Healthcare Policy & Law

HSA405 Healthcare Policy and Law

CHAPTER 9

Health Economics in a Health Policy Context

Starting at page 156 Health Economics Defined

Entire books and courses are devoted to the concept of health economics, and this chapter is not an attempt to distill all the theories and lessons of those texts and courses. Instead, our goal is to introduce you to the basic concepts of health economics, because understanding how economists view health-related problems is one essential component of being a good health policy analyst and decision maker. This chapter begins with an overview of what health economics is, how economists view health care, and how individuals determine whether obtaining health insurance is a priority in their lives. It then moves to a review of the basic economic principles of supply, demand, and market structure. As part of this discussion, you will learn what factors make supply and demand increase or decrease, how the presence of health insurance affects supply and demand, how different market structures function, and what interventions are available when the market fails to achieve desired policy goals.

HEALTH ECONOMICS DEFINED

Economics is concerned with the allocation of scarce resources, as well as the production, distribution, and consumption of goods and services. Macroeconomics studies these areas on a broad level, such as how they relate to national production or national unemployment levels, while microeconomics studies the distribution and production of resources on a smaller level, including individual decisions to purchase a good or a firm’s decision to hire an employee. Microeconomics also considers how smaller economic units, such as firms, combine to form larger units, such as industries or markets.1(p3) Health economics, then, is the study of economics as it relates to the health field.

How Economists View Decision Making

Economists assume that people, given adequate information, are rational decision makers. Rational decision making requires that people have the ability to rank their preferences (whichever preferences are relevant when any sort of decision is being made) and assumes that people will never purposely choose to make themselves worse off. Instead, individuals will make the decision that gives them the most satisfaction, by whatever criteria the individual uses to rate his level of satisfaction. This satisfaction, referred to as utility by economists, may be achieved in many ways, including volunteering time or giving money to charities. Utility in a health context takes into account that individuals have different needs for and find different value in obtaining healthcare goods and services, and that whether and which health resources are purchased will depend on the individual’s preferences and resources.

Utility Analysis

What does utility mean in terms of health care? Most people do not enjoy going to the doctor or taking medicine. It seems strange to think that individuals are happy as a result of or maximize their utility by, for example, receiving weekly allergy shots or getting chemotherapy treatments. However, health care can be discussed in terms of utility because most people enjoy being healthy.

Everyone has a different level of health, some due to their status at birth (e.g., infants born prematurely may have problems with their lungs or mental development) and others due to incidents that occur during their lives (e.g., an individual who is in a serious car accident may suffer from back pain in the future). In addition, people have various tolerance levels for being unhealthy. In other words, the willingness to pay for a particular healthcare good or service will vary among individuals based on their circumstances and preferences.

Furthermore, at some point, obtaining additional “units” of a particular good will bring less satisfaction than the previous units did. For example, although icing a sore knee for 20 minutes may reduce swelling, icing the same knee for 40 minutes will not reduce swelling twice as much, or, although buying one pair of glasses may bring high satisfaction, buying two pairs of glasses will not double the consumer’s satisfaction because the second pair of glasses can’t do more than the first. This is called diminishing marginal utility, and it also affects what goods and services a consumer purchases.

In addition, consumers must consider the opportunity costs of their decisions. Opportunity costs refer to the cost associated with the options that are not chosen. For example, if a consumer decides not to purchase any medication to ease her back pain, there is zero accounting or monetary cost; that is, it did not cost the consumer any money because she did not purchase the medication. However, there may be opportunity costs, monetary or otherwise, because she is not pain-free. She may endure a monetary loss if she has to take time off from work due to her injury. Or, she may endure a nonmonetary loss because she cannot enjoy walking or exercising due to her back pain. Opportunity costs are the hidden costs associated with every decision, and in order to fully assess the cost and benefits of any decision, these hidden costs must be included in the calculation.

