How cross subsidies hinder economic reforms

For a case study in economic inefficiency, look to the air ambulance industry

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Jul 31, 2018

Sections Economics

Cross subsidies are an underappreciated original sin of economic stagnation. To transfer money from A to B, the government could simply raise taxes on A and provide vouchers or otherwise pay competitive suppliers on behalf of B. But our political system doesn’t like to admit the size of government-induced transfers, so instead we force businesses to undercharge B. Since businesses have to cover their costs, they must then overcharge A. The intervention starts as the same thing as a tax on A to subsidize B. But a cross subsidy cannot withstand competition. Someone else can give a better price to A. So our government protects the businesses that overcharge A from that competition. That protection ruins the underlying markets, and the next thing you know, everyone is paying more for less.

This was the story of airlines and telephones: the government wanted to subsidize airline service to small cities, and it wanted to subsidize residential landlines, especially to rural areas. It forced companies to provide those things at a loss, and to cross subsidize those losses from other customers. But then the government had to stop competitors from undercutting the overpriced services. And as deregulation in those industries eventually showed, the result was inefficiency and high prices for everyone, even the people the government was trying to subsidize.

Health care and insurance are the screaming example today. The government wants to provide health care to the poor, the elderly, and other groups. It does not want to forthrightly raise taxes to pay for their health care in competitive markets. So it forces providers to charge less to those groups, and make it up by overcharging the rest of us. But overcharging cannot stand competition, so the government stamps out competition, and gradually the whole system has become bloated and inefficient.

A June 11 Bloomberg article about the cost of air ambulance rides offers a striking illustration of the phenomenon—and of the mind-set that keeps our country from fixing it.

The story starts with the usual human-interest tale, a $45,930 bill for a 70-mile flight for a kid with a 107°F fever.

At the heart of the dispute is a gap between what insurance will pay for the flight and what Air Methods says it must charge to keep flying. Michael Cox, [the boy’s] father and a track coach at Concord University, had health coverage through a plan for public employees. It paid $6,704—the amount, it says, Medicare would have paid for the trip. 

Air Methods billed the family for the rest.

How could a 70-mile ride cost almost $46,000? Because that child’s parents weren’t being asked to just pay for their son’s ride, but also to subsidize a lot of others.

The air-ambulance industry says reimbursements from US government health programs, including Medicare and Medicaid, don’t cover their expenses. Operators say they thus must ask others to pay more—and when health plans balk, patients get stuck with the tab. . . .

Seth Myers, president of Air Evac, said that his company loses money on patients covered by Medicaid and Medicare, as well as those with no insurance. That’s about 75 percent of the people it flies. . . .

According to a 2017 report commissioned by the Association of Air Medical Services, an industry trade group, the typical cost per flight was $10,199 in 2015, and Medicare paid only 59 percent [of] that. 

OK, put your economics hats on. How can it persist that people are double and triple charged what it costs to provide any service? Why, when an emergency room puts out a call, “Air ambulance needed. Paying customer alert,” are there not swarms of helicopters battling it out—and in the process driving the price down to cost?

Supply restrictions are always the answer—and the one just about everyone forgets, as evidenced by this article. 

I don’t know the regulation, but I will hazard guesses about what might limit supply.

a  Not just any helicopter will do. Look at most small airports. There are a lot of helicopters hanging around whose owners would jump in a flash for an Uber Helicopter request that pays $45,000. So it must be true that in every such case you have to have an air ambulance. Which makes a lot of sense, of course—the helicopter should have the standard kind of life-saving equipment on it. Clearly the emergency room is only going to call and allow an air ambulance. 

b  Air ambulances must be properly certified and licensed. OK, but there are still lots of people who could go into this business, or the ones who are there could bid aggressively. 

That brings us to:

c  Air ambulance operators may not distinguish between paying and nonpaying customers. 

That’s the only explanation for this crazy situation. If there were any way to compete for the paying customers, it would happen, and the problem would evaporate.

“I fly people based on need, when a physician calls or when an ambulance calls,” the article quotes Air Evac’s Seth Myers as saying. “We don’t know for days whether a person has the ability to pay.”

Hmm. United Airlines certainly makes sure in advance whether you have the ability to pay. 

Confirming this hunch, Tim Pickering of Air Medical Group Holdings (Air Evac’s parent company) told a meeting of the National Conference of Insurance Legislators in July 2017 that as an emergency service, air ambulances are obligated by licensing guidelines to transport critically ill or injured patients regardless of whether they can pay for the ride. 

It makes sense that we shouldn’t have air ambulance pilots turning patients away at the doors of their helicopters because the critically injured patient lying on the helipad doesn’t have the right (or any) insurance. It doesn’t make sense that we allow companies to make up for their losses on those flights by overcharging everyone else, and forbid active competition for serving paying customers.

