Forest and Trees

HSPM J712

Free market

• Supply and demand work to allocate resources and distribute goods and services

• Through prices

Independence of supply and demand

• Supply is the sum of the decisions of sellers• Demand is the sum of the decisions of buyers

Supply curve

• Shows the relationship between the quantity that sellers want to sell and the price

• Depends on costs (Costs Supply)– Opportunity costs of resources

• And competition (Competition Supply)– Number of sellers– Freedom of entry

Demand curve• Shows the relationship between the quantity that

buyers want to buy and the price• Depends on– Budgets (BudgetsDemand)

• Opportunity cost of the good to the buyer– Preferences, wants, needs (WantsDemand)– Alternatives and their prices

(AlternativesDemand)• Cross-price elasticities

– Competition (Competition Demand)• Number of buyers

Equilibrium

• Bubbles– When expected future prices affect today’s supply

and demand– Momentum of demand and price• Fueled by debt

• Next slide http://www.calculatedriskblog.com/2009/08/house-prices-real-prices-price-to-rent.html

Supply elasticity and housing (and commercial real estate)

• Columbia: Elastic supply– Higher demand led to more houses

• South Florida: Inelastic supply– Higher demand led to higher prices

What makes health care specialin economic theory

HSPM J712

Is health care special?

• Does the free market give good results?

– What are good results?

Free trade makes things better, if certain conditions hold

• As individuals pursue their self-interest in the market, they work for the benefit of others, “as if guided by an invisible hand.” – Adam Smith (1776)

• Prices guide people to use their resources in ways that most benefit others.

Reinhardt’s diagram to illustrate Pareto Optimality and the Kaldor-Hicks criterion (which is behind cost-benefit analysis)

• If a dictator puts you at X, free trade will move you to between Y and Z.

What is “optimal?”What is “efficient?”

• Pareto criterion (strong): No one can be made better off without making someone else worse off.

• Kaldor-Hicks criterion (weaker): If the gains to the winners total more than the losses to the losers.

Free Trade and Optimality or Efficiency

• Free trade will get you to an optimum• If and only if …– Buyers and sellers have full information about

quality and price– No outside subsidies or penalties– No external costs or benefits– Everything that affects well-being can be bought. • (The exclusion of externalities is a subset of this.)

– No collusion or entry barriers

How this works with Pareto optimality

• If there were a way for you to be better off without making me worse off,

• Then we’d both know about it (perfect info)• And we could engineer a trade in which you’d

gain the extra and give me some (free trade)• And no one else would be hurt (no external

costs)• And we wouldn’t be hurt indirectly (because

everything is for sale)

1st and 2nd optimality theorem

• 1st is that those conditions lead to an optimum• 2nd is that, if those conditions hold, society can

get to any particular optimum by manipulating the distribution of wealth– So, OC’s (objects of compassion) should be given

money, not programs

For health care and the free market, let’s start with …

1) Consumers must– Know prices of all alternatives– Know qualities of all alternatives• Qualities = benefits to them

Arrow: Information uncertainty in health care

• Consumers are uncertain about qualities and prices.

• Much of what consumers buy from health professionals is information.

• Buying and selling information – a problem for free market theory

• How do you know how much you’re going to benefit from information without knowing the information?

How do these deals sound?

• “I have some information that it will benefit you to know. Pay me $35 and I’ll tell you the information.”

• “I have some information that it will benefit you to know. Agree in advance to pay me whatever I’ll ask and I’ll tell you the information.”

ProfessionalismTrust

• Arrow: Society develops solutions when market is not optimal. Not necessarily government solutions.

• Professionalism = Behave unlike unfettered business.

• Professionalism encourages trust– That the information will be worth what you are

paying for it.

This is an efficiency problem, not an equity problem

• It’s not about fairness, or what to do about the medically indigent.

