Supply and Demand: Reviewing the Unbreakable Theory That Shall Doom ObamaCare in Short Order

When President Obama spoke to House Democrats the day before the House voted on his health care reform bill, he said:

I am convinced that when you go out there and you are standing tall and you are saying I believe that this is the right thing to do for my constituents and the right thing to do for America, that ultimately the truth will out.

Now that Congress has voted to approve his bill, the truth will out. We can only hope that it won't be too late to repair all the damage that will have occurred by the time it finally does.

A topic noticeably absent from public discussions of bending the health care cost curve down has been the economics of health care supply and demand. The phrase "supply and demand" is often misunderstood. What supply and demand curves measure is the effect of price changes on quantity supplied and quantity demanded. Higher prices encourage greater quantity supplied, while lower prices encourage greater quantity demanded. A professor might illustrate this in an economics class by posing a couple of hypothetical situations.

He might say: "I want to buy a car. Right now. Is there anyone in this classroom willing to sell me theirs? I don't care what it is." Then the professor would make an offer. A lowball offer, maybe $100. No takers.

So the professor would start to up his bid. In the $1,000 to $5,000 range, a few hands might go up. When he gets to the $20,000 to $30,000 range, more hands go up. No surprises there. But if he continues increasing his offer there will come a point, maybe when he gets into the hundreds of thousands of dollars, where everybody in the class will have a hand in the air.

When you plot this phenomenon on the Cartesian plane, you get a line starting in the vicinity of the intersection of the X-axis, which represents quantity supplied, and the Y-axis, which represents price. The supply curve extends upward as you go from left to right -- graphically illustrating that as price goes up, quantity supplied tends to go up.

The inverse is true on the demand side.

The professor might offer to sell his car to anyone in the class who is willing and able to buy it. For the sake of argument, the professor offers his 2010 Porsche Panamera which retails in the $89,800 - $132,600 range.

Offering a Porsche at anything under $10,000 is likely to have every hand in the class up in the air, since it would make wonderful sense to just buy it and flip it. As the price gets closer to $50,000, still well under the retail price, the entire class might still be willing buyers, but not all will be able buyers. Some, maybe most, won't be able to swing it financially. And when the price gets into the suggested retail value range, if there are any takers left they will ask: "OK, so what's in this car? Is it still a good deal at this price?" It's not a good deal once the asking price gets above the suggested retail value, and when it gets significantly higher buying it makes no sense to even consider.

A graph of the demand curve starts in the upper left hand side where price is high and demand is low, extending downward as you go from left to right. This illustrates that as the price goes down quantity demanded goes up, since there are more people who are willing and able to buy.

The fun begins when we superimpose the supply curve over the demand curve and find an "equilibrium point" at their intersection. In a free market the price at the equilibrium point represents the value of whatever thing you're tracking, as determined by buyers and sellers, often numbering in the millions, who have voted on it with the dollars they spend. The equilibrium point has another noteworthy characteristic: at equilibrium, quantity supplied and quantity demanded are roughly the same.

The equilibrium point tends to be a fairly accurate indication of both the value of a thing and how much of it sellers can expect to move. But that doesn't necessarily mean everybody will by happy with that situation.

When OPEC members are unhappy with the low price of oil, they will occasionally try to influence it by agreeing to cut production. Fortunately, the oil market is competitive and OPEC members have a hard time staying in agreement. When OPEC members successfully maintain solidarity, they can be fairly effective at forcing a price change. At least in the short run, since it usually doesn’t take long for one of them to feel the pinch from reduced revenue and boost production.

In the discussion of supply and demand it is important to recognize that an OPEC production cut, which is a change in quantity supplied, does not represent movement along the quantity supplied curve. It is a shift of the entire curve. OPEC's production cuts shift the supply curve to the left, creating a new supply curve, and along with the new supply curve we get a new equilibrium point with a higher equilibrium price and lower quantities demanded and supplied.

