ECO 506– Health Care Economics

1. ECO 506– Health Care Economics Lecture Notes

2. Health Insurance • I. The demand for Health Insurance • Definitions: • Deductible: when the patient pays all the price for a certain range • Coinsurance: the insurer pays only part of the price, the patient pays the rest • Limits: coverage up to a maximum amount • Indemnity Insurance: reimbursement to the patient for medical costs (often fixed price per day in hospital) • Service insurance: reimbursement to the provider for medical costs • Impact of these on demand?

3. An economic theory of demand for health insurance • Why do individuals choose to buy insurance and how much? • Budget constraint and preferences • Expected utility analysis • Expected utility analysis • Risk aversion • Suppose we have the following situation: • 1. an individual has $50,000 in money • 2. there is a 10% probability that the individual will become ill and have to pay $25,000 for treatment.

4. => 1 = “good” state 2 = “bad” state • Let Mg= money income in good state • Mb= money income in bad state • Suppose you can insure against the loss • For example: suppose you can buy $10 of insurance coverage for $1 and that you fully insure against the loss. • 10% change of => Mb = $50,000 – $25,000 + $25,000 – $2,500 • Mb= $47,500 • Mg= 50,000-2,500 = $47,500 • Regardless of which state of nature occurs

5. Let Y = premium cost/dollar of coverage • K= dollars of coverage • => in general.. • 10% change of getting $25,000 + K – YK • 90% chance of getting 50,000 – YK • Now, contingent consumption • N states of nature and consumption is contingent upon which state of nature you’re in. • If states are just different consumption bundles => consumer theory can handle it.

6. Mg A 50,000 B 50,000-yk $25,000 Mb 25,000+ k -yk A= Endowment B= Full

7. How do you attain points where Mb > $50,000 –yk • By over-insuring • In essence by selling insurance– if such a choice is possible which it may not be • Slope = ∆Mg /∆Mb = -yk/k-yk = -y/1-y • Now look at utility function and indifference curves to talk about how individuals make choices. • But 1st, how do probabilities enter info utility? They should, shouldn’t they? • If Pg = .9 Pb =.1 (should get a different choice than if Pg= 1 and Pb = 0

8. Suppose m1, m2, m3 = income in states 1 and 2 • 1 2 3 = probability in states 1, 2, 3 • 2 definitions: • Expected value = 1, M1, + 2, M2, 3, M3. In our example EV = (.9) (50,000) + (.1) (25,000) = 47,500 • Explain • Expected utility = 1, u(M1), + 2 u(M2) + 3 u(M3) +…. • Expected utility hypothesis: you choose that option with the highest expected utility = weight of ability in difference possible states of nature.

9. Now when does an individual choose to insure? • Assume that the premium is actuarially fair (book calls pure premium) • i.e. reflects the true probabilities so that in our example must pay ten cents the dollar => premium = $2,500 = EV • 1. Risk Aversion u (m) $25,000 47.5 50

10. Now look at two possibilities • Don’t buy insurance => Euni = .9 u(50K) + .1 u(25K) • Buy insurance => Eui = u(97,500) • An individual is risk averse for when EU (ins) > EU (no ins.) • Or u (EU (g)) • 3 possibilities • 1. EUNI < EUI => risk averse • 2. EU(NI) = EUI => risk neutral • 3. EUNI > EUI => risk lover

11. So depends upon the individuals shape (preferences) of utility of money curve U U (m) Risk averse U Risk lover U (m) 25 47.5 50

12. u U (m) • Have shown two things that matter in deciding whether to buy insurance • 1. Attitudes toward risk • 2. The insurance premium 25 50 m

13. Risk averse individuals always buy insurance when the premium is actuarially fair as it was in our example. • Now, just look at risk averse individuals • And look at the price or premium • Even with competition, insurance firms can ____ charge an actuarially fair or pure premium • Why? • Suppose 10,000 individuals--- all the same with the same insurance • Each pay $2,500 in premiums for a total of $25,000,000 • 10% of these individuals will incur losses of 25,000. • The company must pay out (25,000)(1,000) = $25,000,000

14. But it costs more money to provide insurance (i.e. transaction costs of gathering premiums, paying for losses, etc. • Even if profit = 0 premium > pure premium • Q: Will a risk averse individual still insure? • A: Perhaps