• It’s about a free market not being able to provide the right amount of medical care to people who can pay.– Without some substitute for consumer

sovereignty, which fails in health care

Professionalism in medicine

• Knowledge and training• Agency– The patient is the “principal.”– The physician or other professional or the hospital

or other institution is the principal’s “agent.”

• Agents are supposed to apply their abilities on behalf of their principals, not themselves.

Professionalism in medicine

• Serves a social purpose• Moves away from the unfettered, anything

goes, market …• … to make the outcome closer to optimal• … to make the outcome more efficient

But violates other free market optimality requirements

• Collusion• Entry barriers

For health care and the free market, let’s continue with …

2) No outside subsidies or penalties– Subsidies unhook the relative prices that

individuals face from the relative costs of their choices

Moral hazard

• Is a consequence of insurance• But insurance is a rational market response to

the uncertainty of health care expense.

Insurance and expense uncertainty

• Consumers are uncertain about how much they will be spending on health care.

• They may have a catastrophe and want to spend more than they can raise.

• So they buy insurance.

Insurance and risk

• Insurance is a financial transaction• You (the insured) pay the insurer to assume

risk for you.• You pay more than the expected value of the

insurance payout. The difference is your risk premium.

• The risk premium covers the cost of administering the insurance.

Risk pool

• A way to think about it instead of expected value

• You and a bunch of others agree that if any of you suffer a loss, you will all chip in to pay for it.

• Mutual insurance

Insurance leads to moral hazard

• Theory says that you will use any service to the point where the marginal value to you equals the price to you.

• If there are diminishing returns to using more service, and the price to you is a fraction of the cost, you will use services that have a higher opportunity cost to society than their benefit to you ...

• … and you won’t bother to shop for a lower price.

Moral hazard

• When having insurance makes it more likely that a claim-triggering event will happen.– Example: The expectation of a rescue by the

government may induce a bank to take bigger risks.

Health insurance and the demand curve

• Insurance increases the demand• And makes it less elastic

• 100% coverage pivots the demand curve around the point where it meets the Quantity axis, and makes the demand curve a vertical line.

Moral hazard makes market inefficient = not optimal

• Insurance with free choice induces people …• … to get society to provide them with services – Society = pubic or private insurance

• … such that there are other things that the person is not getting that would be more valuable to the person than the medical service– Violates the Pareto criterion

To reduce moral hazard within the free market, conservatives advocate:• Catastrophic insurance– Insurance that only pays for big, bad, surprises.

Catastrophic-only insurance

For• Less inducement to moral

hazard– Because less is covered

• Less administrative cost– Because fewer bills paid

• Selection– Risky people want to avoid it,– So low-risk people will pay a

premium closer to their expected value.

Against• Tilts incentive away from

primary care– Discourages prevention

• Bargaining power and market knowledge– Insurer as monopsonist

• Individual payment has administrative cost, too.

• Risk-adjusted premium can stop selection.

The case for catastrophic-only insurance part 1

• Less inducement to moral hazard– Because less is covered

The case for catastrophic-only insurance part 2

• Administrative cost– Through your premium, you pay the insurance

company to do the paperwork for your bills.– If the insurance company handles fewer bills, the

administrative cost is less.– The insurance company can supply a catastrophic

policy at a higher medical loss ratio. That’s more value relative to cost for you.

The case for catastrophic-only insurance part 3

• Selection makes catastrophic insurance a better deal– Comprehensive insurance attracts people who

expect to have more health care. It’s premium will rise accordingly. • (Assumes competitive market for insurance.)

– Catastrophic-only insurance will have a less risky pool, so the cost per member will be less, and the premium will closer to an average person’s expected payout plus administrative cost.

Irony of pre-existing condition exclusions

• Selection by the company overcomes buyer selection and enables lower-risk people to buy comprehensive insurance at an appropriate price.

The case against catastrophic-only insurance, part 1

• Bargaining power and market knowledge– The administrative cost argument assumes the

insurance company will pay the same prices for services that you will. As a mass buyer, however, the insurer (private or public) may get a better prices than you can. This should mean a lower premium for you, and lower total expected health care costs for you.

