EC248 oc: Midterm Review
Lesson 1 Introduction
WHAT IS HEALTH ECONOMICS?
Health economics is the application of standard economic tools as applied to issues in health and
health care. Simply but, health economics studies how scarce resources are allocated to, and
within, the health economy.
MEASURE OF HEALTH:
!! Life expectancy (at birth)
!! Infant Mortality
CAUSES FOR WHY PEOPLE GET SICK
Referred to as three determinants of health
1)! Individual-level determinants of health (focus on individual-level choices and actions)
!! Include two types: individual characteristics and individual behaviours
1.! individual characteristics (people cannot control)
•! person’s genetic make-up, a specific genetic mutation will determine with
certainty if a person will contract a disease
2.! individual behaviours (mostly can control)
•! these can expose them to a wide variety of health risks
•! people make decisions that have potential health effects
2)! Community-level determinants for health
!! Operate at a higher aggregate level beyond individual choices with respect to specific
behaviours.
•! Ex. public health investments in urban water systems, which deliver clean water to
households and remove and dispose of waste water in a safe manner
•! It is difficult for individuals to modify their behaviours in a way that will reduce the
risks associated with these determinants
•! Effectively addressing such determinants of health requires collective action because
the forces are largely driven by factors other than individual choices
3)! Interactions between individual-level and community-level determinants of health
!! They can reinforce or counteract each other
!! Evidence suggests that such interaction exerts some of the most powerful effects on
health
•! Ex. A genetic predisposition toward disease may only be triggered by exposure to an
environmental hazard, although both the genetic predisposition and the
environmental hazard each independently represent a risk to health, the combination
poses a particularly high risk
!! Individual choices are conditioned by the broader social, economic, and physical
environment in which people live. Whether to smoke is an individual decision, but one
strongly influenced by social attitudes toward smoking (highly socially undesirable,
subject to strong social sanction
) –reduce smoking rates
!! Individual determinants interact with the collective action to influence individual choices,
the distinction between individual-level determinants and community determinants
4! MAIN ASPECTS WITHIN HEALTH CARE SYSTEM: (WORK
FURTHER)
1)! Governance
!! Set of institutions that oversee the health care system: governance concerns who makes
what decisions through what processes.
!! The fact that in most countries the design of the health care system reflects a series of
explicit political choices, not simply the outcome of the interplay of market forces
(though such forces do exert influence)
!! CHA (Canada Health Act): primary object is “enforced” by the federal government
through transferring health care funding to the province. To receive a full allocation of
federal health care funding, a provincial/territorial health insurance plan must meet the
five pillars of the CHA
•! Comprehensiveness: Provincial plans must insure all medically necessary services
•! Universality: All provincial residents must be provided with health insurance
coverage on uniform terms and conditions
•! Portability: The provincial plans must cover provincial residents, even when they are
out-of-province
•! Accessibility: Insured persons must have reasonable access to medically necessary
hospital and physician services without financial or other barriers
•! Public Administration: The provincial plan must be publicly administered
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!! Provincial / territorial health insurance plans provide universal coverage for medically
necessary hospital and physician services. The implication is that health care is a
provincial responsibility (with some financial support from the federal government). As
such, each provincial health care system is overseen by its respective provincial ministry
of health which is responsible for the overall operation of the province’s health care
system.
!! Provincial public health insurance plans share many basic features, with variation in: (i)
the precise set of services that are publicly insured; (ii) the way providers are funded for
delivering care; and (iii) the nature of the settings in which care is provided.
2)! Financing
!! Refer to “financing health care”, we are referring to the activity of raising the revenue
requires to support the provision of health care. There are two basic ways: publicly &
privately
i.! Public finance refers to the activity of raising revenue through government
actions such as taxation or social insurance
•! Alternatively, social health insurance refers to a system of insurance through social
insurance organizations. A social insurance organization is normally quasi-public,
non-profit sickness fund. The government heavily regulates contribution rates,
membership, benefit packages, and other aspects of the social insurance
organizations activities.
!!
!!
!!
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ii.! Private finance refers to the activity of raising revenue through private
actions such as private insurance payments, out-of-pocket payments,
donations (health research, hospital non-patient revenue)
•! Private health insurance covers selected services not included in the
public insurance plan (e.g. prescription drugs, dental care,
physiotherapy, certain types of psychological counselling, etc.)
•! In Canada, private health insurance for these types of services is
usually provided as part of employment benefits package. Out-ofpocket spending is simply direct payments by individuals for the
receipt of a health care service. Out-of-pocket payments often arise
due to the absence of insurance, or due to cost-sharing within an
insurance plan. Cost-sharing can take the form of deductibles (i.e.,
pay the full cost up to the amount of the deductible), co-insurance
(i.e., pay a specified proportion of the cost of care), or co-payments
(pay a fixed dollar amount per unit of the service received).
The distinction between the source of finance (public vs. private) can have important
implications for things such as: (i) who bears what financial burden; (ii) who has access
to care; and (iii) the feasible methods of designing delivery systems.
Approximately 70% of total health care expenditures in Canada come from public funds
while the remaining 30% is financed through private sources (e.g., private insurance or
out of pocket payments).
More than 90% of total financing in two of the three largest sectors (hospitals and
physicians) comes from public sources. However, the second largest sector (drugs) is
mainly financed privately (64.2% of total expenditures).
An insured transaction now involves at least three parties: the purchaser (patient), the
seller (physician), and the insurer (health insurance provider). For any transaction, the
purchaser (patient) first contributes to the insurer (via taxes or premiums). When the
purchaser (patient) receives the good/service from the seller (physician), the insurer pays
the seller (physician). The presence of an insurer now creates two distinct money flows:
(i) individual to insurer; and (ii) insurer to provider. The separation into two distinct
monetary flows allows each to be treated as a distinct policy problem. It means the way
society finances health care (publicly vs. privately) can differ from the way it funds care
(i.e., how we pay the providers of care). The main point is that the presence of insurance
modifies incentives as purchasers no longer pay for care directly and providers know.
3)! Delivery – most of the delivery system is private, physicians, and hospitals are private
a.! Physicians (self-regulating profession) can be grouped into two
i.! Primary care physicians
ii.! Specialist physicians
iii.! a patient can only see most specialists after a referral from a primary care
physician
Governments can reimburse physicians in 3 ways:
1.! Fee-for-service (receive a fee each time they provide a
reimbursable services)
2.! Capitation (receives a pre-specified amount of money each
period (month or year))
3.! Salary (receives a specified annual amount of income)
b.! Hospitals ( majority of them were acute-care
general hospitals that treat
short-term illnesses)
4)! Regulation: Refers to the use of authority to guide or direct the behavior of individuals,
providers, and organizations in the health care sector.
a.! Market-led regulatory approach
Attempts to harness
competitive market to achieve social objectives in the
health care sector
b.! Non-market-led regulatory approach
De-emphasizes the role of competitive market forces by tightly controlling
markets, or supplanting
markets, to achieve social objectives in the health
care sector.
Questions:
1.! Insurance coverage likely has little impact on people’s use of needed health care services
2.! Reducing inequalities in health within the population should focus primarily on the
distribution of health care
3.! Because it increases GDP, increased health care spending is a sign of robust economy
4.! The variation in the design of health care systems is a sure sign of inefficiency
5.! The evolution of health care technologies causes the efficient design of a health care system
to change over time
Lesson 2 EFFICIENCY AND EQUITY
technical and cost-effectiveness efficiency require we maximize output produced from a given set of inputs (scarce
resources). Alternatively, allocative efficiency requires we maximize the benefits to society from allocating output
subject to how members of society value the output.
Marginal analysis identifies the optimal level of a good or activity by continually asking the question: What happens
if we do something just a little bit more or just a little bit less?
Efficiency in Production
Q=f (K,L)
Three different efficiency concepts:
1)! Technical Efficiency
a.! Producing the maximum quantity of output from the inputs used
b.! Ask “Is it possible to get more output with the same inputs? “ If yes, then
production is not technically efficient
2)! Cost-Effectiveness Efficiency
a.! Means to produce a good using the least-cost method of production from among
all technically efficient methods.
b.! An iso-cost line is simply a curve (usually a straight line) containing all of the input bundles that
cost the same amount
–Pk/PL = marginal rate of technical substitution
c.!
3)! Allocative Efficiency
a.! Simply refers to using limited resources to produce and distribute goods and
services in accord with the value individuals place on those goods and services.
Pareto Criterion
!! States it impossible to reallocate the resources so as to make at least one person better off
without making someone else worse off
Potential Pareto Criterion
!! States a reallocation of resources is allocatively efficient if the gains to the winners are
sufficiently large that the winners could compensate the losers and still be better off. The
potential pareto criterion does not require that the winners actually compensate the losers
Equity Analysis:
1)! Distributional Equity
a.! Is a situation in which the distribution of a good or a burden among members of
society is judged to be fair
Horizontal Equity: a type of distributional equity whereby those who are equal
with respect to an equity-relevant characteristic (e.g., income, need) are
treated equally
Vertical Equity: A type of distributional equity in which those who are unequal
with respect to an equity-relevant characteristic (e.g., income, need) are
treated in an appropriately unequal manner
2)! Procedural Equity
a.! Concerns the fairness of the process by which resources are allocated
b.! Is less commonly used in economics compared to distributional equity
c.! Is more commonly used in situations where the analysis of distributional equity is
not possible
Efficiency and equity
Social Welfare Function (SWF)
!! depicts how the overall welfare in society depends on the amount and distribution of
welfare among individual members of society.
!! The SWF defines the extent to which members of society stress the importance of the
total amount of welfare versus a more equal distribution of welfare determines the nature
of the social welfare function. The shape of the SWF depends on societies preferences.
Questions:
1. All production points on the production possibilities frontier are allocatively efficient
2. Scarcity of resources results from inefficiency
3. There is no opportunity cost for applications of resources that are technologically efficient,
cost-effective, and allocatively efficient
4. An equitable distribution of a good often implies an unequal distribution of the good among
members of society
5. A cost-effective allocation of productive resources must also be technologically efficient
6. Pareto-effective allocation always maximize welfare in society
7. Achieving an efficient allocation simultaneously ensures that society attains an equitable
allocation of resources
8. Efficiency is a value-laden concept
Lesson 3 THE BASICS OF MARKET
Markets as Institutions for allocating resources
Three kinds of conditions are necessary for market allocation to be efficient:
1. conditions in the broader environment in which a market operates
2. ethical principles consistent with the judgment that a person’s willingness to pay represents
the social value of a good or service
3. technical conditions within the market itself
Market Power
- refers to the ability (of a consumer or producer) to influence price
supply-side market power (monopoly power)
- can arise when firms cannot freely flow into or out of a market in response to profit
opportunities
- when a market cannot sustain a large number of producers
- barriers to entry or exit
Barriers to entry can arise from 3 sources:
1. Monopoly resources: A single firm owns a key resource
2. Government-created monopoly: the government gives a single firm the exclusive right to
produce the good (e.g. patents, copyright, law)
3. Natural monopoly: A single firm can produce the entire market output at lower cost than could
several firms (e.g. there are large fixed cost)
Demand-side market power (monopsony power)
- arises when there are a small number of purchasers
Information
A well-functioning market also requires both demanders and suppliers to have sufficient
information
Asymmetry of information
- participants on one side of a market (e.g., sellers) have more information relevant to a
transaction than do those on the other side(e.g., purchasers). Depending on the situation, either
sellers or purchasers may have an informational advantage
- Asymmetry of information is a source of market power as sellers can exploit their
informational advantage to influence for their services
Externalities
Externality
-refers to the costs imposed (or benefits gained) by individuals other than the individual or
organization that undertakes an action and which are not captured by a relevant market
Markets can allocate resources well only if producers and consumers consider all the effects of
their actions:
1. producers consider all the costs of production, including the use of any finite resource, even if
producer dose not have to pay for use of the resource
2. consumers consider all of the benefits of their consumption, including benefits that may accure
to individuals other than themselves
Rationales for Government Intervention in a Market
1. Market failure
2. Equity
Market failure
- is a situation in which an unregulated market generates an inefficient allocation of resources
Equity
-equity concerns can also justify government intervention
- a market outcome may be efficiency, but judged inequitable
It is important to distinguishing efficiency arguments from equity arguments for three reasons:
1. Efficiency arguments based on market failure generally carry more weight than equity
arguments. However, in some sectors equity concerns weigh as heavily as efficiency concerns
(e.g. Health Care)
2. Efficiency arguments are not effective policymaking
3. Policies aimed at creating both efficiency and equity effects often differ
The Mechanics of The Market
Individual Behaviour and Demand for Goods and Services
The economic model of consumer choice and demand provides a formal framework within
which to analyze how these and other factors affect demand for goods and services. It
emphasizes three factors:
1. what people care about
2. the goal they are trying to achieve through their choices
3. the constraints they face when making a choice
Utility
Diminishing marginal utility: a property of a utility whereby consuming more of a good
increases utility, but at a diminishing rate
Marginal utility: the increase in total utility associated with consuming one more unit of a good
Indifference curve: is a graphical representation of the utility function that represents the set of
all possible consumption bundles(x1,x2) that provide the same level of utility (Q)
Indifference curve map: is simply the complete set of all indifference curves
Budget constraints:
Consumption bundle: m (income) = P1 x1 + P2 x2
Budget line: a line simply a curve (usually a straight line) containing all of the consumption
bundles that cost the same amount
Utility Maximization
Thus, the utility maximizing consumption bundle occurs:
1.! On the highest indifference curve (e.g., U2).
2.! At the tangency between indifference curve and budget line:
Slopeindifference curve = slopebudget line
-P1/P2 = marginal rate of substitution
Ability to exchange good 1 for good 2 = Willingness to exchange good 1 for good 2
Income and Substitution Effects:
Income effect
- the change in the demand for a good caused by the change in real (price-adjusted) income
- increase income, shift the budget line outwards
Substitution (or pure-price) effect
- a change in the demand for a good caused by a change in the relative price of the good, when
real income is constant
Demand Curve
- a graph depicting the relationship between the price of a good and the quantity of the good
demanded, holding all other determinants of demand(e.g., income price of other goods) constant
- a non-price determinant, the price of other goods, consumer preferences, income, etc. therefore,
when anything other than the goods own price changes the demand curve shifts.
Elasticity
- measures the responsiveness of one variable to a change in the value of another variable;
- calculated as: E = (Percentage change in X) / (Percentage change in Y)
1. Own-price elasticity: responsiveness of quantity demand for a good (Q) to changes in its
own price (P)
2. Cross-price elasticity: responsiveness of quantity demand for one good (Qx) to changes in
price of another good (Py)
3. Income-elasticity: responsiveness of the demand for a good (Q) to change in income (I)
Inelastic: 0 <|E|< 1: one variable is relatively unresponsive to changes in another variable
of interest
•! Unit elastic: |E|= 1: a percentage change in one variable will cause an equal percentage
change in a second variable
•! Elastic: 1 <|E|: indicating that one variable is relatively responsive to changes in another
variable of interest
•!
Normal good: is a good for which the quantity demanded increases as income increases. Thus, a
normal good would have a positive income elasticity of demand (EI > 0).
Inferior good: is a good for which the quantity demanded decreases as income increases. Thus,
an inferior good has a negative income elasticity of demand (EI < 0).
From Individual to Market Demand
Market demand is simply the horizontal sum of the individual demands of all those participating
in the market.
Firm Behaviour and Supply of Goods andServices
Firm: Maximisation of Profits:
Profit = TR – TC
TR = Price x Quantity
The increase in total revenue associated with a one-unit increase in sales of a good is called
the marginal revenue
The increase in total output associated with a one unit increase in an input is referred to as
the marginal product
Diminishing marginal returns means that successive incremental additions of one input are
associated with successively smaller increases in total output, holding the amounts of all other
inputs constant.
The marginal cost tells use the increase in total cost associated with producing one more unit of
a good.
supply curve
- is a graph depicting the relationship between the price of a good and the quantity of the good
supplied.
- the supply curve is drawn under the assumption of holding all non-price determinants of supply
(e.g., input prices, production technology, number of sellers in the market) constant.
price elasticity of supply (Es) tells us how much the quantity supplied responds to a change in
price.
Market supply is simply the horizontal sum of the firm supply curves of all firms participating in
the market.
Putting Demand and Supply Together: A Market
Positive Economic Analysis of Market
Market equilibrium (P*, Q*): the price-quantity combination in a market at which there is no
tendency for price or output to change unless one of the determinants of demand or supply
changes
Normative Economic Analysis
Consumer sovereignty
: the assumption that consumers are best judges of their own
welfare, and that their decisions should determine the amount and distribution of goods in
society
Marginal private benefit (MPB): the marginal benefit obtained by the individual who consumes a
good
Marginal social benefit (MSB): the marginal benefit obtained by both the individual who
consumes a good and others in society who obtain external benefits
No externalities: MPB=MSB, MPC=MSC
Markets with Imperfect Competition
Monopoly:
- is a firm that is the sole seller of a product without close substitutes
- Price discrimination occurs when the firm charge higher price to consumers with a higher WTP
Monopoly arise because of barriers to entry:
1. government-granted monopolies (through patents, copy write, or trademarks)
2. monopoly resources (one firms controls a key resource in an industry)
3. natural monopoly (there are economies of scale over the entire range of output)
Monopolistic Competition
- is a market with many firms, selling differentiated products, and free entry, product
differentiation leads to market power (brand loyalty)
- has excess capacity which means they produce less than the quantity that allows them to charge
a price above marginal cost (charge a markup over marginal cost)
Oligopoly
- is a market with only a few (large) producers.
