Agenda

1. Agenda • Questions to this point • Lessons learned in unit 2 • Unit 2 grades • Unit 3 - The Demand for Health Care • Unit 3 assignment • Unit 4 – Supply Issues in Health Care

2. Chapter 3: The Demand for Health

3. Unit 3 Project • Reviewing the Demand for Health Care services by patient’s obesity and cost expenditures for each State for health care services. How does this impact the overall resources for health care services? • Review information pertaining to Unit 3 Project in Docsharing

4. Unit 3 Assignment • Read chapters 3-5 (Health Econ) • Discussion Board • Wednesday seminars • Project

5. Unit 3 project • Discuss the supply and demand economic theory as it applies to the medical diagnosis and treatment of obesity. • Discuss the impact on State funds for Medicare and Medicaid. See Table 1, Estimated Adult Obesity-Attributable Percentages and Expenditures, by State (BRFSS 1998–2000) • Speaking as a health care economist, what would you recommend to lower the costs for your particular state of residence?

6. Learning Objectives • In this chapter, you will learn about: • the determinants of individual and population health status • the models for investment and consumption aspects of health • the international comparisons of health among the United States and other developed countries

7. Good Health • Everyone desires good health both for the sake of quality of life and because it contributes to our remaining productive and earning income • Improving health is not the only characteristic of health care that health economics takes into account • Many types of health care may impact on other aspects of a person’s welfare—for example, providing reassurances or reducing anxiety about their state of health, whether or not their health has changed • Formulating the basis for the demand for health provides the basis for the demand for health care-- which is derived from the demand for health

8. Health as a Form of Human Capital • The most important and powerful insight is that in addition to health care being an economic good, health itself can be thought of as a good, albeit one with special characteristics • Health can be regarded as a fundamental commodity: one of the true objects of people’s wants and for which more tangible goods and services—such as health care—are simply a means to create it • If it is accepted that health is a fundamental commodity, we can analyze the demand for improvements in health in very similar ways to the analysis of demand for other goods and services

9. Health as a Form of Human Capital • A key difference is that because health is not tradable, it is not possible for it to be analyzed in the market framework (i.e., improvements in health cannot be purchased directly) • A model of the demand for health, developed in the 1970s by Michael Grossman, treats investment in health as a form of investment in human capital

10. Grossman’s Investment Model of Health • In Grossman’s model, health is both demanded and produced by individuals. • Health is demanded because it affects the total time available for the production of income and wealth and because it is a source of utility itself • Health is modeled as being produced by individuals, using a variety of means such as diet, lifestyle choices, and medical care • How efficient people are in the production of health depends on their knowledge and education • Medical care is but one input to the production of health • Each individual is modeled as starting life with a ‘stock’ of health, which has characteristics similar to capital: health depreciates through time with age, but can also be increased through investments in time, effort, knowledge, or by seeking health care

11. Grossman’s Investment Model of Health • Grossman’s model captures two important insights • Health care is but one input in generating improvements in health: it is now widely accepted that medical care is not the major determinant of health • Individuals do not demand health care for its own sake • The investment model of health views the demand for health as being conditional on both the cost of health capital and the rate of depreciation of the health stock • Marginal efficiency of capital is a measure of how much extra output can be produced with an extra unit of input. • MEC curve slopes downward because additional units of investment are assumed to yield smaller marginal improvements in the production of health

12. Grossman’s Investment Model of Health • The MEC schedule is the demand curve for health • Can also be seen as a production function for health because it relates inputs and the output of the stock of health • The wage effect • The change in the wage rate as a shift in the MEC schedule because it changes the return from the stock of health • The Consumption Model • It makes sense to shift to a model that focuses on the allocation of the budget (income) between investment in health and expenditure on consumer goods at any given time

13. Additional Factors that Affect the Investment in Health • Age--as one ages, it takes more resources to obtain or maintain a given stock of health • Education--considerable evidence exists that more highly educated people are more efficient in the production of health • Lifestyle effects of wealth-- MEC curve may shift to the left as people become wealthier and consequently eating richer foods and lacking exercise. • Chemical dependency--addiction might be viewed as shifting the marginal efficiency of health capital curve to the left, and it can also be viewed as causing a change in taste that would result in the substitution of the additive good for an expenditure on health