In terms of healthcare goods only, an individual’s utility can be thought of as a function of their health and the healthcare goods and services they desire. Utility maximization in health care is the ideal set of health-related goods and services that an individual purchases. However, people need to purchase a variety of goods and services, not just those relating to health care. Overall, consumers maximize their utility by purchasing what they consider to be an ideal bundle of healthcare goods and services, as well as other goods and services, based on their desire for each good and service and subject to the income they have available to make these purchases.

Scarce Resources

In the healthcare arena, consumers have to make choices about the production, distribution, and consumption of healthcare resources. There are many types of healthcare resources. Healthcare goods include items such as eyeglasses, prescription drugs, and hospital beds; healthcare personnel include providers such as physicians, nurses, and midwives, as well as lab technicians, home healthcare workers, and countless others; and healthcare capital inputs (resources used in a production process) include items such as nursing homes, hospitals, and diagnostic equipment (such as an X-ray machine). All of these things (and others) are considered healthcare resources.

If there were unlimited healthcare resources and an unlimited ability to pay for goods and services, the questions confronted by health policy analysts about what healthcare items should be produced and who should have access to them would still exist, but the answers would be less dire because there would be enough health care available for everyone. In reality, however, there is a finite amount of healthcare goods, personnel, and capital inputs. The financial resources are not available to provide all of the health care demanded by the entire population and still provide other goods and services that are demanded. As a result of this scarcity of resources, choices and very apparent trade-offs must be made.

In general, consumer choices are based on individual preference, as discussed earlier, and the concept of efficiency. In economic terms, an efficient distribution of resources occurs when the resource distribution cannot be changed to make someone better off without making someone else worse off. This notion of efficiency in exchange is also referred to as Pareto-efficient, named after the Italian economist Vilfredo Pareto, who developed the concept. There are several types of efficiency, such as allocative efficiency, production efficiency, and technical efficiency.2(pp9–10),3(p5)Allocative efficiency focuses on providing the most value or benefit with goods and services. Production efficiency focuses on reducing the cost of the inputs used to produce goods and services. Technical efficiency focuses on using the least amount of inputs to create goods or services.

The notion of efficiency raises many questions because there are always trade-offs to be made when producing goods and services. For example, should the production be more automated or more labor-intensive? Should the production sites be located in the United States or overseas? Can a service be provided in a less costly setting? Is there any additional or different service or product that will enhance the benefits of the goods or services consumers receive?

Although they may not use this technical economic jargon, public and private policymakers often consider concepts of efficiency when they answer these types of questions. The answers, in turn, help identify which goods and services should be produced overall in society and which of those goods and services should be related to health care. Because there is a finite amount of resources available, the choice to produce more healthcare goods and services would result in the production of fewer non-healthcare goods and services, and vice versa. Similarly, the choice to produce more of one kind of healthcare good or service will lead to the production of fewer healthcare goods and services of other types.

Finally, policymakers must also decide whether equity or fairness concerns should be taken into account, and in response alter their production and distribution decisions in ways that may make some people better off at the expense of others. For example, when a U.S. flu vaccine shortage occurred, some states required that vaccines be given only to individuals in high-risk groups. Individuals who had access to the vaccine, but were not in those high-risk groups, were made worse off by this decision because they were no longer allowed to receive the inoculation. On the other hand, some individuals in the high-risk group who otherwise would not have been able to obtain the vaccine were made better off under the new policy. The point is not that efficiency is more important than equity or vice versa. However, it is important to understand that these are distinct and not always complementary concerns, and whether and how one decides to influence the market will depend, in part, on how much the decision maker values efficiency and equity. In a world of limited resources, balancing consumer preferences, efficiency, and equity concerns can be a very difficult task for policymakers.