- each firm has some market power (given the small number of firms in the market
Question:
1. when there is a negative consumption externality for a good, the price that leads to an efficient
level of consumption is higher than the price that would from an unregulated private market
2. Demand and supply are assumed to be determined independently in market
3. If two individuals have identical preferences but differing amounts of goods, it is not possible
for both to benefit by trading between themselves
4. The inability of all individuals to buy DVD players constitutes an important source of market
failure
5. The supply curve for tomatoes is less elastic in the short-run than in the long-run
6. Other things equal, the welfare loss associated with a negative production externality for a
good is larger when the demand for the good is elastic than when it is inelastic
7. The introduction of Advil likely caused the demand curve for Aspirin to shift inward and
become more elastic
8. In a market with many producers producing similar goods, a firm will be able to create
significant profits by setting the price of its product higher than the equilibrium price
Lesson 4: Methods of Economic Evaluation
Economic Evaluation: is a systematic, comparative analysis of two (or more) courses of action in
terms of both their costs and their consequences in order to identify which is efficient
1) Systematic: analysis is done within a unified framework that articulates the relevant
components of the analysis, how they relate to each other and how the analysis should be
conducted
2) Course of action: a particular health care policy, program or intervention
3) Comparative: at least two alternatives are compared against each other. Cost are compared
against consequences. The alternatives being compared:
1. Requires two option or comparison with status quo or absence of program
2. Are essential as efficiency requires getting the most “output” from given “input”
Decisions before undertaking economic evaluation:
1)! The policy objective; what is the object we are trying to achieve
2)! The relevant policy alternatives; what are the most relevant alternatives as determined by
the policy objective
3)! The viewpoint: refers to the perspective adopted for an economic evaluation
a.! The adopted viewpoint will determine, for example, which costs and
consequences to include, if we adopt the viewpoint of all society, then all costs
and consequences should be included in the analysis, regardless of where or
whom in society they accrue
b.! The Ministry of Health, only costs paid or consequences felt by the Ministry of
Health would be included
After undertaking the 3 decisions, then begins the three basic stages of an economic evaluation.
1)! Identification of costs and consequences
a.! The enumeration
of all resources used and all the effects generated by, each
alternative being compared
- Health care sector (e.g. physician visits, hospital care)
- Patients and their family (e.g. providing informal care, transportation costs)
- Other sectors (e.g. social services, education)
2)! Measurement of costs and consequences
a.! Is the quantification
of the amount of each resource used and the effect
generated by each alternative being compared. Measurement is done in physical
units of every type of resource (paid/unpaid; medical/non-medical)
1. Resources: number, length and type of health professional visits; amount of
each type of health care equipment, goods and medical supplies consumed; the
quantity (e.g. square footage) of any facilities used by a program
2. Consequences: health-related effects (number of cases of a disease; number of
life-years of survival; dimensions of health-related quality of life(ability to
function) and non-health-health-related effects on patients and families (e.g.
change in hours of work)
3)! Valuation of costs and consequences
a.! Is the process of assigning the social value of the resources used and the effects
generated by each alternative being compared. The valuation of the resources
(costs)values the resources used at market prices. The valuation of consequences
is more complicated both conceptually and empirically
3 methods of Economic Evaluation:
Cost-effectiveness Analysis (CEA): Measures consequences in the natural units in which they
occur (E.g., life-years gained, cases prevented)
1. Assesses efficiency in terms of the cost per unit effect achieves, the results of a CEA can
be expressed as a ratio of the cost to the outcome
2. Incremental Cost-Effectiveness Ratio (ICER): expresses the results of a CEA as the ratio of
the difference in costs between two alternatives to the difference in the effects between the two
alternatives. ICERs are one answer to the question: does the additional cost justify the additional
benefit? ICER = (Cost A – Cost B)/(Effect A – Effect B)
Cost-Utility Analysis (CUA): Values health outcomes in terms of quality-adjusted life-years
(QALYS). A QALY is a measure that evaluates the effect of a health intervention on both the
quantity of life and the quality of life
1. QALY = (# of years) x (weight of health state)
2. Incremental Cost-Utility Ratio: ICUR = (Cost A – Cost B)/(QALY A – QALY B)
3. ICUR tells us the additional cost incurred per additional QALY achieved using
alternative A compared to alternative B
Cost-Benefit Analysis (CBA): Values health outcomes in monetary terms, the monetary value of
health effects is most commonly estimated using one of two basic approaches:
1. Human capital approach: values a health gain in terms of the accompanying increase in
a person’s market productivity, as measured by their wage rate
2. Willingness-to-pay: values a health gain in terms of the amount a person is willing to
pay to obtain the health gain
- Net benefit = (Benefit A – Benefit B) – (Cost A – Cost B)
- If Net Benefit > 0, implementing A would increase welfare for society
- If Net Benefit < 0, implementing A would lead to a welfare loss
Use of the Three Methods in the Health Sector
Common Analytic Challenges
Shadow Price: is the imputed value of a resource; assigned by an analyst when a market price
does not exist or does not reflect the true social cost of the resource
Double-Counting Cost or Consequences: it can be avoided only by careful design and execution
of a study
Discounting: how to account for costs and benefits that occur at different points in time
- Present Discounted Value: is simply the value (in today’s dollars) of a future, multi-period
stream of costs
- Present value: is calculated by determining how far into the future we are considering (t) and
interest rate(r)
-./.01'234.1
- present'value =
9:;
(670)
- present'discounted'value'of'costs =
6
E
/F6 (670)9:; ABCD/
- Rate of time preference: measures the extent to which individuals value benefits and costs that
arise in the future differently (usually less) than of they arise today
6
- present'discounted'value'of'benefits = E/F6
HIJIKLD/
9:;
(670)
Question:
1. Cost-effectiveness analysis id poorly suited for programs with multiple type of health
outcomes
2. A recent study by Health Canada which calculated the economic costs of leading diseases in
Canada constitutes an economic evaluation
3. An economic evaluation of the relative efficiency of two government program options does
not require any equity-related judgments
4.Economists generally recommend that economic evaluations be conducted from the viewpoint
of all members of society
5. Because it incorporates a subjective utility weight into the calculation of quality-adjusted lifeyears, cost-utility analysis can address questions of allocative efficiency
6. As an incentive to induce physicians to locate in under-served rural and remote areas, some
Canadian provinces pay physicians who locate in such regions a special fee premium (e.g., the
fee they receive for each service provided is 10% higher than the fee received by a physician
practising in an urban area). Because a physician visit is the same whether provided by physician
in an under-served area or by a physician practising in a city, an analyst was correct to assign the
same cost to all physician visits made by individuals enrolled in a treatment program being
evaluated
7. Other things equal, the higher the rate of time preference, the more attractive investments in
prevention programs will be from an economic point of view
8. The use of the net-benefit measure to summarize the results of a cost-benefit study follows
directly from the Pareto efficiency principle
9. By not discounting when aggregating benefits that occur at different points in time, it is
possible to avoid making intergenerational equity judgments
Lesson 5: Economics of Health
Individual-level Demand for and Production of Health
Health Captial Model
- an economic model of the individual-level demand for and production of health over a lifetime,
based on the assumption that health can be analyzed as a durable capital good
- Capital Stockt = Capital Stockt-1 - Depreciation + Investment
- Health Stockt = Health Stockt-1 - Depreciation + Investment
- The purpose of health capital model is to understand the individual’s life-long demand for
health and gain insight into how factors such as education, income, and age affect both the
demand for health and ways to achieve a desired level of health.
The main assumptions of health capital model are:
•!
•!
Health is one of many goods that provide utility
People are willing to trade off health against other things that also provide utility (within
bounds)
The Grossman’s Health Capital Model
- is the first unified framework developed by economists for analyzing both an individual’s
demand for health and their production of health and their production of health
-Assuming people desire health for three basic reasons
1. Good health provides direct benefits and enables them to undertake activities that
provide utility
2. Good health enables them to work more days in the labour market and earn a higher
income, which allows them to purchase more goods and services
3. Good health enables them to live longer, enjoying the benefits of their activities and
consumption for more years
- Derived Demand for Health Care: the demand for health care derives from the demand for
health
Mechanics of the Grossman Model
- the simplified utility function can be written as: U = U(ht,Zt)
(2)
- the stock of health capital is not consumed directly
- 3 sources of benefits flow from health capital:
1. Consumption Benefit: (ht) the number of healthy days in period t
2. Investment Benefit: a person is only productive on healthy days
3. Life Expectancy: an individual controls life expectancy (the # of periods n) by
increasing their stock of health
Gross investment in health: the amount of health produced is constrained by different
combinations of health care and time spent producing health: It = It(Mt;THt,Et)
where Mt is the quantity of medical care, THt is the time spent producing Ht, and Et
exogenously given stock of human capital
(3)
Production of a final consumption good: the amount of final consumption goods produced is
constrained by the quantity of market goods and time: Zt = Zt(Xt;Tt,Et)
(4) where Xt
are the market inputs used to produce Zt, Tt is the time spent producing Zt, and Et xogenously
given stock of human capital
Individual’s net investment in their health is given by: Ht+1 - Ht = It - δtHt
(5) where It
is gross investment (always assumed to be positive) and δt is the rate of depreciation of health
capital (we assume 0 < δt < 1) The depreciation rate is assumed to be exogenous, but increasing
with age.
Two key assumptions built into the production models:
1.! Human Capital (i.e., Education, denoted by Et) makes people more efficient
producers (both health and final consumption goods). Someone with more
education can produce more health with a given amount of time and health care
relative to someone with less education.
2.! The depreciation rate (δt) increases with age. Recall, the depreciation rate of
health capital is the amount by which health diminishes each period if an
individual does not invest in maintaining health.
Individuals make choices about how much time to invest in different activities, but are
constrained by the total amount of time available (Ω): TWt + THt + TLt + Tt = Ω
(6)
where TWt is the time spent working, THt is the time spent producing Ht, TLt is the time lost
due to illness, and Tt is the time spent producing Zt
The total amount of money spent must equal the present discounted value of goods purchased in
the market:
(7)
where Pt is the price of medical care(Mt), Vt is the price of Xt (the market inputs used to produce
Zt), Wt is the wage rate, and A0 is the individual’s initial wealth
Individuals choose Ht and Zt to maximize utility (equation (1)), subject to the household
production functions (equations (3) and (4)), their time constraint (equation (6)), and their
income/wealth constraint (equation (7)).
The solution to the Grossman model can be expressed by the following (admittedly complicated)
equilibrium condition:
(8)
where Gt is marginal product of health capital in producing healthy days, Uht is the marginal
utility of a healthy day, λ is the marginal utility of wealth, πt-1 is the marginal cost of gross
investment (and depends on input prices, Pt-1 and Wt-1), πt-1 is the change in the marginal cost of
gross investment between period t - 1 and t, and r is the interest rate. The equilibrium condition
in equation (8) is the basis for analyzing the impact of aging, wage rates, and education on the
optimal level of health capital and health care.
Thus, the equilibrium condition in equation (8) illustrates people demand health for two reasons:
1! Consumption Demand: Health provides a direct “consumption” benefits, as shown by the
second term on the left hand side of equation (8):
. Other things equal,
we all prefer to be healthy.
2! Investment Demand: good health increases the time available to work and generate income
(WtGt). Since a person’s stock of health capital depreciates slowly, investing in health
this year creates effects that persist many years into the future. When deciding the
optimal level of health in each year, individuals must take into account the effect of
health on lifetime utility.
Investment Demand for Health
we assume an individual’s demand for health derives only from the monetary benefits associated
with improved health (due to increased time available for work, or WtGt ≠ 0). We also assume
people derive no direct benefit from being healthy:
assumptions simplify the equilibrium condition in equation (8) to:
. These two
(9)
To graphically determine the equilibrium, we can draw a demand curve for health capital (to
represent the marginal benefit of a unit of health capital: WtGt)) and a supply curve for health
capital (to represent the equals the marginal cost of health capital:
). Figure
1 illustrates how we can analyze the investment demand for health and determine the optimal
level of health capital (H*).
A. Aging and the Optimal Level of Health
A change in the depreciation rate has no effect on the marginal benefit of health capital (since the
marginal benefit of a unit of health capital is WtGt) However, a change in the depreciation rate
will affect the marginal cost of holding health capital (since it is equal to
).
Thus, as shown in Figure 2, as a person ages and their depreciation rate increases, shifting the
supply curve of health capital up. The shift up in the supply curve (from S1 to S2) results in a new
equilibrium quantity of health capital that is less than before: H*t,0 > H*t,1.
B. Wage Rate and the Optimal Level of Health
An increase in a person’s wage (Wt) increases the marginal benefit of health capital (since the
marginal benefit of a unit of health capital is WtGt). However, an increase in a person’s wage
does not affect the marginal cost of holding health capital (since it is equal to
). Thus, as shown in Figure 3, an increase in a person’s wage shifts the
demand curve of health capital up. The shift up in the demand curve (from D0 to D1) results in a
new equilibrium quantity of health capital that is greater than before: H*t,0 < H*t,1.
C. Education and the Optimal Level of Health
an increase in a person’s level of education increases the marginal benefit of health capital.
However, an increase in a person’s education does not affect the marginal cost of holding health
capital. Thus, as shown in Figure 4, an increase in a person’s education shifts the demand curve
of health capital up. The shift up in the demand curve (from D0 to D1) results in a new
equilibrium quantity of health capital that is greater than before: H*t,0 < H*t,1.
Consumption Demand for Health
We assume better health provides no monetary reward through an effect on earnings (WtGt = 0).
Analyzing the consumption demand for health introduces a range of new considerations, such as
an individual’s rate of time preference (which can be thought of as the elasticity of substitution
between present and future consumption). The rate of time preference plays a role analogous to
the elasticity demand in the investment model.
A. Aging and the optimal level of health capital
If someone has a positive rate of time preference, this means they prefer the present to the future.
People with a high rate of time preference strongly prefer current health to future health. As we
saw above, aging and the associated increase in the depreciation rate of health capital (δ) cause
the optimal quantity of health capital (H*) to decrease over the life cycle. People with a high rate
of time preference will result in a faster decrease in the optimal quantity of health capital (H*).
B. Wage Rate and the optimal level of health capital
The impact of an increase in the wage rate (W) on the optimal quantity of health capital (H*) is
ambiguous. The effect depends in part on whether the production of health is more time intensive
(e.g., relies on exercising) or health-care intensive (e.g., relies on drugs).
If health production is time intensive, an increase in the wage rate will increase the relative price
of health compared with final consumption goods and decrease in the optimal quantity of health
capital (H*).
If health production is health-care intensive, an increase in the wage rate will decrease the
relative price of health compared with final consumption goods and increase in the optimal
quantity of health capital (H*).
C. Education and the optimal level of health capital
the Grossman model assumes more Human Capital (i.e., Education, denoted by Et) makes people
more efficient producers of both health (Ht) and final consumption goods (Zt). Being more
efficient in the production of Ht and Zt decreases the real cost of both Ht and Zt and increases an
individual’s real wealth.
However, if there are different productivity effects across the different goods this may induce a
substitution effect:
1.! If the productivity effects are equal across goods, only the income effect occurs. If the
demand for health increases with wealth, then there will be an increase in the optimal
quantity of health capital (H*).
2.! If the productivity effects are larger with respect to the production of health (Ht) than
with the production of final consumption goods (Zt), there will be both an income effect
and substitution effect. In fact, the income and substitution effect reinforce each other to
increase the optimal quantity of health capital (H*).
3.! If the productivity effects are larger with respect to the production of final consumption
goods (Zt) than with the production of health (Ht), the income effect and substitution
effect work in opposite directions. Their relative size determines the ultimate impact on
the optimal quantity of health capital (H*).
Therefore, the impact of an increase in education on health is not clear, and depends on the
values of a number of parameters.
Health Human Capital Model
The formal human capital model makes a number of unrealistic assumptions, such as:
Individuals do not have full and perfect information (over producing health, or the impact
of health on both income and utility), and
•! There is uncertainty regarding individual’s health status and the effectiveness of health
care
•!
By definition, a model is an abstraction from reality. The central issue is not abstraction versus
reality, but whether the model abstracts in useful ways. Does the model provide insight into the
relationships of interest? Most economists would judge the health capital framework a success as
it provides a structured way to think about individual-level demand for and production of health.
The Education-Health Gradient
A gradient simply refers to movement in one variable that is associated with movement in
another variable (throughout the relevant range of the variables).
Causation and correlation
While the education-health gradient is well documented, the underlying causes are not. From a
policy perspective, three questions are of particular importance with respect to the educationhealth gradient:
Does the positive gradient represent a causal relationship or is it a spurious correlation?
If the relationship is causal, to what extent does the causation run from education to
health or from health to education?
•! If education contributes importantly to health, what is the mechanism by which education
does this?
•!
•!
