ECONOMICS OF HEALTH

1
ECONOMICS OF HEALTH
January 2004 Dr. Michael Metzger Oklahoma
Policy Research Center University of Central
Oklahoma
2
FOUR HEALTH CRISES TO EXPLAIN

• Crisis 1 Health care costs are spiraling
  upward, 3 of GDP in 1950, 14 today.
• Crisis 2 About 40 million Americans do not
  have health care coverage.

3
FOUR HEALTH CRISES TO EXPLAIN

• Crisis 3 The U.S. spends more per capita on
  health care, yet its citizens are not
  significantly healthier than some countries that
  spend less.
• Crisis 4 The government (federal, state and
  local) has a huge presence in most health care
  markets, more so than in other markets.

4
WHY HEALTH ECONOMICS?

• Economics is the study of
• The behavior (choices) of individuals, firms,
  resource owners, not-for-profits, voters,
  politicians, and government.
• The interaction of these decision-makers in
  market, political, and social settings.
• The failure of markets, political processes, and
  social institutions.
• The appropriate role of government, and, when
  warranted, the cost-effective design of market
  interventions.

5
WHY HEALTH ECONOMICS?

• Economics studies health because
• Individual behavior is not always healthy.
• Health care markets are unusual in the sheer
  number and significance of market failures ?
  inefficient use of resources ? invitation for
  government action.
• Government interventions should occur only in
  response to market failures and, if so, be
  cost-effective.

6
WHAT IS A MARKET FAILURE?

• The market system sometimes leads to an output,
  quality, or distribution of goods and services
  that is inefficient ? economic growth and
  standard of living are not maximized.
• A key condition for efficiency is that the
  marginal social benefit of any activity is equal
  to the marginal social cost.
• Private and social benefits/costs diverge in the
  case of a market failure, leading to incorrect
  market signals that misallocate resources.

7
MARKET FAILURES LEAD TO

• Inefficiency (wasted resources) ? reduced
  economic growth and standard of living and/or,
• Market adaptations Markets are very innovative
  in responding with new goods, services, or
  practices and/or
• Government intervention The only legitimate role
  for government is providing those services that
  markets cannot provide efficiently.

8
SECONDARY MARKET FAILURES

• Both government interventions and market
  adaptations sometimes lead to significant
  secondary market failures.
• The same three possible outcomes can occur in
  such cases inefficiency, market adaptation,
  and/or government intervention.

9
The 100 Billion Law of Economics
The Appropriate Role of Government

• Two conditions must both be satisfied
• A genuine, significant market failure must occur
  -- an incorrect output, quality, or distribution
  of goods and,
• Any government intervention must be
  cost-justified -- benefits must at least exceed
  costs.

10
100 Billion Annual Loss Due To

• An inappropriate government intervention creates
  a market failure, squandering both resources and
  tax dollars.
• A justified, but poorly designed government
  intervention wastes resources, compounding the
  original market failure.

11
Why Inappropriate or Poorly Designed Government
Interventions???

• Political process failures
• desire to put equity above efficiency,
• Quid pro quo compromises,
• exploitation of process by influential groups, or
• Lack of expertise, or, simple ignorance.

12
Causes of Market Failure Summary List

• Monopoly
• Imperfect Information -- Uncertainty
• Imperfect Asymmetric Information
• Externalities (positive negative)
• Public Goods
• Essential Goods Poverty
• Government Interventions
• Market adaptations

13
Causes of Market Failure 1 Monopoly

• Monopoly pricing -- inflated prices reduce
  consumption of health care.
• Anticompetitive practices -- price-fixing,
  deterring entry of potential competitors, or
  delaying introduction of substitute products ?
  inflated prices.
• Natural monopolies -- markets in which a single
  provider is more efficient.
• Monopsonistic pricing -- large buyers or
  employers reduce price of an input, reducing its
  use in health care.

14
Causes of Market Failure 2 Imperfect
Information -- Uncertainty

• Unknown probability of an accident, illness, or
  adverse treatment outcome. Low probability, high
  cost events are difficult to budget for, reducing
  the demand or supply of health care.
• Insurance is a successful market adaptation for
  low probability, high cost uncertainties. The
  market provides an incentive for firms to pool
  risk of a large number of potential claimants in
  order to pay the unexpected costs and still earn
  a profit. The health care use is greater,
  benefiting both consumers and providers.

15
Important Distinction Health Insurance(a la
carte) vs.Pre-Paid Health Care(all-you-can-eat
)

• Health insurance covers only insurable risks
  low probability, high cost risks.
• Pre-paid health plans cover both insurable and
  non-insurable risks, where many of the latter
  would not normally be provided by markets.

16
Causes of Market Failure 3 Imperfect Asymmetric
Information

• Because quality or cost is known only to one
  party in a transaction, markets may undersupply
  quantity or quality, or even fail to exist.
• Food, drugs, and health services are prime
  examples where consumers have relatively less
  information as to quality than sellers.