14. Understanding the Investment Aspects of the Grossman Model • Grossman’s theory is based on the idea of household and production. • The theory of health demand starts by assuming that people derive utility from two goods: health (H) and a composite of all other fundamental commodities (O), such that: • U=U(H,O) • Both H and O are sums over time, weighted by the person’s time preference • Health stock as a particular time (HSt) is determined by the health stock in the previous period (HS t-1) less any depreciation in health stock that has taken place over that period (dt), plus any investment in health (It) that the person has undertaken, such that: • HSt =HSt-1 – dt + It[J1]

15. Understanding the Investment Aspects of the Grossman Model • Both O and I are produced within the household • Production of O and I uses market goods, medical care (M) and all other market goods (X) respectively, and time spent on either in the production of health (TH) or in the production of other goods (TO) • A third input to both is human capital, usually characterized as the level of education (E). The production functions are therefore: It = I(Mt, TH, Et) • Ot=O(Xt,TO, Et) • It is assumed that a person will attempt to maximize their utility, subject to two cnnstraints: • The time budget (T) is fixed at 365.25 per year, where time is further constrained to time spent on working (TW) and time spent being sick (TS), such that:

16. Understanding the Investment Aspects of the Grossman Model • Tt = THt + Tot + TWt + TSt[J2] • The constraint on the expenditure budget is income, which depends on how much time is spent working and the wage rate (W). How much is spent depends on the costs of the market goods, M and X, and it is assumed that all income is spent, such that: • PMxM + PXxX =TWxW • Both sides of the equation are in terms of present discounted values • Maximization of the utility function, subjected to these constraints and taking into account the production function, leads to an equilibrium condition which can be interpreted as a person equalizing the marginal benefits of health capital and its marginal cost

17. Critics of the Grossman Model • Decisions about health care as part of a rational strategy for investing in health is belied by the facts • One argument: expenditures on medical care are, in fact, correlated with ill health • Higher expenditures on health is simply a result of responses to negative shocks to the state of health • Others: a great amount of uncertainty associated with the onset of illness makes it impossible to develop a rational plan for investing in health

18. Summary • Economists see the demand for health as an investment decision • Using this model, health care is not a consumer good, but an input into the production of the capital good—the stock of health • This chapter presented the widely-used model of the demand for health developed by Michael Grossman

19. Chapter 4: The Demand for Health Care

20. Learning Objectives • In this chapter, you will learn about: • the role of health care as an input to the production of health • the responsiveness of demand for health care with respect to time, price, and income • the relation of income and the demand for health care

21. The Demand for Health Care • The demand for health care depends on the particular production function for health • The effect of education on the demand for health care is not predictable • If education makes a person more efficient in producing health, an increased awareness of the value of good nutrition and prevention of disease will reduce the quantity of health care required to produce a given stock of health

22. The Demand for Health Care • Education can also increase the demand for health itself • The more educated will demand more health, but less health care, if the effect of education on the productivity of inputs into health outweighs the shift in health care demand • The effect of age on the demand for health care has been found to vary by type of health care required • Health insurance influences the price of health care, which is a movement along a given demand curve for health care

23. The Demand for Health Care • In analyzing the demand for health care, it is important to take into account the concept of need when considering both the characteristics of health policy and an individual’s consumption of health care • Needs and demands can therefore be regarded as two very different ways of viewing matters

24. Asymmetry of Information and Imperfect Agency • Information is itself an economic good • The relationship between doctor and patient is often presented as a principal-agent problem • The doctor is the agent acting on behalf of a principal, who is the patient, in making decisions about what health care to purchase • If doctors made these decisions in a manner fully consistent with patients’ preferences, unaffected by the consequences for themselves, they would be acting as perfect agents

25. Asymmetry of Information and Imperfect Agency • the hypothesis of supplier-induced demand (SID) purports that doctors engage in some persuasive activity to shift the patients’ demand curve in or out depending on the physicians’ self-interest • Empirical evidence shows that physicians do respond to financial incentives and they do appear to influence demand and do so partly in response to self interest

26. Estimates of the Price Elasticity of Demand for Health Care • We measure the responsiveness of consumers to changes in the price of a good or service by the price elasticity of demand • The formula for elasticity of demand with respect to price is: • % change in the quantity of health care demanded • % change in price of health care • In general, goods and services which are close substitutes have higher price elasticities, and complementary goods and services have lower price elasticities.

