San José State University
Department of Economics
& Tornado Alley
For decades the American Medical Association (AMA) defended a policy of price discrimination for medical care. According to the propaganda the wealthier patients were charged more in order for the poorer to be charged less. It sounds plausible, but Reuben Kessel is a classic article, Price Discrimination in Medicine, established that the major factor in the policy was that it was more profitable than a system in which all patients were charged the same price for the same services. Because price discrimination was more profitable the AMA went to great lengths to maintain it. This involved legislative lobbying to keep government out of the field of medical care. It also involved finding ways to punish any doctors who engaged in price cutting or any practice such as advertising which injected competitive behavior into the market. The AMA also fought the creation of prepaid health plans which would syphon all the wealthier patients away from the discriminating doctors. Ultimately the AMA failed in the matter of price discrimination but the medical establishment maintained the medical cartels which raised the price of medical services by artificially restricting the training of physicians and other medical professionals. For more on the medical cartels see Medical Cartels and Healthcare Reform.
This material presents the exposé that Reuben Kessel ruthless tactics of the AMA in trying to maintain the policy of price discrimination in medicine. However before presenting that information it is worthwhile to work through a simple example to illustrate the profitability of price discrimination for a monopolist.
Consider a market in which there are two types of consumers, say Richer and Poorer. The demand functions for the two types are shown below.
In the graph the intercept of the Richer patients demand schedule with vertical price axis is 10, whereas for the Poorer patients it is 5. Call these figures the pmax for each consumer type. For a monopolist dealing with a straight line demand schedule and having a constant unit cost of c, the profit-maximizing price pmon is simply the average of pmax and the unit cost c. To keep the example simple and remove any element of the transfer of production cost from one consumer group to the other let the unit cost c be equal to zero. This means that with price discrimination the richer patients would be charged a price of 10/2=5 and the poorer patients a price of 5/2=2.5. The operating profit, revenue less production cost, is then 10*5+7.5*2.5=68.75.
Without discrimination the revenue received as a function of quantity sold is shown below.
The price that maximizes profit, which in this example is the same as revenue, is 3.5, at which 17.5 units are sold for a total revenue of 17.5*3.5=61.25. This is 7.5 less than the profit achieved with price discrimination. Note that the Richer patients would pay 5 in the absence of the Poorer patient market. They also pay 5 with discrimination. However with the Poorer patient there and no discrimination they pay 3.5. They are not worse off for the Poorer patient market being there. They may not be better off but they are not worse off.
However it is the case that the poorer patients are better off with price discrimination. However the benefit of the lower price to the poorer patients is less than what they would gain if they sold the additional services to richer patients.
Now we are ready to consider Reuben Kessel's material concerning price discrimination in medicine.
The following is an excerpt from Reuben Kessel's article. The footnotes for each excerpt are displayed in green enclosed between two horizontal lines at the end of each excerpt.
The standard position of the medical profession on price discrimination is in conflict with what might be regarded as the standard position of the economics profession. Economists argue that price discrimination by doctors represents the profit maximizing behavior of a discriminating monopolist; the medical profession takes the contrary position that price discrimination exists because doctors represent a collection agency for medical charities.5 The income of these charities is derived from a loading charge imposed upon well-to-do patients. This income is used to finance the costs of hiring doctors to provide medical care for the poor who are sick. The doctor who is hired by the medical charity and the medical charity itself are typically the same person. Since the loading charge that is imposed upon non-charity patients to support the activities of medical charities is proportional to income or wealth, discriminatory prices result. The following quotation from an unnamed but highly respected surgeon presents the position of the medical profession.
I don't feel that I am robbing the rich because I charge them more when I know they can well afford it, the sliding scale is just as democratic as the income tax. I operated today upon two people for the same surgical condition—one a widow whom I charged $50, the other a banker whom I charged $250. I let the widow set her own fee. I charged the banker an amount which he probably carries around in his wallet to entertain his business friends.6
It is relevant to inquire, why have we had the development of charities operated by a substantial fraction of the non-salaried practitioners of a profession in medicine alone? Why hasn't a parallel development occurred for
such closely related services as nursing and dental care? Why is it possible to observe discrimination by the Mayo Clinic but not the A and P? Clearly food is as much of a "necessity" as medical care. The intellectual foundation for the existence of price discrimination and the operation of medical charities by doctors appears to rest upon the postulate that medicine is in some sense unlike any other commodity or service. More specifically, the state is willing to provide food, clothing, and shelter for the indigent but not medical care.` Since medical care is so important, doctors do not refuse to accept patients if they are unable to pay. As a consequence, discrimination in pricing medical services is almost inevitable if doctors themselves are not to finance the costs of operating medical charities.