15. U (m) U3 • 1st look at EV of the gamble = • M3 => EU = U3 and willing to pay (M2-M4) at most to insure the distance M3 – M4 = the additional amount willing to pay above the pure premium if prem >M2 – M4 => don’t insure M1 M4 M3 M2

16. Implications of this Analysis • 1. as the probability of the loss gets larger => M3-M4 gets smaller => less likely to buy insurance • i.e. if you are sure to pay for the expense => not willing to buy insurance. Why? • 2. As the probability of the loss gets smaller => M3-M4 gets smaller => less likely to buy insurance • i.e. as you become more sure that loss will not occur less likely to buy insurance. Why? • 3. As the magnitude of the loss decreases less likely to buy insurance because M4-M3 decreases. • 4. As an individual becomes more risk averse=> more likely to buy insurance.

17. 5. As the price of insurance increases => buy insurance for fewer events (less insurance) where price = amount willing to pay above pure premium. • 0 1 line = amount person willing to pay above pure premium • AA = price of insurance (above fair premium (pure)) P A A P1 P2

18. Rises assuming costs increases as the # of claims increases due to rising transaction costs • Individual only buys for P1< Prob. < P2 • If price increases => this interval gets smaller • 6. The starting income of the individual • At high income levels => MU low so less willing to pay above fair premium • At low income levels => MU is high again because the distance between actual and EU is less • This is wrong, at least the part about income levels affecting the distance. It still may be true that lower income people are less likely to buy insurance but this is because of budget constraints not the distances between the curves.

19. Now look at the evidence: Tables 6.1 and 6.2 • We see • 1. if prob. is low => use is low • 2. if prob. is high => use is low • 3. if magnitude is high => use is high • 4. if magnitude is low => use is low • => model predicts relatively well • The above assumed that D for M.C. perfectly inelastic once an illness occurs. Suppose its not. • Moral Hazard: the tendency for insurance to affect the individual’s behavior. i.e. the individual can affect the size of the loss under insurance.

20. Examples: • 1. fire insurance => less likely to install fire alarms, smoke detectors • 2. Car insurance => may drive faster • 3. Health insurance => individuals may invest in less preventative care. Why? • Preventative care is not paid for but other care is. • Other examples depends upon how the insurance is set up

21. P • Look at 2 impacts of the moral hazard using Demand Analysis • Full Insurance Coverage: P=0 to consumer and buys Q = Q2 > Q* • This is inefficient since time cost is MC = P* at Q2 • MB = 0 => MC >MB • With no insurance, individuals consume Q = Q* with P=P* P* MC = S D Q* Q2 Q

22. Is this behavior rational? Yes, individual is equating MB with MC = 0 • Given that Q increases, what happens to the premium? Clearly, it must rise as well. Both because Q increases and because P increase if S is upward sloping. • Suppose • P* = 1,000 • Q* = 10 • P2+ 2,000 • Q2 = 20 • Probability of illness = .2 • Assume moral hazard does not cause this to change P2 S P* D Q* Q2

23. With no moral hazard and no inefficient… • Pure Premium = (.2) (1,000)(10) + (.8) (0) = $2,000 • With moral hazard: pure premium = (.2)(2,000)(20) + (.8)(0) = $8,000 • Premium rises to pay additional costs • Q: Why don’t individually obserce? Increase insurance premium and stop increase QD? • A: 1st, individuals make choices on the margin. The effect of insurance is to decrease the MC to the individual • 2nd: need to understand the concept that insurance groups people together => by your decrease in QD you get very little benefit.

24. Implications of the Moral Hazard • 1. QD increases with insurance ( P increases as well) • 2. Premium rises => fewer people insure • Recall P A A P1 P2

25. 3 methods to decrease moral hazard problem • 1. Deductibles • Assume MC constant for simplicity • Let Q1 = deductible amount of services • Actually, deductibles are usually in dollar amounts P P* S=MC A C B Q* Q2 Q1

26. Look at 2 situations: • 1st: Q1 < Q* => will always buy the insurance at the pure premium. Why? • 2nd: Q1 > Q* => either don’t buy insurance an consume at Q* or do buy insurance and consume at Q2 • How do you decide? If you do buy… • Pay P* x Q1 => • Extra cost = (P*)(Q1-Q*) = area a + area c • Extra benefit= Area under from Q* to Qz = Area c + Area b • =>But only if extra benefits > Extra costs • OR if a + c < c + b or B > A • => Deductibles do not reduce the amount of Q purchased if have insurance…just reduces the # of people who buy insurance.

