Supplier-Induced Demand

Traditional economic theory assumes that the market for health services is characterized by an upward-sloping supply curve and a downward-sloping demand curve. Patients are assumed to be rational consumers who make informed utility-maximizing choices, while physicians are profit maximizers. The theory predicts that an excess supply of physicians in relation to the population will result in an outward shift of the physician supply curve, lower fees charged for services, and lower revenues. To avoid the loss of revenues, most economists believe that physicians exploit the information asymmetry (a result of patients' lack of clinical knowledge) in the market for their services and shift the demand curve up, resulting in higher revenues. This phenomenon is termed supplier-induced demand. It occurs when a physician has a financial incentive to recommend treatments whose medical benefits are outweighed by [Page 1107]the costs. Supplier-induced demand is equated with unethical behavior because of the social welfare loss associated with inefficient treatment. Due to the prominent role physicians play in the healthcare industry, cost control measures will be difficult to implement under supplier-induced demand. By studying this phenomenon, policymakers will be able to design and develop relevant tools to minimize waste and improve access to healthcare.

Traditional economic theory predicts that when physicians have mixed patient caseloads (Medicare, Medicaid, and privately insured patients), a decrease in the fees charged to Medicare and Medicaid patients will result in substitution and income effects. Under the substitution effect, physicians will reduce their Medicare patient caseload and treat more privately insured patients. The income effect will result in the delivery of more services to both the Medicare and the privately insured patients to make up the income lost from the reduction in fees paid by Medicare patients. The observed increase in services to privately insured patients is consistent with both physicians' profit-maximizing behavior and demand inducement.

Why is demand inducement an interesting problem for economists to study? In addition to the waste involved, the existence of demand inducement contradicts the predictions of neoclassical economic theories of demand and supply, where the excess supply of physicians should lead to fee reductions. Proponents believe that if the market does not work as expected for physician services, the practitioners must be inducing demand. While this observation may be true, it does not consider the uncertainties involved in medical decision making.