Sources of Spurious Correlation
A spurious correlation refers to two variables being are correlated, but neither is causally
related to the other. The positive correlation between education and heath would be spurious if it
was caused by a third factor (or set of factors) that influenced both health and education (e.g.,
genetic endowment, family life, and household wealth). One specific third factor economists
have focused on the rate of time preference. The positive correlation between education and
health may simply reflect variation across individuals in rates of time preference as people with:
Low rates of time preference (i.e., future benefits are not heavily discounted) invest a lot
today to achieve both high education and high health levels in the future.
•! High rates of time preference (i.e., future benefits are heavily discounted) invest
relatively little today and achieve both low education and low health levels in the future.
•!
Two conditions are necessary for the education-health gradient to be caused by the impact of
health on education:
1.! Health in childhood and adolescence must affect educational attainment (possibly
through absenteeism)
2.! Health in childhood and adolescence must affect adult health
Education is hypothesized to contribute to improved health in four ways:
1.! Education Affects Health Through the Income Effect: Higher education leads to
higher income in the labour market. Higher income could affect health status by
increasing demand for health as per Grossman’s human capital investment model, or
increasing demand for (and access to) health care.
2.! Education Improves Efficiency in Producing Health: Improving a person’s efficiency
in production enables them to choose a better, more efficient mix of health inputs.
3.! Education Changes Preferences: Education has the potential to change preferences in
ways that lead individuals to invest in better health (i.e. may lower their rate of time
preference)
4.! Education Improves Rank in the Social Hierarchy: Evidence increasingly indicates
that health status is strongly linked to rank in the social hierarchy. The higher a person’s
social rank, the better their health.
Health-related Behaviours
-emphasize how people respond to changes in relative money and time prices, changing patterns
of income, the economic returns of certain behaviours, and complementarity and substitute
relationships among behaviours.
Economics of Obesity
Obesity refers to the proportion of body weight that is composed of fat. The most common way
to measure whether a person is obese is using the Body Mass Index (BMI). The BMI is
calculated by taking a person’s weight (in kilograms) and divided by the square of their height
(in meters):
The larger the value of BMI, the more body mass an individual has for their given height.
Causes of the Obesity Epidemic
Hypothesis 1: Primal Tastes
Hypothesis 2: Increased Labour Force Participation by Women
Hypothesis 3: Changing Prices for Food and Meals
Economics of Smoking
Smoking as Irrational Behaviour
Irrational behaviour (in an economic sense) would mean peoples’ behaviour is not governed in
any rational way by assessments of risk, costs, or benefits. At first glance, this may seem
reasonable to think of smoking as an irrational behaviour since smoking behaviour tends to be
ruled by emotional responses, circumstances, and the immediate effects of consumption. Once
addicted, the individual finds it difficult or impossible to quit therefore consumption must defy
normal economic laws such as responsiveness to price.
The Rational Addiction Model
The Rational Addiction Model is an economic model of the consumption of addictive
substances that assumes people make fully rational choices. The model incorporates three salient
features of addiction
1.! Tolerance: assumes the higher the past rate of consumption, the less utility derived from
a specific level of current consumption
2.! Reinforcement: people consuming larger amounts of cigarettes derive greater utility
from the consumption of an additional cigarette than people who consume fewer
cigarettes
3.! Withdrawal: overall utility falls when the individual stops smoking
The Rational Addiction Model makes a number of predictions regarding the behaviour of
smokers:
1.! Current prices for cigarettes: an increase in the current price of cigarettes will decrease
the quantity of cigarettes demanded.
2.! Past prices and expected future prices of cigarettes: a change in the past or future
prices of cigarettes will affect current and future consumption of cigarettes. This arises
from the link between: (i) past smoking and current utility from smoking; and (ii) current
smoking and future utility of smoking. An expected increase in the future price of
cigarettes will decrease current consumption.
3.! Rate of time preference affects an individual’s responsiveness to the information on
the negative health consequences of smoking. Smoking rates have fallen most among
highly educated and high-income individuals since the negative health effects of smoking
have become widely understood.
4.! The most effective way to quit smoking will be to go “cold turkey”. Cold turkey refers
to the actions of a person who gives up their addiction suddenly. The model predicts that
gradual quitting does not work because an addicted smoker derives utility from smoking
a cigarette (recall that addiction raises the marginal utility of the next cigarette). The key
to quitting is reduce the marginal utility from smoking the next cigarette (i.e., break the
addiction), which can only be done “cold turkey”.
The Quasi-rational Addiction Model
The Quasi Rational Addiction Model is an economic model of the consumption of addictive
substances that assume people strive to be rational but suffer from biases in decision-making.
Specifically, people are assumed to be quasi rational because they have:
1.! Time-Inconsistent Preferences: rates of time preference in which judgments of what
will be optimal at a future time are no longer judged to be optimal when the time arrives,
even though nothing has changed but the passage of time. Such preferences can be
characterized by rates of discount that are not constant but which decrease the further an
event is in the future.
Time inconsistency can result from a number of biases in decision-making. For example, it is
always optimal for time-inconsistent individuals to quit “tomorrow”. Time inconsistency creates
intra-personal conflict whereby individuals always foil their best-laid plans. Sophisticated
individuals who know that they are time inconsistent anticipate this and use self-control or
commitment devices.
2.! Underestimate the probability of becoming addicted
3.! Misperceive the negative effects of smoking
The Quasi-Rational Addiction Model makes a number of predictions regarding the behaviour of
smokers:
1.! Current consumption depends on past and future prices: individuals are still forward
looking, are still subject to addiction, and still attempt to optimize
2.! Patterns of smoking behaviour the rational addiction model fails to predict: regret
over a previous decision to start smoking, unfulfilled promises to try to quit smoking,
failed attempts to quit smoking, and the use of commitment devices when attempting to
quit.
The Determinants of Population Health
Population health focuses on broader (non-individual) determinants of the level and distribution
of health in a population.
1. Economic Growth
Economic growth raised a populations living standards and improved nutrition. This had a large
effect on population health up until the early 20th century.
2. Public Health Initiatives
Public health initiatives arose in response to the terrible conditions in urban centers of
industrialized countries that had ended the decades-long increases in longevity (e.g., such as
sanitization and clean water etc.). There is good evidence to suggest health and social policies of
the public health movement played a major role in increasing health from middle of 19th century
to the early well into the 20th century.
3. Modern Medicine
Beginning in the 1920s and 1930s, the development of antibiotics, insulin, and vaccines launched
the era of modern medicine, which has been responsible for much of the increase in life
expectancy since the middle of the 20th century.
Health Inequalities
An aspect of the unequal distribution of health that is of great concern is the social gradient in
health: individuals of lower status experience worse health than individuals of high status. The
social gradient in health exists for different measures of socio-economic status (e.g., income,
education) and different measures of health (e.g., self-reported health status, chronic disease,
disability). The social gradient in health is not eliminated when everyone has access to good
housing, clean water, and decent nutrition (though all of these things help reduce the gradient)
and continues to persist in all societies and extends throughout the range of social status.
Question:
1.! Variation across individuals in rates of time preference is one possible explanations for the
observed correlations between smoking, education levels, and health levels.
2.! An increase in the demand for health always causes the demand for health care to increase.
3.! A recent study found that an expansion in MRI capacity in Canada (where MRIs are fully
insured by the public insurance system) was associated with an increase in the income gradient
in the use of MRIs. This increase in the income gradient in the use of MRIs is inconsistent with
predictions from the Grossman model.
4.! The unrealistic assumptions of the Grossman model invalidate its use as a tool for policyoriented economic analysis.
5.! People with a low rate of time preference will make only small sacrifices to current
consumption to achieve higher levels of consumption in the future.
6.! More-educated people tend to demand more health capital.
7.! Externality arguments are more compelling for government intervention to reduce obesity
levels than they are for policies to reduce smoking levels.
8.! Evidence that Canadians over age 65 make up 25-30 percent more physician visits each year
than those under age 35 is inconsistent with the predictions of the Grossman model that demand
for health decreases with age.
9.! Within the Grossman health capital framework, an increase in unearned income (e.g., a pension
for a retired person) would be expected to increase the demand for health.
10.!Unlike the rational addiction framework, within a quasi-rational addiction framework a
reduction in tobacco taxes is not expected to increase tobacco consumption.
Lesson 6 ( chp7): The Nature of Health Care as an
Economic Commodity
What is Health Care?
Define the subset of goods and services that constitute “healthcare” by focusing on:
i) the primary purpose of the good or service is to improve health
ii) whether the good or service is provided by a health care professional
iii) whether the good or service is provided through individual-exchange
Five characteristics of Health Care as an Economics Commodity
1. Derived Demand
2. Externalities
3. Informational Asymmetries
4. Uncertainty (in need and the effectiveness of health care)
5. Vulnerability of individuals at the time they consume health care
Derived Demand
Generally consuming health care causes discomfort, pain and short-term disability.
Health care must be demanded for what it produces: better health
Assume an individual’s utility is given by U= u(H(Z,HC),HC,X)
Where U=utility, H=health status, H()=the production function for health
Z= non-health-care goods, services, and activities that affect health status
HC= health care goods and services
X= the set of all other goods, services, and activities that provide utility
the partial derivative of utility (U) with respect to health care (HC):
The first term (∂u(.)/∂HC) is interpreted as the change in utility from a one unit change in health
care (i.e., the marginal utility of health care). To the extent we think people don’t like consuming
health care (as it may cause discomfort, pain and short-term disability), then (∂u(.)/∂HC<0). The
first term can be thought of as the direct effect of health care on utility.
The second term can be thought of as the indirect effect of health care on utility. We can think of
the indirect effect as the contribution of health care to health status (∂H(.)/∂HC), combined with
the contribution of health status to utility (∂u(.)/∂H). The contribution of health care to health
status (∂H(.)/∂HC)is simply the marginal product of health care (in producing health). The
contribution of health status to utility (∂u(.)/∂H) is simply the marginal utility of health.
The marginal utility of health (∂u(.)/∂H) is subjective and only known to the individual (i.e., it is
unobservable). However, the marginal product of health care in producing health (∂H(.)/∂HC) is
a technical relationship (generally established by medical research) and knowable by a third
party (i.e., it is observable).
The marginal product of health care (in producing health) (∂H(.)/∂HC) is a production
relationship, we can use our efficiency concepts (from Lesson 2) to assess consumption
decisions:
If ∂H(.)/∂HC = 0, then consuming health care will produce no benefit. Therefore, it is not
technically efficient.
•! If ∂H(.)/∂HC > 0, then consuming health care will produce more health (i.e., it is
technically efficient). However, if someone uses a higher-cost service (e.g., a brand-name
drug instead of a bio-equivalent generic), this would not be cost-effective. If an allocation
is not technically or cost-effectively efficient then it is not allocatively efficient.
•!
A good is judged to be needed if it meets two conditions:
1.! the good is effective in achieving a stated objective, and
2.! the objective has been judged as a legitimate reason for drawing on others’ resources to
attain the objective
If we think of health as a “commodity”, then health is a basic prerequisite for living (thus,
meeting condition 1) and often fails people randomly, for reasons beyond their control (thus,
meeting condition 2). However, other goods can satisfy these two conditions, but health care
differs. First, there is limited substitutability among health care services (which allows for a more
precise assessment of health care need). Second, people do not derive positive utility from much
health care. Health care needs can often be distinguished from wants. For example, we saw in
Lesson 1 the Canada Health Act strives to ensure equitable access to medically necessary
physician and hospital services. Health care is easily classified as necessary or unnecessary.
Externalities
Health care generates important externalities causing market failture
An externality of an economic transaction is the impact on a party that is not directly involved
in the transaction. The presence of externalities leads to inefficient market exchange (as ignoring
externalities yields a socially sub-optimal levels of exchange).
Alternatively, an externality means market prices do not reflect the full costs or benefits in
production or consumption of a product or service.
Two specific types of externalities:
1.! Selfish Externalities physical
A selfish externality is a health-related externality in which even a purely selfish person
cares about others’ consumption of health care because such care reduces the chances
that a communicable disease is spread. Selfish externalities provide an economic
rationale for public provision/subsidization of public health services (such as
vaccinations). We can observe this through public health interventions responsible for
increases in health and well-being (such as the response to outbreaks of SARS, Avian
Flu, H1N1, and Ebola).
2.! Caring Externalities
A caring externality is a health-related externality that arises when a person cares about
the health status of others and, consequently, their consumption of needed health
care. Caring externalities provide rationale for public role in the financing, organization,
and delivery of needed health care. Distinguishing between needed and non-needed
health care provides an economic rationale for public finance for medically necessary
health care services (as in Canada). For example, an ultrasound to verify the health of a
fetus is publicly financed, while an ultrasound to generate 3D pictures to show relatives is
privately financed.
Informational Asymmetry between Patients and Providers
Think for a moment about why a patient would visit a health care provider: patients normally
seek two types of information from providers:
1. Diagnostic Information
What is wrong with me?
2. Treatment Information: Given the diagnosis, what should I do to restore my health?
Informational Asymmetry occurs when one party to a transaction has more information
pertinent to the transaction than does the other party (the better-informed party may exploit the
less-informed party)
If any informational problems exist in a well-functioning market, such problems are at least
symmetric between both buyers and sellers.
The efficient level of health care consumption (where marginal benefit equals marginal cost)
requires two distinct kinds of information:
1. The expected impact a health care service will have on health. Health care providers
tend to have better information regarding how health care affects your health (as shown
by the term
).
2. The value to the individual of that health improvement. Patients know best how
improvements in their health will affect their well-being (as shown by the term
).
Both types of information must be integrated to make good decisions regarding health care
utilization. When both are not integrated, a health care market generates inefficient outcomes as
individuals may fail to obtain care because they are not well informed about its effectiveness, or
they may purchase care they would not have purchased if they had more information, or they
may purchase care of differing quality than expected.
The costs of acquiring information are high for patients because:
1.! Learning by Gathering Information: technical complexity of medical information.
2.! Learning Through Experience: risky to learn by unnecessary trial and error; difficult
when undergoing a treatment; uncertainty of effectiveness.
3.! Counterfactual Problem: the difficulty in knowing what the outcome would have been
had an alternative course of action (the counterfactual) been pursued. To learn from
experience, a person has to know what could have happened had they not obtained health
care.
Uncertainty regarding need and effectiveness
Uncertainty in the need for health care arises due to the random occurrence of illness and injury
(for the most part).
For individuals, the demand for health care and health care expenditures are highly uncertain
leading to an individual’s demand for health care insurance. Health care insurance has the
potential to make people better off by reducing the financial risk of illness. However, health care
insurance complicates the operation of health care markets
Uncertainty in the effectiveness of health care arises from not knowing the effectiveness of a
particular treatment on a specific individual. The medical research demonstrating the efficacy of
a particular health care treatment only demonstrates effectiveness ‘on average’. Medical research
does not demonstrate the effectiveness of a treatment for a particular individual.
Vulnerability at Time of Consumption
People must often make health care decisions in highly stressful contexts which may
compromise their ability to make rational decisions in times of need for care as their sense of self
may be under assault from disease, injury, or the health care itself
The patient’s vulnerability affects their ability to make thoughtful, reasoned choices assumed by
economics. This can affect the ethical, equitable allocation of health care or the mechanisms by
which society governs access to and the allocation of health care resources. This heightens
concern for fairness and ethical standards in care process and in allocation of resources.
Is Health Care Different?
The five characteristics of health care (discussed above) are not unique to health care. For
example:
The demand for schooling is a derived demand (for knowledge, for employment).
Externalities arise in other settings (e.g., caring externalities arise in social policy, the
justice system)
•! Informational asymmetry arises in automobile repair and financial services
•! Insurance for many goods (housing, automobiles, life) reflects the uncertainty in many
aspects of our lives
•!
•!
What makes health care unique is the simultaneous presence of all these characteristics.
Questions:
1. Uncertainty regarding the effectiveness of a specific health service for a particular individual
is an important reason why patients have difficulty assessing quality of care
2. A finding that Canadian hospitals are technically inefficient in producing operations is a good
example of the kinds of efficiency analysis possible in health care that are not possible in other
sectors
3. The problem of information asymmetry in health care markets can undermine the normative
interpretation of the demand curve as representing marginal benefit
4. Regulations that prohibit people from obtaining certain medications except by physician
prescription are most likely a response to informational asymmetry
5. Doctors who act as perfect agents for their patients will always provide care that is expected to
improve patients’ health
6. The Internet has eliminated problems of informational asymmetry in health care
7. A physician’s ability to influence the consumption of health care services arises from
externalities
8. Uncertainly regarding the effectiveness of a car repair is less than that associated with health
care treatment
9. If we define a health care service as “needed” when the expected health effect for a person is
positive, the society should ensure that all health care needs are met
10. The concept of “need” in health care derives from the presence of externalities in health care
markets
FINAL:
Lesson 7
Chp8
: The Demand for Health Care
Need, Demand and Utilization:
1. Need: health care need does not depend on an individual’s preferences. It does depend on;
(i) an individual’s health status, (ii) the availability of an effective health care that can
improve health, (iii) social judgment about what constitutes a need vs. a want.
2. Demand: Is the expression of a desire to obtain health care. Demand for health care
depends on an individual’s preferences and resources
3. Utilization: the quantity of health care consumed. The demand for health care determines
utilization. Utilization is often the only one of the three that is directly observable.