How Economists View Health Care

Health economics helps explain how health-related choices are made, what choices should be made, and the ramifications of those choices. Evaluating the consequences of these choices is referred to as positive economics. Positive economics identifies, predicts, and evaluates who receives a benefit and who pays for a public policy choice. Positive economics answers the questions, “What is the current situation?” and “What already happened?” Normativeeconomics discusses what public policy should be implemented based on the decision maker’s values. It answers the question, “What should be?”3(p14),4(p5) For example:

A positive statement: In 2013 approximately 42 million people in the United States did not have health insurance for the entire year.

A normative statement: All people living in the United States should have health insurance.

As shown by the concepts of positive and normative economics, health economists, like other analysts, cannot avoid discussing how health care should be perceived. Is health care a good or service like any other good or service such as food, shelter, or clothing that consumers obtain or refrain from obtaining based on availability, price, resources, and preference? Or is health care a special and unique commodity for reasons such as its importance to individuals’ quality of life or how the healthcare market is structured? Bear in mind that health policymakers take their own view of health care’s place in the market into account when they argue for or against a policy.

The following box identifies two theories of how to view health care. Many economists’ views fall somewhere in the middle of these two theories or combine aspects of the two theories to create a hybrid theory. These theories were not presented to be an either/or choice, but to illustrate that even within the field of economics there is a fundamental debate about how to view health care.

ECONOMIC BASICS: DEMAND

Consumers, whether an individual, firm, or country, purchase goods and services. Demand is the quantity of goods and services that a consumer is willing and able to purchase over a specified time. In the case of health care, for example, demand equals the total demand for healthcare goods and services by all the consumers in a given market.

Demand Changers

In general, as the price of a good or service increases, demand for that good or service will fall. Conversely, as the price of goods or services decreases, demand for those goods or services will rise.

Various factors in addition to price also increase or decrease the demand for a product. Insurance is an important factor relating to demand that is discussed separately later in this chapter. A few of the other factors that may change the demand for a product include the following:

Consumer’s income: As a consumer’s income increases, demand for a product may increase. For example, a consumer may desire a new pair of eyeglasses but cannot afford it. Once the consumer’s income increases, the consumer can purchase the eyeglasses.

Quality: Consumers have preferences based on quality, both actual and perceived. In addition, a change in quality will likely result in a change in demand. A decrease in the quality of a product may result in a decrease in demand because consumers decide the product is no longer worth the price charged. For example, a consumer may discover that the eyeglasses he wants fall apart easily, thus he may decide not to buy the product. Price of substitutes:A substitute is a different product that satisfies the same demand. For example, contact lenses may be a substitute for eyeglasses. As the price of contact lenses drops, a consumer may decide he prefers contact lenses to eyeglasses.

The physical profile of a consumer has an impact on demand for healthcare services in some predictable ways. Women generally demand more healthcare services than men before reaching age 65, primarily due to health needs related to childbearing, whereas men over age 65 use more care than do women in the same age group. In addition, many diseases are more prevalent in women than in men, resulting in an expected increase in demand for health services by women. Some of these diseases include cardiovascular disease, osteoporosis, and immunologic diseases.3(p111),5(pp149–150) Regardless of gender, an individual who is born with a medical problem, or who develops one at a relatively young age, can be expected to have a higher than average demand for healthcare services. Aging consumers are more likely to have higher healthcare needs than younger consumers. Of course, any factor that usually leads to increases in demand for healthcare services may be offset by lack of financial resources or lack of access to providers.

In addition to the physical profile of a consumer, interesting research is being conducted in relation to consumers’ level of education and their demand for services. Although there is no consensus on the direct impact of general education on demand for health services, some studies show a positive relationship between medical knowledge and demand for healthcare services—that is, the more the consumer knows about medicine, the higher the level of consumption of healthcare services. This association may indicate that consumers without as much medical knowledge underestimate the appropriate amount of health services they need, or it may mean that consumers with more medical education have a greater ability to purchase medical care. Other explanations are possible as well.3(p127)

Elasticity

Two of the demand changers discussed previously are shifts in price and shifts in income. Elasticity is the term used to describe how responsive the change in demand or supply is when there is either a change in price or a change in income. The concept of elasticity is important to understand as a policy analyst because it is essential to know whether changes in consumers’ incomes (say, through a tax credit) or changes in the price of a product (perhaps through incentives given to producers) will result in the desired outcome. The desired outcome may be increased consumption, which might be the case if the service is well-child checkups. Conversely, the desired outcome may be decreased consumption, which might be the case if cigarettes are the product being consumed.

