Recognizing the Differences between Healthcare and Other Industries

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Why Hospitals, Clinics and Medical Offices are Not Hotels, or Manufacturing Plants or Production Assembly Lines, etc.

By Dr. David E. Marcinko FACFAS, MBA, CMP™

[Editor-in-Chief]

The rising cost of health insurance remains a major concern for business; despite the Affordable Care Act [ACA] of March 2010. Local and national news publications have trumpeted that healthcare costs are not just rising but are growing in proportion to the cost of other goods and services.

Many of these publications have expressed the widely held view that because of the “inflation gap,” the cost of medical expenses needs curbing.  Proponents of this viewpoint attribute the growth in the gross domestic product (GDP) devoted to personal medical services (from 5% in 1965 to approximately 14% in 2005 and 17% in 2012) to increases in both total national medical expenditures as well as prices for specific services, and then conclude that there is a need to rein in the growing costs of healthcare services for the average American, even if it be through a legislative mandate.

Healthcare Is the Economy

According to colleague Robert James Cimasi MHA, AVA, CMP™ of Health Capital Consultants LLC in St. Louis, MO, healthcare cannot be separated from the economy at large. Although economists have cited the aging population as the reason for the increase in healthcare’s share of the GDP, other voices assert that financial greed among HMOs, pharmaceutical companies, hospitals, and medical providers like doctors and nurses is responsible.  In reality, the rise in healthcare expenditures is, at least in large part, the result of a much deeper economic force.

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As economist William J. Baumol of New York University explained in a November 1993 New Republic article: “the relative increase in healthcare costs compared with the rest of the economy is inevitable and an ineradicable part of a developed economy. The attempt [to control relative costs] may be as foolhardy as it is impossible”.

Baumol’s observation is based on documented and significant differences in productivity growth between the healthcare sector of the economy and the economy as a whole.

Low Productivity Growth

Healthcare services have experienced significantly lower productivity growth rates than other industry sectors for three reasons, according to Cimasi:

1) Healthcare services are inherently resistant to automation. Innovation in the form of technological advancement has not made the same impact on healthcare productivity as it has in other industry sectors of the economy.  The manufacturing process can be carried out on an assembly line where thousands of identical (or very similar) items can be produced under the supervision of a few humans utilizing robots and statistical sampling techniques (e.g., defects per 1,000 units). The robot increases assembly line productivity by accelerating the process and reducing labor input. In medicine, most technology is still applied in a patient-by-patient manner — a labor-intensive process. Patients are cared for one at a time. Hospitals and physician offices cannot (and, most would agree, should not) try to operate as factories because patients are each unique and disease is widely variable.

2) Healthcare is local. Unlike other labor-intensive industries (e.g., shoe making), healthcare services are essentially local in nature. They cannot regularly be delivered from Mexico, India or Malaysia.  They must be provided locally by local labor.  Healthcare organizations must compete within a local community with low or no unemployment among skilled workers for high quality and higher cost labor.

3) Healthcare quality is — or is believed to be — correlated with the amount of labor expended. For example, a 30-minute office visit with a physician is perceived to be of higher quality than a 10-minute office visit. In mass production, the number of work-hours per unit is not as important a predictor of product quality as the skills and talents of a small engineering team, which may quickly produce a single design element for thousands of products (e.g., a common car chassis).

Assessment

Healthcare suffers a number of serious consequences when its productivity grows at a slower rate than other industries, the most serious being higher relative costs for healthcare services. The situation is an inevitable and ineradicable part of a developed economy.

For example, as technological advancements increase productivity in the computer, and eHR, manufacturing industry, wages for computer industry labor likewise increase. However, the total cost per computer produced actually declines.  But in healthcare (where technological advancements do not currently have the same impact on productivity), wage increases that would be consistent with other sectors of the economy yield a problem: the cost per unit of healthcare produced increases.

Conclusion

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The Living Legacy of Dr. Harry Markowitz

Creating Diversified Portfolios of Uncorrelated Assets

By Dr. David Edward Marcinko MBA CMP™

[Publisher-in-Chief]

More than a half century ago, a paper appeared in The Journal of Finance written by a 24-year-old doctoral candidate in economics at the University of Chicago—Harry Markowitz. It was called “Portfolio Selection” and suggested that investors take into account risk in pursuit of the highest return—a concept that we take for granted today [Modern Portfolio Theory].

Markowitz drew a trade-off curve between risk and reward and called it the “efficient frontier.” A rational physician executive or other investor who knew his or her risk tolerance could choose an appropriate portfolio from a point on this curve. Markowitz led investors to diversified portfolios of uncorrelated investments.

Dissertation Follow-up

Markowitz followed up his dissertation in 1959 with a book entitled Portfolio Selection [Efficient Diversification of Investment]. His many contributions to finance earned him the Nobel Prize in Economic Science in 1990 along with William Sharpe and Merton Miller. He reasoned that diversification is about avoiding the covariance.

If risks are uncorrelated, you can reduce the risk of a portfolio to practically zero by sufficient diversification. This doesn’t work if risks are correlated. If one invests in a very large number of securities that are correlated, risk does not approach zero but rather the average covariance, which is a very substantial amount of risk.

Where It All Started

It was at the RAND Corporation that Markowitz met William [Bill] Sharpe who was working on his PhD at UCLA. Markowitz takes issue with Sharpe’s Capital Asset Pricing Model (CAPM), which claims that the expected return of a security depends only on its beta—ignoring fundamental analysis.

CAPM also implies that the market portfolio is efficient, even though investors in the market may not act rationally. It says that the market portfolio is a mean-variance efficient portfolio. Markowitz disputes this conclusion. He points to Fama and French and others who have found that expected returns are more closely related to book-to-price or size—not to beta.

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Assessment

The still living Markowitz fends off criticism of mean-variance analysis only being valid when probability distributions are normal by stating that he realizes that probability distributions are not normal in the real world.

But, if they are similar to a normal distribution, mean variance does a good job at approximating expected utility. He admits that when they are too dispersed, mean variance doesn’t work well.

Note: Travels along the Efficient Frontier,” an interview with Harry Markowitz by Jonathan Burton, Dow Jones Asset Management, May/June 1997, pp. 21–28, Dow Jones Financial Publishing Corp.

Conclusion

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