27. Estimates of the Price Elasticity of Demand for Health Care • The highest price elasticity estimates observed are for those demanding hospital outpatient services and for nursing home services • The lower number of substitutes for hospitals make the elasticity for hospital services lower than that for physician services • However, once a physician is chosen, this also limits the number of hospitals that the patient can utilize as well due to the limits on admitting privileges of physicians 

28. Time Costs and Price Elasticities • The time cost is the value of time used in a given activity • Estimates of the price elasticity of demand for any good or service that requires time will tend to be biased if one does not take into account the time and money costs as well • The time cost of consuming a healthcare service would be the time involved in waiting for the appointment, as well as the travel time • The total cost of services that require time will be higher for patient with higher wage rates because they have a higher opportunity cost of time • Any factor that increases the value of time will increase the opportunity cost of time

29. Aggregate Demand for Health Care • It is clear that there is a positive relation between income and the demand for health care: the richer the country, the greater the demand for health care

30. Healthcare: A Normal, Superior, or Inferior Good? • A normal good is a good for which income elasticity is positive but less than one • If income increases by a given percentage, the quantity of the good consumed increases, but at a lower percentage than associated with the income increase • If the percentage increase in the quantity consumed is greater than the associated percentage increase in income, the good is called a superior good • If the percentage increase in the quantity consumed is less than the associated percentage increase in income, the good is called an inferior good

31. Healthcare: A Normal, Superior, or Inferior Good? • The answer to whether health care is a normal, superior, or inferior good, differs depending on whether we look at studies based on individual responses or those utilizing aggregate data • Studies in the 1960s through 1990s provides estimates of income elasticities for health care based on survey data derived from individual responses • These studies show consensus that most health care services have coefficients of income elasticity that are positive and in the r range of 0–1, and can be classified as normal goods. • Studies using macroeconomic data do yield considerably higher income elasticity coefficients for health care • A wide range of studies have generally found health care to be a superior good

32. Summary • The demand for health care depends on age, education, income, and health status • The demand for health care is generally sensitive to price and income • Price elasticities have values ranging between 0 to -1 • Health care for which substitutes exist have higher elasticities than those with fewer substitutes, such as an acute care hospitalization • The association between income and the amount of health care utilized shows that health care can be a normal good when studies are based on individual responses • Macroeconomic data that compare country-wide aggregates in income and healthcare spending show that health care is a superior good

33. Chapter 5:The Market for Health Insurance

34. Learning Objectives • In this chapter, you will learn about: • The characteristics of the insurance market • The role of and implications of employer-based insurance • The trends in insurance markets

35. The Insurance Market • People buy insurance because they are risk-averse • Buying insurance allows a person to pay a certain known amount in order to transfer the risk of a much larger expenditure (in the case of an adverse event) to an insurer, known as a third party payer • There are a number of types of risk associated with health • Risk to one’s health and life associated with illness or disease • Risk that if one undertakes treatment, it may or may not cure or alleviate symptoms of disease • The costs associated with the treatments of illness and disease

36. The Insurance Market • People can insure themselves against some or all of the financial loss associated with the treatment of illness by buying health insurance policies • Even people with extensive wealth buy insurance due to the fact that most people are “risk-averse” • Economists define risk aversion as a characteristic of people’s utility functions • If the marginal utility of wealth decreases as wealth increases, there is a small probability of a smaller amount of wealth when the probability-weighted or expected value of the alternatives is equal • That is a situation of risk aversion

37. Setting Insurance Premiums • The price that an insurance company charges for an insurance policy, or premium, is based on the expected payout (amount paid out on average for a large group of insured persons), plus administrative costs, reserve funds, and profits or surpluses of the insured company • Premiums charged generally exceed the fair value of the risk that the insurance company has assumed, where the fair value is the expected payout

38. Setting Insurance Premiums • The part of the insurance premium that exceeds the fair value of the insurance is called the loading fee • Particularly when comparing different insurance policies, it is convenient to express the loading fee as a percentage based on the ratio of premium to expected payout: • L=100 x ((premium/E)-1), where E=probability of illness x treatment costs. • Suppliers of insurance will be more willing to enter market situations where they can make a reasonable estimate of what their payouts will be, or where they can assess the degree of risk they are assuming

39. Experience versus Community Rating • One common method of pricing insurance is experience rating • Insurance companies base premiums on past levels of payouts, which is often done in the case of car or homeowners’ insurance. • Community rating applies when each member of an insurance pool pays the same premium per person or per family for the same coverage • Community rating is inefficient in the sense that the price of insurance to an individual subscriber does not reflect the marginal costs of that individual to the insurer.