What we ought to be trying to achieve with health care reform is just the opposite of what OPEC does. For health care reform to have any hope of success at bending the cost curve down there must be something in it that encourages a greater supply of health care services. We need to shift the health care supply curves from left to right. Without some technological leap -- which is not something that can be legislated -- this means increasing the supply of doctors, nurses, medical technicians, and other providers.

It so happens, the health care reform bill just approved contains a provision for a fairly significant personnel increase. Unfortunately, it does not call for more trained medical talent.

This bill authorizes the IRS to hire 16,000 new agents to enforce the bill's requirement for individuals and businesses to buy “government-approved” health insurance.

Instead of increasing health care capacity and moving the supply curve in a direction that will drive down costs, Democrats prefer to impose price controls. They favor a plan to give the federal government the power to reject proposed health insurance rate increases. They would also like to give the secretary of health and human services the power to order insurance companies to give back part of premiums if the government should decide that companies spent too much on salaries or advertising. Though Democrats couldn’t get it into the current bill, they will continue to push for federal authority to "prevent unfair rate hikes."

But here is what government imposed price controls actually do and what problems they cause. Back in the '70s when OPEC was able to shift the supply curve, our federal government, in its infinite wisdom, maintained a price limit in the vicinity of the old equilibrium point.

Reminder: what supply and demand curves measure is the effect of price changes on quantity supplied and quantity demanded.

Maintaining an artificially low price provides a measurable disincentive for suppliers to supply.

Notice the point on the new supply curve where it intersects with the imposed price limit. The artificially low price also provides great incentive for buyers to demand more. Notice the point where the imposed price limit intersects with the demand curve. The difference between quantity demanded at the imposed price limit and quantity supplied at the imposed price limit represents a shortage.

Anyone old enough to remember life under Jimmy Carter may recall the summer of 1979 when a price control on gasoline caused a shortage that had cars lined up at gas stations across the nation. Rationing schemes were instituted, like using odd and even numbered license plates to say who was allowed to pull into a gas station on which days.

On the health care front there are additional complications. Democrats contemplate imposing price limits at several levels.

Besides the "unfair rate hikes" that they will no doubt seek to prevent by regulatory means, there are already controversial limits on physician reimbursement for services provided under Medicare. Doctors have been opting out of Medicare for years, and that trend can be expected to get much worse. Once our new health care reform bill has had time to take effect, we can expect fewer insurance options as price limits take their toll on that supply.

In an article describing the bill's passage, this morning's Washington Post put the spotlight on the factor that will do the most to drive medical costs through the roof:

House Democrats scored a historic victory in the century-long battle to reform the nation's health care system late Sunday night, winning final approval of legislation that expands coverage to 32 million people and attempts to contain spiraling costs.

By suggesting that the bill attempts to contain costs, the Post is oblivious to the significance of expanding health insurance coverage to 32 million more people.

Adding that many to the insurance rolls will shift the health care demand curve to the right, creating an even higher equilibrium price for any care that is not subject to federal price controls. For medicine and medical services subject to price controls, shortages will be even more pronounced.

The health care takeover that House Democrats have approved will take us back to those days of shortages and malaise.

The fight over it is so much like the one we had back then when Democrats railed against oil company profiteering, and pretended to champion the "little guy" by promising to keep gasoline affordable.

They succeeded in making it painfully scarce.

Today’s Democrats rail against the evil insurance companies and their profits, and once again pretend to champion the little guy. This time it’s medical care, not gasoline, that will be in short supply. The new bill will have a significant impact on seniors, since cuts to Medicare and Medicare Advantage are a large part of the plan's advertised savings, and that means more doctors will be opting out as the cost of everything medical skyrockets.

If there is a ray of hope in all this, it is that Washington finally woke up to the fact that gasoline price controls didn’t work, but it took a Republican president to get them lifted. It will take a Republican president and a Republican Congress to straighten this mess out as well, and there is no guarantee they will be successful.