Sixth Edition

THE ECONOMICS OF HEALTHAND HEALTH CARE

Sherman FollandProfessor of Economics, Oakland University

Allen C. GoodmanProfessor of Economics, Wayne State University

Miron StanoProfessor of Economics and Management, Oakland University

Prentice HallBoston Columbus Indianapolis New York San Francisco Upper Saddle River

Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal TorontoDelhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

BRIEF CONTENTS

PART I Basic Economics Tools 1

Chapter 1 Introduction 2

Chapter 2 Microeconomic Tools for Health Economics 20

Chapter 3 Statistical Tools for Health Economics 48

Chapter 4 Economic Efficiency and Cost-Benefit Analysis 64

PART II Supply and Demand 85Chapter 5 Production of Health 86

Chapter 6 The Production, Cost, and Technology of Health Care 105

Chapter 7 Demand for Health Capital 128

Chapter 8 Demand and Supply of Health Insurance 143

Chapter 9 Consumer Choice and Demand 167

PART III Information and Insurance Markets 189Chapter 10 Asymmetric Information and Agency 190

Chapter 11 The Organization of Health Insurance Markets 204

Chapter 12 Managed Care 230

Chapter 13 Nonprofit Firms 258

PART IV Key Players in the Health Care Sector 279Chapter 14 Hospitals and Long-Term Care 280

Chapter 15 The Physician's Practice 299

Chapter 16 Health Care Labor Markets and Professional Training 317

Chapter 17 The Pharmaceutical Industry 342

PART V Social Insurance 365

Chapter 18 Equity, Efficiency, and Need 366

Chapter 19 Government Intervention in Health Care Markets 389

Chapter 20 Government Regulation: Principal Regulatory Mechanisms 406

Chapter 21 Social Insurance 436

Chapter 22 Comparative Health Care Systems 467

Chapter 23 Health System Reform 493

PART VI Special Topics 511

Chapter 24 The Health Economics of Bads 512

Chapter 25 Epidemiology and Economics: HIV/AIDS in Africa 530

in

CONTENTS

Preface xix

Part I Basic Economics Tools 1

Chapter 1 Introduction 2What Is Health Economics? 3The Relevance of Health Economics 4

The Size and Scope of the Health Economy 4Health Care's Share of GDP in the United States 5Health Care Spending in Other Countries 6Importance of the Health Economy in Personal Spending 7Importance of Labor and Capital in the Health Economy 7Time—The Ultimate Resource 8The Importance Attached to Economic Problems of Health Care DeliveryInflation 10Access 10Quality 10

"* The Economic Side to Other Health Issues 10Economic Methods and Examples of Analysis 10

Features of Economic Analysis 11Examples of Health Economics Analysis 11

Does Economics Apply to Health and Health Care? 12An Example: Does Price Matter? 13

Is Health Care Different? 14Presence and Extent of Uncertainty 14Prominence of Insurance 14Problems of Information 15Large Role of Nonprofit Firms 15Restrictions on Competition 15Role of Equity and Need 16Government Subsidies and Public Provision 16

Conclusions 16Summary 17 • Discussion Questions 18 • Exercises 18

Chapter 2 Microeconomic Tools for Health Economics 20Scarcity and the Production Possibilities Frontier 21Practice with Supply and Demand 24

The Demand Curve and Demand Shifters 24The Supply Curve and Supply Shifters 25Equilibrium 25Comparative Statistics 26

IV

Contents

Functions and Curves 27Linear Functions 27Demand Functions 27Derived Demand 29

Consumer Theory: Ideas Behind the Demand Curve 29Utility 29Indifference Curves 30Budget Constraints 31Consumer Equilibrium 32

Individual and Market Demands 33Elasticities 34Production and Market Supply 35

The Production Function 36Production Functions 37Isocost Curves 39Cost Minimization or Output Maximization 40Marginal and Average Cost Curves 40

The Firm Supply Curve Under Perfect Competition 41Monopoly and Other Market Structures 43Welfare Losses 44Conclusions 46

Summary 46 • Discussion Questions 47 • Exercises

48

47

Chapter 3 Statistical Tools for Health EconomicsHypothesis Testing 49Difference of Means 50

The Variance of a Distribution 50Standard Error of the Mean 51Hypothesis and Inferences 52