Failure to distinguish among need, demand, and utilization can to poor policy analysis:
1.! Health human resource planning
Health human resource planning (i.e., determining the quantity of physician or nonphysician labour to supply) often accepts observed patterns of utilization as representing
need. However, equating utilization with need fails to appreciate that need is only one
determinant of observed utilization. This will, potentially, underestimate the demand for
health care services, leading to an under-provision of health human resources.
2.! Analyses of income-related inequity of health care utilization
Studies looking at income-related inequity of health care utilization (i.e., how the use of
health care services differs between high-income and low-income individuals, controlling
for other determinants of utilization) often find a pro-rich bias (even when care is free).
The finding high-income people use more health care services (even though they are
generally in better health) assumes the cause lies with system barriers. However, this
approach fails to recognize some of the pro-rich bias may arise from differences in the
demand for health care by those of differing incomes.
Demand for Health Care within the Standard Economic Framework
The standard demand framework is general enough to be used to analyze demand for different
types of health care, such as: (i) all health care, (ii) a broad sets of services (such as physician
services, hospital services, dental services, drugs, or long-term care), (iii) a specific subset of
goods or services within sectors (such as family physician vs. specialist services, prescription
versus non-prescription drugs, specific classes of drugs such as cholesterol-lowering drugs), or
(iv) specific products or services (such as MRI scans, a particular brand of cholesterol-lowering
drug). The type of health care analyzed will affect the relative importance of different
determinants on demand.
When deciding whether to demand health care, economists assume people:
•!
•!
•!
•!
pursue their own well-being in light of their health status
have preferences regarding their health, health care, and other goods
know the prices of all goods and services
know their financial and other constraints
We can formalize an individual’s demand for health care by writing out their demand function.
The demand function highlights how an individual’s demand for health care is determined by
factors such as: (i) their preferences (over health, health care, and other goods), (ii) the price of
health care (PHC), (iii) the price of substitute goods (PSub), (iii) the price of complementary goods
(PComp), (iv) the individual’s income, (v) the individual’s health status (HS), and (vi) the health
care provider:
DemandHC = F(Preferences; PHC; PSub; PComp; Income; HS; Provider)
Preference, prices and income are all perfectly standard determinants. The presence of health in
the demand function simply reflects the derived nature of demand for health care. The presence
of “provider” reflects the potential for a health care provider to influence demand because of
asymmetry of information. We will examine each determinant in turn and discuss how they
affect an individual’s demand for health care.
Preferences: over health, over health care, and toward risk
!! Preferences over health: how much a person values good health
!! Preferences over health care itself: some people dislike being poked and prodded by a
health care professional, staying in a hospital, and other aspects of health care consumption.
Other things equal, such people demand less health care
!! Preference regarding risk (risk attitude): health care outcomes, both positive and negative,
are inherently uncertain. Deciding whether or not to obtain care often requires weighing
positive and negative risks. Some individuals are more willing to risk a negative outcome
for the chance to improve their health; others are less willing to risk, and in the same
situation prefer a more conservative, watchful-waiting approach.
First, an individual’s demand for health care will be affected by their preferences over health,
health care, and other goods. An individual’s preferences over health simply refer to how healthy
an individual prefers to be. An individual’s preference over health care simply refers to how
strong a preference an individual has towards consuming health care.
One of the most important preferences, is an individual’s preference regarding risk (e.g., their
risk attitudes). Risk attitude is the extent to which a person likes or dislikes risk. Since health
care outcomes, both positive and negative, are inherently uncertain some individuals are more
willing to risk a negative outcome for the chance to improve their health (risk-loving). Others are
less willing to take a risk (risk-averse). Some individuals are indifferent towards taking a risk
(risk-neutral).
Price of Health Care
Second, the price of health care includes both the monetary price and the non-monetary price of
consuming health care. The monetary price is the financial cost of obtaining a health care
service. The non-monetary price of health care includes other costs incurred by the patient. For
example, there are time costs associated with travel to the clinic, waiting for an appointment,
receiving care itself, and recovery from care. Differences in non-money prices can play a
particularly important role in the choice among alternative providers or services.
In general, when the price (monetary or non-monetary) increases the quantity of health care
demanded decreases. This follows the law of demand.
We can measure the impact a change in price has on the change in quantity of health care
demanded using the own-price elasticity of demand. Note, in practice the money price often
depends on the patient’s insurance coverage (although, an individual’s level of insurance
coverage can be the result of personal choice where individuals who expect to need a lot of
health care are more likely to purchase health care insurance that provides generous coverage).
Price of Substitutes/Complements
The third determinant of demand is the price of substitutes or complements.
As the price of substitute goods decreases, the demand for health care decreases. For example,
assume the health care service “psychotherapy” can be provided by a psychiatrist (MD) or a
clinical psychologist (PhD). Since psychiatrist services are often insured more generously than
those of a psychologist (Ppsychiatrist < Ppsychologist) then the demand for psychiatrists is greater than
the demand for psychologists. As another example, some services are covered as a hospital inpatient but not as an out-patient or in the community. This may result in admitting people who
do not really need to be hospitalized to obtain free access to services.
As the price of complementary goods decreases, the demand for health care increases. For
example, prescription drugs and physician visits are complementary health care goods (since you
need to visit your physician in order to get a prescription). Thus, as the price of prescription
drugs increases, the demand for physician visits will decrease. As another example, the costs of
immunosuppressant drugs (needed by a transplant recipient) can exceed the cost of the transplant
itself. Thus, the price of drugs can influence demand for transplants.
The key to understanding patterns of health care utilization requires we consider all relevant
prices. This is particularly important because insurance coverage varies across different
providers and services in health care.
Income
The fourth determinant of demand, income, exerts influence on demand in three ways:
1.! Individual (or household) income or wealth is a primary determinant of the ability to pay
for health care (except where people can obtain care free of charge).
2.! The investment demand for health care (as discussed in Lesson 5) is positively related to
an individual’s earning ability. Recall, the Grossman model finds the higher an
individual’s earning capacity, the more value is placed on good health status (because the
value of lost work time is higher).
3.! The time cost of obtaining care increases with an individual’s income.
Estimates of the income-elasticity of demand for health care are positive but small, ranging from
0.2 to 0.6 (which means a 10% increase in income results in a 2% to 6% increase in the quantity
of health care demanded). The estimates are consistent with health care being a necessity (where
demand is determined primarily by health status). The relatively small estimates of the incomeelasticity of demand may be due to health care consumption being subsidized by insurance. The
estimates still suggest health care is a normal good, but is relatively income inelastic.
Aggregate cross-national studies find income (per capita) is the most important determinant of a
country’s health care spending (per capita). Estimates of aggregate income-elasticity of demand
are about 1.0 (which means a 10% increase in a country’s per capita income results in a 10%
increase in the quantity of health care demanded). At the aggregate level, health care is unit
elastic.
The relatively low estimates of individual-level income-elasticities and the relative high
aggregate elasticities are not necessarily incompatible. At the individual-level, the budget
constraint is substantially relaxed because health care consumption for most individuals is
heavily subsidized by insurance. However, at the national-level the budget constraint always
binds (since a country cannot purchase health insurance the same way an individual in the
country can).
Health Status
Health status is generally the single most important determinant of an individual’s demand for
health care. As health status decreases (i.e., an individual becomes sicker) then their demand for
health care increases
.
Health status also plays a role distinct from other determinants. Health status affects the
relationship between other determinants and health care demand (interaction effect). For
example, how responsive demand is to the price of health care, the price of
substitutes/complements, or income depends on how sick someone is.
Strengths and Limitations of the Standard Model of Demand
Overall, the standard demand model provides a useful tool to think about the demand for health
care. It provides a structured way to think about the effect of different determinants (the price of
health care, the price of complementary/substitute goods, income, and health status) on an
individual’s demand for health care.
However, as useful as the standard model of demand can be, it suffers from a serious limitation:
assumes no informational problems. We have briefly discussed the existence of informational
asymmetry between patients and providers. Which means, the standard demand model likely has
limitations when applied to certain types of health care. If we integrate information asymmetry
into the analysis, some of the principal conclusions of the standard framework may no longer
hold. The standard model must be used carefully, with a full understanding of its limitations in
health care. Where necessary, it must be modified to accommodate special aspects of health care
markets.
Informational Asymmetry and Demand for Health Care
Information Asymmetry gives Physicians Market Power: Potential for Supplier-induced
Demand
In the health care market, the interaction between patient and provider is an agency relationship,
where the provider acts as an agent for the patient given their informational advantage. The
provider has more information than the patient (by design) and may exploit their agency
relationship and use their information advantage to influence the patient’s demand for their
service. The phenomenon of providers influencing demand is referred to as Supplier-Induced
Demand (SID). At its most general, SID refers to an individual’s demand for care that arises at
least in part from the influence of the individual’s care provider.
Different definitions of SID fall roughly into two categories:
1.! Positive Definitions: stress simply the ability of physicians to shift the demand curve (for
better or for worse).
2.! Normative Definitions: stress the financial self-interest of physicians in providing
unnecessary services.
Perhaps the most commonly cited definition of SID is very much in this spirit: services are
provided in response to economic self-interest (of the provider), but a patient with the same
knowledge as the provider would not demand.
Labelle et al. (1994) stressed the heterogeneous nature of SID. Most forms of SID are efficient
and desirable: the provider, acting as agent, recommends needed care that a poorly informed
patient would not otherwise have demanded. In this case, the physician’s motive does not matter
as the delivery of good-quality, effective care may or may not be motivated by self-interest.
Labelle et al. recommend investigations of SID ask two questions:
1.! Would the patient have demanded the service if he or she had the same information as the
physician? (i.e., the effectiveness of the agency relationship)
2.! Did the service contribute positively to the patient’s health status? (i.e. the effectiveness
of the services provided)
If the answer is ‘yes’ to both questions, then the physician acted in the patient’s interest. The
patient’s health was improved (which is a good outcome). However, if the answer is ‘no’ to first
question, but ‘yes’ to the second then the physician and patient disagree. The services do
improve health, but the patient does not value those health gains. This type of care may
commonly arise near the end of life. If the answer is ‘yes’ to the first question and ‘no’ to the
second, then the outcome reflects poor information on the part of the provider, the patient, or
both. Finally, if the answer is ‘no’ to both questions, then this approaches the pejorative type of
SID where the provider is not acting as agent, and is recommending services that are ineffective
or even harmful.
Implications of Supplier-induced Demand
The consequences of SID differ depending on the type of inducement. Most health economists
acknowledge physicians have the power to shift demand (Feldman and Morrissey 1990), the real
question though is to what extent do physicians use their power?
There would seem to be two crucial issues:
1.! Where does such inducement fall in Labelle et al.’s Framework for Supplier-Induced
Demand?
2.! Can physicians systematically exploit this power for their own economic advantage (and
potentially to the detriment of patients), especially in response to health care policies?
Much of the empirical literature on supplier-induced demand focuses on issue 2.
Supplier-induced demand and positive economic analysis
Predictions of the impact of many types of policies, including physician supply policies, payment
policies and patient cost-sharing, may be misleading unless the possibility of supplier-induced
demand is taken into account.
Asymmetry of Information and the Normative Interpretation of the Demand Curve
Asymmetry of information undermines consumer sovereignty and the normative interpretation of
the demand curve, even if one accepts in principle willingness-to-pay as a measure of value.
Undermines standard approach to assessing insurance-induced changes in health care
consumption in response to price changes.
Individuals demand for Health care (CHANGES):
Will be affected by their preferences over health, health care, and other goods.
Price of health care includes both the monetary price and the non-monetary price, which
consists of waiting for an appointment, receiving care itself, and recovery from care.
As the price of substitute goods decreases, the demand for health care decreases
As the price of complementary goods decreases, the demand for health care increases.
Prescription drugs & Physician visits
th
4 determinant, Income; exerts influence on demand in three ways:
Individual income is a primary determinant of the ability to pay for health care
(except where people can obtain care free of charge)
Investment demand for health care is positively related to an individual’s earning
capacity, the more value is place on good health status
The time cost of obtaining care increases with an individual’s income
Standard demand model provides a structure way to think about the effect of different
determinants (price of health care, price of complementary/substitute goods, income,
health status) on an individual’s demand for health care.
Suffers from a serious problem; doesn’t assume any informational problems
(asymmetry problems)
The provider has more information than the patient and may exploit their agency
relationship and use their information advantage to influence the patient’s demand for
their service. The phenomenon of providers influencing demand is referred to as
Supplier-Induced Demand (SID) referring to an individual’s demand for care that arises
at least in part from the influence of the individual’s care provider (physician).
Lesson 8 (
Chp9): The Demand for Health Care Insurance
The Demand for Health Care Insurance
Most illness and injury is unpredictable, making health expenditures difficult to budget for
(particularly since health expenditures can be very large). Thus, it has become important to
devise mechanisms to reduce the financial uncertainty with respect to illness and injury while
helping to finance large expenditures. Mechanisms (such as insurance) to reduce the financial
risk associated with illness and injury can increase welfare.
We will first discuss the benefits associated with insurance, why people demand insurance, and
the nature of the benefits derived from insurance.
3.1 Definition of risk
Risk is present when we are uncertain whether an event will happen. The amount of risk a
person faces is determined by two factors: (i) the probability of an event occurring; and (ii) the
potential size of the loss (or gain) associated with the event.
For example, if a person faces two lotteries:
1.! 95% chance of winning $10,000 and a 5% chance of winning $0
2.! 50% chance of winning $10,000 and 50% chance of winning $0
We would say the risk is greater in second lottery.
3.2 Risk Pooling
Risk pooling occurs when each member of a large group contributes a small amount (of money
or effort) to the “pool” in return for the promise that, if a specified risky event happens to one of
the members, money from the pool will be used to compensate the individual for the loss
experienced. Risk pooling does not just share risks, it reduces the total risk borne by the group
and the risk reduction is a source of welfare gain.
For example, assume 100,000 people form a risk pool. Each member of the risk pool has a 20%
chance of falling seriously ill (costing thousands of dollars on health care). For each person, the
outcome is uncertain. However, for the group we know approximately 20,000 will become ill
(more certain). Now, assume the 100,000 people pool their risks through a collective insurance
agency. Note this does not eliminate the individual’s health risk but it does eliminate their
expenditure risk since the insurance company will compensate an individual if they get sick.
Because the number of group members who will get sick can be predicted with accuracy, the
insurance agency does not bear much risk. This simply example illustrates the basic principle of
insurance.
Not all risks can be pooled. Only risks that can be traded among individuals can be pooled. As
you may note from the above example, people in the risk pool were only able to pool their
financial risk. Each individual still faced the risk of becoming ill (since health cannot be traded
among individuals). Health risks, therefore, cannot be pooled (nor can many other aspects of
illness, injury, and disability).
How effective a risk pooling is will depend on three factors:
1.! Size of the risk pool. Generally, a larger risk pool is preferred. The optimal size of the
risk pool depends on the nature of the underlying risks (i.e., the probability of loss and
the size of loss).
2.! Independence of risks across members of the risk pool. It is important for
illness/injury for one person in the risk pool not to materially affect the probability of
illness/injury for another person in the pool.
3.! Independence between having insurance and the size of loss. For example, it is
important the health care a person receives when ill is the same whether or not they have
insurance. If the presence of insurance affects the size of loss, this is called moral
hazard. Moral hazard can potentially bankrupt the risk pool.
3.3 Demand for Insurance
To start thinking about why people might demand insurance, we will first introduce an
economic model of the demand for insurance. The idea is to formalizes the intuitive ideas
about the benefits of risk pooling (as discussed above) and provides a framework for
analyzing important aspects of insurance and insurance markets.
At its core, the economic model of the demand for insurance assumes: people know all
possible outcomes, the probability of a specific outcome, and the monetary loss (or gain)
of a specific outcome. To be clear, assuming a person knows the monetary loss of a
specific outcome we simply mean they know the financial cost associated with a bad
health outcome. This is sometimes referred to as the monetary equivalent of the loss.
The Standard Insurance Model
As with most economic models, we first assume individuals have a utility function that describes
their preferences. In this model, we assume individuals care only about their absolute level of
wealth: U=U(W). We assume individuals know the expected value of a gamble and they proceed
to make choices that maximize their expected utility. The expected value of a gamble is the sum
of the probability of event i (denoted by pi) multiplied by the value (in monetary terms) of the
event i (denoted by Vi ):
Similarly, the individual’s expected utility is the sum of the probability of event i (again, denoted
by pi) multiplied by the utility of the event (denoted by Ui):
While the summation operator used to calculate the expected value and the expected utility may
look complicated, think about the case where there are only two events being considered (i.e.,
n=2). Then expected utility from the two possible events simply becomes:
Expected Utility = p1U1 + (1 - p1)U2
Since the probability of event 2 occurring is simply 1 minus the probability of event 1 occurring
(i.e., p2= 1 - p1).
Example 1
Assume for a given lottery, a person has a 60% chance of winning $30,000 (i.e.,p1=0.6 and V1 =
30000) and a 40% chance of winning $50,000 (i.e., p2 = 0.4 = 1 - 0.6 and V2 = 50000). Assume:
U1 = 173 and U2 = 224. Thus, the expected value of this lottery is $38,000 and the expected
utility of this lottery is 193. You can see this easily from the following calculations:
Expected Value = p1 V1 + p2 V2 = 0.6 X 30000 + 0.4 X 50000 = 38000
Expected Utility = p1U1 + p2U2 = 0.6 X 173 + 0.4 X 224 = 193
Given the above example, you may notice there is uncertainty regarding which of the two events
will occur. With the uncertainty comes risk. At this point, you may ask how a person’s attitude
towards risk affects their choices. Recall, a person can have one of three risk attitudes:
3! Risk Averse: a person who prefers a certain level of wealth over a risky alternative with the
same expected value.