17
Causes of Market Failure 3 Imperfect Asymmetric
InformationTwo Special Types

• Imperfect information in insurance markets ?
• Adverse Selection occurs prior to a transaction
  in that the insured has better information as to
  the probability and size of claims. The
  unhealthy or accident-prone are more likely to
  seek insurance.
• Moral Hazard occurs post-transaction in that the
  insured have less incentive to minimize the
  number and size of claims.
• ? Both increase insurance costs, premiums,
  and self-insurance.

18
Causes of Market Failure 4 Externalities

• Externalities are unintended spillovers in either
  consumption or production ? too much or little
  of the activity from a social perspective.
• A positive externality occurs when the spillover
  benefits another person or business -- a
  vaccination benefits a child by reducing illness,
  plus reduces contagion to other children.
• A negative externality occurs when the spillover
  adversely affects another person or business
  second-hand smoke, drunken driving.

19
Causes of Market Failure 5 Public Goods

• A public good occurs when one persons
  consumption or benefit does not subtract from
  anothers, e.g., national defense.
• Private markets fail because individuals who
  benefit cannot be excluded even if they dont
  pay. Free-riding behavior causes the good to be
  under-provided by private markets, or not at all.
  
• Government has a primary role here -- food, drug
  and health regulations Centers for Disease
  Control.

20
Causes of Market Failure 6 Essential Goods
Poverty

• Markets may yield a distribution of essential
  goods or services that is undesirable in some
  social sense.
• What is essential?
• Food
• Shelter
• Education
• Health?

21
Causes of Market Failure 6 Essential Goods
PovertyWhy?

• Entitlement? Do all citizens deserve some basic
  access to these goods?
• Externality? Does the sight or presence of
  deprivation create discomfort or distress for the
  more fortunate?
• Public good or investment? Access to these
  goods, particularly for children,
• promotes their integration into the socioeconomic
  system, and
• increases productivity, and thereby
• improves future standards of living.

22
Causes of Market Failure 7 Government
Interventions

• Even necessary and cost-effective
  interventions can unintentionally create
  secondary market failures -- e.g., taxes are
  needed to finance an intervention creating
  distortions and inefficiencies in those markets
  taxed.

23
Causes of Market Failure 7 Government
Interventions

• Some necessary and cost-effective
  interventions will intentionally create secondary
  market failures -- e.g., patents establish a
  legal monopoly for years to re-coup RD costs as
  an incentive for future innovation, leading to
  higher prices and reduced consumption.

24
Causes of Market Failure 7 Government
Interventions

• Inappropriate interventions (i.e., either
  unnecessary or cost-ineffective) create new
  market failures, squander tax dollars, waste
  resources, and reduce living standards.

25
Causes of Market Failure 8 Market Adaptations

• The market adaptation, insurance, led to two
  asymmetric information market failures
• Adverse selection ? market adaptations health
  exams, pre-existing condition clauses, employer
  group insurance
• Moral hazard ? market adaptations deductibles
  and co-payments

26
Causes of Market Failure 8 Market Adaptations

• Professional association licensing, a market
  adaptation to asymmetric quality information, can
  lead to monopoly market failures in the form of
• restricted entry ? higher prices
• restrictions on competition (e.g., advertising)
  ? higher prices

27
Market Failures Important to Understanding the
Four Health Care Crises

• Imperfect Information
• Uncertainty
• Asymmetric Information
• Essential Goods Poverty
• Government Interventions
• Market adaptations

28
An American Health OdysseySeven Decades of
Haphazardry

• 1930s
• Uncertainty (MF) ? Health Insurance (MA)
• Blue Cross Blue Shield.
• Insurable risks only (low probability, high cost
  events) e.g., major medical.
• Third-party payer phenomenon first occurs
  consumer does not pay, so not concerned with
  price. This is not a problem with major medical
  services which are not demand elastic.

29
An American Health OdysseySeven Decades of
Haphazardry

• 1940s
• Asymmetric Information (Adverse Selection) (MF)
• ? Employer Group Health Insurance (MA)
• Inextricably tied coverage to employment and to
  certain employers (e.g., job-lock).
• Provided a cross-section of the general
  population, reducing risks, costs and premiums.
• Non-group (individual) insurance rates remained
  higher, often unaffordable.

30
An American Health OdysseySeven Decades of
Haphazardry

• 1940s
• Essential Goods Poverty (MF)
• ? Tax Exempt Employer Health Benefits (GI)
• Tax-subsidy to encourage more employer-provided
  health benefits, thereby promoting universal
  coverage.
• A 50 marginal tax rate creates a choice of .50
  take-home or 1 in health benefits. Unions
  succeeded in shifting pay to more benefits.
  Labor markets copied.
• Health benefits expanded to non-insurable risks,
  most of these services demand elastic.

31
An American Health OdysseySeven Decades of
Haphazardry

• 1960s
• Essential Goods Poverty (MF)
• ? Medicare and Medicaid (GI)
• Third party payer government programs for elderly
  and poor was another step toward universal
  coverage.
• Covered health benefits increasingly included
  non-insurable risks, many of those services
  demand elastic.