Regression Analysis 54Ordinary Least Squares (OLS) Regressions 55A Demand Regression 56Eliminating Elasticities 57

Multiple Regression Analysis 58Interpreting Regression Coefficients 58Dummy Variables 60

Statistical Inference in the Sciences and Social Sciences 61Conclusions 61

Summary 61 • Discussion Questions 62 • Exercises 62

Chapter 4 Economic Efficiency and Cost-Benefit AnalysisEconomic Efficiency 64Cost-Benefit Analysis: Background 67Cost-Benefit Analysis: Basic Principles 67

Measuring Costs 68

64

vi Contents

Risk Equity Versus Equality of Marginal Costs per Life Saved 68Marginal Analysis in CBA 69Discounting 70Risk Adjustment and CBA 72Distributional Adjustments 72Inflation 73

Valuing Human Life 73Willingness to Pay and Willingness to Accept 73Contingent Valuation 73How Valuable Is i:he Last Year of Life? 74Cost-Benefit Analyses of Heart Care Treatment 75

' Cost-Effectiveness Analysis 76Advantages of CEA 77

Cost-Utility Analysis, QALYs, and DALYs 77An ACE Inhibitor Application of Cost-Effectiveness

Analysis 78QALYs Revisited: Praise and Criticism 79

Are QALYs Consistent with Standard Welfare Economics? 79Extra-Welfarism 79Sen's Capability Approach and QALYs 79

* Linearity Versus What People Think 79The Ageism Critique of QALYs 80

Conclusions 80Summary 81 • Discussion Questions 82 • Exercises 82

Part II Supply and Demand 85

Chapter 5 Production of Health 86The Production Function of Health 86The Historical Role of Medicine and Health Care 89

The Rising Population and the Role of Medicine 89What Caused the Mortality Rate Declines? Was It Medicine? 91What Lessons Are Learned from the Medical Historian? 93

The Production of Health in the Modern Day 94Preliminary Issues 95The Contribution of Health Care to Population Health:

The Modern Era 95Is Health Care Worth It? 96Issues of Race and Gender 96Prenatal Care 96The World's Pharmacies 98Morbidity Studies 98

How Does Health Care Affect Other Measures of Health? 98On the Importance of Lifestyle and Environment 99Cigarettes, Exercise, and a Good Night's Sleep 100

Contents vii

The Family as Producer of Health 100Social Capital and Health 101Environmental Pollution 101Income and Health 102

The Role of Schooling 102Two Theories About the Role of Schooling 102Empirical Studies on the Role of Schooling in Health 103

Conclusions 103Summary 103 • Discussion Questions 104 • Exercises 104

Chapter 6 The Production, Cost, and Technologyof Health Care 105

Production and the Possibilities for Substitution 106Substitution 106What Degree of Substitution Is Possible? 107Elasticity of Substitution 108Estimates for Hospital Care 109

Costs in Theory and Practice 109Deriving the Cost Function 109Cost Minimization 111

"* Economies of Scale and Scope 112Why Would Economies of Scale and Scope

Be Important? 113Empirical Cost-Function Studies 114Difficulties Faced by All Hospital Cost Studies 114Modern Results 116Summary: Empirical Cost Studies and Economies of Scale 116

Technical and Allocative Inefficiency 116Technical Inefficiency 116Al locative I nefficiency 117Frontier Analysis 118The Uses of Hospital Efficiency Studies 119For-profit Versus Nonprofit Hospitals 120Efficiency and Hospital Quality 120Performance-Based Budgeting 120

Technological Changes and Costs 121Technological Change: Cost Increasing or Decreasing? 121Health Care Price Increases When Technological

Change Occurs 122Diffusion of New Health Care Technologies 123

Who Adopts and Why? 123Other Factors That May Affect Adoption Rates 125Diffusion of Technology and Managed Care 125

Conclusions 125Summary 126 • Discussion Questions 126 • Exercises 127

viii Contents

Chapter 7 Demand for Health Capital 128The Demand for Health 128

The Consumer as Health Producer 128Time Spent Producing Health 129

Labor-Leisure Trade-Offs 130Trading Leisure for Wages 131Preferences Between Leisure and Income 131