The foregoing argument in defense of price discrimination in medicine implies that a competitive market for the sale of medical services is inconsistent with the provision of free services to the indigent. This implication is not supported by what can be observed elsewhere in our economy. Clearly there exist a number of competitive markets in which individual practitioners provide free goods or services and price discrimination is absent. Merchants, in their capacity of merchants, give resources to charities yet do not discriminate in pricing their services. Similarly many businesses give huge sums for educational purposes. Charity is consistent with non-discriminatory pricing because the costs of charity can be and are paid for out of the receipts of the donors without recourse to price discrimination.
However the fact that non-discriminatory pricing is consistent with charity work by doctors doesn't imply that discriminatory pricing of medical services is inconsistent with the charity hypothesis. Clearly what can be done without discrimination can, a fortiori, be done with discrimination. Therefore, it is pertinent to ask, is there any evidence that bears directly on the validity of the charity interpretation of price discrimination? The maximizing hypothesis of economics implies that differences in fees can be explained by differences in demand. The charity hypothesis propounded by the medical profession implies that differences in fees result from income differences. The pricing of medical sevices to those who have medical insurance provides that what might be regarded as a crucial experiment for discriminating between these hypotheses. Whether or not one has medical insurance affects the demand for medical service but does not affect personal income. Consequently if the charity hypothesis is correct, then there should be no difference in fees, for specified services, for those who do and those who do not have medical insurance. On the other hand, if the maximizing hypothesis of economics is correct, then fees for those who have medical insurance ought to be higher than for those who do not have such insurance. Existing evidence indicates that if income and wealth differences are held constant, people who have medical insurance pay more for the same service than people who do not have such insurance. Union leaders have found that the fees charged have risen as a result of the acquisition of medical insurance by their members; fees, particularly for surgery, are higher than they would otherwise be if the union member were not insured.8 Members of the insurance industry have found that ". . . the greater the benefit provided the higher the surgical bill. ..."9 This suggests that the principle used for the determinations of fees is, as Means pointed out, what the traffic will bear. Obviously fees determined by this principle will be highly correlated with income, although income will have no independent predictive content for fees if the correlation between income and what the traffic will bear is abstracted.10
Other departures from the implications of the hypothesis that price discrimination results from the desires of the medical profession to finance the costs of medical care for the indigent exist. These are: (1) Doctors typically do not charge each other for medical care when clearly inter-physician fees ought to be relatively high since doctors have relatively high incomes. (2) The volume of free medical care, particularly in surgery, has declined as a result of the rise in real per capita income in this country in the last twenty years. Yet there has been no change in the extent of price discrimination. As real per capita income rises, price discrimination ought to fade away. There is no evidence that this has been the case." (3) There exists no machinery for matching the receipts and disbursements of medical charities operated by individual doctors. There are no audits of the receipts and the expenditures of medical charities and well-to-do patients are not informed of the magnitude of the loading charges imposed. Moreover one study of medical care and the family budget reported ". . . no relation in the case of the individual doctor between the free services actually rendered and this recoupment, the whole system is haphazard any way you look at it." 12
5 However, there is not a unanimity of views either among economists or medical men. Means, a retired professor of clinical medicine at Harvard and a former president of the American College of Surgeons, takes the point of view of the economists. He describes this price policy as charging what the traffic will bear. J. H. Means, Doctors, People and Government, p. 66 (1953).
6 Seham, "Who Pays the Doctor?", 135 New Republic 10, 11 (July 9, 1956). Those who favor price discrimination for this reason ought to be in favor of a single price plan with a system of subsidies and taxes. Such a scheme, in principle, could improve the welfare of both the poor and the well-to-do relative to what it was under price discrimination.
The equity of a tax that is imposed upon the sick who are well-to-do as contrasted with a tax upon the well-to-do generally has not troubled the proponents of this method of taxation.
7 H. Cabot contends that the community is unwilling to provide for the medical care of the indigent. Therefore the system of a sliding scale of fees has evolved; pp. 123, 266 ff. He estimates that the more opulent members of the community pay ". . . from five to thirty times the average fee" p. 270, The Doctors Bill (1935).
Robinson has defended discriminatory pricing of medical services in sparsely populated areas by using an argument based on indivisibilities. "A Fundamental Objection to Laissez-Faire," 45 Economic Journal 580 (1935). For a refutation of this position, see Hutt, "Discriminating Monopoly and the Consumer", 46 Economic Journal 61, 74 (1936).
