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 : : : : : !! 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. !! !! !! !! 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.