4! Risk Loving: a person who prefers a risky alternative with a given expected value over a
certain level of wealth equal to the expected value.
5! Risk Neutral: a person who is indifferent between a certain level of wealth and a risky
alternative with the same expected value.
If an individual is faced with the choice among different risk options, their risk attitude will
influence the choice they make regarding risk.
Example 2
Assume an individual is offered a choice between two gambles.
Gamble 1: $38,000 with certainty. Thus, the expected value of gamble 1 is $38,000.
Gamble 2: The same gamble from Example 1: a 60% chance of $30,000 and a 40% chance of
$50,000. Thus, the expected value of gamble 2 is $38,000.
Note: both gambles have the same expected value. However, gamble 1 has no risk (since it
provides $38,000 with certainty), while gamble 2 has risk. Which gamble would an individual
choose? It depends: an individual’s degree of risk aversion will tell us whether they prefer
gamble 1 or 2 (or if they are indifferent).
•! A risk averse person would prefer $38,000 with certainty, as there is no risk involved.
•! A risk neutral person would be indifferent (as both gambles have the same expected value).
•! A risk loving person would choose gamble 2, as there is some risk involved.
How does our discussion up to this point (regarding gambles, risk, and risk attitudes) relate to
health insurance? Let’s reframe Example 1 in the context of an individual who faces (financial)
risk from becoming ill. Assume the individual has a specific utility function and they only care
about their absolute level of wealth: U = u(W) = √W (this specific functional form will give us a
specific shape to their indifference curve over wealth). Their initial wealth is $50,000 and they
face a 60% chance of becoming ill. If they become ill, they will lose a total of $20,000 (in lost
wages, the cost of care, etc.). Note this is the same gamble as Example 1, we have just changed
the description slightly. Figure 1 provides a graphical representation of this gamble.
Figure 1: Graphical representation of Utility over wealth
The loss from becoming ill is $20,000 (the difference between $50,000 and $30,000). However,
the expected loss from the gamble is only $12,000. The individual receives the highest level of
utility from $50,000 (point A), and the lowest level of utility from $30,000 (point B). In this
example, the level of utility they derive from the expected value of $38,000 (point D) is less than
the utility from $50,000 but more than the utility from $38,000.
If we extend this graph by drawing a line segment connecting points A and B, as shown in
Figure 2, we can graphically represent the expected utility from the two possible events (having
$50,000 or having $30,000). Note this comes from the formula for expected utility, which is just
a linear function of the probability of being ill: Expected Utility = p150000+(1 - p1)30000.
Figure 2: Graphical Representation of Expected Utility
Note that point C is the level of expected utility the individual derives from the gamble with a
60% probability of becoming ill. We can confirm from the above graph that a person with the
utility function U = √W is risk averse. Why? Since point C is below point D, this means the
person receives more utility from a certain outcome of $38,000 then the expected utility from a
gamble with an expected value of $38,000. That is, given example 2 above a risk averse person
would prefer $38,000 with certainty, as there is no risk involved.
Now the question becomes, should the person in the above example buy insurance? Insurance
can make them better off (given by the distance between points C and D). However, the person
will only buy insurance depending on the price of insurance. Assume the price of insurance is
equal to the expected loss: $12,000. This price is referred to as the actuarially fair premium. If
the person is charged the actuarially fair premium, they will be left with a certain level of wealth
of $38,000 (point D).
Would an insurance company charge the actuarially fair premium? No. The insurance company
has loading costs (i.e., the administrative costs associated with providing insurance) that they
would need to cover. No insurance company can survive unless it charges a premium that covers
both the expected losses and the loading costs. Which means, they must charge a price (or
premium) greater than the actuarially fair premium. So, would a person be willing to pay a
premium above the actuarially fair premium? Again, it depends.
A risk averse person prefers the certain outcome (point D) to the uncertain outcome with the
same expected value (point C). They are also willing to pay some amount of money to eliminate
the risk (in addition to the actuarially fair premium). This amount of money is called the risk
premium. Figure 3 illustrates the risk premium the individual is willing to pay.
Figure 3: Graphical Representation of the Risk Premium
Why is the individual willing to pay a risk premium? The utility of the after-risk-premium
certain wealth (point E) is equal to the expected level of utility with no insurance (point C). The
individual is willing to have lower wealth with certainty than higher wealth with risk.
The welfare gain of risk pooling through insurance arises from individual’s who are risk averse
and willing to pay to avoid risk. The greater a person’s risk aversion, the larger the welfare gain
from insurance. Why? The greater a person’s risk aversion is represented by more curvature in
their utility function. More curvature increases the vertical distance between points C and D
(which represents the welfare gain from insurance to the individual). Similarly, the greater the
level of risk, the larger the welfare gain from insurance (recall, the level of risk varies with the
size of the loss and the probability of the loss).
Limitations of the Standard Insurance Model
The standard insurance model (which is really an expected utility model) may not always
accurately reflect how individuals make decisions in risky situations for a number of reasons:
1.! Implies individuals view gains and losses symmetrically. This relates to the idea
of Loss Aversion: a tendency to prefer to avoid losses rather than accruing gains, when
making decisions under uncertainty. The standard insurance model assumes gains and
losses (of the same size) are viewed the same way (i.e., individuals are not loss averse).
2.! Implies the magnitudes of the gains and losses do not matter. Assume a gamble with a
50-50 chance of winning $10 and losing $10 is equivalent to one with a 50-50 chance of
winning $100,000 and losing $100,000. The standard insurance model assumes both
gambles are viewed the same, even though the second gamble has much larger
gains/losses.
3.! Sensitivity to how a gamble is framed. Often people’s choices change when two
formally identical problems are posed differently (like what we discussed above when we
reframed Example 1 in a health context).
4.! Risk reduction is the only source of welfare gain. It has been argued those who buy
insurance may purchase insurance for benefits other than risk reduction. For example, see
the textbook’s discussion (page 239) by John Nyman.
5.! Insurance may have an access motive. Once specific benefit Nyman suggests is
the access motive: benefit of insurance that arises because insurance enables an
individual to obtain extremely high-cost care to which they would otherwise not have
access. See the textbook’s discussion (page 241) on the access motive.
Nature of Insurance Contract
The standard insurance model discussed thus far posits an individual purchases full insurance to
cover all the costs of care. However, most health insurance contracts do not cover the full cost of
care. In fact, individuals are often required to pay part of the cost (called cost-sharing). Cost
sharing can take several forms:
Deductibles: require an individual to pay the full cost of care up to the amount of the
deductible. (e.g., the first $100 per year on all prescription drug expenditures).
•! Co-insurance: requires an individual to pay a specified proportion of costs (e.g., 20% of
the total cost of prescription drugs).
•! Co-payments: require an individual to pay a fixed amount for each unit of care
consumed (e.g., a charge of $5 per prescription).
•!
Some policies may even limit the benefits they provide. This is referred to as a Coverage Limit:
some insurance contracts specify that once the dollar amount of benefits paid to an individual by
the insurer reaches a certain amount, no further coverage is provided.
In practice, informational problems (such as not knowing the probability of illness, or the size of
the loss from illness) are often present and make it impossible for insurance companies to
calculate each individual’s actuarially fair premium. One way insurance companies deal with this
problem is through risk adjustment: the process by which insurers adjust premiums to reflect
observable characteristics of an individual that are associated with expected health care costs.
Currently, risk adjustment remains relatively crude as it only relies on a small set of
characteristics (such as age, sex, and certain chronic conditions). Premiums for which no risk
adjustment is performed are called community-rated premiums: insurance premiums for which
there is no risk adjustment; the premium is the same for everyone.
Risk Pooling: occurs when each member of a large group contributes a small amount of money
to the ‘pool’ in return for the promise that, if a specified risky event happens to one of the
members, money from the pool will be used to compensate the individual for the loss
experienced. How effective a risk pooling is will depend on:
1. Size of the risk pool; generally a larger risk pool is preferred depending on the nature
of the underlying risk
2. Independence of risks across member of the risk pool
3. Independence between having insurance and the size of loss: it is important the health
care a person receives when ill is the same whether or not they have insurance. Moral
hazard if the presence of insurance affects the size of loss
Standard Insurance Model:
Risk Averse: Avoids risk at all costs
Risk loving: Risks > Wealth
Risk neutral: Not bother by either
Standard insurance model may not always accurately reflect how individuals make decisions in
risky situation for a number of reasons:
Implies individuals view gains and losses symmetrically, tendency for loss aversion
Implies the magnitudes of the gains and losses do not matter
Assume a gamble with a 50-50 chance of winning $10 and losing $10 is
equivalent to one with a 50-50 chance of winning $100,000 and losing $100,000.
The standard insurance model assumes both gambles are viewed the same.
Sensitivity to how a gamble is framed
Peoples choices change when two formally identical problems are posed
differently
Risk reduction is the only source of welfare gain
Insurance may have an access motive
Benefit of insurance that arises because insurance enables an individual to obtain
extremely high-cost care to which they would otherwise not have access.
Cost sharing: often required to pay additional costs with insurance
Deductibles:
1.! Require an individual to pay the full cost of care up to the amount of the
deductible
Co-insurance: requires an individual to pay a specified proportion of costs
Co payments: require an individual to pay a fixed amount for each unit of care
consumed.
Lesson 9(
Chp10): Private Insurance Markets
Private Insurance Markets
Private markets for health care insurance developed in the early part of the twentieth century.
They expanded greatly in the decades following World War II (particularly in the United States).
As the effectiveness of medicine to cure illness and injury grew, so did the view that all citizens
should have access to necessary health care. This, in turn, spurred the analysis of markets for
health care insurance.
As you may have notice in our discussion above, the standard insurance model requires both
individuals and insurance companies to have enough information on the risk being insured
(specifically, enough information on the probability of becoming ill and the size of the loss when
ill). Given the information needed, it may not be surprising private markets for health insurance
inherently suffer from forms of market failure. We will discuss four specific sources of market
failure:
1.!
2.!
3.!
4.!
Moral hazard
Risk selection
Economies of scale in insurance provision
Missing (or incomplete) markets for insurance
Moral Hazard
Recall, the standard insurance model assumes insurance coverage does not influence the size of a
person’s expected loss. Moral hazard refers to the tendency of insurance coverage to change
behaviour and, thereby, changing the expected value of the loss (i.e., change the expected costs
of health care). A commonly used phrase to describe this situation is “free care may lead to
frivolous use”.
Most health insurance plans decreases the price beneficiaries pay for health care. Individuals
with insurance respond to a lower price by using more health care than they would if they did not
have insurance. If the individual values such insurance-induced care below societies cost of
producing the care, the additional consumption is inefficient.
There are two types of moral hazard economists are concerned with:
1.! Ex ante moral hazard: insurance-induced changes in behaviour that alter the probability
of an insured event occurring. Ex ante moral hazard is less of a concern with respect to
health insurance as individuals are unlikely to take greater health risks just because they
have insurance. Ex ante moral hazard is more of a concern with respect to insurance on
material possessions (e.g., house, car, etc.).
2.! Ex post moral hazard: insurance-induced changes in behaviour that alter the insured
loss after the insured event occurs. Since insurance lowers the price of health care;
individuals consume more health care than they would if they were not insured.
Standard Analysis of Moral Hazard
Mark Pauly (Pauly (1968)) introduced the standard analysis of moral hazard. Pauly’s analysis of
moral hazard treats health care as a standard economic commodity exchanged in perfectly
competitive markets (i.e., no externalities, symmetric information, etc.).
The value of health care consumption is measured using willingness-to-pay as measured by the
area under the health care demand curve (i.e., the way we measure value in the standard
economic model for a standard economic commodity). If you refer to section 10.1.1 in the
textbook, you will find a great discussion walking you through Pauly’s analysis. In particular,
pay attention to Figure 10.1.
From a societal perspective, insurance has two counteracting welfare effects:
1.! The social welfare gain of insurance. The risk reduction for individuals through
insurance and the ability for insurance to provide greater access to care make society
better off.
2.! The social welfare loss of increased utilization of health care.
The design for optimal insurance coverage balances these two counteracting welfare effects of
insurance. The answer usually is partial insurance, or demand side cost-sharing and that full
insurance coverage can never be optimal (because it does not account for the second welfare
effect from increased utilization).
The key assumption of Pauly’s analysis is that health care markets are no different than other
markets. Thus, the implied policy solution is demand side cost-sharing (make people pay part of
the cost of the care they obtain). But as we previously discussed (in Lesson 6), health care has a
number of features that can distinguish it from a standard economic commodity. Therefore, the
validity of the standard assumptions in the standard economic model (used to analyze moral
hazard) is questioned and may invalidate welfare analysis based on them.
Combating Moral Hazard from the Supply-side
Supply-side approaches to combat moral hazard tend to target policies at providers in an attempt
to ensure that only necessary, effective care is provided. Combating moral hazard from the
supply side is motivated by two main reasons:
1.! Providers possess the knowledge and information required to judge when a service is
necessary and to selectively reduce use of low-benefit care
2.! Providers themselves can be a source of moral hazard (i.e., supplier-induced demand
(SID))
Three main approaches used to combat moral hazard from the supply side (as discussed in the
textbook):
1.! Gatekeeper Model of Access
2.! Managed Care Model
3.! Capacity-Constraint Model
Risk Selection
The second source of market failure in private insurance markets is risk selection. Recall, the
standard insurance model assumes an insurer charges each individual a premium exactly
reflecting the person’s true financial risk status. However, in reality risk adjustment (whereby an
insurer adjusts premiums to reflect a person’s expected health care costs) is imperfect.
Imperfect risk adjustment causes no problems as long as neither the individuals themselves nor
the insurer know more about a patient’s true risk status relative to the average within a risk class.
A risk class is where individuals are classified by an insurance agency as having the same risk
(based on observable characteristics) and are each charged the same premium.
With imperfect risk adjustment, insurers will then charge all individuals with the same
observable characteristics the same premium equal to the average risk status of people with those
characteristics. However, observationally equivalent people do not all have the same risk
statuses.
However, if individuals have better information about their risk status than does an insurer, or if
the insurer has better information than the individuals, the informational asymmetry can give rise
to risk selection.
Risk Selection is the phenomenon whereby an insurer’s risk pool systematically attracts
individuals of either below-average or above-average risk status given the premiums charged.
Two types of risk selection that can occur:
1. Adverse Risk Selection: when an insurance pool systematically attracts individuals of
above-average risk status within a risk class
2. Favorable Risk Selection: when the insurance pool systematically attracts individuals
of below-average risk status. Favorable risk selection is also known as “CreamSkimming” or “Cherry Picking”.
Example 3: Market Failure Cause by Adverse Selection
Assume there is one risk class with 5 (observationally equivalent) members. However, each
member of the risk class has a different individual risk status (i.e., annual expected health care
costs). Individual 1 expects health care to cost them $10 in the coming year. Individual 2 expects
health care to cost them $50 in the coming year. Individual 3 expects health care to cost them
$100 in the coming year. Individual 4 expects health care to cost them $200 in the coming year.
And, individual 5 expects health care to cost them $500 in the coming year. Figure 4 provides a
graphical depiction of the example.
With all 5 members in the risk class, the annual expected health care costs for the risk class is
$172 (=(10+50+100+200+500)/5 = 860/5). Now assume the insurance company charges a
premium of $172, which is exactly equal to the annual expected health care costs for the risk
class.
If you are person 1, would you pay a premium of $172 to insure against your cover your annual
expected health care costs of $10? Likely not. So, person 1 would drop out of the risk pool. With
person 1 removed from the risk pool, the annual expected health care costs for the remaining 4
members of the risk class increase to $212.50 (=(50+100+200+500)/4 = 850/4).
Now, if you are person 2, would you pay a premium of $212.50 to insure against your cover your
annual expected health care costs of $50? Again, likely not. So, person 2 would drop out of the
risk pool. With person 1 and 2 removed from the risk pool, the annual expected health care costs
for the remaining 3 members of the risk class increase to $266.67 (=(100+200+500)/3 = 800/3).
This process (sometimes referred to as the insurance death spiral) continues until the entire risk
pool breaks up.
Figure 4: Hypothetical example of Market Failure caused by Adverse Selection
Policies to Combat Adverse Selection
Policies to combat adverse selection usually entail either better risk adjustment or better
definitions of risk pools to prevent adverse selection.
Better risk adjustment is of only limited effectiveness as even the most sophisticated approaches
to risk adjustment are crude (leaving considerable scope for selection problems) since too many
risk factors associated with health care expenditures are unobservable. Fully risk-adjusted
premiums raise important equity concerns, such as those with higher risk are of lower income
and least able to afford high premiums.
Better definitions of risk pools could be done by, say, selling only group insurance policies. By
definition, all members of a group are automatically included (and can not opt out). For example,
private health care insurance provided as a benefit of employment.
