Good Health • Everyone desires good health, both for the sake of

quality of life and because it contributes to our remaining productive years and earning income

• Improving health is not the only characteristic of health care that health economics takes into account– Many types of health care may impact on other

aspects of people’s welfare—for example, providing reassurances or reducing anxiety about their state of health, whether or not their health has changed

• Formulating the basis for the demand for health provides the basis for the demand for health care

Health as a Form of Human Capital

• The most important and powerful insight is that in addition to health care being an economic good, health itself can be thought of as a good, albeit one with special characteristics– Health can be regarded as a fundamental

commodity: one of the true objects of people’s wants. Tangible goods and services—such as health care—are simply a means to create it

• If it is accepted that health is a fundamental commodity, we can analyze the demand for improvements in health in very similar ways to the analysis of demand for other goods and services

The Demand for Health Care

• The demand for health care depends on the

particular production function for health

• The effect of education on the demand for health

care is not predictable

– If education makes a person more efficient in

producing health, an increased awareness of

the value of good nutrition and prevention of

disease will reduce the quantity of health care

required to produce a given stock of health

The Demand for Health Care– Education can also increase the demand for

health itself• The more educated will demand more health,

but less health care, if the effect of education on the productivity of inputs into health outweighs the shift in health care demand

• The effect of age on the demand for health care has been found to vary by type of health care required

• Health insurance influences the price of health care, which is a movement along a given demand curve for health care

The Demand for Health Care

• In analyzing the demand for health care, it is

important to take into account the concept of

need when considering both the characteristics

of health policy and an individual’s consumption

of health care

– Needs and demands can therefore be

regarded as two very different ways of

viewing matters

Asymmetry of Information and Imperfect Agency

• Information is itself an economic good• The relationship between doctor and patient is

often presented as a principal-agent problem– The doctor is the agent acting on behalf of a

principal, who is the patient, in making decisions about what health care to purchase• If doctors made these decisions in a

manner fully consistent with patients’ preferences, unaffected by the consequences for themselves, they would be acting as perfect agents

Estimates of the Price Elasticity of Demand for Health Care

• We measure the responsiveness of consumers to changes in the price of a good or service by the price elasticity of demand

• The formula for elasticity of demand with respect to price is:

• % change in the quantity of health care demanded

• % change in price of health care• In general, goods and services, which are close

substitutes, have higher price elasticities, and complementary goods and services have lower price elasticities.

Estimates of the Price Elasticity of Demand for Health Care

• The highest price elasticity estimates observed are for those demanding hospital outpatient services and for nursing home services

• The lower number of substitutes for hospitals make the elasticity for hospital services lower than that for physician services– However, once a physician is chosen, this

also limits the number of hospitals that the patient can utilize as well, due to the limits on admitting privileges of physicians 

Aggregate Demand for Health Care

• It is clear that there is a positive relation between income and the demand for health care: the richer the country, the greater the demand for health care

• In the U.S., health insurance has been the means by which the employed have met their health care needs

The Insurance Market• People buy insurance because they are risk-averse

– Buying insurance allows a person to pay a certain known amount in order to transfer the risk of a much larger expenditure (in the case of an adverse event) to an insurer, known as a third party payer

• There are a number of types of risk associated with health– Risk to one’s health and life associated with illness or

disease– Risk that if one undertakes treatment, it may or may not

cure or alleviate symptoms of disease– The costs associated with the treatments of illness and

disease

The Insurance Market• People can insure themselves against some or all

of the financial loss associated with the treatment of illness by buying health insurance policies

– Even people with extensive wealth buy insurance due to the fact that most people are “risk-averse”

• Economists define risk aversion as a characteristic of people’s utility (satisfaction) functions

• People are more likely to buy insurance to cover low-probability events (large losses) than high probability events (small losses)

Setting Insurance Premiums

• The price that an insurance company charges for an insurance policy, or premium, is based on the expected payout (amount paid out on average for a large group of insured persons), plus administrative costs, reserve funds, and profits or surpluses of the insured company– Premiums charged generally exceed the fair

value of the risk that the insurance company has assumed, where the fair value is the expected payout

Experience versus Community Rating

• One common method of pricing insurance is experience rating– Insurance companies base premiums on past

levels of payouts, which is often done in the case of car or homeowners’ insurance.

• Community rating applies when each member of an insurance pool pays the same premium per person or per family for the same coverage– Community rating is inefficient in the sense

that the price of insurance to an individual subscriber does not reflect the marginal costs of that individual to the insurer.

Moral Hazard

• Moral hazard refers to the phenomenon of a person’s behavior being affected by his or her insurance coverage– Moral hazard is known to exist is in all types of

insurance markets• People may be more careless with property that

is insured• The main way that moral hazard comes into

play in the health insurance market is through an increase in demand for healthcare services utilized

Moral Hazard and the Structure of Health Insurance Contracts

• Some degree of moral hazard exists when the price elasticity of demand for covered healthcare services is greater than zero– In theory, the problem of moral hazard should

be greater in the case of policies covering a broader range of services, including more discretionary or elective ones, because the price elasticity of demand for these services is believed to be higher

Moral Hazard and the Structure of Health Insurance Contracts

• The reason that moral hazard operates differently in the health insurance market than in other insurance markets is that health insurance contracts differ from most other forms of insurance

Moral Hazard and the Structure of Health Insurance Contracts

• Major healthcare services contracts also differ from most types of insurance in that they generally cover more than just unlikely catastrophic events, fulfilling a function analogous to that of a service contract on an automobile– they also include reimbursement for annual

physical exams, vaccinations, treatment for chronic conditions, and various types of routine tests

Cost Sharing to Offset Effects of Moral Hazard

• Deductibles. A deductible is a level expenditure that must be incurred before any benefits are paid out – Health insurance policies generally have

yearly deductibles, which is less effective in removing moral hazard

• Coinsurance. Coinsurance is the proportion of the total expenditure that is paid by the insured– Coinsurance helps to reduce the moral

hazard factor for the insured that have spent more than their deductible because health care is not free to them

Cost Sharing to Offset Effects of Moral Hazard

• Use of Usual, Customary Fees to Limit Payments. It has become common practice for insurance policies that reimburse on the basis of fee-for-service to limit payment for covered services to customary or usual fee within given geographic markets

• Managed Care. Care is actually managed or rationed using such mechanisms as “gatekeepers,” who are primary care physicians that make all referrals to specialists, limit coverage to service providers with whom the insurance company has a contractual agreement, and require precertification or approval from the insurance company before services are rendered

Cost Sharing to Offset Effects of Moral Hazard

– Controls are on the supply side as well as the use of risk-sharing arrangements with providers of health care

• Stop-Loss Provisions. Many policies also have annual limits on out-of-pocket expenditures (per person or per family) that must be borne by the insured

– Stop-loss provision

Integration Between Third Party Payers and Healthcare Providers

• There are three different kinds of integration between third party payers and healthcare providers– First, the third party payer and provider are separate

entities with separate aims and objectives– Second, there is selective contracting, with the third-

party payer agreeing to steer individuals insured on their plans to selected providers, and, in turn, the selected providers charge lower prices to the insurers

– Third, there is vertical integration in which the insurance provider and healthcare provider merge to become different parts of the same organization

End