The claim by hospital chains and pharmaceutical companies that their pricing reflects the free market is pure fiction. The alternative touted by their opponents, of transferring the whole business to the government, would undoubtedly make matters worse. So what’s a poor free market economist to believe?

Medical pricing does not reflect the free market because very few transactions take place on a willing buyer/willing seller basis, where the beneficiary of the service is paying for it and there are no subsidies involved. Consider:

— U.S. consumers cover almost all the research and development costs of the world’s pharmaceutical industry, since the drugs markets in other advanced countries are subject to price regulation. These R&D costs are greatly increased by the time-consuming and bureaucratic process of obtaining Food and Drug Administration approval for a new drug.

— Most U.S. consumers are covered by tax-deductible corporate health insurance, which allows medical services to cost very little directly to consumers. When someone loses their job, the biggest nightmare is suddenly becoming uninsured.

— Prices paid by health insurance companies and Medicare for medical services and drugs are far lower than those charged to the uninsured. A recent simple set of tests I had was billed at $850, for which the insurance company had an “allowed reimbursement” of $125. Presumably a single consumer paying cash would have paid the whole $850.

— Around 15 to 20 percent of most hospitals’ costs covers un-reimbursed emergency treatment for the uninsured and indigent; these costs are loaded onto the bills of other patients

— Doctors make a good income directly, but are allowed to supplement their income by investing in such facilities as Magnetic Resonance Imaging units, the patients for which are referred by the doctors and the income from which accrues to the doctors as investors — a positively eighteenth century conflict of interest

— Democrat vice presidential candidate John Edwards and many like him are able to amass huge earnings from lawsuit contingency fees levied on doctors who make mistakes. As a result malpractice insurance premiums for many specialties exceed $100,000 per annum.

— Around a third of medical costs are incurred in the last few months of life, generally by a consumer who is old and infirm, running down the last of his savings

As I said, to call the U.S. medical services industry a free market, and expect the price mechanism to work properly, is laughable. The amount of added costs and hidden subsidies is hopelessly distorting and without question allows for free-riding rent seekers at all points in the supply chain, including malpractice lawyers, but also many hospital chains, insurance company executives and of course doctors.

The economics of being a doctor adds hugely to medical costs. The training is lengthy and very expensive, the malpractice insurance is extremely expensive, and has to be paid before you’ve ever treated a patient, and the doctor, if independent, has to undertake the pseudo-entrepreneurship of opening his own practice. Of course, with such high barriers to entry, it’s not surprising that well-established doctors, without necessarily having medically superior skills, are able to overcharge ruthlessly, thus extracting truly exciting rents from their patients and better still the patients’ insurance companies.

The proposed solution, to bring the whole industry, now 15 percent of gross domestic product, under the tender and enlightened management of the state sector is equally unattractive. No doubt malpractice awards would shrink rapidly if each penny thereof was extracted from taxpayers, and Britain has shown that doctors will work satisfactorily, at a barely acceptable quality level, as wards of the state, paid more or less civil service remuneration.

However, experience in Britain has also shown that if the price of a service is around zero, the demand for it becomes approximately infinite, and doctors’ waiting rooms are besieged by daft old ladies coming in every Thursday to have their back twinges inspected. Furthermore, if nobody is paid for quality improvements and efficiency, quality improvements and efficiency don’t happen, so tens of thousands of French people die in a heat-wave in summer 2003 — because heat-waves, of course, tend to happen in August, when the country’s medical staff are at the beach.

The solution to this horrible mess is not obvious, but the direction from which a solution must come is quite clear: the amount of cross-subsidization and freeloading must be drastically reduced. Thereby, to the greatest extent possible, the price mechanism can be allowed to work and services can be efficiently provided where they are needed.

There are three sets of people who may need a subsidy, as distinct from taking one happily if it is offered at the expense of the taxpayer or some other deep pocket. These are the truly catastrophically ill, the modest percentage of the population who cannot support themselves by work or pensions, and the very old whose medical and nursing costs in extreme old age may spiral out of control. Everybody else should pay cash.

