Chapter 1: Introduction
Health Economics
Can we apply the tools of
economics to study the health
care sector?
Outline
The 4 basic questions of health
economics.
 The production possibilities curve
 Economic models
 Positive and normative analysis
 Net Benefit calculus

The following slides summarize material in Santerre & Neun, Health
Economics: Theories, Insights and Industry Studies, Dryden, 2000.
Health Economics

…studies the supply and demand of
health care resources and the impact of
health care resources on a population.
(Mosby Medical Encyclopedia 1992, p. 361)
The 4 Basic Questions
1)
What combination of nonmedical and
medical goods and services should be
produced in the macroeconomy?
a)
Should the federal government spend more on
missile defense or to reduce the number of
uninsured children?
b)
Should the federal government spend more on
education or prescription drugs for the elderly?
The 4 Basic Questions (cont.)
2)
What particular medical goods and
services should be produced in the
health economy?
a)
b)
Should the federal government spend
more on prescription drugs for the elderly
or on home health care?
Should the federal government spend
more on research to cure cancer or on
cancer screening programs?
The 4 Basic Questions (cont.)
3)
What specific health care resources should
be used to produce the final medical goods
and services?
a)
b)
4)
Should more ambulatory patients be cared for by
nurse practitioners instead of physicians?
When is medical vs. surgical management of a
health condition appropriate?
Who should receive the medical goods and
services?
The 4 Basic Questions (cont.)
4)
Who should receive the medical goods
and services?
a)
b)
Should all of the elderly receive
prescription drug coverage from the
federal gov’t, or only the low-income
elderly?
Should illegal immigrants receive free
care in county clinics and hospitals?
The Production Possibilities Curve
(PPC)

A framework for answering the 4 basic
questions.

Depicts the availability of resources and
indicates what can be produced.
A PPC for the Federal Gov’t:
National Defense vs. Health Care
Full-proofness of the
U.S. against terrorist
attacks
100%
Points outside the PPC are
not achievable with current
technological know-how.
Points inside the
PPC represent
production
inefficiency
100%
% of Children covered
by health insurance
A PPC for the Federal Gov’t (cont.)

The federal gov’t must make tradeoffs.
more on health insurance  spending
less on defense
 Tradeoffs  the PPC slopes downwards.
 Spending

Tradeoffs imply opportunity costs.
 The
value resources would yield if they were put
to an alternative use.
 The opportunity cost of raising health insurance
coverage by 1% could be a 2% reduction in the
number of armed forces trained to deal w/ terrorist
attacks.
A PPC for the Federal Gov’t (cont.)

Resources are allocated optimally if the
value obtained from a particular
expenditure (e.g. raising health
insurance coverage by 1%) is greater
than its opportunity cost.
 Who’s
value? In this case, one must come
up with a valid measure of “society’s
value”…
A PPC for the Federal Gov’t (cont.)

Resources are imperfectly substitutable
Each additional unit of production has a
rising opportunity cost.
• e.g. Raising health insurance coverage
from 10 to 20% may reduce the fullproofness of the U.S. defense system from
95% to 94%. But raising insurance
coverage from 90% to 100% could reduce
the readiness of the U.S. defense system
from 10% to 0%.
The PPC is concave.
A PPC for the Federal Gov’t (cont.):
National Defense vs. Health Care
Full-proofness of the
U.S. against terrorist
attacks
100%
Identical increases in
health insurance
coverage require larger
reductions in defense
readiness as more
resources are devoted
to insurance.
100%
% of Children covered
by health insurance
A PPC for the Federal Gov’t (cont.)

All points on the PPC are efficient, and
the point which is chosen will depend on
society’s preferences.

But is the optimal point “fair”??
 To
the poor?
 To those who would die in a terrorist
attack?
A PPC for the Federal Gov’t (cont.)

As we will see in this course, market
competition often leads to an efficient
allocation of resources.

However, a society which is also
concerned with equity can redistribute
resources, often using taxation.
 However,
taxation leads to inefficiencies.
 A tradeoff often exists between efficiency
and equity.
Economic Models

“Models are abstractions of reality and
are used in economics to simplify a very
complex world.”

Usually describes a hypothesized
relation between two or more variables.

Can be expressed in verbal, graphical,
or mathematical form.
Economic Models (cont.)

