People who have imbibed from the cup of free-market-fundamentalism get very confused about markets. They think "free" market means little government intervention - not that it means a market where the goods are essentially identical, where information is available to every one on price and quality, where there are almost no barriers to entry and where there are a pile of producers of the good or service in question, all of whom can easily be replaced by the other.

In such circumstances, indeed, the market will operate in the way free market fundamentalists think it operates. Otherwise... it won't.

I bring this up because the topic today is health care. Let's jump in with an example [1] (hat tip: Lean Blog:) [2]

...the hospital revamped how it treated some expensive ailments, cutting down high-tech tests and high-end specialists.

But a troublesome pattern emerged: The more cost-effective it became, the bigger financial hit the medical center took. "Everyone gained but Virginia Mason," says its chief of medicine, Robert Mecklenburg.

More After the Jump

With each MRI that Aetna and the employers avoided at around $850, Virginia Mason lost about $450 in profit. The payment system of government-sponsored Medicare, which private health plans also use as a template, tends to reward the big capital expenses of buying high-tech machines such as MRIs. The more the machines are used, the bigger profit margin they pack. Meanwhile, reimbursement fees for doctors' visits have stagnated.

"The payment system is so toxic," says Francois de Brantes, a former health-care program director at General Electric Co. "Unless you tackle it, any health-care reform doesn't have much chance." Mr. de Brantes coordinates a program funded by employers that pays doctors bonuses based on patients' outcomes.

Notice the perverse incentives? You could hardly miss them. When the goal of healthcare is to make profits - when doctors are individual contractors, when hospitals are profit making centers, then they will act to maximize profits - not the health of their patients, and certainly they won't act to reduce how much they can bill people by.

Then there's Dr. Hu, in China: [3]

"Dr. Hu Weimin has attracted a wide following among the poor in this city by providing free advice on how to avoid high blood pressure and dispensing cheap drugs to treat the condition, one of the biggest killers in China.

His efforts have won him national recognition, and he counsels thousands of patients via the Internet. But Dr. Hu's public health message has turned him into an outcast at his hospital. Fellow physicians shun him, and administrators bar him from the wards."

The bottom line: Dr. Hu is bad for business at the Loudi Central Hospital. By making treatment widely affordable and talking up prevention, Dr. Hu says he has cost the hospital a small fortune in lost profits.

Like hospitals all over China, Loudi Central earns the bulk of its income from sales of drugs and high-tech testing. Doctors who pull in the most revenue earn the biggest bonuses. That gives them an incentive to pad the bills, not slim them down. Academic studies show that 50% of all Chinese health-care spending is for drugs. In the U.S., the figure stands at about 10%. "Every prescription is a money-making opportunity," says Dr. Hu.

I am here to tell you right now that this sort of thing happens all the time in US hospitals. Surgeons actively fight against cheaper alternatives to surgery, even when those alternatives have as good, or better, patient outcomes. Entire departments are underfunded in hospitals because they are not profit centers (for example, it is very hard to justify obstetrics, except as a loss leader).

In the US all the primary actors have as their main goal making money. That's what they concentrate on. It shouldn't surprise anyone, then, that the US pays more per capita on health care than any other modernized country, and gets the worst metrics - after all, you aren't trying to get good health care, you're trying to make money for health care providers and all of their hangers on like drug companies, insurance companies, appliance manufacturer's (whose markups, by the way, are often multiple hundreds of percent.)

The incentives are all wrong - the US does more surgery than any other country in the world, per capita, and that's not because it leads to better outcomes - that's because surgery pays the surgeon, and the hospital, more.

This is partially an information problem. Procedures and medicines are not compared against each other, they are generally compared against placebos. You can't tell if medicine X is better than medicine Y, because there's never been a trial comparing the two. You can't usually tell which of two surgical procedures treating the same problem are better, because there's never been a study comparing the two. And certainly there's rarely been a study comparing a surgical solution with a non-surgical one.

The information often isnt' available - even to doctors - let alone to patients or anyone else. And when it is, it is often deliberately ignored and downplayed - drug companies and appliance companies spend a lot of money putting doctors on their advisory committees and using them to fight any suggestion that their new drug or surgical appliance is only as good as, or worse than, some older and cheaper method.

Incentives matter - if there is anything that those who claim to understand markets should understand, it is that. And the incentives in the health care system right now are geared mostly towards making money, and not towards increasing the health of patients. As such, costs will continue to soar and health outcmes won't - because you get the behaviour you reward and that's the way the US system is set up.