industry; however, the central planner, by definition, will never comprehend or have the means to comprehend and test how his pricing decisions cause changes in the structure of health care production, because the only rational way to test these cause and effect relationships is via the monetary calculation made possible by exchanges between patients, providers and other producers of healthcare goods and services in a free market.

At the outset of the Medicare program, its central planners were able to set their prices as parasites of the then existing competitive private health care price structure, just like their Soviet Union counterparts unable to resolve the economic calculation problem were forced to copy and use the price structure of Western economies to direct Soviet production processes and subsist for 80 years, albeit at inefficient and meager levels. This strategy was recommended by the Medicare Payment Advisory Commission in it’s first Report to Congress in March of 1999 which argued that Medicare’s primary payment system objective is “to establish payment rates that approximate the competitive prices that would prevail in the long run in local health care markets.”12

But as the proportion of Medicare expenditures continue to grow as a result subsidization and unintended stimulation of demand, as additional Medicare programs are brought on line, such as prescription coverage, as the proportion of Medicare eligible population increases relative to the rest of the population and as additional government programs such as Medicaid grow faster than the private sector, the percentage of the health care economy under the control of the government expand and central planners crowd out the fewer pricing signals produced by a diminishing private sector. If to this one adds the already existing inadequacies of the pricing signals produced by the private health sector, such as the distortions produced by a tax policy that encourages employer provided health insurance arrangements, the mixing of both uncontrolled risk (e.g., family history) as well as controlled risk (e.g., eating habits) in health insurance risk pools, is it any wonder that health costs are out of control and that unsubsidized members of society have been priced out of the market for health services?

In addition to facing the practical calculation problem outlined above, the labyrinthine payment methods created by Medicare totally misunderstand the theoretical nature of prices and hence do not recognize the theoretical impossibility of its attempt. Unlike the weather forecaster who faces a technical problem that can be ameliorated by the use of better satellites and faster supercomputers, the Medicare planner simply cannot determine the market prices for the services that it reimburses because by definition health care prices can only be arrived by the free and unencumbered interaction between patients and providers.

There are two reasons why it is theoretically impossible for the Medicare planner to arrive at a rational pricing structure for healthcare. The first, prices of goods and services are not determined by their costs of production. Prices are determined by the instantaneous valuations made by consumers bidding for goods and services. By a process of imputation that flows from the consumer to the producer, prices of goods and services impute value to the factors of production necessary to make the goods and service that consumers demand. This imputation of value occurs when producers and entrepreneurs bid for the factors of production (labor and materials) in response to expected future profits and which sets wages for labor and prices of materials.

For more than two decades now, Medicare planners have come up with alternative valuation methods that unsuccessfully attempt to arrive at a rational price structure for health services. Despite the Commission’s assertion that cost-based payment methods (in which reimbursement is determined by allowable costs supplied by providers) are being phased out because “they are complex, they result in unpredictable payments and spending for providers and Medicare, and they weaken provider’s incentives for efficiency”13 and that they are being substituted for prospective payment methods (in which an initial operating and capital payment base rate is adjusted by wage indexes, case mix, medical education costs, charity burden, short or long lengths of stay, etc.), payment rates are still determined by cost information. This is because the initial operating and capital payment base rate that prospective systems use is determined by “the operating and capital costs that efficient facilities would be expected to incur in furnishing covered” health services.14 “Operating payments cover labor and supply costs; capital payments cover costs for depreciation, interest, rent and property-related insurance and taxes.” 15 Despite the fact that this initial base rate is later modified by wage rates, geographic differences, case mix, etc., the initial rate is still cost based. Again, the first reason why it is theoretically impossible for Medicare to rationally set prices is that prices determine production costs and not the other way around. When the Medicare planner tries to use cost information to arrive at a price, he has the economic cause and effect relationship backwards.