Group policies enable the insurer to reduce administrative costs compared to selling individual
policies. Employer based insurance can effectively combat adverse selection, but it can have
important negative side effects. For example, insurance effectively becomes available only to
those who are employed in positions that offer such benefits. People who do not work, work
part-time, or work in low-wage jobs without health insurance benefits will not be covered.
Relying on employer provided insurance could also reduce the efficiency of the labour market by
impeding the mobility of workers. This is a phenomenon is referred to as job lock.
Favorable Risk Selection(Cream-Skimming)
Up to this point we have focused our discussion on how adverse selection leads to market failure.
However, the other type of risk selection (favorable risk selection, or cream skimming) can also
create market failures. Favorable risk selection can occur in two ways:
Exploiting an Informational Advantage: an insurer may be able to assess a person’s
risk status better than the individual since insurers have access to the basic characteristics
and utilization histories of millions of beneficiaries).
•! Strategic Policy Design: an insurer can strategically design and market insurance
policies that induce individuals to sort themselves according to their risk status. This can
include using a high deductible and a more limited range of service coverage to attract
relatively low-risk individuals. Alternatively, providing a comprehensive policy with
generous coverage may attract relatively high-risk individuals. Private insurers can
market policies to selectively attract low-risk individuals (free health club memberships
to new members).
•!
Favorable risk selection constitutes a market failure as insurers spend real resources in a way that
is socially wasteful as it simply redistributes income from patients to insurers. Favorable risk
selection is normally addressed through regulation. For example, prohibiting insurers from
refusing insurance to an applicant on the basis of health status or restricting the types of
insurance policies that an insurer can offer.
Risk selection can also be eliminated through universal, single-payer insurance systems. Since
risk selection arises from the voluntary choices of either individuals or insurers, a universal,
single-payer insurance systems eliminate such choice. A couple of examples of a universal,
single-payer insurance system:
Canada: every resident of a province is covered by the public insurer for medically
necessary physician and hospital services
•! United Kingdom: residents are covered by the National Health Service (NHS)
•!
Eliminating risk selection is therefore one important economic rationale for universal, singlepayer insurance systems.
Economies of Scale
Economies of scale refer to a situation in which the average cost of production falls as
output rises over most of the relevant range of production in the industry. The provision of
insurance is subject to large fixed costs that generate economies of scale (e.g., calculating
risk-adjusted premiums must be done regardless of the number of people covered). The
optimal size of an insurance firm will depend on factors such as: the risk being insured, the
regulatory environment.
There is little evidence on the optimal size of an insurance firm. Large markets (e.g., the
U.S.) can likely sustain a competitive market with insurers that exploit economies of scale.
However, smaller markets (e.g., Canada) will likely have to rely on insurance provided by
either a large number of small firms, regulation of a small number of large firms, or public
insurance.
Missing Market for Insurance Against Premium Increases
The nature of the problem when insurance contracts must be renewed each year: risk of
becoming a “high-risk” beneficiary in future and having to pay increased premiums. Once
you get a chronic illness, insurance premiums often increase drastically. For example, ask
someone who just suffered a heart-attack how much their health insurance or travel-health
insurance will now cost them.
The missing market here is “premium insurance”. That is, the market for insurance that
would cover you from possible increases in future insurance premiums. In a universal,
single payer, public insurance system (e.g., Canada) a person’s contribution to support
public insurance depends primarily on their income level, not their risk status. Therefore, in
a universal, single payer, public insurance system, there is no concern of increased
premium payments from becoming a high health risk.
Moral Hazard
a. Ex ante moral hazard: insurance-induced changes in behaviour that alter the
probability of an insured event occurring. Ex ante moral hazard is less of a concern
with respect to health insurance as individuals are unlikely to take greater health risks
just because they have insurance. Ex ante moral hazard is more of a concern with
respect to insurance on material possessions (e.g., house, car, etc.).
b. Ex post moral hazard: insurance-induced changes in behaviour that alter the
insured loss after the insured event occurs. Since insurance lowers the price of health care;
individuals consume more health care than they would if they were not insured.
c. Insurance has 2 counteracting welfare effects:
2.! Social welfare gain of insurance. The risk reduction for individuals
through insurance and the ability for insurance to provide greater access
to care make society better off
3.! The social welfare loss of increased utilization of health care
b.! Combating moral hazard from the supply side has 2 reasons
1.! Providers possess the knowledge and information required to judge
when a service is necessary and to selectively reduce use of low-benefit
care
2.! Providers themselves can be a source of moral hazard (i.e., supplierinduced demand (SID))
3.! Gatekeeper model of access
4.! Managed care model
5.! Capacity-constraint model
4)! Risk Selection
a.! An insurer charges each individual a premium exactly reflecting the person’s true
financial risk status.
b.! A risk class in where individuals are classified by an insurance agency as having
the same risk and are each charged the same premium
c.! If individuals have better info then the insurer about their risk status or if its vice
versa, then informational asymmetry can give rise to risk selection.
d.! Risk selection is the phenomenon whereby an insurer’s risk pool systematically
attracts individuals of either below-average or above-average risk status given the
premiums charged
1.! Adverse risk selection: when an insurance pool systematically attracts
individuals of above-average risk status within a risk class
2.! Favourable risk selection: when the insurance pool systematically
attracts individuals of below-average risk status. Favourable risk
selection is also known as cream-skimming
1.! Exploiting an informational advantage: an insurer may be able to
assess a person’s risk status better than the individual since
insurers have access to the basic characteristics and utilization
histories of millions of beneficiaries
2.! Strategic Policy Design: an insurer can strategically design and
market insurance policies that induce individuals to sort
themselves according to their risk status
3.! Risk selection can also be eliminated through universal, singalpayer insurance systems. E.g NHS in england
e.! Policies to combat adverse selection:
1.! Better define the risk pools; selling only group insurance policies, all
member of the group are automatically include and can’t opt out
2.! Group policies enable the insurer to reduce administrative costs
compared to selling individual policies, employer based insurance can
effectively combat adverse selection but it can have important negative
side effects. Example: Insurance only becomes available to someone
who is employed in positions that offer such benefits, people who do not
work will not be covered. Relying on employer provided insurance
could also reduce the efficiency of the labour market by impeding the
mobility of workers. This is a phenomenon is referred to as job lock.
3.!
5)! Economies of Scale
6)! Missing markets for insurance
a.! The nature of the problem when insurance contracts must be renewed each year;
risk of becoming a ‘high-risk’ beneficiary in future and having to pay increased
premiums. Insurance often rises after heart attacks etc.
b.! “premium insurance’ market, market for insurance that would cover you from
possible increases in future insurance premiums.
c.! A persons contribution to support public insurance depends primarily on their
income level, not their risk status. Therefore, in a universal, single payer, public
insurance system, there is no concern of increased premium payments from
become a high health risk
Lesson 10 (
Chp11&12): Flow of funds within a health care system.
There are three principal means by which funds flow within a health care system:
•!
•!
•!
Financing: raising the monies required to pay for the operation of the health care system.
Funding: the allocation of revenue to alternative activities within the health care sector
Remuneration: compensation to individuals employed in the health care sector
Efficiency and Equity in Pure Private and Pure Public Systems of Finance
Before we begin, there are three caveats to mention about the analysis:
1.! Pure private and pure public systems of finance can each include a tremendous variety of
possible designs. For example, private finance systems can rely on private insurance or
out-of-pocket payments. The private insurance systems can vary with respect to the
calculation of premiums, regulations, etc. Public finance systems can use taxes or social
insurance contributions. The public finance system can vary with respect to the types of
taxes, structure of the tax schedules, regulation, etc. Specific systems of health care
finance must be evaluated on a case-by-case basis.
2.! Judgments of efficiency and equity on aspects of financing depend on the chosen
normative framework. If we use the standard welfare economic framework (where
benefit is assessed by willingness-to-pay) will result in different conclusions than if we
used an extra-welfarist framework (where benefit is assessed by health benefits).
3.! It will be helpful to familiarize yourself with alternative sources of finance (see Table
11.1 in the textbook)
Efficiency in the system of finance itself
When thinking about judging efficiency in the system of health care finance, we think in terms of
its technical and cost-effectiveness efficiency with respect to collecting revenue, and allocative
efficiency in responding to the risk preferences of members of society.
Technical efficiency and cost effectiveness requires the financing method should minimize the
administrative costs per dollar of revenue raised. In this light, public insurance financed through
the tax system is generally more cost effective than is private finance as the cost per dollar raised
in tax-financed systems is generally less. This is due to the ability of revenue collection to
piggyback on the already established infrastructure for collecting taxes. Tax finance avoids the
cost of calculating premiums and related charges to individuals. By this standard, single-payer,
tax-financed systems can substantially reduce administrative costs incurred by providers.
Allocative efficiency requires the consumption of health care insurance conform to people’s
preferences (risk and the income transfers associated with insurance). Where such preferences
vary importantly across individuals a voluntary, multi-payer (multi-plan) private insurance
system is more allocatively efficient than a mandatory public insurance system. Hence, public
and private systems of finance suffer from allocative inefficiency in risk-pooling:. However, if
one system is more allocatively efficient is an empirical matter and depends on the distribution
of risks and risk preferences in society and the extent of market failure in private insurance
markets.
Efficiency in the Market for Health Care Services
How health care is financed also affects allocative efficiency within the market for health care
services since financing influences the:
•!
•!
•!
Prices of health care services
Provider options concerning delivery of services
Patterns of health care consumption
Thinking about how private or public finance affects the efficiency of utilization depends, in
part, on your judgment regarding the operation of health care markets and how serious are
market failures. Specifically, what your judgment is regarding the magnitude of externalities, the
degree of imperfect competition in health care markets, and the normative framework of
analysis.
If we look at pure private finance, say through private health insurance with cost-sharing, this
may be judged to be more efficient if we think health markets as closely approximating perfectly
competitive markets and the individual willingness-to-pay is the appropriate metric for assigning
the social value.
Alternatively, if we look at pure public finance, this may be judged to be more efficient if we
view externalities, imperfect competition, and income effects as important; and if we think health
gain is the appropriate metric for assigning the social value to utilization.
Under a single-payer public approach (like in Canada), supporters argue it is better able to
control moral hazard (by removing plan choice from individuals and insurance companies). It
has been argued to better target resources in line with health care needs. However, critics
highlight the allocative inefficiencies associated with wait-times.
An important note on wait-times: wait-times are not an inherent feature of public systems. Wait
times allocate care on the basis of time, much like price would allocate care in monetary
terms. Focusing on wait-times and wait-lists alone misses the fundamental issue for allocative
efficiency: are individuals able to obtain services for which the social benefit is greater than the
social cost? For example, in the U.S. there are no published wait-lists, yet there is a lack of
access to health care for the uninsured (or under-insured) which constitutes allocative
inefficiency.
Health Care FINANCE: focuses on how we raise the monies required to pay the operation of
the health care system
Efficiency in the Broader Economy
Finally, how health care is financed also affects efficiency in the broader economy. Two
commonly cited effects on allocative efficiency outside the health care sector are; i) efficiency in
the labour market; and ii) general welfare losses associated with taxation
Private health care finance can affect efficiency in the labour market, private insurance
markets, can influence a number of labour market outcomes, including:
1. Job mobility among workers (Job lock)
2. Decisions to enter or exit the work force
3. Wages
4. Hours worked
5. Retirement decisions
All of these effects can reduce labour mobility and allocative efficiency in the labour
market.
Public health care finance can lead to general welfare losses associated with taxation, for
example public health care finance systems, where revenues are generated through taxation,
are likely to introduce welfare reducing price distortions. Any price distortion in a wellfunctioning market creates allocative. Consumption taxes create inefficiency by distorting the
choice between consumption and saving. Alternatively, payroll taxes and income taxes create
a welfare loss in the labour market. Does this imply that all taxes are bad? No. It does imply the
government should use tax revenue in ways that generate benefit for society.
Equity of health care finance
Analyses of equity in financing health care emphasize the impact of alternative approaches on
distributional equity with respect to: (i) the burden of payment (equity of health care finance);
and (ii) health care utilization (equity of health care utilization).
Distributional equity normally draws on two general principles of finance.
1. Benefit principle: the amount individuals contributed should be proportional to the
benefit they receive from the goods financed
2. Ability-to-pay principle: the amount individuals contribute should depend on
their ability to pay, not their need or their ability to benefit from the goods financed.
Ability-to-pay is normally measured by income or wealth
Economists describe how payments vary with income in three ways
1. Regressive financing: the proportion on income a person pays falls as income
increases
2. Proportional financing: the proportion of income a person pays remains constant
as income increases
3. Progressive financing: the proportion on income a person pays increases as
income increases
Example 1: Progressive, Proportional, and Regressive Systems of Finance
Example 1 is a reproduction of an example from the textbook (see Table 11.2 in the text book).
Table 1 presents a hypothetical example to illustrate regressive, progressive, and proportional
systems of finance. In Country One, the proportion of income contributed is constant across all
income levels (Country 1 has a proportional tax system). In Country Two, the proportion of
income paid in taxes increases with income (Country 2 has a progressive tax system). In
Countries Three and Four the proportions of contributions decrease as income increases (they,
therefore, have regressive systems).
Figure 1: Progressive, Proportional, and Regressive Systems of Finance (TABLE 11.2 in the
text)
Equity of Health Care Utilization
Empirical evidence documents more equitable utilization under public finance
The system of finance plays an important role in determining equity in the utilization of health
care as it determines the extent to which individuals face financial barriers when seeking care. In
general, the greater the breadth and depth of health care insurance coverage the more equitable
the patterns of utilization. For example, “first-dollar” public coverage results in more equitable
patterns of health care utilization than do systems of private insurance.
Net Incidence
Net Incidence: refers to the distribution of the difference between tax benefits and burdens, Net
incidence analysis examines how society’s resources are redistributed through both the system of
finance and the patterns of service utilization. The difference between the two reveals the
redistribution of resources among members of society.
The general results from net incidence analyses:
1. Observed utilization of health care services is highly regressive, where low-income
individuals tend to use more services than high-income individuals.
2. Tax contributions are proportional
3. The incidence of net benefits is highly regressive for low-income groups in Canada as the
value of publicly financed services received far exceeds those groups’ contributions.
Generally, the health care system redistributes economic resources from high-income
groups to low-income groups.
Public and Private Roles in Mixed Systems
There are 3 fundamental configurations of public and private roles in a mixed system of health
care finance:
1)! Joint Financing: in which a given service is partly paid for through public sources and
partly through private sources. The 2 factors do not compete with each other, nor are they
seen as alternatives. When evaluating the efficiency the results will depend on the
baseline of comparison. For example, is public finance used to expand individuals’
private market choices? Or, alternatively, is private finance used to displace public
expenditure and or provide a steering effect
2)! Alternatives: either public or private financing is chosen (someone chooses to pay
privately for service that is also publicly insured). 2 primary forms
a.! Supplementary(or parallel) private finance: exists when a service that is
included within the public plan can also be obtained privately if desired..
b.! Substitutive private finance: exists when an individual is permitted to opt out of
the public plan altogether and finance care privately
3) Complimentary financing: the private sector pays for expenses not covered by the
public plan. Complementary private finance often takes the form of private voluntary
insurance for expenses not covered by the public insurance plan, including services
excluded from the public coverage (e.g., drug and dental insurance in Canada), costsharing required by the public system (e.g., in France), and ancillary non-medical costs
associated with utilizing publicly insured services (e.g., an upgrade from ward
accommodation to a semi-private or private room during an in-patient stay).
Health Care Funding
Health care funding (the allocation of revenue raised to alternative activities within the health
care sector). Funding provides health care organizations with the financial resources required to
carry out a defined set of health-related activities. The “funding problem” arises because a thirdparty insurer must allocate the revenue it has collected to providers and programs that deliver
health care services to individuals.
Funding influences system performance because it creates financial incentives related to:
•!
•!
•!
•!
•!
Who provides services
What services are provided
The quality of the services provided
Where services are provided
To whom services are provided
A central concern of health economics and health policy is designing funding schemes that
encourage efficiency in the production and distribution of health care.
Funding Schemes
All funding schemes share the same three basic elements:
1.! Participants: include the parties to the exchange or transfer of funds. Participants include
government, health care insurers, providers, health care organizations, and enrollees.
2.! Funded services and activities: a list of services and activities to be funded. The list can
range from a narrow subset to a broad basket of services.
3.! Funding mechanism: the method by which funds are transferred between two
participants
These three basic elements correspond to the three questions to ask about any payment
arrangement: (i) WHO is being paid?, (ii) WHAT is being paid for?, and (iii) What is the UNIT
of payment?
Example: Paying for Primary Health Care
There are a few funding schemes that could be (and often are) used to fund primary health care.
Remember, the design of each funding scheme indicates who has financial incentive to do what
in the health care system. Consider the following three examples:
1.! Fund primary care physicians by fee-for-service
Funding primary health care by fee-for-service to pay the physician for each service
provided will encourage the provision of services as listed in the fee schedule (because
only such care is funded). However, it will discourage the provision of care not explicitly
defined in the fee schedule or the provision of services from non-physician providers
(because only physicians can bill the insurer).
2.! Fund primary care organization directly (rather than a physician) by fee-forservice
Funding primary health care by fee-for-service to pay the primary care organization
encourages the same behaviour as above. However, it also encourages delivery by both
physician and non- physician providers (because both physicians and non-physicians can
now bill the insurer).
