Douglas E. Hough is Associate Professor at Johns Hopkins University, where he teaches health economics, behavioral economics, and strategy at the Carey Business School and the Bloomberg School of Public Health. Hough has served as a research economist at the American Medical Association and as a consultant in three health care strategy firms.

Irrationality in Health Care

What Behavioral Economics Reveals About What We Do and Why

By Douglas E. Hough

Stanford University Press

Copyright © 2005 Rutsongs Music and Ocean Music
All rights reserved.
ISBN: 978-0-8047-7797-1

Contents

List of Anomalies………………………………………………….ixPreface and Acknowledgments…………………………………………xiii1 What Is Behavioral Economics—and Why Should We Care?…………………12 Keeping What We Have, Even If We Don’t Like It………………………253 Managing Expectations and Behavior…………………………………694 Understanding the Stubbornly Inconsistent Patient……………………1005 Understanding the Stubbornly Inconsistent Consumer…………………..1366 Understanding the Medical Decision-Making Process, or Why a Physician
Can Make the Same Mistakes as a Patient………………………………1737 Explaining the Cumulative Impact of Physicians’ Decisions…………….2018 Can We Use the Concepts of Behavioral Economics to Transform Health
Care?…………………………………………………………….229References………………………………………………………..249Index…………………………………………………………….279

Excerpt

CHAPTER 1

WHAT IS BEHAVIORALECONOMICS—AND WHYSHOULD WE CARE?

It is time, therefore, for a fundamental change in our approach.It is time to take account—and not merely as a residual category—ofthe empirical limits of human rationality, of its finiteness incomparison with the complexities of the world with which it must cope.—Herbert Simon (1957)

The health care industry in the United States is peculiar. We spend closeto 18 percent of our gross domestic product on health care, yet othercountries seem to get better results—and we really don’t know why.Most health care products and services are produced by private organizations,yet federal and state governments pay for about half of theseservices. More starkly, those who consume health care do not pay for it,and those who do pay for that care do not consume it. That is, patientspay less than 15 percent of their care at the point of purchase, the restbeing picked up by their employers, private insurance companies, Medicare,or Medicaid (which have no need for physician visits, medications,or surgeries themselves). Health care is also peculiar on the supply side.Unlike in every other industry, the people who fundamentally determinehow resources are allocated—that is, the physicians—rarely have any financialstake (as owners or employees) in the resources that they controlin hospitals, nursing homes, or other facilities.

It is no wonder, then, that economists like myself are fascinated bythis industry and are turning our theoretical and empirical tools to allaspects of demand and supply. Although we have made some headway inunderstanding the health care industry, the standard tools do not seemto be helping us to understand much about the behavior of patients,physicians, and even society as a whole. In this book I will offer a neweconomic lens that I hope will provide more clarity in diagnosing theproblems facing the business side of health care. This lens—behavioraleconomics—is helpful in understanding the “micro” decisions that wemake as patients and that physicians make as they care for us. In addition,it yields insights into the “macro” decisions we make as a nationregarding how we organize and pay for health care. I will introduce theconcepts of behavioral economics by discussing a series of what I call”anomalies,” that is, behavior—both individual and societal—that justdoes not seem to be rational. For example, we will consider:

• Why would requiring everyone to buy health insurance makeeveryone—including those who don’t want to buy health insurance—betteroff?

• Why do patients insist on getting a prescription, shot, test … whenthey go to a physician with an ailment—yet many patients do notadhere to their diagnostic and treatment regimens?

• Why do tens of thousands of patients die each year in the UnitedStates from central line–associated bloodstream infections—eventhough a simple five-step checklist used by physicians and nursescould reduce that number by two-thirds?

My point is not that these anomalies occur because people are stupid ornaïve or easily manipulated. Rather, it is that we—as consumers, providers,and society—need to recognize the power of arational behavior if weare to improve the performance of the health care system and get whatwe pay for.

MAINSTREAM ECONOMICS AND ITS ASSUMPTIONS

Most economists practicing today learned their trade in what is known asthe neoclassical tradition. We were trained in a school of economic thoughtthat traces its heritage back to Adam Smith and The Wealth of Nations,published in 1776. In this world, markets—properly organized—allocatescarce resources to their highest and best use through the application ofSmith’s famous “invisible hand.” The primary role of the government is toensure that markets are properly organized and operated and then to getout of the way. Buyers and sellers, in seeking to further their own gainsand with little or no conscious intent to improve public welfare, will beled to maximize their “utility” (economists’ term for happiness or satisfaction)or profit. In fact, using both graceful exposition and elegantmathematics, neoclassical economists have been able to prove what becameknown as the “fundamental theorem of welfare economics,” that acompetitive market will generate a Pareto-optimal allocation of resources.That is, this market-generated allocation will yield the highest collectivevalue of those resources. They proved that any deviation from that allocationwould benefit some buyers and sellers only at the expense of others.