Demand Elasticity

Demand elasticity is based on the percentage change in the quantity demanded resulting from a 1% change in price or income. In other words, does consumer demand for a product, such as a vaccination, increase as the price of a product decreases by 1%? Or, how much does consumer demand for the vaccine decrease as the consumer’s income drops 1%? The calculation to determine elasticity is:

Demand elasticity=% change in quantity demanded% change in priceDemand elasticity=% change in quantity demanded% change in price

Demand for a product is considered elastic if the sum is greater than 1 or greater than –1; it is inelastic if the calculation results in a sum that is between 0 and 1 or 0 and –1.

For example, suppose a vaccine costs $20 per dose and at that price a family buys four doses, for a total of $80. The next year the price increases 20% to $24 per dose and the family only buys three doses for a total of $72.

Elaxticity=−25% change in demand20% change in priceElaxticity=−1.25Elaxticity=−25% change in demand20% change in priceElaxticity=−1.25

Because elasticity equals –1.25, the product is considered elastic (because the result of the elasticity calculation is greater than –1). In this example, for every 1% increase in vaccine price, demand decreases by 1.25%. If the price decreases, the quantity demanded would be expected to increase.

Of course, goods may also be inelastic, which means the demand for the good is not as sensitive to a change in price. As a result, when price increases, the quantity demanded will not decrease at the same rate as the price increases. For example, some people will not reduce their consumption of cigarettes even if the price of cigarettes increases. However, at some point the price could become high enough that consumer behavior will change, resulting in a decrease in demand.

However, elasticity works in the opposite way in the case of inferior goods. An inferior good, as the name suggests, is less desirable than a normal good. As a result, as a consumer’s income increases, demand for the inferior good will decrease. Instead of buying more of the inferior good, the consumer will prefer to buy the normal good. For example, suppose a generic over-the-counter pain medication is cheaper than a particular prescription pain medication, but the prescription pain medication is more effective. Consumers with low income may choose to purchase the over-the-counter medicine, the inferior good. If their income increases, they will not buy more of the inferior good, but instead will switch to the prescription pain medicine because it is a better good, for their purposes, than the inferior good.

Supply Elasticity

Supply elasticity works in much the same way as demand elasticity, except it refers to the relationship between the quantity of goods supplied and the price of the goods. Supply elasticity is often defined as the percentage change in quantity supplied resulting from a 1% increase in the price of buying the good. The change is usually positive because producers have an incentive to increase output as the price they will receive for the good rises. However, if supply elasticity refers to variables other than the price of the good, such as the cost of raw materials or wages, then the supply elasticity will be negative; that is, as prices of labor or other inputs rise, the quantity supplied will fall (all other things being equal).

Supply elasticity=% change in quantity supplied% change in priceSupply elasticity=% change in quantity supplied% change in price

Supply elasticity (with respect to price) is calculated as the quantity of the good supplied divided by the percentage change in its price. For example, assume a medical device supplier is selling 25 needles for $20. Based on the supply elasticity formula, the needles have a supply elasticity of 1.25.

Elasticity=25/20Elasticity=1.25Elasticity=25/20Elasticity=1.25

Therefore, if the market price increases 10% to $22, the quantity supplied will increase 12.5% to 28 needles.