3.! Fund primary care organization directly by capitation
Capitation is the funding mechanism where a provider receives a fixed, specified
payment per time period (e.g. month, year) for each individual for whom it accepts
responsibility to meet defined health care needs. Funding primary health care
organizations by capitation gives the incentive to use a mix of providers when delivery
primary health care. There is also an incentive to reduce the provision of unnecessary
services (incentive to under-provide care) as well as an incentive to increase the provision
of preventive services (as, in theory, this will improve health and reduce utilization of
services in the future).
Principal-Agent Framework
A principal-agent problem arises whenever one individual or organization (the principal) wants
to accomplish some task or objective, but must contract with another individual or organization
(the agent) to undertake the work necessary. The challenge is for the principal to motivate the
agent through financial and non-financial incentives so the agent performs well according to the
principal’s objectives.
Most of the design of funding schemes in health economics relies on the principal-agent
framework. For health care funding, the principal is usually a public/private insurer and the agent
is a provider (hospital or physician). The funder wants a provider to efficiently meet the health
care needs of beneficiaries.
The principal-agent framework includes five key elements (aside from the principal):
1.! Agents
In health care systems, the “agent” is usually the providers of health care. Providers can
differ in ways relevant to the contracting situation. For example, some are more able, or
more hard working than others.
2.! Actions
Actions simply refer to the delivery of a health care service undertaken by an agent that
affect the achievement of the desired outcome (e.g., improved health). It is assumed that
undertaking an action is costly to an agent.
3.! Random Factors
There is usually something beyond the control of both the principal and the agent that
influence the outcome in addition to any actions undertaken by the agent. For example,
an individual’s health can change at random (outside the control of the agent). As another
example, the effectiveness of a given health care service is known on average, but is
random for a specific individual.
4.! Outcomes
The outcome (e.g., health) that is observable to both the principal and the agent.
5.! Asymmetric Information
There likely exists an asymmetry of information between the principal and the agent.
This will vary depending on the context. For example, only the agent is aware of its own
capabilities (e.g., ability, work ethic) and/or actions while the principal may observe the
action undertaken by the agent (e.g., what service was provided) but not the random
factor.
There are a number of strategies a funder (principal) can use for solving the principal-agent
problem. Three primary strategies in the face of these challenges are:
1.! Reduce the asymmetry of information and uncertainty
2.! Non-financial system of rewards and penalties to create a culture to induce desired
behaviour
3.! Design a payment system to align the incentives of the principal and agent: this is
the strategy on which economic analysis has focused.
Designing a funding scheme
A well-designed funding scheme, that accounts for the principal-agent problem described above,
must encourage efficiency in the production and use of health services by providing the right
incentives to the right participants, and be administratively efficient. As noted above, all funding
schemes have three basic elements: (i) participants; (ii) a list of funded services and activities;
and (iii) a funding mechanism.
Participants
There are three basic types of participants (or, parties to the exchange) in a funding scheme: (i)
financial intermediaries; (ii) beneficiaries; and (iii) providers. The role of each participant must
correspond to the information to which they have access, their ability to bear risk, and their
ability to monitor and enforce funding arrangements.
Financial Intermediaries are organizations that collect money and pay for health care services
on behalf of beneficiaries. For example, a financial intermediary could be a government (Federal,
provincial etc.) or a private insurance company, or a charitable organization. Financial
Intermediaries are not always present. For instance when purchasing health care goods/services
not covered by private/public insurance (ex. crutches, chiropractor services, etc.) or for most
other out-of-pocket medical expenses.
Beneficiaries are individuals who receive the health care services paid for under a payment
scheme. For example: patients covered by a health plan, or patients of a health centre or clinic, or
cash paying patients, or residents of a province. The key is that each payment scheme must
properly specify who are the beneficiaries.
Providers are whomever it is that can (or must) provide health care in exchange for payment.
For example: individual providers (physicians etc.) or groups of providers (organizations,
companies, hospitals etc.). The providers may range in size (from small to large), may be private
or public, or may be for-profit or not-for-profit.
Funding mechanisms and the properties of each
The funding mechanism refers to the method by which funds are transferred among participants
in a funding system. A number of different funding mechanisms could be used (depending on the
context), such as fee-for-service, capitation, case-based funding, and global budget. No one
single mechanism is used for the whole of a health care system as different mechanisms are used
for different services and settings. We discuss some funding mechanisms below.
Fee-for-service is the funding mechanism where the funder pays the provider / organization a
fixed dollar value for each unit of a reimbursable health care service. The reimbursable service
and the fee are pre-determined (in a fee schedule). Total payment depends on the number of
services provided (times the pre-determined fee). Fee-for-service is used in some form in nearly
all health care systems, especially for physician services.
Incentives with fee-for-service
Produce services in the least-cost way consistent with funding regulations
•!
The difference between the fee and their costs determines their income/profit
Limits ability to produce a service with the least-cost combination of inputs
•!
as the fee is paid only when the designated provider delivers the service (rather than a
qualified assistant)
Over-provision of reimbursable services
•!
provider is paid whether the reimbursable service is needed or not.
Under-provision of non-reimbursable services
Case-based payment is the funding mechanism where providers receive a fixed, specified
payment for each “case” treated. This mechanism is used primarily for funding hospital care,
where a case is defined as a hospital admission and the payment varies according to the diagnosis
(e.g., pneumonia, myocardial infarction, Caesarean section). The payment amount is set in
advance and is designed to equal the expected costs of treating a given diagnosis. Under casebased payment the provider bears some risks associated with treatment costs for each case
treated.
Incentives with case-based funding
Produce services in the least-cost manner
Provide only necessary services
Under-treat patients (skimp on care)
Cream-skim the less severe cases within a diagnostic category
Up-coding
Capitation is the funding mechanism where a provider receives a fixed, specified payment per
time period (e.g. month, year) for each individual for whom it accepts responsibility to meet
defined health care needs. Payment is fixed in advance and it does not vary with actual services
provided. Total payment depends on the number of people enrolled with the provider (times the
fixed payment amount). The provider bears financial risk associated with meeting health needs.
Incentives with capitation
Produce services in the least-cost manner
Provide only necessary, effective health care services
Under-treat patients (skimp on care)
Cream-skim relatively low-risk, healthy individuals within each risk class
Capitation payment can be used for a geographically defined population to fund a broad basket
of services
Global Budget is the funding mechanism where a provider receives a fixed budget for a given
period of time. The budget size is pre-determined, where the budget size is the total payment and
often comes with some pre-specified expectations. The size of the total budget can be based on a
number of factors such as historical costs, the number of services provided last period, the
number of cases treated last period, and the size of the population served. When the budget is
fixed ahead of time, global budgets can be effective in containing health care costs, and provide
considerable discretion for use of funds. Historically used in Canada to fund hospitals.
Retrospectiveness, Prospectiveness and Risk
Most payment mechanisms have prospective and retrospective components.
Payment Component
Prospective
Retrospective
payment for a service is determined before the provision of the
service
payment for a service is determined only after the provision of the
service
The extent of prospectiveness or retrospectiveness will depend on the mix of funding
mechanisms used in the funding scheme. It will also determine who bears the financial risk
associated with meeting the health care needs of individuals and affects the providers incentive
to produce and use health care services efficiently to improve health
Lesson 11 (Chapter 13): Health Care Delivery- Physicians
Health care can be provided publicly or privately, by which we mean:
Public Provision: services provided by employees of an organization owned by a local, regional,
provincial or federal government. The rationale behind public provision is based on the view a
publicly provided service will be equitable.
Private Provision: services delivered by employees of an organization with private-sector
owners (limited-liability firms, partnerships, sole-proprietorships etc.). The rationale behind
private provision is based on the belief privately provided services are produced more efficiently.
Delivery of health care can be done by organizations with different profit motives, for example:
(i) not-for-profit organizations; (ii) not-only-for-profit organizations; or (iii) for-profit
organizations. These three profit types can be applied to all firms in the health care industry from
primary care physicians, to hospitals to pharmaceutical multi-nationals.
All three types of organizations can be either public or private. For example: physicians in
Canada are mostly private not-only-for-profit, while physicians in the UK are mostly public notonly-for-profit.
Our analysis of health care delivery (in lesson 11 and 12) will focus in particular on
Physicians: constitute the most influential provider group within health care (mostly
considered not-only-for-profit)
•! Hospitals: constitute the dominant delivery institution (mostly not-for-profit)
•! Pharmaceuticals/drugs: constitute the most common type of health care good used to treat
individuals (mostly for-profit)
•!
Each are important for understanding the supply-side of health care as a whole, but each
represents distinct segments of health care supply.
Institutional Background of Physicians in Canada
Economic analysis must distinguish three distinct elements of the physician sector:
!! Physicians themselves
!! Physician practices which combines physician inputs with other inputs to produce
physician services
!! The market for physician services, which sets the economic context within which
individual physicians contribute their labour and expertise to a physician practice
As shown in Figure 1, expenditure on physicians constituted 15.5% of all Canadian health care
expenditures in 2014. The share remained relatively constant (between 14% and 16%) until early
1990s, before falling to approximately 13% in the early 2000s. Since then, the share has been
steadily increasing. However, Figure 1 understates the importance of physicians with respect to
their broader control of health care resources (e.g., hospital services, prescription drugs, etc.).
Figure 1: Public-Sector Physician Expenditures per Capita Share of Total Health Expenditure,
Canada, 1975 to 2014
Source: Canadian Institute for Health Information, National Health Expenditure Trends, 1975 to
2014, Figure 23
Most policy attention regarding physicians focuses on changes in the number of physicians as the
primary reason for physician ‘shortages’. Figure 2 shows the number of physicians per 100,000
population from 1979-2009 in all jurisdictions (except Nunavut). What is immediately apparent
is the number of physicians per 100,000 population has increased in all jurisdictions (although, I
will note, the figure does not reveal differences between primary care physicians and Specialist
physicians). So the argument we are facing a “physician shortage” because of a lack of
physicians is not supported by the data. However, Figure 2 also does not reveal the intensity of
physician work (i.e. how may hours per week they work, or how many patients per day they see).
Figure 2: Number of Physicians per 100,000 Population, by Jurisdiction, Canada, 1979, 1989,
1999 and 2009
Source: CIHI, Supply, Distribution and Migration of Canadian Physicians, 2009
There is some evidence that between 1982 and 2003, there was a decrease among primary care
physicians in the average hours of direct patient care provided from just over 45 hours per week
to approximately 38 hours per week. It has been argued this change in work intensity reflects
three factors:
•! Increase in proportion of female physicians. In 1981, 13% of all physicians were female and
by 2007 this increase to 33% of all physicians. Females currently make up more than half
of medical students, interns, and residents (suggesting there will continue to be an
increase in the proportion of female physicians). There is also evidence to suggest female
physicians have a different practice style than male physicians. Specifically, female
physicians tend to work fewer hours than male physicians.
•! The physician workforce is aging. The proportion of physicians under 35 years of age fell
from 22% in 1988 to 13% in 2000. At the same time, the proportion of physicians 65
years of age and older increased from 8% in 1988 to 15% in 2007. Again, physicians of
different ages have different practice styles.
•! The average hours of direct patient care by male physicians fell (the causes of which are not
well understood).
Modeling the Physician Practice and Physician Behaviour
Historically, most physician practices have been structured like owner-operated small firms,
where the physician plays two roles:
1.! The physician supplies labour to the practice, combined with other labour inputs (e.g.,
nurses) and capital (e.g., examining rooms, stethoscopes, laboratory equipment) to
produce physician services for patients
2.! The physician is the owner of the practice with a right to the net income (profits) of the
practice. Their implicit wage is the net income of the practice divided by the number of
hours the physician works.
Economics models of physician behaviour have three key elements:
1.! The physician objective function (i.e., their preferences, or their utility function)
2.! The production function (practice)
3.! The constraints
Physician Preferences
We generally assume Physicians maximize utility subject to the constraints imposed by
production technology, time, and market conditions. The question is, what arguments are in a
physician’s utility function? We will discuss this in more detail below, but as a first pass it is
probably fair to say physicians are economic agents who care about consumption (C), leisure (L),
and ethics (E):
(1)
U = U(C, L, E).
Consumption (C) reflects a physician’s desire to purchase consumer goods with the income
earned from their practice. We generally assume consumption to be a normal good (meaning
consumption increases as income increases).
Leisure (L) reflects the time a physician spends not working. Mathematically, if a physician
works A hours a day then they have L (= 24-A) hours of leisure per day. Again, we generally
assume leisure to be a normal good (meaning leisure increases as income increases).
Ethics (E) represents the idea physicians are socialized to provide appropriate, good-quality care
and to abide by certain professional ethics. We generally assume a physician’s utility decreases
when the care provided deviates from the appropriate level of care.
The Production Function for Medical Serives
The production function refers to the process by which inputs are converted into outputs. In this
case, we are referring to how we produce medical services (the output) by combining physician
labour with other inputs. A simple representation of the production function is given by:
(2)
M = M(A; I)
where M is the quantity of medical care provided, A is the hours of physician labour , and I is the
other inputs to the practice. For simplicity, most models assume: (i) the production function
exhibits constant returns to scale (so if all inputs double, output doubles); and (ii) there is some
substitutability between physician labour (A) and other inputs (I).
Constraints
We generally think of physicians facing two types of constraints: (i) their personal budget
constraint, and (ii) a time constraint.
Budget Constraint
A simple representation of the physician’s budget constraint is:
(3)
O + FMM = PII + PCC,
where O is non-practice income, FM is the fee received for providing a unit of medical care, PI is
the price of a unit of non-physician input, and PC is the price of a unit of consumption. Equation
(3) simply says a physician’s total expenditures do not exceed the total amount of money
available to the physician. We generally assume physicians are “price takers”, which means
PC and PI are beyond the control of physicians (and determined by the market) while FM is
assumed also outside the control of a physician (as it is set by funders).
Time Constraint
The time constraint simply notes a physician has a fixed amount of time (say, 24 hours in a day)
to allocate between labour (A) and leisure (L):
(4)
L + A = 24
The Choice Problem
Ultimately, the choice problem of a physician is they must decide on their level of consumption
(C), leisure (L), other inputs, and medical care so as to maximize their utility. Formalizing the
physician’s choice through an economic model allows us to analyze the effects of changes (such
as a change in physician preferences, the level and manner of physician remuneration), and the
price of non-physician inputs).
Physician Responses to Fee Changes (McGuire and Pauly Model)
The key purpose of the McGuire and Pauly (1991) was to analyze the impact of fee changes to
the service provision by physicians. To do this, McGuire and Pauly (1991) describe physicians as
utility maximizers, where physicians’ value items besides profit (similar to the model described
above). The key difference is that physicians care about their net income (rather than
consumption, denoted Y), leisure (L), and ethics (E):
(5)
U = U(Y, L, E)
We assume a physicians utility increases with Y and L, but decreases as E increases. A very
simple production function is assume, where one unit of physician labour (A) equals one unit of
medical care (M). In this set up, equation (5) essentially tells us physicians are willing to tradeoff between three pairs of goals: (i) net income (Y) and leisure (L), (ii) leisure (L), and
ethics/inducement (E), and (iii) net income (Y) and ethics/inducement (E).
Income and Leisure Tradeoff
The McGuire and Pauly model demonstrates the direction of the effect of a change to the fee
paid for medical services (on a physician’s provision of services) depends on two counteracting
effects:
Substitution Effect: as wage increases, a physician will substitute leisure for labour to increase
their income.
Income Effect: a physician’s income is high enough they choose to spend more time enjoying
their high income.
Since the substitution effect and income effect can work in opposite directions (conditional on
income being above a certain level), we can observe a backward bending labour supply function.
Figure 3 (below) replicates Figure 13.2 in the textbook.
Figure 3: Labour Supply Curve
Source: Figure 13.2, Hurley (2010).
A physician’s income equals their hours worked (H) times the wage rate (w). As wage increases,
so does the opportunity cost of leisure. As long as the wage rate is less than some level (say, w*)
the substitution effect is greater than in the income effect (i.e., the substitution effect dominates)
and physicians will increase their hours worked. However, when the wage rate exceeds w*, the
income effect dominates and as wage continues to increase the physician’s hours worked will
decrease (hence, the backward bending labour supply curve).
So what does this mean in the policy context of increasing physician fees? Well, a physician fee
increase will causes two effects:
1. a substitution effect between work and leisure, providing a greater incentive for the
physician to work more (since they get paid more per service)
2. an income effect, which provides less incentive for the physician to work since an
additional hour of labour generates more income, the physician will want to consume more
leisure (given the assumption leisure is a normal good).
Thus, the impact of a change in fees on the level of service provision cannot be determined from
theory alone.
Income and Ethics/Inducement Tradeoff
A change in fees creates two sets of counteracting effects. First, a fee increase raises the
physician’s implicit wage (which, in turn, creates both an income effect and substitution effect in
labour supply discussed above). Second, the fee increase may lead to disutility from inducing
demand. An increase in the fee provides the incentive for a physician to provide more services.
However, in order to provide more services (than they are currently providing) may require
inducement (above the appropriate level). As defined in Equation (5), inducement (an increase in
E) will decrease the physician’s level of utility.