– The doctor, as your agent, as supposed to charge you a fair price. The insurance company handles lots of bills and knows what’s customary. “Trust, but verify.”

The case against catastrophic-only insurance, part 2

• Billing individuals has administrative cost, more per bill than billing a big insurer.

• Big savings if you don’t bill patients. – In Canada, hospitals operate on lump-sum annual

payments from government. There are no patient copayments. Hospitals there have tiny billing departments, only to charge foreigners. The paperwork cost reduction is substantial.

The case against catastrophic-only insurance, part 3

• Tilts incentive away from primary care– If you have to pay for your car’s oil changes, but

will get a new engine for free if needed, will you stop changing your oil?

– Do people think like that regarding medical care? Getting a new tooth or new lungs is a lot of trouble, even if you don’t have to pay.

– On the other hand, it’s tempting to be short-sighted

• When the big dollars flow, moral hazard is back.

The case against catastrophic-only insurance, part 4?

• The selection problem can be solved two ways:

1.Make insurance mandatory and community rated– Which is a further departure from the free market

2.Fine tune risk adjustment of premiums to each person’s riskiness– Provide information to make the free-market

work better (but that has costs – like people avoiding getting diagnosed)

… which leads to another free market optimality condition violated

3) … that you can buy anything you need

In a free market for insurance …

• … there will be a range of coverage options – high or low copayments– stricter or looser exclusions

• People with risks will pay more for their insurance– By flocking to more comprehensive plans, which

raises the average cost of those plans– By paying risk adjusted premiums

Non-marketability of risk insurance

• You can’t buy insurance against having a risk– in a free competitive market

• Having a risk identified is a financial catastrophe

• You might be willing to pay to cover that risk, but you can’t.

Risk insurance example

• You can buy: Insurance that pays for treatment if you get cancer.

• You can’t buy: Insurance that will pay you if you need more money to pay for your health insurance because you have a family history of cancer.

Solving the lack of risk insurance?

• Put everyone on Medicare• Mandate that everyone buy insurance– While prohibiting risk adjustment of premiums or

coverage (no “pre-existing conditions” conditions)

• Either takes us further from the free market

Mike Huckabee at the Value Voters Summit

– Sept. 17, 2010

• “… from a common sense perspective …” • = “unencumbered by the thought process”

• http://sambaker.com/Econ/Clips/Huckabee.mp3

• Fries 1993 and Richter 2009 – distractions in the health reform debates

External benefits of health care

• Another free market condition violated4)No external costs of benefits

• Already talked about external benefits of immunizations – the herd effect– In a free market, too few people might get

immunized

External benefit of health care

– Normative and positive economics intertwined

• People (except Rush Limbaugh) have “concern for the health of others.”

• If you can’t buy the health care that I think you need, I get sad. If you get the health care that I think you need, I’m happier.

• A free market would provide less health care than what would make everybody happy

External benefit of health care

– Normative and positive economics intertwined

• A free rider problem: – I’m happier if others get health care, but I’m also

happier if someone else pays than if I pay.– The external benefit to me justifies taxing me to

help pay for others’ health care– But what about Rush Limbaugh, who doesn’t care.

He gains no external benefit, so should he be taxed anyway?

Can there be market justice in health care?

– Information– Moral hazard– Impossibility of risk insurance– External benefits

• These are all efficiency issues• Not just fairness issues

Conclusion:

• There will be a healthy dose of societal intervention in health care. No society can tolerate leaving health care to the free market.

• Providers developed our health care system.• It has evolved since, through market forces,

into a mess that is not efficient or equitable.

• http://theincidentaleconomist.com/wordpress/wp-content/uploads/2010/09/Above-expected.jpg

Health Savings Accounts

• Catastrophic-only insurance • With tax-break-subsidized out-of-pocket

spending

• “Consumer-driven”?– Like Fred Farmer, Marina Perez, Jake, or Jenny

drive their health care