Example: We hypothesize that health
care expenditures are dependent upon
an individual’s income.
•
E = f(Y)
In stating this hypothesis, we assume
that all other likely determinants of E
(e.g. prices, tastes, preferences) stay
constant.
Economic Models (cont.)
• We can hypothesize that health care
expenditures are linearly related to
income.
E = a + bY
a = expenditures if income is zero.
b = slope of the expenditure function.
b = E/Y
Economic Models (cont.)
• We can quantify the linear relation
between income and health
expenditures.
E = 1000 + .1Y
$1000 = expenditures if income is zero.
• Each $1,000 increase in consumer
income raises health care expenditures
by .1*(1000) = $100.
Annual health care
expenditures per
household ($1000's) (E)
Health Care Expenditure Function:
E=1000+.1Y
8
7
6
5
4
3
2
1
0
0
10
20
30
40
50
60
Yearly income per household ($1000's) (Y)
Economic Models (cont.)
• The economic models states that
ceteris paribus, E=1000 + .1Y.
• We can incorporate changes in other
factors into the model as well.
• Suppose that the population has aged,
so that yearly medical costs rise by
$500 for the typical household.
Economic Models (cont.)
• We respecify the model as:
E = 1500 + .1 Y
• In our graphical representation of the
model, this represents a shift up in the
entire health care expenditure function.
Annual health care
expenditures per
household ($1000's) (E)
A Shift in the Health Care
Expenditure Function:
8
7
6
E1 = 1500 + .1Y
5
4
3
E0 = 1000 + .1Y
2
1
0
0
10
20
30
40
50
60
Yearly income per household ($1000's) (Y)
•We will rely on the results of multiple regression
analysis to quantify models like this in this course.
Positive and Normative Analysis

Positive analysis makes statements or
predictions regarding economic
behavior.
 What
is?
 What happened?

Normative analysis deals with the
appropriateness or desirability of an
economic outcome or policy.
 What
ought to be?
 Which is better?
Positive and Normative Analysis (cont.)

According to Becker and Murphy
(1988), a 10% increase in the price of
cigarettes leads to a 6% reduction in the
number of cigarettes consumed.

The government should increase the tax
on cigarettes to prevent people from
smoking.
Positive and Normative Analysis (cont.)

It is in our country’s best interests that
the federal government take a more
active role in the prevention of AIDS.

A study by Hellinger (1991) estimates
that the average yearly cost of treating
someone with AIDS is $38,300, while
the lifetime costs equal $102,000.
Positive and Normative Analysis (cont.)

To control health care expenditures, the
United States should adopt a national
health insurance program similar to
Canada’s.

National health care expenditures per
capita in the U.S. equaled $4,094 in
1998.
The Net Benefit Calculus

Economic models assume that
individuals are rational.
 People
can rank their preferences from
high to low, or best to worst.
 People never purposely choose to make
themselves worse off.
If expected benefits>expected costs for
a given choice, it is in the agent’s best
interest to make that choice.
The Net Benefit Calculus (cont.)
NB*(X) = B*(X) – C*(X)
X = choice or activity under consideration
NB* = expected net benefits
B* = expected benefits
C* = expected costs
B*(X) = Pr(X)•B(X)
1Pr(X)0
The Net Benefit Calculus (cont.)

Health care providers, government
agencies, and individual consumers use
such cost-benefit analysis to make
decisions.
 Explicitly
or implicitly.
Conclusion

Because resources are limited, health
economists are concerned with
determining what medical services to
produce, how they should be produced,
and who should receive them.

As we will see in this course, the tools
of economics can be applied to the
health care sector to derive valuable
insights about our health care system.
Industry Overview
Health Economics
Health Care Expenditures in the
United States, 1960-2001
1960
1970
1980
1990
1995
1999
2001*
Nominal health expenditures
(billions of dollars)
$26.9
73.2
247.3
699.4
987.0
1210.7
1424.2
Annual rate of growth
(average annual % change
from previous period shown)
Nominal per capita health
expenditures
--
10.6%
12.9
10.9
6.7
5.2
8.4
$143
341
1,052
2,690
3,686
4,358
5,043
Health expenditures as
percentage of GDP
5.1%
7.1
8.9
12.2
13.3
13.0
13.4
*Projected
Source: Health Care Financing Administration Homepage: http://www.hcfa.gov/stats/stats.htm
The Health Care Industry is
Rapidly Evolving.

Advances in medical technology and drugs
are dramatically improving patient care.
 But,

these improvements are costly.
Aging U.S. population.
% 65 years+
1950
8.1
1970
9.8
2000
12.7
The Health Care Industry is
Rapidly Evolving.

Increased cost containment efforts.
 Changes
in government reimbursement of health
care providers.
 Private insurers are exercising more control over
patient care.

Increased competitive pressures.
 Mergers
of existing providers.
 Entry of new competitors.
 Where
are the most promising business
opportunities?
HOSPITAL CARE

32% of all health care expenditures in 1999.