32
An American Health OdysseySeven Decades of
Haphazardry

• 1960-1980s
• Health care expenditures exploded due to
• Expanded coverage through new employer and
  government programs.
• Because of 3rd party payer system
• consumers had no incentive to shop price,
• consumers had incentive to demand goods and
  services they would not without insurance.
• physicians had a profit incentive to prescribe
  extra visits, tests, procedures, and other care.
• Providers competed for patients and physicians,
  not with price, but quality, so raising costs.
• ? Quality, quantity, prices increased.

33
RECAP OF 1960-1980s
The historic explosion in expenditures is
primarily due to, first, Government Intervention
in the form of a Tax Subsidy.

• Tax subsidy induced workers to take more of their
  income in exempt health benefits ? pre-paid
  health plans.
• Tax subsidy reduced the private cost of 1 of
  health care to zero for those in highest tax
  brackets ? over-consumption.

34
RECAP OF 1960-1980s
The historic explosion in expenditures is
primarily due to, second, Asymmetric Information
in the form of Moral Hazard.

• The 3rd party payer cannot determine whether the
  price, quantity and quality of care is
  cost-justified.
• There is a lack of incentive for price
  competition on either the buyer or seller side of
  the markets.

35
An American Health OdysseySeven Decades of
Haphazardry

• 1980s to present
• Asymmetric Information (Moral Hazard) (MF)
• ? Managed Care (HMOs, etc..) (MA)
• M.C. became the preferred means of health care
  delivery by limiting price, quality, and quantity
  of care. Its virtue is exactly what makes it
  unpopular.
• M.C. would be unnecessary if employer- and
  government-provided health plans covered only
  insurable risks. Private markets could provide
  additional coverage for those willing and able to
  afford it.

36
An American Health OdysseySeven Decades of
Haphazardry

• 1980s to present
• Asymmetric Information (Moral Hazard) (MF)
• ? Price Controls (GI)
• Medicare adopted a prospective payment system of
  prices (Diagnostic Related Groups).
• Medicare encouraged Managed Care delivery through
  fixed capitated payments.
• There have been repeated measures to limit
  pharmaceutical prices -- weakening role of
  patents in fostering RD.

37
Health Care Crisis 1 Spiraling Health Care
Costs

• What is meant by cost? Price or expenditure?
  Probably expenditure.
• Do we have a personal computer cost crisis?
  There has been a very similar increase in
  expenditures for home and office computing and
  word-processing.
• What causes of health expenditure increases are
  justified? Manageable?

38
Components Share of Health Care Expenditure
Growth 1950-2000
39
Empirically Significant Determinants of Health

• Socioeconomic variables (e.g., income
  education) are today most significant, even after
  controlling for expenditures.
• Lifestyle choices are major determinants.
• Public Health Education has been most significant
  in explaining historic declines in mortality due
  to major diseases -- not medical breakthroughs
  and interventions.
• Prevention can be very cost effective (e.g.,
  pre-natal care and WIC program).

40
Empirically Insignificant Determinants of Health

• Health care expenditure is not generally
  significant. The Rand HIS experimental study of
  families under different health plans found those
  that consumed 40 more health care had little or
  no benefit.
• Consequently, on the average, the marginal
  benefit of 1 of care is about zero. This
  implies serious over-consumption, as might be
  expected from the federal and state tax subsidies.

41
Re-Interpreting the Empirical Evidence on Health
Expenditures
The conclusion expenditure is insignificant
(i.e., the marginal benefit of 1 of care is
zero) fails to distinguish between the

• Intensive margin, e.g., a 1 increase in total
  expenditures is spent on everyone in proportion
  to previous expenditures 1 more for all.
• Extensive margin, e.g., a 1 increase in total
  expenditures is spent on those whose previous
  expenditure was zero.

42
Health Care Crisis? Yes.

• Intensive Margin Due to misguided tax subsidies
  that apply to non-insurable risks plus subsidizes
  higher income families more for each 1 spent,
  there is over-consumption by those in
  employer-based health plans.
• Intensive Margin Due to government programs that
  cover non-insurable, demand-elastic risks, there
  is over-consumption by beneficiaries.

43
Health Care Crisis? Yes.

• Extensive Margin There is under-consumption by
  the uninsured.

44
Effective Remedy Requires Major, Controversial
Reforms

• If the goal is to provide universal access to
  basic health insurance, the tax treatment of
  health benefits should be changed from a
  deduction to a credit, with a maximum credit
  equal to the cost of a policy covering only
  insurable risks.
• With the over 100 billion in new tax revenues,
  basic health insurance could then be provided to
  the uninsured.

45
Politically Realistic Reform?

• The current system is a haphazard collection of
  artifacts of the last seven decades. Many are
  accustomed to its idiosyncrasies, and others have
  a vested interest in maintaining the system.
• In all likelihood, we will continue to tinker
  with markets, introducing new market failures and
  inefficiencies, always at tax-payers expense.
  Universal access will not be achieved, or if so,
  only at a high cost.

46
But, then, I am a confessed political cynic.
Someone, prove me wrong.
Please.