27. 2nd: Coinsurance • Pure premium: (P* -Pc)(Q1)(.2) < (P*)(Q2)(.2) • Let Pc = coinsurance price => even with insurance must pay some of the price • 1- Moral hazard problem is less • 2-pure premium is lower with coinsurance => more people buy insurance P Pc P* S Q* Q1 Q2

28. 3rd: Prepaid plans like HMOs and PPOs focus on Drs and patient incentives not just patient thru coinsurane or deductibles. • Adverse Selection: Consider 2 groups of people • 1st group: prob. of illness =.8 • 2nd group: prob. of illness =.2 • Suppose that the insurance company cannot distinguish between individuals in the 2 groups. • Results? • Assume equal number of individuals in both groups=> company observes a group who prob. of illness =.5 and bases its premium upon that.

29. Let Mg = 10,000 MB = 2,000 • Pure premium for Group 1 (high risk) = (.8)(8,000) =6,400 • M = 10,000 -6,400 = 3,600 • Pure premium for Group 2 (low risk) = (.2)(8,000) =1,600 • M= 10,000-1600 = 8,400 u u (m) m 2,000 3,600 6,0008400 10,000

30. Both would be willing to buy at average premium of $4,000 (m= $6,000) • In our graph, Group 2 does not buy but Group 1 will always buy. Why? • Group 2 may buy dependent upon several factors but most important is how different the risk levels for the 2 groups. • Conclusions: • Adverse selection • 1. causes fewer low risk individuals to buy insurance and more high risk individuals to buy • 2. Premium must rise if this is true, more low risk individuals drop out

31. Controls? • 1. experience ratings but perfect experience rations = no insurance. • 2. exclusions for pre-existing conditions • 3. decrease premium the longer insured • 4. unwillingness to pay deductible and coinsurance may signal risk status

32. Conclusions for the Chapter • 1. forced coverage for all expenses is inefficient. Both high and low prob. events should likely not be covered. Why? => 100% coverage not optimal • 2. moral hazard and adverse selection problems: • 3. Public Policy: • National health insurance? • Coerced coverage for all individuals • discrimination % of ind. Major medical Co ins. ded Size of exp.

33. Other issues • 1. Differential Health Insurances • Suppose Health insurance reimburses hospital expenditures but not physician services • If decrease P of H => substitutes hospitals for Drs and inefficient since original iso-cost represented true costs. • This is a service policy => results in overuse of those services which are reimbursed. Drs D* D1 Mc = mc* Hosp. H* H1

34. An indemmity policy keeps the relative prices of the two goods the same since it reimburses for all medical expenditures • This does cause D more MC to increase but does not change relative prices => no technological inefficiency • Note: figure 6.9 indicates allocative efficiency but this is incorrect Dr MC= MC1 MC = MC* H

35. Service benefit insurance creates more problems. i.e. inefficiency while indemmity insurance does not. • 3 Problems • Increased use of insured services • Point where MP = 0 • Increase demand for quality which is inefficient

36. Tax Advantages • Health insurance as a fringe benefit is not taxed • Look at the individual who has two choices • 1. Get a $300/month raise (BL2) • 2. Get health insurance benefits (BL3) worth $300/month M + 300/Pc M/Pe Health insurance M/Ph M + 300/Ph

37. Q: Why ever choose (2)? Since it cuts off part of BL? • A: Tax benefits– suppose $300 is taxed but health insurance is not +> for 1 actually face BL4 • => Plan 2 Makes everyone better off but does cause inefficiencies since forces some individuals to use more health insurance…then optimal • Note: there is one type of ___ that may not be better off—the individual would choose no health care and depends on tax rate if ind. A would be better off

38. The Market for Health Insurance • Public Policy: 2 Questions • 1. is intervention justified? • 2. what type of intervention? • Efficiency in 2 senses • Supply Side: • 1st- firm technological efficiency (use resources to min. cost of production) • 2nd- Industry: does each firm produce at min point on LRAC? [suppose not any reason why this might be okay?]

