I have this demand: Every weekday, I want to get from home to school and back again with as little travel time as possible. I could fulfill this desire in various ways: drive a car, ride a bike, walk, fly a helicopter. Let’s pretend my demand is currently being fulfilled by a helicopter because that’s the fastest way available. So, you could say that my demand to get to school as quickly as possible is being fulfilled to some extent, but it’s not being completely fulfilled, which would entail getting to school and back with zero total travel time. Technology is limiting my demand from being completely fulfilled.
I will call my fulfilled demand active, because I’m actively spending money to fulfill it, and my unfulfilled demand latent, because it exists but is not currently being fulfilled.
What does this have to do with innovation? Well, not much, except that it lays the background for understanding my next sentence. Innovation (which I will define as finding a new way to fulfill demand) comes in two varieties: (1) the variety that creates cheaper ways to fulfill active demand and (2) innovation that activates latent demand.
Let’s make this concrete. If a new helicopter company comes up with a cheaper way to sell a similar-quality helicopter as the one I have, then I could have gotten that one instead. This would be an example of fulfilling active demand in a cheaper way. And if a teleportation company comes along, then I could get one of those and all of my latent demand would be activated.
All of this assumes money is no object, which, when we’re talking about healthcare, it often isn’t. But this post isn’t about that.
So now you should understand that when innovation has the net effect of increasing total spending in an industry (like healthcare), it’s probably because a lot of latent demand is getting activated (i.e., we’re spending money to fulfill demands that weren’t previously being fulfilled). This is great! . . . Except when it bankrupts us. So we probably need to somehow ration (especially the high-cost-yet-marginally-better-outcome stuff) and encourage innovation of the cost-lowering kind.
Ignoring (for now) the rationing suggestion, here are my thoughts about who we can expect/encourage to provide the cost-lowering innovation.
Providers (doctors and hospitals). I don’t see providers as activating much latent demand in healthcare. They kind of have to just use what treatment techniques they’re provided and find the most cost-effective way to administer them to the right patients. So, provider innovation should be a major source of the cost-lowering variety (think about IHC or Mayo Clinic).
Suppliers (device manufacturers and pharmaceutical companies). When thinking about supplier innovation, they do both kinds. Often they are coming up with miracle drugs and devices that activate latent demand (think about insulin, which prolonged the life expectancy for diabetics from months to decades), and sometimes they are also coming up with devices that make it cheaper to fulfill already active demand (think about at-home dialysis machines).
Clear Thinking on Healthcare 
Do you think cost effectiveness is something doctors or hospitals consider when prescribing treatment? Certainly not for pharmaceuticals – why do you think drug companies use drug reps? Why do drug companies advertise on TV? To save money or to sell more high margin drugs? Many doctors have no idea how much any of the drugs they prescribe even cost.As far as hospitals go, to the extent that they are reimbursed by the insurance company or Medicare, they face little risk – they are getting a predetermined rate – again, the incentive to do more tests, not to manage costs.
In countries where insurance is provided by the government, price controls are used – drug prices are negotiated – to manage costs. Doctors are paid less.
Insulin is a good example of a miracle drug – to extend life from weeks to decades is a miracle. Apparently modern plumbing was huge for extending life expectancy. Tarceva – the drug that extends life a few weeks and costs $100s of thousands – not so much. Much of the low fruit has been picked. What remains is lower return, higher cost treatments. And again, the suppliers are profit seeking enterprises. Also, they have the ability to lobby the government to get dollars spent on their products.
I agree that there will be some kind of rationing in order to manage cost growth. Either we spend less on people near the end of their lives (Death panels!) or we leave a large percentage of our population with no health insurance and limited access to healthcare. It’s easier to leave children off – they can’t vote yet.