40. Moral Hazard • Moral hazard refers to the phenomenon of a person’s behavior being affected by his or her insurance coverage • Moral hazard is known to exist is in all types of insurance markets • People may be more careless with property that is insured • The main way that moral hazard comes into play in the health insurance market is through an increase in demand for healthcare services utilized

41. Moral Hazard and the Structure of Health Insurance Contracts • The reason that moral hazard operates differently in the health insurance market than in other insurance markets is that health insurance contracts differ from most other forms of insurance • Instead of paying a sum of money to the insured in the case of an adverse event, they reduce the price of the health care associated with the adverse event or illness

42. Moral Hazard and the Structure of Health Insurance Contracts • Some degree of moral hazard exists when the price elasticity of demand for covered healthcare services is greater than zero • In theory, the problem of moral hazard should be greater in the case of policies covering a broader range of services, including more discretionary or elective ones, because the price elasticity of demand for these services is believed to be higher

43. Moral Hazard and the Structure of Health Insurance Contracts • Major healthcare services contracts also differ from most types of insurance in that they generally cover more than just unlikely catastrophic events, also fulfilling a function analogous to that of a service contract on an automobile • they also include reimbursement for annual physical exams, vaccinations, treatment for chronic conditions, and various types of routine tests

44. Cost Sharing to Offset Effects of Moral Hazard • Deductibles. A deductible is a level expenditure that must be incurred before any benefits are paid out • Health insurance policies generally have yearly deductibles, which is less effective in removing moral hazard • Coinsurance. Coinsurance is the proportion of the total expenditure that is paid by the insured • Coinsurance helps to reduce the moral hazard factor for the insured that have spent more than their deductible because health care is not free to them

45. Cost Sharing to Offset Effects of Moral Hazard • Use of Usual, Customary Fees to Limit Payments. It has become common practice for insurance policies that reimburse on the basis of fee-for-service to limit payment for covered services to customary or usual fee within given geographic markets • Managed Care. Care is actually managed or rationed using such mechanisms as “gatekeepers,” who are primary care physicians that make all referrals to specialists, limit coverage to service providers with whom the insurance company has a contractual agreement, and require precertification or approval from the insurance company before services are rendered

46. Cost Sharing to Offset Effects of Moral Hazard • Controls are on the supply side as well as the use of risk-sharing arrangements with providers of health care • Stop-Loss Provisions. Many policies also have annual limits on out-of-pocket expenditures (per person or per family) that must be borne by the insured • Stop-loss provision

47. Adverse Selection • Adverse selection exists when people with different health-related characteristics than the average person increase the amount of health insurance purchased • People know more about their own health status than insurers, and this inequality of information is the basis for risk to insurers • In the health insurance market, high risk people are those with more severe health problems than the average person • These people would be overrepresented in the insurance markets, particularly those markets with more inclusive policies • This would drive up the premium because the high risk persons would use more health care and drive off those with better health from buying the insurance policies

48. Insurers’ Responses to Selection Problems • Insurers engage in positive selection, where the companies structure coverage to both avoid adverse selection and also to attract lower-than-average risk subscribers • The disappearance of insurance options due to the spiraling costs associated with adverse selection has been a serious problem in the market for individual direct pay policies in regions that require community rating

49. Offsetting Adverse Selection • Some economists have questioned whether health insurance markets can reach equilibrium, given the role of adverse selection • Consumers no longer have much of the information advantage in choosing the best package of insurance to cover their future expenditures • The condition necessary for insurance markets to function is that individuals with different risk properties differ on some characteristic that can be linked to the purchase of insurance and that there is some way that insurance company can discover the link

50. Employer-Based Insurance • Advantages of employer-based insurance • Group insurance is important for offsetting adverse selection • Community rating applies within the employment group, which results in some degree of risk sharing • Economies of scale in administrative rates are lower than those for individual or direct pay policies • Insurance companies may still use experience rating to charge higher prices to higher-risk groups .