As you might imagine, this finding has been used to justify capitalismand the market economy. At the same time, it has been used to explainthe evils of monopolies (because monopolies typically raise pricesabove what would be charged in a truly competitive market) and to defendthe intervention of the government to limit pollution (because privatemarkets typically do not factor in the costs of pollution to society).

This theory of economics rests on a number of critical assumptionsabout the structure of the market and the behavior of buyers and sellersin the market. It is important for the discussion here to describethese assumptions, why they are important, and how the theory can failif the assumptions are not valid. The first—and most fundamental—assumptionis that everyone is rational. That is, standard economics assumesthat buyers and sellers, individuals and organizations, always actin their own best interests. If participants in the market are not alwaysrational, then they will not make decisions that promote their well-being(either satisfaction/happiness on the part of consumers or profits on thepart of sellers), and mainstream economists will be at a loss as to howto proceed.

Second, mainstream neoclassical economics assumes that all participantsin the market know their preferences. Again, it would be difficultfor a consumer to maximize his or her preferences without knowingwhat they were. Third, the theory assumes that all participants in themarket have full information—about the products in the market, theirfeatures and drawbacks, and the prices being offered by various sellers.Understandably, if consumers are not aware of the alternatives that facethem, it will be difficult for them to make the right decisions. Similarly,sellers need to know about the preferences of consumers and the rangeof products being offered by competitors if they are to offer the rightproduct at the right price and sell their wares.

A somewhat less intuitive assumption of standard economics is thatconsumer preferences and decisions are path independent. The preferencesthat consumers have and the decisions that they make should notdepend on how they arrive at those preferences or decisions. For example,a consumer’s willingness to buy a particular car should not dependon whether he saw a more expensive or less expensive car first orwhether he saw a blue car (a color he loves) before or after a green car(a color he despises). If consumer preferences and decisions are based onthese external and seemingly irrelevant factors, then one has to questionthe validity of his choices.

Finally, even mainstream economists admit that consumers and producerssometimes make mistakes. Even so, these economists assume thatthe mistakes are random and not systematic. So, if people miss the markin making decisions that improve their situation, sometimes they willbe above the mark, and sometimes they will be below—and we have noway to predict what mistakes they will make.

It may be pretty obvious that these assumptions do not accuratelydescribe reality all of the time or, in fact, most of the time. People donot always act rationally; they often do not have full information aboutthe products or services they may want to purchase; and occasionallythey may not know exactly what they prefer. Mainstream economistshave spent a lot of energy over the past several decades analyzing whathappens when these assumptions are violated. Going into this work willtake us too far afield. However, we should note a rather profound argumentmade by two prominent economists—Milton Friedman and LeonardSavage—regarding the importance of assumptions.

In an influential article written over sixty years ago, Friedman andSavage (1948) confronted the contention that bad assumptions lead tobad theory. They argued that economic theory does not assert that peopleact exactly as the assumptions claim that they do; instead, it is sufficientthat people only act as if they were obeying the assumptions. Friedmanand Savage argue that this “as if” nuance is crucial. They maintain thatany theory should be evaluated on the accuracy of its predictions, not onthe reality of its assumptions. If the assumptions allow the economist todevelop a theory that yields results that outperform other theories, thenthe assumptions themselves are irrelevant.

Friedman and Savage support their argument by their now-famousanalogy of a billiards player. A scientist might want to predict the pathof a ball struck by an expert billiards player during a match. Friedmanand Savage offer that it might be possible to develop mathematical formulasthat predict the optimal force and direction of the cue and all theballs on the table. Such a theory of billiards behavior may require anassumption that the player knows and uses these formulas, more correctlythat the player acts as if she knows and uses the formulas. AsFriedman and Savage argue, “It would in no way disprove or contradictthe hypothesis, or weaken our confidence in it, if it should turn out thatthe billiard player had never studied any branch of mathematics andwas utterly incapable to making the necessary calculations” (p. 298),as long as the assumption was necessary for the development of the hypothesisand the theory predicted the results of the billiards shot betterthan any competing theory. The implication of this line of reasoning foreconomics is that the realism of the assumptions may not matter if thetheory of behavior that uses these assumptions generates the most accuratepredictions.

Given this criterion, mainstream neoclassical economics has heldup very well over the past several decades compared to other competingeconomic theories. It has dispatched radical political economics (akaMarxism) following the fall of the Soviet Union and the Berlin Wall.It has proved to be more discriminating than institutional economics,which has failed to generate much interest since John Kenneth Galbraithretired. Evolutionary economics, despite the best efforts of renownedeconomists such as Sidney Winter and Richard Nelson, has not yet generatedtestable hypotheses that rival neoclassical economics.

