In his excellent analysis of health care costs, Alex Tabarrok refers to a widely touted finding by health economist Joseph P. Newhouse that the main driver of increases in health care costs has been increased technology. Alex links to this article by Newhouse, but the earlier Newhouse article that received so much attention was his  “Medical Care Costs: How Much Welfare Loss?” Journal of Economic Perspectives (Summer 1992 ): 3-21 .

The 1992 article is excellent and I used it in every economic policy course in which I covered health care policy.

But it has one major flaw that health economists seemed to have missed. I pointed this out in my 2015 review of Amy Finkelstein (with Kenneth J. Arrow, Jonathan Gruber, Joseph P. Newhouse, and Joseph E. Stiglitz), Moral Hazard in Health Insurance because in her reference to Newhouse’s 1992 article, she makes the mistake he does.

Here’s what I wrote in my review:

Nevertheless, by not performing a simple multiplication, he [Newhouse] minimizes the role of factors other than technology in driving spending.

In the 1992 article, Newhouse considers the role of population aging (older people use substantially more health care than younger people), increased insurance (the less people pay out of pocket, the more health care they buy), and increased income per capita (as people’s income increases, their use of health care increases). He finds the effect of each of those factors to be low, but he doesn’t consider them together. The correct way to consider the combined effects of those factors is to multiply them, not add them. So, for example, if aging causes a 15 percent increase in spending per capita, and increased insurance causes a 50 percent increase in per capita spending, the combined effect is not a 65 percent increase, but a 72.5 percent increase (1.5 × 1.15 – 1 = 0.725.) Adding in the role of income means that the three factors together, using Newhouse’s estimates, account for a 193 percent increase in health care spending per capita from 1950 to 1990. This is 39 percent of the overall increase in health care spending per capita.

Notice that this deals with increases in health care spending, not increases in health care costs. The two are related but are not the same.

I go on to add:

Newhouse is probably still right that the most important factor in increased spending is increased technology. But most readers of his article would probably be surprised to learn that his own data imply that almost 40 percent of the increased health care spending is not due to increased technology. One such reader, I believe, is Finkelstein. When she writes, “Technological change in medicine is the driving force behind the growth in health care spending,” she overstates. It is probably the main driving force, but it is not the driving force.

Alex Tabarrok’s work has made me wonder whether I should have even said “Newhouse is still probably right that the most important factor in increased spending is increased technology.”

By the way, I am generally good at “reading” students. When I taught this article, year by year I noticed that the lightbulbs going on in class when I laid out the simple math were fewer and fewer. I think basic math is a lost art among U.S. students.