8 E. A. Schuler, R. J. Mowitz, and A. J. Mayer, Medical Public Relations (1952), report the attitude of lay leaders of the community towards the medical profession. For the attitudes of union leaders and why they have these attitudes, see p. 97 ff.
9 Lorber in Hearings Before the House Committee on Interstate and Foreign Commerce on Health Inquiry, 83d Cong. 2d Sess. pt. 7, p. 1954 (1954) ; Also Joanis, Hospital and Medical Costs, Proceedings of the Fourth Annual Group Meeting of the Health and Accident Underwriters Conference, p. 18 (Feb. 1920, 1952).
10 The principle of what the traffic will bear and the indemnity principle of insurance are fundamentally incompatible and in principle make medical care uninsurable. This has been a real problem for the insurance industry and in part accounts for the relative absence from the market of major medical insurance plans. See the unpublished doctoral dissertation of A. Yousri, Prepayment of Medical and Surgical Care in Wisconsin, p. 438, University of Wisconsin Library (1956).
11 Berger, "Are Surgical Fees Too High?", 32 Medical Economics 97, 100 ff. (June 1955).
12 Deardorff and Clark, op. cit. supra note 9, pt. 6, p. 1646.
Having made his case that price discrimination in medicine is simply of charging what the traffic will bear he goes on to document how a cartel involving hundreds of thousand members is maintained.
Part of nearly every doctor's medical education consists of internship and for many also a period of hospital service known as residency. Internship is a necessary condition for licensure in most states. This training is administered by hospitals. However, hospitals must be approved by the AMA for intern and residency training, and most non-proprietary, i.e., nonprofit, hospitals in this country are in fact approved for at least intern training. Each approved hospital is allocated a quota of positions that can be filled by interns as part of their training. Hospitals value highly participation in internship and residency training programs. These programs are valued highly because at the prevailing wage for intern services it is possible to produce hospital care more cheaply with interns than without them. Interns to hospitals are like coke to the steel industry: in both cases, it is perfectly possible to produce the final product without these raw materials; in both cases, the final product can be produced more cheaply by using these particular raw materials.
There exist some grounds for suspecting that the wages of interns are maintained at an artificially low level, i.e., that interns receive compensation that is less than the value of their marginal product: (1) Hospitals are reporting that there is a "shortage" of interns and have been known to send representatives to Europe and Asia to invite doctors to serve as interns. (2) University hospitals are more aggressive bidders for intern services than non-university hospitals. The fraction of the available intern positions that are filled by university hospitals is greater than by non-university hospitals.25 If controls are exercised over what hospitals can offer in wages to interns, university hospitals are apt to be less vulnerable to the threat of loss of their class A hospital ratings than non-university hospitals. This would be true for the same reason that Johns Hopkins would have a freer hand in determining the size of its freshman class. The status of university hospitals is stronger because these hospitals are likely to be among the better hospitals in the country. Therefore, if controls over intern wages exist then it seems reasonable to suspect they would be relatively weaker over the wages of interns in university hospitals. For this reason, one would expect university hospitals to be more aggressive in bidding for interns.
However, whether or not interns are underpaid, the AMA has control over the supply of a vital, in an economic sense, agent of production for producing hospital care. Revocation of a hospital's Class A rating implies the loss of interns. In turn, the loss of interns implies higher costs of production. Higher costs of production result in a deterioration of the competitive position of any given hospital vis-a-vis other hospitals in the medical care market. This control over hospitals by the AMA has been used to induce hospitals to abide by the Mundt Resolution." This resolution advises hospitals that are certified for intern training that their staff ought to be composed solely of members of local medical societies.27 As a result of this AMA control over hospitals, membership in local medical societies is a matter of enormous importance to practicing physicians. Lack of membership implies inability to become a member of a hospital staff.28
County medical societies are for all practical purposes private clubs with their own rules concerning eligibility for membership and grounds for expulsion. A system of appeals from the rulings of county medical societies with respect to their members is provided. On the other hand, for non-members attempting to obtain membership in county medical societies, there is no provision for appeal. The highest court in the medical judicial system is the judicial Council of the AMA. Between this council and the county medical societies are state medical societies. Judicial review is bound by findings of fact made at the local level.29 For doctors dependent upon hospitals in order to carry out their practice, and presumably this constitutes the bulk of the profession, being cut off from access to hospitals constitutes a partial revocation of their license to practice medicine. Consequently, more doctors belong to their county medical associations than is true of lawyers with respect to local bar associations. More significantly, doctors are subject to very severe losses indeed if they should be expelled from their local county medical associations or be refused admission to membership. It is this weapon, expulsion from county medical associations, that is probably the most formidable sanction employed to keep doctors from maximizing their personal incomes by cutting prices to high income patients. "Unethical" doctors, i.e., price cutters, can be in large part removed as a threat to a structure of prices that discriminates in terms of income by the use of this weapon.°° For potential unethical physicians, it pays not to cut prices if cutting prices means being cut off from hospitals.