THE CHALLENGE OF BEHAVIORAL ECONOMICS

Then came behavioral economics. This field was formed largely throughthe work of Daniel Kahneman and Amos Tversky in the 1970s. Ironically,Kahneman and Tversky (who died in 1996) are behavioral psychologists,not economists. Kahneman and Tversky first became knownto most economists through a 1979 article, “Prospect Theory: An Analysisof Decision Under Risk,” in the highly respected and mathematicallyrigorous journal, Econometrica (Kahneman and Tversky 1979). In thatarticle, they presented the first explication of the tenets of behavioral economics.Despite its scarcity of mathematics, the article is the most frequentlycited article ever published in Econometrica and the second mostfrequently cited article in the economics literature in the past forty years(Kim, Morse, and Zingales 2006).

What Kahneman and Tversky termed prospect theory has sinceevolved into what is generally referred to as behavioral economics. It hasoffered an interesting, and often compelling, alternative to mainstreamneoclassical economics. First, it makes assumptions about human behaviorthat have greater face validity to both economists and laypeople. Forexample, it acknowledges that not everyone is rational, at least not all thetime. Rather, buyers and sellers, individuals and organizations, do notalways act in their own best interests. In addition, behavioral economicsassumes that people do not have what neoclassical economists call autility function, which maps all of the available goods and services andother contributions to happiness into a permanent set of preferences foreach individual. Instead, behavioral economics assumes that people learntheir preferences through experience, via trial and error. In addition, theymake their decisions based on their current situation (which acts like areference point), not from some overarching utility function.

A further assumption is that incomplete information abounds. Neitherbuyers nor sellers have all the information that they would like.Sometimes, the buyers do not have enough information, such as whenthey are buying a used car from the original owner. Sometimes it is thesellers that lack information, such as an insurance company writing alife insurance policy for an individual; the buyer knows his behavior,health history, and other risk factors, but the insurer does not.

Behavioral economists have found that preferences are, indeed, pathdependent. Economic decisions are often influenced by factors independentof the individual: Buyers buy differently if they are shown a moreexpensive house before a less expensive house, a fully equipped car beforea stripped-down model, a fifty-two-inch LCD television before amore modest set.

Not only does behavioral economics assume that buyers and sellersare not always rational; the theory also has a fundamental tenet that deviationsfrom rational choice are systematic and can be predicted. Thisaspect of behavioral economics ultimately sets it apart conceptuallyfrom mainstream neoclassical economics and provides the focal pointfor testing the relative effectiveness of the two approaches for viewinghuman behavior.

I should note one final difference between mainstream neoclassicaleconomics and behavioral economics. Neoclassical economics haslargely been a self-contained discipline, developed by economists, foreconomists. If neoclassical economists have borrowed concepts from anotherfield, it’s been mathematics. On the other hand, behavioral economicsowes a very large intellectual debt to the discipline of psychology,especially behavioral psychology. By the nature of its assumptions, behavioraleconomics depends fundamentally on the perspective, hypotheses,and empirical studies of behavioral psychologists. In fact, there willbe times in this book in which it is not clear whether we are looking atbehavioral economics or behavioral psychology phenomena—and thatis by design.

THE CONTRIBUTIONS—SO FAR—OFBEHAVIORAL ECONOMICS

In the next chapters we will be exploring the full range of explanationsand predictions that behavioral economics can offer. However, I want toillustrate the relative power of behavioral economics here by examiningthree areas in which this theory provides explanations that are superiorto mainstream neoclassical economics: decision biases, the power of thedefault, and the special value of zero.

First, let’s take a look at decision bias. Everyone makes mistakes,even neoclassical economists. What behavioral psychologists have demonstrated—andbehavioral economists have used—is that peopletend to make bad decisions in a particular way. (Note that I used theword tend; what behavioral psychologists have found are tendencies,not immutable laws of behavior. People cannot be as predictable as atoms,so psychology and economics cannot be as definitive as physics.)For example, a host of psychology studies have found that most peopleare overconfident about their abilities. In a famous study, universitystudents in Oregon and Stockholm were asked to rate their drivingcompared to other students (Svenson 1981). About 80 percent of theAmerican students thought that they were safer than the median studentdriver, and about 75 percent thought they were more skilled thanthe median student driver. Only 12.5 percent thought that they wereless safe than the average, and only 7.2 percent thought that they wereless skilled than the average. (The Swedish students were somewhat lessconfident than their American counterparts.) Perhaps the researcher juststumbled on a group of NASCAR protégés, but more likely this findingis an example of a “Lake Wobegon” effect, where all the children arethought to be above average.
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