The Investment/Consumption Aspects of Health 132Production of Healthy Days 132Production of Health and Home Goods 133

Investment over Time 134The Cost of Capital 134

The Demand for Health Capital 135Marginal Efficiency of Investment and Rate of Return 135The Decreasing MEI 135

Changes in Equilibrium: Age, Wage, Education, and Uncertainty 136Age 136Wage Rate 137Education 137Uncertainty 138

Empirical Analyses Using Grossman's Model 139Conclusions 140

Summary 141 • Discussion Questions 141 • Exercises 142

Chapter 8 Demand and Supply of Health Insurance 143What Is Insurance? 143

Insurance Versus Social Insurance 144Insurance Terminology 144

Risk and Insurance 145Expected Value 145Marginal Utility of Wealth and Risk Aversion 146Purchasing Insurance 147

The Demand for Insurance 148How Much Insurance? 148Changes in Premiums 150Changes in Expected Loss 150Changes in Wealth 151

The Supply of Insurance 151Competition and Normal Profits 151

The Case of Moral Hazard 154Demand for Care and Moral Hazard 154Effects of Coinsurance and Deductibles 156

Health Insurance and the Efficient Allocation of Resources 157The Impact of Coinsurance 157

Contents ix

The Demand for Insurance and the Price of Care 160The Welfare Loss of Excess Health Insurance 160

The Income Transfer Effects of Insurance 162Conclusions 164

Summary 165 • Discussion Questions 165 • Exercises 166

Chapter 9 Consumer Choice and Demand 167Applying the Standard Budget Constraint Model 168

The Consumer's Equilibrium 169Demand Shifters 170Health Status and Demand 172

Two Additional Demand Shifters—Time and Coinsurance 172The Role of Time 172The Role of Coinsurance 174

Issues in Measuring Health Care Demand 176Individual and Market Demand Functions 176Measurement and Definitions 177Differences in the Study Populations 177Data Sources 177Experimental and Nonexperimental Data 178

* Empirical Measurements of Demand Elasticities 178Price Elasticities 178Individual Income Elasticities 180Income Elasticities Across Countries 180Insurance Elasticities 181

Impacts of Insurance on Aggregate Expenditures 183Other Variables Affecting Demand 183

Ethnicity and Gender 183Urban Versus Rural 184Education 184Age, Health Status, and Uncertainty 185

Conclusions 185Summary 186 • Discussion Questions 187 • Exercises 187

Part III Information and Insurance Markets 189

Chapter 10 Asymmetric Information and Agency 190Overview of Information Issues 191Asymmetric Information 191

On the Extent of Information Problems in the Health Sector 191Asymmetric Information in the Used-Car Market:

The Lemons Principle 193Application of the Lemons Principle: Health Insurance 194

Inefficiencies of Adverse Selection 195Experience Rating and Adverse Selection 196

Contents

The Agency Relationship 197Agency and Health Care 197

Consumer Information, Prices, and Quality 197Consumer Information and Prices 198Consumer Information and Quality 199Other Quality Indicators 200

Conclusions 201Summary 202 • Discussion Questions 203 • Exercises 203

Chapter 11 The Organization of Health Insurance Markets 204Loading Costs and the Behavior of Insurance Firms 204

Impacts of Loading Costs 205Insurance for Heart Attacks and Hangnails 206Loading Costs and the Uninsured 206

Employer Provision of Health Insurance: Who Pays? 206Spousal Coverage: Who Pays? 209How the Tax System Influences Health Insurance Demand 209Who Pays the Compensating Differentials?—Empirical Tests 211Other Impacts of Employer Provision of Health Insurance 212

Employer-Based Health Insurance and Labor Supply 213•* Health Insurance and Retirement 213

Health Insurance and Mobility 213The Market for Insurance 215

The Market for Private Insurance 215Insurance Practices 215The Past 30 Years 217

The Uninsured: An Analytical Framework 218The Working Uninsured 222The Impacts of Mandated Coverage 223

Technological Change, Higher Costs, and Inflation 225The Cost-Increasing Bias Hypothesis 225Goddeeris's Model—Innovative Change over Time 225Evidence on Technological Change and Inflation 227