The principle of medical savings accounts is helpful, and can be extended to those with catastrophic medical bills by allowing an extra medical surcharge of 10 percent of income (or 20 percent of the estate in the case of a patient’s death) to be imposed through the tax system to reimburse unpaid medical bills. The subsidization of the indigent would be removed from the hospital system and placed on the government, where it belongs, with the government getting reimbursement where possible through the medical surcharge. By this means, the loading of hospital charges on the non-indigent would be removed. By providing catastrophic coverage with reimbursement through the tax system, the government would obviate the necessity for medical insurance.

Medicare for senior citizens, including by all means prescription drugs coverage, could also work this way. Those seniors with high drugs or other medical costs and low income would receive a public subsidy, as their medical surcharge would be less than their medical costs. Other seniors would either pay cash or reimburse the government through the tax system.

Legislation would prohibit differential pricing to different groups, so that the government and insurance companies would be compelled to pay as much as the uninsured for drugs and medical services. Price controls themselves are unnecessary, but differential pricing should be outlawed.

The tax exemption for medical insurance costs would be removed; they would count as a “medical cost” in the general basket, tax-deductible at present if total medical costs exceed 7 1/2 percent of income. By this provision and the previous three, medical insurance would become scarce, since it would be neither necessary nor subsidized. This would remove a substantial layer of costs from the system.

Through these changes, the great majority of medical costs would be met directly by the beneficiary, either immediately or through the medical cost reimbursement surcharge. Since most consumers would now pay for their own medical costs, either directly or through tax payments, their incentive to save money on medical bills would be maximized. Hospitals, doctors and pharmacies could usefully maintain websites, through which medical costs could be compared.

There would not be price controls, but a Federal “Excess Medical Price Commission” would be formed, that would examine price gouging either on new pharmaceuticals or on hospitals and other medical costs, and where appropriate would order a reimbursement or a mandatory price reduction or both. The cost and bad publicity of hearings before the EMPC should be sufficient to deter most abuses.

Research and development into new drugs would be affected by limiting drug companies’ pricing freedom, but drug R&D does exist outside the United States, as a patent-protected monopoly even at a regulated price is still by no means valueless. This reduction in drug R&D seems a price worth paying to reduce drug costs generally and avoid the cross-subsidization of price-control markets by the U.S. It is in any case likely that the reduced drug R&D would still produce the major technological advances, since most of the cost of a new drug accrues in the development and FDA approval stage rather than in basic research, where the big advances are made.

Doctors would not be permitted to refer patients to facilities in which they had an ownership stake. If a doctor wishes to invest his savings in a new MRI facility, using his technical knowledge to improve its quality and efficiency, he must do so in an area from which he does not take patients — the “other side of town” should be fine, since medical catchment areas in big cities are quite small.

“Pain and suffering” malpractice suit awards should be capped at $500,000, thus discouraging but not prohibiting malpractice suits. If after a couple of years medical malpractice suits and excessive malpractice insurance costs were still a problem, medical malpractice suits should be prohibited and replaced by a government compensation scheme. This is not an area in which entrepreneurship should be encouraged.

Small Business Administration loans should be made available to cover medical school bills and the start-up costs of a medical practice, in particular the first 2 years’ malpractice insurance premiums. Any reduction in the barriers to entry for medical practice should be encouraged or even subsidized, since increasing the supply of qualified doctors should usefully depress their price.

I think these reforms should just about do it, except possibly for the problem of excessive medical and nursing home costs for the very old and the dying. Of course, since this combination of reforms affects every entrenched lobby at once, it is absolutely and completely politically impossible. But hey — we get a vote in November — let’s vote for a candidate, any candidate, who promises to do it anyway, and keep voting for such candidates. Eventually, maybe, the “politically impossible” will become reality.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.