Target Income Model
A special case of the McGuire and Pauly model is known as the target-income model of
physician behaviour. The target income model assumes physicians have a specific level of
income (or “target income”) they are trying to achieve. As the physician sector changes,
physicians adjust their service activity (i.e., by adjusting L or E) to reach their desired level of
income.
The target income hypothesis was first proposed by Evans (1974), who observed that when fees
fell, utilization increased, and when fees increased, utilization fell. It was as if the physicians had
a “target income” to which they aspired, and adjusted their practice activities to reach that target.
Lesson 12 (CH14&15)
Health Care Delivery-Hospitals and Pharmaceuticals
Health Care Institution: Hospitals
A hospital is the archetypal health care institution as it is where we go when we are injured or
acutely ill and the setting of health care’s life-and-death dramas. People used to obtained care in
three basic settings: (i) home; (ii) an in-patient hospital; (iii) “the old folks home”. Economic
pressures and changes in medical technology have altered the nature and scope of many hospitalbased activities. The majority of hospital-based procedures are now done on an out-patient basis.
There is now increased pressure to discharge patients quickly. There are now more sophisticated
non-hospital settings (e.g. nursing facilities) and more complex care is migrating into patient’s
homes (e.g., home care). “Old folks homes” are now the long-term care sector.
The Hospital Sector-Canada
Hospitals represent the largest (but shrinking) sector in the health care system. In 2014, hospitals
accounted for 29.6% of total health expenditures. Approximately 90% of health care
expenditures on hospitals come from public funds. As noted, over time the share of public funds
spent on hospitals has fallen. As shown in Figure 1, in 1975 hospitals accounted for
approximately 50% of total public sector health care expenditures, but by 2014 they have
stabilized around 35%. If you refer to Figure 14.1 in the textbook, you will see hospital spending
per capita has increased over time (except in the mid-1990s), yet the growth in hospital spending
has been smaller than that in other sectors.
Figure 1: Hospital Share of Public-Sector Health Expenditure, Canada, 1976–2014
Source: Canadian Institute for Health Information, National Health Expenditure Trends, 1975 to
2014, Figure 19
As of 2004, Canada had about 740 hospitals. The majority of hospitals were general hospitals
treating acute illnesses. Nearly all hospitals in Canada are non-profit institutions – privately
owned with community or religious boards or publicly owned. Most hospitals are relatively
small (under 100 beds) but care is concentrated in larger, urban hospitals with hundreds of beds.
In comparison, the long-term care sector is characterized by greater heterogeneity. Of the 4,313
residential care facilities in Canada in 2007, only 1,615 provided nursing home level care. The
long-term care sector has a larger for-profit sector than acute care sector and is financed through
a mix of public and private funding.
There are four characteristics that distinguish hospitals:
1.! Length of patient stay (long-term or short-term)
2.! Type of hospital (community, teaching, psychiatric, etc.)
3.! Ownership (private non-profit, private for-profit, public)
4.! Size (number of beds)
Hospitals display two distinctive features compared to standard firms: (i) a dominance of not-forprofit ownership (which begs the question: what objectives do hospitals pursue?), and (ii) an
unusual organizational structure. A standard business organization’s accountability and decisionmaking are fully integrated among the units and individuals. Hospitals do not fit this model.
Most physicians who treat patients in a hospital are not formally employed by the hospital, but
are affiliated through “admitting privileges”. The affiliated physicians largely determine how a
hospital’s resources are allocated. Evans (1981; 1984) has termed this incomplete vertical
integration.
Incomplete Vertical Integration: an organizational form typical of North American hospitals in
which physicians have a long-term relationship with a hospital but are neither employed by nor
fully independent of the hospital. This raises two questions central to any effort to model hospital
behaviour:
1.! Who runs a hospital (board, management, or medical staff)?
2.! What objectives do they pursue?
Economic Models of Hospital Behaviour
Early economic models of hospitals tended to downplay (ignore) incomplete vertical
integration by assuming a hospital functioned as a unified organization. This assumption
was usually justified by the argument that the interests at all levels were sufficiently aligned
that a hospital could be treated as a unified decision-making organization. Various models
made somewhat different assumptions about a hospital’s objectives, but in most cases
hospitals were assumed to care about two dimensions of output:
•!
•!
Quantity: usually measured by the number of patients treated.
Quality: usually conceptualized as intensity of servicing (i.e., more services or more
higher-tech service per patient indicated higher quality).
3.2.1 Models of Quantity-Quality Trade-off (Newhouse)
Hospitals are assumed to have preferences over the Quality and Quantity of health care provided.
In the model, quality is equated with costs (higher cost care is an indicator of higher quality care,
a dubious assumption) while quantity is assumed to be number of patient-days of treatment. For
each quality level there is an associated demand curve (which shifts right when quality
increases). Figure 2 (below) represents the average cost and demand relationship to determine
the “optimal” quantity of patient-days of treatment (at a given level of quality) and still break
even.
Figure 2: Optimal Quantity Given Chosen Level of Quality in the Newhouse Model
Source: Figure 14.3, Hurley (2010).
When quality increases, the demand curve shifts right (say, from D0 to D1) and the hospital can
increase the number of patient-days of treatment it provides (say, from q0 to q1).
The Quality-Quantity Trade-Off Frontier
The trade-off frontier represents all possible optimal combinations of quantity and quality
available to the hospital. The optimal combination of quantity and quality a hospital will choose
is the point at which the hospital’s preferences over quantity and quality are tangent to the
quality-quantity tradeoff frontier.
So what?
In the Newhouse model, we assume the hospital is not-for-profit. A not-for-profit hospital still
has incentive to produce services in the least-cost manner. If it did not, by adopting efficient
production techniques it could shift the frontier outward, increasing its utility. As long as a notfor-profit institution is a maximizer, it has incentive to produce services in a least-cost manner.
Like a for-profit firm, the not-for-profit hospital has an incentive to produce efficiently.
The Newhouse model argues the chosen output combination will be allocatively inefficient since
the hospital will produce an inefficiently high level of quality (arising from the hospital’s own
preference for quality). This follows as a consequence of assuming the demand curve represents
the fully informed preferences of individuals.
Hospital Markets and Hospital Competition
There are a number of important features of hospital markets to distinguish it from a perfectly
competitive market. If we think about a hospital’s competitors (in the market for hospital
services) their competitors are other hospitals (and, increasingly, other types of provider
organizations).
Hospital Markets are Local
Markets for most hospital services are local (true for emergency services and for many routine
elective services, less so for highly specialized care). At the same time, patients rarely use nonlocal hospitals. This means hospitals enjoy local monopoly power as it is rare for a municipality
to have more than two or three hospitals. Thus, for the bulk of hospital services, competition in
such markets is best characterized as a monopoly or oligopolistic, with strategic interaction
among a small number of organizations.
Regulation and Competition in the Hospital Sector
In addition to the “competition” among hospitals, hospitals operate within a regulatory scheme,
both in the health sector and in a country’s broader competition policy. The regulatory scheme is
important as it sets the context for competition among hospitals. A crucial part of the regulatory
scheme is the funding method used by major payers. Other components of the regulatory scheme
in Canada are discussed in detail in Chapter 14.
Pharmaceuticals
Pharmaceuticals constitute an increasingly important component of health care. Therapeutically,
prescription drugs are becoming an ever-more-important input to health production. Drugs are
now used to treat a growing array of conditions for which no treatment was previously available
(e.g., Alzheimer’s disease, AIDS), or previously required major surgery (e.g., ulcers). Drugs are
also now used prophylactically for an array of preventable health conditions (e.g., statins drugs
to lower cholesterol).
As you can see in Figure 15.1 in the textbook (reproduced as Figure 3 below), the
pharmaceutical sector in Canada has increased (as a share of total health care expenditures) from
9.5% in 1985 to 17.4% in 2008 (it has decreased slightly to 15.8% in 2014). On a per-capita
basis, annual spending on prescription drugs in Canada also rose from just under $100 in 1985 to
$750 in 2008 (with private spending rising slightly faster than public spending).
Figure 3: Prescription Drug Expenditures Per Capita, and Prescription Drug Expenditures
as a Proportion of Total Health Care Expenditures, Canada, 1985–2008
Source: Figure 15.1, Hurley (2010).
Developing new drugs is a research-intensive endeavor. Research and development (R&D) is
undertaken predominately by large, multinational, for-profit companies. Pharmaceutical R&D
accounts for nearly 10% of all industrial R&D spending in Canada (Statistics Canada 2008). To
undertake R&D, companies must invest upfront with the chance of recovering the R&D costs in
the future (assuming, among other things, that the final research becomes a viable product).
Public policy with respect to R&D must recognize the special nature of research as an economic
activity and acknowledge it as an economic commodity; the strategic challenges in regulating an
industry that moves investments across borders with ease; and the increasing calls for policy
coordination among countries, most notably the pressure for international harmonization of
patent policies through international trade agreements.
The Pharmaceutical Industry
The pharmaceutical industry includes two distinct types of drug manufacturers:
1.! Brand-Name Drug Manufacturers: pharmaceutical companies who undertake research
to develop new drugs (e.g., Bayer, Glaxo-Smith-Kline, and Merck-Frosst)
2.! Generic Drug Manufacturers: pharmaceutical companies who produce and sell drug
products already developed, either under license from a brand-name manufacturer or after
the brand-name manufacturer’s patent has expired.
Regulation of the Pharmaceutical Industry
Government regulation of the pharmaceutical industry takes four important forms:
1.!
2.!
3.!
4.!
regulation of intellectual property through patent policy
regulation of drug safety
regulation of drug prices
regulation of drug advertising and promotion
Regulations with respect to patents and drug safety are relatively standardized internationally.
Regulations related to pricing, advertising, and promotion of drugs are more country-specific and
can best be appreciated through an examination of the nature of competition in the drug sector.
R&D is a central activity of the brand-name drug manufacturers, with the goal being to produce
new knowledge. However, the costs associated with R&D are not trivial (there are massive
fixed/sunk costs involved). Undertaking R&D is risky, as many chemical compounds never end
up making it to market. In order to finance research, a firm must charge a premium price per unit
(above marginal cost) and sell enough units to recoup the R&D costs. However, the problem
facing pharmaceutical companies is information is costly to produce but cheap to disseminate.
Economists view heath care knowledge (and pharmaceutical R&D specifically) as a public good.
Recall, a public good is defined as a good that can be simultaneously consumed by many
individuals (non-rival in consumption) and which it is very costly to exclude others from
consuming (non-excludable). Hence, knowledge is a public good.
Theoretically, competition makes recouping R&D costs impossible since competition would
drive the market price to marginal cost, preventing the firm who invested in R&D from
recovering their R&D costs. This is the reason market allocation fails for such public goods and
why markets produce too little of a public good. The policy response to this market failure takes
two basic forms: direct public investment in research, and patent protection.
4.2.1 Direct Public Investment in Research
Direct public investment partially fills the void left by a lack of private investment as it focuses
particularly on basic scientific research. The Government of Canada funds basic scientific
research through tri-council (research) grants such as: (i) National Science and Engineering
Research Council (NSERC), (ii) Social Sciences and Humanities Research Council (SSHRC),
and (iii) Canadian Institutes of Health Research (CIHR). Additionally, the Government of
Canada also has research infrastructure programs, such as Canadian Foundation for Innovation
(CFI).
4.2.2 Patent Protection
A patent is an exclusive right, granted by government, to produce and sell a patented product for
a defined period of time. It grants a legal monopoly to the developer of the good or process
covered by the patent. By granting a monopoly, the holder of the patent can charge a price above
marginal cost to help recover the R&D costs. Patent policy must balance two counteracting
effects on social welfare: (i) by increasing the chances of earning a profit on a new product,
patents spur the development of important new knowledge and products (hence, improving
social welfare); and (ii) by granting monopoly power to the developer for a period of time, the
price for the product is (temporarily) set above the socially optimal level (hence, reducing access
to this welfare-enhancing product).
When a brand-name drug goes “off patent” a generic version can enter the market. More generic
entrants lead to lower generic prices, as price usually gets bid down towards marginal cost with
competition. In reality, brand name drugs tend to not lower prices in response (due to their firstmover advantage). Note that generic drugs are NOT like no-name peanut butter as they are
certified as chemically equivalent to brand names, and evidence finds no systematic differences
in health outcomes.
Drug Safety and Drug Approval Process
Before a newly developed drug can be sold to the public it must be certified as safe and
efficacious by the relevant government agency. In Canada, this is done by the Therapeutic
Products Branch of Health Canada. The modern era of safety and efficacy regulation began in
the early 1960s, following a number of cases where drugs marketed to the public were found to
cause severe harmful side effects. For example, the drug “thalidomide” was marketed to
pregnant woman then subsequently found to cause severe birth defects in children. This is a
problem still facing Canadians today:
Designing a funding scheme:
7)! Number of different funding mechanisms (methods of transfer of funds)
a.! Fee-for-service is the funding mechanism where the funder pays the provider a
fixed dollar value for each unit of a reimbursable health care service
predetermined in a fee schedule. Fee-for-service is used in nearly all health care
systems, especially for physician services
b.! Incentives:
1.! Produce service in the least-cost way consistent with funding regulation
1.! Difference in fee and cost determines their profit
2.! Limits ability to produce a service with the least-cost combination of
inputs
1.! As the fee is paid only when the designated provider delivers the
service
3.! Over-provision of reimbursable services
1.! Provider is paid whether the reimbursable service is needed or not
c.! Case-based payment: is the funding mechanism where providers receive a fixed
specified payment for each case treated, this method is used primarily for funding
hospital care.. Under this payment the provider bears some risks associated with
treatment costs for each case treated as payment amount is set in advance.
d.! Incentives:
1.! Produce services in least-cos manner
2.! Provide only necessary services
3.! Under-treat patients
4.! Cream-skim the less severe cases within a diagnostic category
5.! Up-coding
e.! Capitation is the funding mechanism where a provider receives a fixed, specified
payment per time period (month, year) for each individual for whom it accepts
responsibility to meet defined health care needs. Payments fixed in advance. Can
be used to fund broad basket of services
f.! Incentives:
1.! Produce services in the least-cost manner
2.! Provide omly necessary, effective health care services
3.! Under-treat patients
g.! Global budget is the funding mechanism where a provider receives a fixed budget
for a given period of time. The budget is pre-determined, where the budget size is
the total payment and often come with some pre-specified expectations.
Historically used in Canada to fund hospitals.
8)! Prospective: payments for a service determined before the provision of service
9)! Retrospective: payments for a service determined after the provision of service
Lesson 11(Chp13): Health Care Delivery – Physicians
Health care can be provided either publicly or privately:
1. Public provision: services delivered by employees of an organization owned by a
local, regional, provincial, or federal government. Rationale behind public provision is
based on the view a publicly provided service is EQUITABLE
2. Private provision: services delivered by employees of an organization with privatesector owners, belief that privately provided services are producered more efficiently
Physicians: constitute the most influential producer group within health care (mostly considered
not-only-for-profit)
Hospitals: Constitute the dominant delivery institution (mostly not-for-profit)
Pharmaceuticals/drugs: constitute the most common type of health care good used to treat
individuals (mostly-for-profit)
Physicians are economic agents who care about:
!! Consumption reflects a physicians desire to purchase consumer goods with the income
earned from their practice. Generally assume it to be a normal good, consumption
increases with income increase
!! Leisure reflects the time a physician spends not working. Mathematically, if a physician
works A hours a day then they have L (= 24-A) hours of leisure per day. Again, we
generally assume leisure to be a normal good (meaning leisure increases as income
increases).
!! Ethics represents the idea physicians are socialized to provide appropriate, good-quality
care and to abide by certain professional ethics. We generally assume a physician’s utility
decreases when the care provided deviates from the appropriate level of care.
Physicians face 2 types of constraints:
1)! Personal budget constraint
a.! O + FMM = PII + PCC
b.! O non-practice income, Fm is the fee received for providing a unit of medical
care, p1 is the price of the inputs other then physician and pcc is price of
consumption
c.! Physician are price takers
2)! Time constraint simply notes a physician has a fixed amount of time (say, 24 hours in a
day) to allocate between work and leisure ( L + A = 24)
The choice problem: of a physician is they must decide on their level of Consumption, Leisure,
other input and medical care so as to maximize their utility
Income and leisure tradeoff
!! Substitution effect: as wage increases, a physician will substitute leisure for labour to
increase their income
!! Income effect: a physician income is high enough they choose to spend more time
enjoying their high income.
Target income model: a special case assumes physicians have a specific level of income they are
trying to achieve. As the physician sector changes, physicians adjust their service activity (by
adjusting L or E) to reach their desired level of income.
When fees fell, utilization increased, and when fees increased, utilization fell.
Lesson 12(Chp14&15):Health Care Delivery - Hospitals and pharmaceuticals
Most physicians who treat patients in a hospital are not formally employed by the hospital, but
are affiliated through “admitting privileges”. The affiliated physicians largely determine how a
hospital’s resources are allocated. Evans (1981; 1984) has termed this incomplete vertical
integration.
Incomplete Vertical Integration: an organizational form typical of North American hospitals in
which physicians have a long-term relationship with a hospital but are neither employed by nor
fully independent of the hospital.
Markets for most hospital services are local (true for emergency services and for many routine
elective services, less so for highly specialized care). At the same time, patients rarely use nonlocal hospitals. This means hospitals enjoy local monopoly power as it is rare for a municipality
to have more than two or three hospitals.