Conclusions 227 ,Summary 228 • Discussion Questions 228 • Exercises 229

Chapter 12 Managed Care 230What Is the Organizational Structure? 231What Are the Economic Characteristics? 232The Emergence of Managed Care Plans 233

Employer-Sponsored Managed Care 234Medicaid Managed Care Plans 235Managed Care Contracts with Physicians 235Managed Care Contracts with Hospitals 236

Contents xi

Development and Growth of Managed Care—Why Did ItTake So Long? 237

Federal Policy and the Growth of Managed Care 238The Economics of Managed Care 239

Modeling Managed Care 239Modeling Individual HMOs 240How Much Care? 240What Types of Care? 241Framework for Prediction 242Where Managed Care Differs from FFS—Dumping,

^Creaming, and Skimping 242» Equilibrjum and Adverse Selection in a Market with HMOs 243

How Does "Managed Care Differ?—Empirical Results 244Methodological Issues—Selection Bias and Quality of Care 245Comparative Utilization and Costs 245The RAND Study—A Randomized Experiment 246The Most Recent Evidence 247 '

Growth in Spending 248Competitive Effects 250

Theoretical Issues 250"* Managed Care Competition in Hospital Markets 251

Managed Care Competition in Insurance Markets 252Managed Care and Technological Change 253

The Managed Care Backlash 253Conclusions 255

Summary 255 • Discussion Questions 256 • Exercises 257

Chapter 13 Nonprofit Firms 258An Introduction to Nonprofits 258Why Nonprofits Exist and Why They Are Prevalent in Health Care 259

Nonprofits as Providers of Unmet Demands for Public Goods 259The Public Good-Private Good Aspect of Donations 260Relevance to Health Care Markets 262Nonprofits as a Response to Contract Failure 262Applications of Contract Failure to Nursing Home Care 263Relevance of Contract Failure to Hospitals and Other Firms 263Financial Matters and the Nonprofit 264Summary of the Reasons for the Prevalence of Nonprofits 264

Models of Nonprofit Hospital Behavior 264The Quality-Quantity Nonprofit Theory 264The Profit-Deviating Nonprofit Hospital 266The Hospital as a Physicians' Cooperative 267Maximizing Net Revenue per Physician 268

xii Contents

A Comparison of the Quantity-Quality and the Physicians'Cooperative Theories 268

The Evidence: Do Nonprofit Hospitals Differ fromFor-Profit Hospitals? 270

Summary of Models of Hospital Behavior 273What Causes Conversion of Nonprofits into For-Profits? 273

The Relative Efficiency of Nonprofits Versus For-Profits 274Property Rights Theory and Its Application to Nonprofits 274Are Nonprofit Health Care Firms Less Efficient?—Hospitals and

Nursing Home Studies 275Conclusions 277

Summary 277 • Discussion Questions 278 • Exercises 278

Part IV Key Players in the Health Care Sector 279

Chapter 14 Hospitals and Long-Term Care 280Background and Overview of Hospitals, 280

History 281Organization 282Regulation and Accreditation 283

^ Hospital Utilization and Costs 283Competition and Costs 284

Closures, Mergers, and Restructuring 288Quality of Care 290Nursing Homes 291

Background and Costs 291Quality of Care 291Excess Demand 292Financing Long-Term Care 294

Hospice, Home Health, and Informal Care 295Conclusions 296

Summary 297 » Discussion Questions 297 • Exercises 298

Chapter 15 The Physician's Practice 299A Benchmark Model of the Physician's Practice 300

Do Physicians Respond to Financial Incentives? 302Physician Agency and Suppler-Induced Demand 302

Modeling Supplier-Induced Demand 303The Target Income Hypothesis 303The Benchmark Model as a Synthesis 305The Parallel Between Inducement and Marketing 306What Do the Data Say About Supplier-Induced Demand? 306Physician Fees, Fee Tests, and Fee Controls 307

Diffusion of Information and Small Area Variations 308Contributions to These Variations 309The Physician Practice Style Hypothesis 309

Contents xiii

Multiple Regression Approaches 310SAV and the Social Cost of Inappropriate Utilization 311Other SAV Applications 312

Other Physician Issues and Policy Puzzles 312Physician Pricing and Price Discrimination 312Paying for Outcomes 314