39. Demand Side • Allocative efficiency MB=MC? • Note: will basically take the same approach for all the other markets as well. • A) Demand • Market: Recall that market demand is determined by: • 1. price of insurance • 2. prob. of loss • 3. magnitude of loss • Income of the consumer • Risk aversion • Price elasticity ~ -1 => increase P of 10%, decrease QD by 10%

40. Firm Demand • Look at 3 different types of insurance • 1. Blue Cross/Blue Shield= non profit • 2. other commercial plans= profit • 3. Independent plans= prepaid plans (HMOs); self insurance; service contracts • Look at the changes embodied in table 11-2, p. 237 • Trends: • 1. increas in % of Pop. covered but slight especially in later years • 2. decrease in BC/BS and big increase in Independent • =>market demand is relatively inelastic but firm demand is elastic due to substitutes and competition

41. Differences in • 1. type of benefit • 2. price • 3. extent of coverage (Coinsurance, Deductibles) • 4. reimbursement • 5. reputation • Predictions: • 1. price will vary as the product varies • 2. the product will change over time as pref. change (or as costs change)

42. Now look at efficiency • Is there an information argument that consumers find buying insurance inefficient since costly to gain information about competing co’s? • Probably not. • 1. large benefit item=> pays individuals to gain info • 2. insurance often bought by groups and cost/person of gaining information is less. • => information probably not a problem (note table 8-2 suggests it is for individual policies)

43. Now look at Benefit/Premium Ratio • Benefit = average benefit paid for by group • Premium= price of insurance for that group • If B/P ratio = 1 => premium = price • Premium: • If B/P ratio < 1 => price > pure premium as B/P ratio decreases, price increases • If industry competitive expect to see B/P ratio close to 1 • If monopoly=> B/P ratio would be low • Look at table 8-2 to see how this has worked • Note: book concludes that a fair amount of competition exists in the health insurance market, especially in the later years.

44. Community Rating • Why don’t we just put everyone into the same basket, charge them the same premium and get the same benefit? = community rating • This is what Blue Cross did • Problems: • Suppose we have 2 large goals • 1. efficiency • 2. redistribution so low income individuals can afford medical care • Look at how community rating affects both of these goals

45. Assume 2 groups: High risk and low risk • What you are trying to do is cross subsidize the high risk group. But 3 problems: • 1) Inefficiency: low risk will be paying too high a price => may choose to self-insure even though for cost they should not. • 2) Is the high risk group the one that we want to subsidize? • Blue Cross subsidized the old but are they low income? • Evidence suggests that Blue Cross actually subsidized the middle to high income. • 3) Is community rating the efficient method of subsidizing? • No, because it distorts choices by others => just use direct subsidies to achieve the goal. • Competition ensured the demise of community rating. Low risk groups would leave the Blue Cross system with more options and this is what happened.

46. The uninsured • Look at table 11.3 / 11.4 (p. 241-42) • Why do people choose no insurance? What does our theory tell us? • P increase or decrease (prob.) • Loading costs • Lack of competition

47. Working uninsured • Book discusses 3 major reasons • 1. see figure 11.4 (p. 242)—Basically firm has limited exp. Rating => must pay i1 not i0 => can’t compete • 2. Pre-existing conditions may keep out certain industries with high % of such people—Book discusses beauty shop workers (temporary, young, etc.) • 3. Attitudes • Solutions—mandated coverage? • Separate insurance from work

48. Conclusion: • D relatively competitive especially in recent years => allocatively efficient • 2 points to support this: price is close to pure premium and demise of community rating is probably a result of increased competition in the market. • B) Supply: look at 2 issues n determining the technological efficiency of production of health insurance • 1. economies of scale = right # of firms in industry • 2. each firm produces at min. cost • Note: in normal model, competition ensures these 2 things but may have (1) information problems and (2) non-profit firms like BC BS.

49. (1) Economies of Scale: book notes that there are many firms (> 1,000) in the insurance industry • Empirical evidence seems to suggest that costs/claim decreases as the insurance firm gets larger. This appears to be true for commercial firms and BC BS. • Problems • How do you measure costs? • General problems with all these quality and type of service varies => may get bias. • The type of policy matters as well • For example: group v. individual policies. 2nd is likely to be more costly to administer => may get additional bias.

50. (2) Internal efficiency • Theoretical • Small information problems => Competition and profit-max will result in internal efficiency • Currently doesn’t exist in a large sector especially w.r.t. BC & BS for 2 reasons: • 1. BC & BS (BC est. by hospitals directly) have some monopoly power (competitive advantages) due to: • BC & BS non-profit => favorable tax treatment but premium increases are regulated. [note: lost federal tax exempt status in 1986] • Blues do not compete with each other => legal collusive arrangement between them. • BC (hospital portion) receives a discount on hospital charges that most commercial insures do not. Why?