What’s the alternative? Well, pass a tax on air ambulance rides, and use the proceeds to pay for rides for the poor or indigent. It’s the same thing—except with a tax, there needs to be no regulation or bar on competition. Or pass an income-tax surcharge and do the same thing, which spreads the cost much more evenly. Yes, I don’t like taxes any more than you do, but given we’re going to grossly subsidize air ambulance rides, a tax and subsidy is much more efficient than banning competition and allowing an ex post free-for-all price gouge.

When you arrive at an airport at 11 p.m. and want a rental car, you’re not in a great negotiating position either. Somehow they don’t charge $45,000 then.

The Bloomberg article is most revealing, I think, in that neither the author nor anyone he interviews even thinks of supply. Their explanations are as usual: demand, the patient’s negotiating position, and lack of regulation. 

It is true that when faced with an emergency in which a loved one is in danger of dying and needs an air ambulance, you are in a poor position to negotiate. But supply competition should solve that problem. If you can charge paying customers $45,000 for a 70-mile helicopter ride, and receive vouchers or payments that actually cover costs for the rest, competing helicopter companies would have representatives sitting in the emergency rooms! When you arrive at an airport at 11 p.m. and want a rental car, you’re not in a great negotiating position either. Somehow they don’t charge $45,000 then! Why not? Supply competition—and the need to have good reputations in any business. 

The ex post negotiation is surreal. 

. . . the Cox family went through two appeals with their health plan. After they retained a lawyer, Air Methods offered to reduce their balance to $10,000 on reviewing their tax returns, bank statements, pay stubs, and a list of assets. The family decided to sue instead.

“I felt like they were screening us to see just how much money they could get out of us,” Tabitha Cox said. 

You got it, Mrs. Cox. On what planet do you get on a helicopter with no mention of cost, and then the operator afterward looks at your tax returns, bank statements, pay stubs, and lists of assets to figure out how much you can pay? Only universities get away with that outside of health care!

The article puts the blame squarely on . . . wait for it . . . the lack of price controls and other regulations:

Favorable treatment under federal law means air-ambulance companies, unlike their counterparts on the ground, have few restrictions on what they can charge for their services. Through a quirk of the 1978 Airline Deregulation Act, air-ambulance operators are considered air carriers—similar to Delta Air Lines or American Airlines—and states have no power to put in place their own curbs. . . .

Air-ambulance operators’ special legal status has helped them thwart efforts to control their rates. West Virginia’s legislature passed a law in 2016 capping what its employee-health plan—which covered West Cox—and its worker-compensation program would pay for air ambulances.

It is a sad day in America that the average reporter, faced with insane pricing behavior, can only come up with the lack of price control and regulation as an explanation. If voters don’t understand that consumer protection comes from supply competition, we cannot expect politicians to shove that enlightenment down our throats.

Does it take a genius to figure out what price controls mean? Well, Medicare, Medicaid, and indigent people aren’t about to pay the cost. So if the companies can’t cover costs by looking at our tax returns and coming up with a tailored price gouge for each of us, that means less air ambulance flights. The kids with the 107°F temperature will end up driving in rush-hour traffic to the hospital that can help them. Some will die in the process. Actually, it means who “needs” an air ambulance will depend on connections.

That’s the problem with negotiation as the answer to everything. Negotiation can shift costs from one person to another, but we can’t all negotiate for a better deal.

Actually, there is some supply competition—just not of the sort that brings down costs for nonindigent customers. The business has grown in response to its overall profitability.

The number of aircraft grew faster than the number of patients flown. In the 1990s, each helicopter flew about 600 patients a year, on average, according to Blumen’s data. That’s fallen to about 350 in the current decade, spreading the expense of keeping each helicopter at the ready among a smaller pool of patients. 

While adding helicopters has expanded the reach of emergency care, “there are fewer and fewer patients that are having to pay higher and higher charges in order to facilitate this increase in access,” Aaron D. Todd, chief executive officer of Air Methods, said on an earnings call in May of 2015, before the company was taken private. “If you ask me personally, do we need 900 air medical helicopters to serve this country, I’d say probably not,” he said. 

This is sad. The answer to excessive costs is to . . . reduce supply? This sort of thinking was behind the nefarious “certificate of need” legislation. In many states, regulators thought hospitals were overinvesting in things like MRI machines. So they passed laws that every purchase, expansion, or new service must get a “certificate of need” from the state, and conditions include that the new service should not affect the profits of existing competitors. The competitors need those profits to provide cross subsidies. Needless to say, certificates of need have not reduced costs! 

No. The air ambulance business is expanding because the right to pillage the paying customer with outrageous charges remains profitable even with the cost of providing free or underpriced flights to nonpaying customers. The only answer: free the skies to competition for paying customers, and subsidize flights for those the government wants to subsidize, out in the open, using tax revenue and appropriated expenditures.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.