Conclusions 314Summary 315 • Discussion Questions 315 • Exercises 316

Chapter 16 Health Care Labor Markets and Professional Training 317The Demand for and Supply of Health Care Labor 317

Production Functions and Isoquants 318Marginal Productivity of Labor 319Factor Substitution and Labor Demand 320The Supply of Labor 320

Factor Productivity and Substitution Among Factors 322Measurement of Physician Productivity 322The Efficient Utilization of Physician Assistants: Substitution Among

Inputs 322Health Manpower Availability and the Meaning of Shortages 323

w Availability of Physicians 324Economic Definitions of Shortages of Health Professionals 325The Role of Monopsony Power: Shortages of

Registered Nurses 328Medical Education Issues and the Question of Control 330

Sources of Medical School Revenues 330Capital Market Imperfections Justify Subsidies 330Teaching Hospitals, Medical Schools, and Joint Production 331Foreign Medical School Graduates 332The Control of Medical Education 332Control over Entry 333Another View: The Donor Preference Hypothesis 334

Licensure and Monopoly Rents 334Public Interest or Self-Interest 335Licensure and Quality 336

Other Physician Labor Issues 337Specialization 338Physician Income by Gender 338

Conclusions 339Summary 340 • Discussion Questions 341 • Exercises 341

Chapter 17 The Pharmaceutical Industry 342Structure and Regulation 344

Competition 344Barriers to Entry 345Regulation 346

xiv Contents

The Production of Health and Substitutability 348Least-Cost Production 349Insurance and Substitutability 350Technological Change 350

Drug Pricing and Profits 352Monopoly Pricing 352Price Discrimination 353Monopsony Pricing and Price Controls 354Competition and Generic Entry 355

R&D and Innovation ̂ 355Investment Decisions 356R&D Spending 357Firm Size and Innovation 358Prices, Price^Regulation, and Innovation 358

Cost Containment 359Copayments 360Generic Substitutes 361Drug Formularies 361

Conclusions 362Summary 363 • Discussion Questions 363 • Exercises 364

Part V Social Insurance 365

Chapter 18 Equity, Efficiency, and Need 366Efficiency and Competitive Markets 367

The Concept of Pareto Efficiency (Optimality) 367Trading Along the Budget Line 368The Competitive Equilibrium 369The First Fundamental Theorem of Welfare Economics 369Redistribution of the Endowment 370Price Discrimination 371Trade-offs Between Equity and Efficiency 371

Deviations from the Competitive Model in the HealthCare Sector 372

The Assumptions Under Perfect Competition 372Promoting Competition in the Health Care Sector 373

The Theorem of the Second Best 373An Economic Efficiency Rationale for Social Health Insurance 374Need and Need-Based Distributions 375

Health Care Needs and the Social Welfare Function 376Norman Daniels's Concept of Health Care Need 380Economic Criticisms of Need-Based Distributions 381

Horizontal Equity and Need 381

Contents xv

Theories of Social Justice 384Utilitarianism 384Rawls and Justice as Fairness 384Liberalism, Classical and Modern 385

Conclusions 386Summary 387 • Discussion Questions 387 • Exercises 388

389Chapter 19 Government Intervention in Health Care MarketsEconomic Rationale for Government Intervention 389

Monopoly Power 390Public Goods 391Externalities 393Other Rationales for Government Intervention 393

Forms of Government Intervention 394Commodity Taxes and Subsidies 394Public Provision 395Transfer Programs 395Regulation 396

Government Involvement in Health Care Markets 396Support of Hospitals 397The Hill-Burton Act 397The Veterans Administration and CHAMPUS 397Food and Drug Administration 398Mandated Health Insurance Benefits 398Tax Policy 398Public Health 398Other Government Programs 399

Government Failure 399Who Does the Regulator Represent? 401Bureaucracy and Efficiency 402

Conclusions 404Summary 404 • Discussion Questions 405 • Exercises 405

Chapter 20 Government Regulation: Principal RegulatoryMechanisms 406

Do the Laws of Supply and Demand Apply? 406Objectives of Regulation 408

Regulatory Policy 408Regulatory Instruments in Health Care 408

Regulation of the Hospital Sector 409Empirical Findings on Regulation 409

Prospective Payment 413Description of PPS 413

xvi Contents

The Theory of Yardstick Competition and DRGs 415On the Effects of Medicare's Prospective