The second reason is that prices in a market economy are continually, instantaneously and simultaneously being created, destroyed and recreated by the individual subjective valuations of consumers and producers facing the passage of time and hence changing expectations, economic conditions, wants, needs, technological advancements, etc. This information about valuations is not created until after consumers and producers place their respective bids in the intellectual division of labor process outlined above, so it is impossible to transmit it before it is created. Before bids are made, all you have is a universe of possibility in the minds of each economic participant that do not constitute information. But once bids take place and information created, transmitted to the central planner, processed and returned to the market place in its original or distorted form, it is old and useless information that cannot have rational guiding content. Moreover, if the information returned by the planner is coercive in nature, bids do not take place and future pricing information cannot be created.

As a result, all the Medicare planner does, to use Mises’ phrase, is grope in the dark. The Medicare planner may know exactly what final health care goods and services are needed to meet the needs of Medicare patients. Indeed, in the Commission’s own words, “Medicare’s primary goal is to ensure that its elderly and disabled beneficiaries have access to medically necessary acute care of high quality.” 16 But as Mises points out, this is only one of two simultaneous equations that are needed to resolve the economic calculation problem. The second equation is the valuation of the means of production to ensure that those needed goods and services are produced. Without market derived pricing signals, hospitals, physicians and producers of healthcare goods and services up and down the production structure (and the Medicare planner) are all left without the bearings of economic calculation. The Commission’s greatest concern, therefore, should not be that “the Medicare program is fiscally unsustainable over the long run,” as worrisome as that is, but that our entire healthcare system, including the capital structure needed to support a wide array of lengthy production processes, is unsustainable over the long run, being left, to quote Mises, “floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation.” 17

It is highly unlikely that the arguments advanced here will slow the accelerated movement toward the complete socialization of the healthcare delivery system in the US. Most supporters of socialized medicine do so for aesthetic, moral, political or religious reasons. But at a minimum, it is my hope that the above ideas will be a warning to those who expect a rational system of economic calculation that will guide consumers and producers of healthcare services to come out of command and control Medicare reimbursement systems.

Ludwig von Mises warned Marxists economists in the 1920’s that economic calculation in a command and control economy was literally impossible. In the end, the collapse of the Soviet Union and the rest of the Eastern Block caught unaware the great majority of Western economists. It is not just that these economists were unable to play their expected role and spare humanity of all of the grave errors committed by the planned economies in the East, but that on the contrary, economists encouraged the very same policies that caused untold misery and human suffering in the East. Sadly, Western economists instead of openly manifesting profound regret for their failure and instead of rethinking the theoretical underpinnings of their science, to this day continue to study their science and make policy recommendations as if nothing had happened.

In blindly following the advice of health economists who practice within a bankrupt theoretical framework and in suggesting that Medicare central planners can come up with rational pricing and payment methods for health services, the Medicare Payment Advisory Commission makes exactly the same intellectual error that Soviet planners made 90 years ago. One can only qualify as overbearing arrogance the Commission’s presumption: that Medicare central planners in the US are smarter than their Soviet counterparts.



1 Medicare Payment Advisory Commission, “Report to Congress Reforming the Delivery System, June 2008” http://www.medpac.gov/documents/Jun08_EntireReport.pdf

2 idem, p. xi

3 idem, p. xi

4 idem, p. 107

5 idem, p. 108

6 Ludwig von Mises, “Economic Calculation in the Socialist Commonwealth” http://mises.org/pdf/econcalc.pdf.

7 Jesus Huerta de Soto, “Socialismo, Calculo Economico y Funcion Empresarial”, p. 105,

8 See Joseph T. Salerno, “Poscript: Why a Socialist Economy is “Impossible”.”, p. 35 http://mises.org/pdf/econcalc.pdf.

9 Mises, p. 9.

10 Mises, p. 15

11 Mises, p. 15

12Medicare Payment Advisory Commission, “Report to Congress Medicare Payment Policy, March 1999” p. 5 http://www.medpac.gov/documents/Mar99%20Entire%20report.pdf

13 idem, p. 4

14 Medicare Payment Advisory Commission, “Hospital Acute Inpatient Services Payment System”, October 2007 p. 3 http://www.medpac.gov/documents/MedPAC_Payment_Basics_07_hospital.pdf

15 idem, p. 3

16 Medicare Payment Advisory Commission, “Hospital Acute Inpatient Services Payment System”, October 2007 p. 4

17 Mises, p. 15-17