50
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15
10
5
0
Jaki Jenni
Jill John Jack

30
25
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5
0
1st unit 2nd unit 3rd unit 4th unit 5th unit

• When a unit is produced for $x and sold to someone who values it at $y, value is created as long as y > x. $y-x is the value that is created in dollars.
• Economists say “what markets are supposed to do” is create as much value as possible. Markets that attain this standard are called “efficient.”
• Value creation applies to the production of a good as well as its sale to consumers. Lowering costs without harming quality creates value. Improving quality when the benefit to consumers exceeds the cost to producers creates value.

• Those buying the product or service pay the full price and receive all the benefits (of the product).
• All costs accrue to those making the product, and the seller receives the full selling price.
• There are enough buyers/sellers to ensure competition.
• Sellers compete against each other for sales, as do buyers. They don’t collude.
(cont)

• Product characteristics/quality can be accurately and easily assessed.
• Buyers are free to sample sellers’ price/quality and can travel inexpensively from one seller to another.
• Sellers are free to produce as much as they wish, and to choose their selling price freely; buyers are free to buy as much as they wish.
• Sellers can enter/exit the market at will.

The Market Responds in to Changes in Conditions in a Way that Tries to
Maintain Efficiency

• Almost every assumption listed is violated in health care markets!!!
• Government involvement can limit price, entry, and exit
• Few sellers of hospital services in many markets, large HMOs can also mean few buyers
• Information problems mean quality/patient risk often hard to assess; it’s difficult to sample sellers
• “Externalities” and insurance (moral hazard) mean benefits/costs accrue to others besides those buying or selling health care

• Insurance creates value by spreading risk. The value created is estimated by all those messy diagrams.
• Competition brings premiums toward expected payouts, plus administrative expenses
• With “perfectly fair” premium and no administrative overhead, risk-averse consumers would tend to fully insure so their “wealth” would be identical if sick or healthy
• Two primary “market imperfections” in insurance markets: moral hazard and adverse selection

• Agent not acting in the best interest of the principal.
• In terms of insurance, it means that insured consumers will request services for which the benefit is less than the total cost, as long as the benefit exceeds the cost out of pocket
• Coinsurance is one way to reduce moral hazard, but it increases consumer risk
• Deductibles—do they reduce moral hazard?

• Adverse selection is when disproportionately risky consumers are disproportionately likely to purchase insurance.
• Stems from “asymmetric information”—the consumer knows more about his risk than the insurer does.
• Reduces the “size of the market”—less insurance purchased overall from adverse selection as it tends to drive up prices
• Experience rating reduces adverse selection

• Poor information about physician/hospital price/quality effectively reduces competition and prevents consumers from choosing an appropriate provider
• Poor information about the appropriateness of a procedure, even ex post , permits inducement
• Poor information about appropriateness of a procedure probably also gives rise to enormous variation in practice style across physicians and across areas. The latter is called “Small Area
Variation” but in my own research I have found the former is far more significant.

• Externalities aren’t discussed in the assigned chapters but are relevant to HC markets
• Externalities occur when the full cost of treatment isn’t incurred by the provider or when the full benefit of treatment isn’t received by the purchaser.
• Most obvious externality is that, by getting well, a consumer does not continue to expose others to contagious diseases.

What are we going to do about them?