Payment System 419Prospective Payment: Recent Evidence 423Regulation of Physician Payment 424

UCR Reimbursement, Assignment, and Alternative PaymentMechanisms 425

Relative Value Scales 425Antitrust 426

Enforcement 42-7-Exemptions 427

, Measuring Monopoly Power 429Antitrust Procedures 430The Elzinga-Hogarty (EH) Criterion 431

Conclusions *432Summary 433 • Discussion Questions 433 • Exercises 434

Chapter 21 Social Insurance 436Social Insurance and Social Programs 436

Program Features 437„, Historical Roots of Social Insurance 438

European Beginnings 438Early Experience in the United States 439The Establishment of Medicare and Medicaid 439

Medicare and Medicaid in the United States 441Medicare 441Part D Prescription Drug Insurance 442Medicaid 445Medicaid Eligibility 446The Medicaid-Medicare Relationship 449Medicare and Medicaid: Conflicting Incentives

for Long-Term Care 449State Children's Health Insurance Program 450

Public Insurance and Health 451The Effects of Medicare and Medicaid 454

Costs and Inflation 454Health Status 459Medicare: Recent Changes and Future Prospects 459

Criticisms of the U.S. Health Care System 462Conclusions 464

Summary 465 • Discussion Questions 465 • Exercises 465

Chapter 22 Comparative Health Care Systems 467Contemporary Health Care Systems 467

A Typology of Contemporary Health Care Systems 467

Contents xvii

National Health Programs: United Kingdom and Germany 468The United Kingdom: The National Health Service 470Germany 473

The Canadian Health Care System 477Background 477Physician Fees and Quantity 479Why Are Fees and Hospital Costs Lower in Canada? 480Administrative Costs 480A Comparison 482

Different SystemsrThe Public's Evaluation 485Differences in Health Care Spending Across Countries 488

A Model of Health Expenditure Sales 488Conclusions 490

Summary 491 • Discussion Questions 492 • Exercises 492

Chapter 23 Health System Reform 493Goals of Reform 493

Basic Issues in Reform 495The Costs of Universal Coverage 495

Ensuring Access to Care 496Employer Versus Individual Mandates 496Separation of Health Insurance from Employment 497Single Payer Versus Multiple Insurers 497

Competitive Strategies 498Development of Alternative Delivery Systems 499Consumer-Drive Health Plans and Health Savings Accounts 499Other Market Reforms 501Representation of the Competitive Approach 502Government Versus Markets: The Obama and McCain Proposals 503

Health System Reform and International Competitiveness 505Quality of Care 506Conclusions 508

Summary 508 • Discussion Questions 509 • Exercises 510

Part VI Special Topics 511

Chapter 24 The Health Economics of Bads 512An Introduction to Bads 513Models of Addiction 515

Imperfectly Rational Addiction Models 515Myopic Addiction Models 515Rational Addiction 515

Rationales for Public Intervention 518Other Interventions 518

xviii Contents

Advertising Restrictions on Cigarettes and Alcohol 519The Possible Effects of Brand Switching 521Increased Demand or Brand Switching? 521Advertising and Alcohol Consumption 522

Excise Taxes and Consumption of Cigarettes and Alcohol 523The Consumption-Reducing Effects of Excise Taxes in TheoryExcise Taxes and Cigarette Consumption in Practice 523Excise Taxes and Alcohol Consumption 526

Conclusions 527Summary 528 — • Discussion Questions 528 • Exercises

530

523

528

Chapter 25 Epidemiology and Economics: HIV/AIDS in AfricaConcepts from Epidemiology 530Economic Epidemiology 533

Rational Epidemics 533The Prevalence Elasticity of Demand for Prevention 533The Economic Consequences of Epidemics 534The Difficulty of Eradicating Diseases 535Information 536The Role of Government in Battling Epidemics 536

Case Study: HIV/AIDS in Africa 537HIV/AIDS 537Costs of AIDS in Forgone Productivity 538Fighting AIDS 540Economic Theory and African Reality 542

Conclusions 544Summary 544 • Discussion Questions 545 • Exercises 545

Glossary 546

References 553

Index 589