In this post I shall argue two things which together may confuse people. First, that life expectancy is so valuable that the money the US spends on healthcare relative to Europe could be well spent. Second that the extra spending is not in fact due to higher quality and does not explain rising prices over time.

What explains rising prices in some sectors of the economy? A common argument, at least from economists, is that there may be unmeasured improvements in quality. I don’t think that there have been marked improvements in quality in education so that argument doesn’t get off the ground (see my earlier post and the book for evidence). But health care quality has increased. Moreover, the value of life is so high that the improvements in quality could justify the cost increases. Here from Why Are The Prices So D*mn High is a back of the envelope calculation:

The United States spends about 5 percent more of GDP on health-care than do other developed countries. US GDP is almost $20 trillion, so 5 percent is approximately $1 trillion. The US population is 325 million, so the United States spends an extra $3,000 per person each year on healthcare. Is the expense worthwhile? A value of a statistical life-year of around $200,000 is a mid-range, widely used estimate in the United States. Thus, if the extra US spending generated an extra $3,000 per $200,000 of a life-year, it would pay for itself. In other words, for the extra US spending to be worthwhile it must generate 3,000/200,000 × 365 = 5.45 extra days of statistical life, and, of course, it must do so every year. In recent years, life expectancy in the United States has increased by about 52 days a year. Thus, a little more than 10 percent of the increase in actual life expectancy must be a result of the extra US spending for that spending to be worthwhile. That hardly appears impossible. It’s also not impossible that the increase in life expectancy was not caused by the extra spending. The bottom line is that the value of life is so high that US levels of spending could be worthwhile, but the high value of life and the difficulty of measuring the effectiveness of healthcare makes the question impossible to answer with certainty.

Nevertheless,I don’t think the increases in quality explain the increases in cost:

…even if the spending on healthcare is well justified by the improvements in life expectancy, it does not follow that the cause of higher spending is the improvement in life expectancy. As with education, many of the increases in life expectancy come from better knowledge, which does not necessarily cost more to use. It does not cost much more to treat an infection with antibiotics than with bloodletting; perhaps it costs less. We do use more technology in healthcare than in previous years—this includes computerized tomography (CT) scanners, magnetic resonance imaging (MRI) systems, and positron emission tomography (PET). Technology, however, is falling in price. At some point one would expect that decreases in the cost of existing technologies would overwhelm increases in costs owing to the introduction of new technologies. As with education, it would be peculiar if the only place in which technology raised costs was in healthcare (but see Joseph P. Newhouse for a strong argument that healthcare costs are driven by technology.)

Let’s put this argument more generally. Most increases in quality *over time* are similar to increases in productivity, i.e. A in A*f(K,L), an unpriced factor. Computers today are much higher quality than in the past. Indeed, so much so that today’s computers couldn’t be bought at any price not that long ago but we don’t pay more because what makes them higher quality is general knowledge.

In my view, most quality increases over time are due to improvements in knowledge. In other words, quality increases over time are much more about better recipes than better cooks. As a result, at a given point in time, higher quality is associated with higher prices but over time higher quality is more often associated with *lower* prices. Thus, in general, higher quality is not a good explanation for higher prices over time.

Tomorrow: The Baumol Effect.

Addendum: Other posts in this series.