Physicians often spend a decade or more after college acquiring knowledge and skills needed to practice their medical specialties. As a result, most Americans rely heavily on the expertise of their doctors. This is a classic case of the principal–agent problem covered in earlier chapters. One problem posed by asymmetric information is that patients may have only a vague sense about how qualified a physician is.

Another problem is that providers may use their superior knowledge to influence demand in their self-interest. This possibility is at the heart of many policy controversies.

Supplier-induced demand (SID) occurs when an agent (a doctor) uses superior knowledge to induce a principal (a patient) to buy more of a good or service.

Patients (principals) rely on doctors (agents) to guide medical care treatment. Most doctors are still paid on a fee-for-service basis.

Fee for service entails payment tailored to each treatment. Capitation is the practice of charging a fixed fee to provide medical services to a patient for a year at a time.

In a sense, capitation is like the pricing for the buffet at an all-you-can-eat restaurant, while fee for service is like ordering a la carte.

Capitation embodies substantial incentives for care providers to minimize the resource costs of health care. However, in a fee-for-service arrangement, the doctor as an agent has financial incentives to extend services beyond the amount the patient would want if the patient had the same information as the doctor. For example, doctors with financial interests in medical laboratories may order redundant tests to bolster lab revenues. Supplier-induced demand has been shown to affect the rate of C-sections (delivery of a baby by operation), with insured women having far more than the uninsured, even in the same hospital. However, we should note that in addition to price (a C-section being more costly), the convenience for the insured patient of scheduling a birth may be a consideration.

Is resource allocation more efficiently achieved through prices and consumer choice on the demand side? Or are regulatory controls needed on the supply side? Obviously, the more important supplier-induced demand is, the less efficient will be markets based on consumer sovereignty. However, the excessive demand that might foster overuse of health resources may be offset by restrictions on the supply of physicians.