Many analysts, policy makers, and politicians argue that the U.S. health care system would perform better if market or market-like institutions played a larger role. This view is based on the belief held by economists that markets generally work most efficiently when left alone, provided that certain conditions are met. These conditions essentially state that consumption or production by one person does not affect others, that no one has a privileged position in the market, and that property rights are well-defined. If those conditions are violated, however, markets may function inefficiently, which is what economists call "market failure." Government intervention may enhance economic efficiency, although in other cases government action may exacerbate market failure. The special characteristics of health care often lead to market failures. The extent of government activity vis-a-vis the health system is seen by many economists and health care analysts as a policy response to the inequalities and inefficiencies associated with such market failures. Health care professionals often view a market orientation as a threat to their traditions, ethics, and culture. A bottom-line mentality, they argue, cannot deliver the same high quality of care as the so-called traditional approach based on professional ethics and responsibilities. Critics such as Arnold Relman, editor emeritus of the New England Journal of Medicine , denounce the "medical-industrial complex" for its dedication to profitability rather than patient well-being. Nevertheless, health care institutions have always cared about their pecuniary interests as well as their patients. As one historian noted, "in many respects [hospitals] have behaved as businesses. But, ... hospitals have simultaneously carried symbolic and social significance as embodiments of American hopes and ideals." Even if some view market forces and the use of the price system to allocate health care services as an intrusion, consumers and providers of health care are strongly affected by economic incentives. Hospitals cut the average length of an inpatient stay sharply after Medicare switched from cost-based reimbursement to paying a flat diagnosis-related fee. Physicians increased the volume (i.e., number of patient visits) and intensity of patient care (i.e., number or complexity of services provided in an average visit) seen after reductions in Medicare Part B payments. Consumers use less health care when they must pay a larger share of the cost. These behavioral responses, although predicted by economic theory, do not necessarily enhance economic efficiency. The challenge for those who wish to expand the use of market incentives in health care is to design policies that align material incentives facing consumers and providers of health care so that changes in behavior enhance economic efficiency. Both friends and foes of the expanding role of markets have sometimes relied on crude ideas about what markets can or cannot accomplish. This report explains what well-grounded economic theory has to say about the limits and capabilities of the market in the health care sector. These limits and capabilities then outline what the government can or cannot do to improve the health care system's performance. The report provides an overview of efforts to expand the use of market or market-like institutions in health care and considers effects of these initiatives or proposals on the federal budget. Reforms that are designed to address sources of market failure have better chances of enhancing economic performance than those that are not. Nonetheless, improving the performance and efficiency of the health system presents significant policy and political challenges even to well-designed reforms. The U.S. health care system is a complex mixture of public and private providers of care, paid for by a mixture of public and private payers, staffed by dozens of health professions, working in clinics, hospitals, nursing homes, private offices, health maintenance organizations, work sites, and home settings, among other venues. This patchwork system provides patients with a broad set of alternatives; gives health professionals in general, and physicians in particular, a substantial degree of autonomy; and assigns separate, if often overlapping, responsibilities among various levels of government. The complexity of the U.S. health system, which gives it considerable flexibility, is also one of the principal causes of its inefficiencies. Dissatisfaction with the performance of the U.S. health care system has spurred wider interest in using market or market-like institutions to generate better results and lower costs. While the United States is a leader in areas of medical technology, outcomes for several key public health indicators, such as average longevity and infant mortality, are among the bottom quarter of the 30 advanced industrial countries that comprise the Organization for Economic Cooperation and Development (OECD). Comparisons of specific conditions or procedures find the U.S. health system does better in some areas and worse in others. An OECD study of ischemic heart care found that the United States used more intensive procedures and had lower mortality rates for older patients, but had higher mortality rates for younger (40-64) patients compared with other OECD countries. Another study used data from Australia, Canada, England, New Zealand, and the United States to compare quality. Twenty-one quality of care indicators were selected on the basis of comparability and importance. These researchers found that each country was best on at least one indicator and worst on at least one indicator. Among these five countries, the United States did worst on kidney transplant survival rates, second worst on liver transplants, and worst on incidence of Hepatitis B, but did best for breast cancer survival, incidence of measles, and the cervical cancer screening rate. The United States spends far more on health care by any measure than any other country in the world. National health expenditures per capita are expected to reach $7,498 in 2007. One of every six dollars spent in the United States is spent on health care, and by 2016, projections indicate that proportion will rise to one in five. According to the latest OECD figures, U.S. health care spending in 2004 was about a third higher than Switzerland, which had the second highest level of spending. This spending is not due to differences in the proportion of population aged 65 or older nor to higher direct costs of malpractice claims. While the United States spends more on health care than other countries, fewer health care resources per capita are available compared with many other advanced nations. The number of physicians per capita in the United States is about two-thirds of the OECD average, and the number of hospital beds per capita is lower than the OECD average, so greater availability of medical inputs cannot explain the spending difference between the United States and other OECD countries. Greater intensity and complexity of medical care in the United States may account for some of the difference. A 1996 McKinsey research project found that health care providers in the United States were more efficient, in the sense of producing more outputs for a given amount on inputs, than those in Germany and to some extent than those in the United Kingdom. Many analysts, however, emphasize other explanations for why medical care in the United States costs more than in other advanced countries. Prices of medical inputs and administrative costs are much higher in the United States than in other OECD countries. For example, average remuneration for medical specialists in the United States, as compared with per capita national income, is higher than for any other OECD country, while the number of specialists per capita in the United States is below the OECD average. A group of Harvard Medical School researchers estimated that administrative costs accounted for about a quarter of health care expenditures in 1999. Administrative costs in Canada and Europe appear to be much lower, although the extent of the difference is subject to controversy. Other factors that help explain differences in health costs between the United States and other countries include differences in payment systems, average national income, average population age as well as other factors. Health care costs take up a large and growing part of the economy and of public budgets. Medicare, the largest health expenditure in the federal budget, will cost in total $428 billion in FY2007, according to CBO baseline projections, or 3.1% of gross domestic product (GDP), and the federal portion of Medicaid is expected to cost $193 billion, or 1.4% of GDP. Medicare Part A costs per beneficiary grew on average 4.66% a year between 1970 and 2005, and Part B costs grew on average 8.76% a year over the same period. One Congressional Budget Office (CBO) scenario anticipates that in 2050 Medicare spending will take up 8.6% of GDP, with Medicaid taking up another 4.0% of GDP, even aside from state contributions to Medicaid. Medicaid is one of the largest and fastest growing components of state spending budgets. In FY2004, Medicaid accounted for 22.3% of total state spending, which was slightly larger than the 21.4% spent on elementary and secondary education. The size and rapid growth of Medicaid spending led the National Governors' Association and the National Association of State Budget Officers to call the program "the dominant force in state spending." Governments in general and the federal government in particular are deeply involved in health care markets. Public spending in 2007 is expected to account for 47% of national health expenditures, up from 38% in 1970. Federal spending alone was expected to reach 34% of national health expenditures in 2007, up from 24% in 1970. Furthermore, federal involvement in health care extends well beyond spending. Health care markets are extensively regulated, and the federal tax code affects health care markets in important ways. In particular, the cost of the federal tax exemption for employer-paid health insurance premiums exceeds that of any federal health program other than Medicare and Medicaid. This exemption will decrease federal revenues by an estimated $100 billion in FY2007. The pace of health care costs and the expanding public role in health care have stoked interest in using market incentives to slow or limit costs and to improve quality of outcomes. The nature of health care, however, provides some inherent limits to the effectiveness of the market.