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...