But insurers moved from cost-based
reimbursement to fixed price reimbursement
in the 1980’s.
 Slower

revenue growth
In order to attract patients, many hospitals
overspent on high-tech equipment.
HOSPITAL CARE

Improved surgical techniques led to shorter
stays in hospital after surgery, more
outpatient surgery.
 Lower
demand for hospital beds and operating
room time.
 1998 community hospital occupancy rate = 62.5%

A glut of hospital beds and high-tech services
has led to too many hospitals competing for
too few patients.
NYT 10/25/96
Modern Healthcare 2/8/99
If hospital revenues are shrinking,
which sectors of the industry are
growing?
America’s Top 100 Fastest-Growing Companies
FORTUNE, September 4, 2000
100
RANK
16
23
COMPANY
VISX
EPS
GROWTH REVENUES
(millions)
RATE
100%
$266.8
78%
$1968.4
WHAT THEY DO
Holds 150 patents for laser
technology, charges a perprocedure licensing fee.
Prescription-drug benefit
23
Advance
Paradigm
Forest
105 %
$959.9
Licenses drugs developed by
other companies & markets
them.
28
Minimed
71%
$252.1
30
Polymedica
48%
$156.9
30
Sunrise
124%
$280.6
Infusion pump worn like a
pager for diabetes patients to
avoid injections.
Sells diabetes-testing
equipment to seniors covered
by Medicare.
Assisted Living Homes
Laboratories
manager
Assisted Living
69
Biogen
60%
$881.1
Biotech drug company,
leader in MS drugs.
92
Impath
38%
$99.0
Collects and interprets
Cancer data
PHARMACEUTICAL INDUSTRY

U.S. prescription drug expenditures reached
$99.6b in 1999.

Industry highly dependent on research and
development (R&D).
 $300m

to bring a new drug to market.
Aggressive marketing to physicians,
hospitals, pharmacists, and even the patient.
PHARMACEUTICAL INDUSTRY

Merck
 $40.4b
in sales in 2000
 50% of sales come from Merck-Medco
(pharmaceutical benefits management)
 50% of human health sales come from 5
drugs: Vioxx, Zocor, Fosamax,
Cozaar/Hyzaar, and Singulair
WSJ 2/10/99
MANAGED CARE

Systems which manage the quality and
cost of patient care.

Most common:
 Health
Maintenance Organization (HMO)
Consumer pays a fixed annual capitation fee, for
which HMO agrees to provide comprehensive
medical services.
 60% of U.S. population (66.8m) enrolled in 2000.

MANAGED CARE

ADVANTAGE: If capitation fee > costs,
HMO keeps the profit.

DISADVANTAGE: HMO responsible for
cost overruns.
 Subject
care.
to lawsuits if provides sub-optimal
WSJ 2/17/98
Integration and Disintegration
On One Hand...
Between 1995 and 1998, over 2,800 hospitals were
involved in mergers, acquisitions, joint ventures,
long-term leases, and other partnerships.
Hospital Consolidation Trends
1,000
750
768
735
687
627
Facilities Involved
Number of Deals
500
250
230
235
217
198
0
1995
1996
1997
1998
Source: Modern Healthcare. January 11, 1999. “Deals” include mergers, acquisitions, joint operating companies, joint ventures, long term leases, and system
affiliations.
On the Other...
Who?
–
–
–
–
Allegheny Health,
Education and
Research
Foundation (AHERF)
At Their Peak…
Today…
345 hospitals throughout the U.S.
$20B in annual revenue
$1B in annual home-health revenue
Acquires Value Health (pharmacy, IT,
managed care services) for $1B
Sells off hospitals en masse in an attempt
to extinguish nearly $9B in debt
Sells off nearly all non-hospital businesses
– 13 acute-care hospitals throughout
Pennsylvania and in New Jersey
– St. Christopher’s Children’s Hospital
– Allegheny University of the Health
Sciences, including Medical College of
Pennsylvania
July 1998, filed for Chapter 11 protection
owing creditors over $1.5B
Philadelphia hospitals sold to Tenet
Pittsburgh hospitals to Western
Pennsylvania Healthcare System
– Over 7,500 physicians, with locations in
25 states
– $3.5B in net revenue
$1.2B net loss in 4Q 1998
Merger with PhyCor falls through
March 1999, California regulators seize
physician operations in the state
September 1999, renamed Caremark Rx
reflecting new focus on pharmaceutical
services; 12 physician practices remain
– Over 1.5M enrolled members
– $176.5M in earnings on $3.1B in net
revenue in 1996, increases of 90 and 75
percent over 1995, respectively
– Rated #1 in customer satisfaction in NY
for HMO and POS products
Computer glitch leads to nearly $1B in
losses in 1997-1998
Subpoenaed by the SEC and New York
state earlier this year to “review market
conduct”
LONG-RUN KEY TO SURVIVAL
Be
an efficient provider of highquality patient care.