Thus far we have argued that control over the individual price policies of the members of the medical profession has been achieved by the AMA through its control over post-graduate medical education. By means of its power to certify a hospital for intern training, the AMA controls the source of supply of a crucial agent for the production of hospital care. Control over the supply of interns has been used to induce hospitals to admit to their staffs only members of county medical associations. Since membership in the county medical associations is in the control of organized medicine, and membership in a hospital staff is extremely important for the successful practice of most branches of medicine, the individual doctor can be easily manipulated by those who control membership in county medical associations.
Members of the medical profession are also subject to another type of control, derived from AMA control over post-graduate medical education, that is particularly effective over younger members. Membership in a county medical society is a necessary condition for admission to specialty board examinations for a number of specialties, and passing these examinations is a necessary condition for specialty ratings.31 Non-society members cannot win board membership in these specialties. This is a particularly important form of control over newcomers to the medical profession because newcomers tend to be young doctors who aspire to specialty board ratings.31 Consequently the AMA has particularly powerful sanctions over those who are most likely to be price cutters. These are young doctors trying to establish a practice.33
24 "Congress to Probe Doctor Shortage", 33 Medical Economics 111 ;: June 1956
25 162 Journal of the American Medical Association 281 1956).
26 "By a long record of authoritative inspection and grading of facilities, organized medicine has placed itself in a position to deny alternatively the services of doctor and hospital to each other."" O. Garceau, Political Life of the American Medical Association, p. 109 (1941).
27 Hyde and Wolff. op. cit. note 19, at 952. The certification of hospitals for nursing training and the value of nursing training programs to hospitals may be on a par with intern training.
28 The strike is another instrument for control over hospitals by the AMA. Doctors have refused to work in hospitals that have admitted osteopaths to their staff. Hyde and Wolff, op. cit. supra note 19, at 96; M. M. Belli, Ready for the Plaintiff, p. 115 (1956). The threat of a strike has been used to induce hospitals to refuse staff membership to "unethical" doctors. Group Health Etc. vs. King Co. Med. Soc., 39 Wash. 2d 586, 624, 237 P. 2d 737, 757—758 (1951).
29 Hyde and Wolff, on. cit. supra note 19 at 919-950.
30 "Ethics has always been a flexible, developing, notion in medicine, with a strong flavor of economics from the start" Garceau, op. cit. supra note 26, at p. 106. Also consult the Hippocratic Oath.
31 Hyde and Wolff, op. cit. supra note 19, at p. 952.
32 A statement of sanctions similar to that noted above appears in Restrictions on Free Enterprise in Medicine, p. 9 (April 1949), pamphlet, Committee on Research in Medical Economics.
33 Other things being equal, old well-established concerns tend to be more hostile to price cutting than younger concerns." G. Stocking and M. Watkins, Monopoly and Free Enterprise, p. 117 (1951).
34 Most of these plans have services provisions; that is, they agree to provide the service required to treat particular ailments only if the subscriber's income is below some pre-assigned level. Of the 78 plans approved by organized medicine, 58 have service provisions. Of these, only 3 provide service to all income classes. The remainder provide a cash indemnity to subscribers whose income exceeds the relevant pre-assigned income levels. Therefore, these plans do not interfere with the discriminatory pricing, policies of doctors. Consult Voluntary Prepayment Medical Benefit Plans, American Medical Association (1954).
There is more, particularly concerning the AMA's opposition to prepaid medical plans, but they are dealt with elsewhere.
The evidence, theoretical and empirical, is that price discrimination was profitable for the medical establishment. Rather than being altruistic it was a matter of charging what the traffic will bear. Even in the case in which medical services are given free Reuben Kessel points out that the providers gain experience that enhances their skills. For example, in times past it was common practice for surgeons who were going to specialize in the correction of cataracts to go to India and do thousands of these operations for free before going into practice in the U.S. The fact that the surgeons gained something from the free surgery they provided in no way is counter to the poor having gained from the surgery. And more generally, the fact that physicians gained by price discrimination is in no way is contradictory to the poor having gained by this policy. Likewise the poor having gained by the policy is not contrary to the physicians having also gained.