Health Insurance and Demand

In addition to the general economic rules of demand for health services, the presence of health insurance affects demand for healthcare goods and services. Health insurance acts as a buffer between consumers and the cost of healthcare goods and services. In an insured consumer’s view, healthcare goods or services cost less because instead of paying full price, the consumer may only have to pay, for example, a co-insurance rate of 20% (after satisfying the deductible). For example, if a surgical procedure normally costs $10,000, the insured consumer may only have to consider the cost of paying $2,000 for the benefit of the surgery because his insurance company pays for the remainder. In this way, the presence of health insurance can have an effect on the consumer—to increase demand—in the same way that an increase in the consumer’s income can increase demand.

In general, insured consumers are not as sensitive to the cost of healthcare goods and services as uninsured consumers.2(p38) Because of this, the presence of health insurance creates the problem of moral hazard. Moral hazard can occur in a variety of economic situations when consumers buy more goods or services than necessary because they do not have to pay the full cost of acquiring the good or service. In relation to health insurance, moral hazard results when an insured consumer uses more services than she would otherwise because part of the cost is covered by insurance.

For example, if a consumer has a $500 health insurance deductible, the consumer pays 100% of the first $500 of health care received. If there is a 20% co-insurance charge after that, the consumer pays only $.20 per dollar for every dollar spent after $500. If the consumer values a particular healthcare service, such as a preventive dental exam, at $50 but the service costs $100, the consumer will not purchase the service before meeting the deductible. However, after the deductible has been met, the dental exam (assuming it is a covered benefit) will cost the consumer $20 (20% of $100), so the consumer will purchase the service because it is under the consumer’s $50 value threshold.

As the portion of the healthcare cost that a consumer pays based on co-payments or co-insurance decreases, the consumer becomes less sensitive to changes in the price of the product. Say a consumer decides he is unwilling to pay more than $2,500 for surgery. If the consumer owes a 10% co-insurance charge, the consumer will be willing to pay for surgery as long as it is not priced at more than $25,000. At $25,000, the consumer would pay $2,500 and the insurance company would pay $22,500. However, if the same consumer has a 20% co-insurance rate, he will not elect surgery once the price rises above $12,500 because the cost to the consumer would be more than the consumer’s $2,500 limit; for example, if the surgery cost $15,000, the consumer would owe $3,000 and the insurance company would cover the other $12,000.

The problem of moral hazard is particularly relevant in health care because consumers have an incentive to seek out more medical care—they think it will make them feel better. And, as noted earlier, an insured consumer is more likely to purchase a desirable healthcare good or service because the presence of insurance reduces her cost. The same cannot be said of owning a home or auto insurance; although consumers may be a little less careful because of the protection fire or car insurance affords them, it is unlikely that people will seek out a car accident or intentionally burn down their house just because they are insured.

ECONOMIC BASICS: SUPPLY

Supply is the amount of goods and services that producers are able and willing to sell at a given price over a given period of time. As with demand, the price of a product is a key factor in determining the level of supply. However, unlike demand, where there is often an inverse relationship between price and demand, an increase in the price a good is sold for usually leads to an increase in quantity supplied. Conversely, as the price consumers will pay for a product decreases, supply will often decrease as well. As with demand, there are many factors that affect the quantity of a good or service being supplied.

Costs

Costs are a key factor in determining the level of supply. Costs refer to what inputs are needed to produce a good or service. For example, the price of cotton may impact the cost of producing medical scrubs or bed linens made out of cotton, or the price of steel may affect the cost of producing an autoclave or X-ray machine made with steel. As the cost of these inputs increases, the cost of producing the final good increases as well. If the price for a good or service does not increase as the cost of inputs increases, the quantity supplied is likely to decrease. Thus, if it costs a manufacturer $100 more to build an X-ray machine because the cost of steel has risen, it is likely that the manufacturer will pass that production cost increase on to the consumer by raising the purchase price of the X-ray machine. Alternately, the manufacturer may choose to absorb the $100 cost increase and not raise the purchase price, which will lead the manufacturer to supply fewer X-ray machines, find a way to produce the good more cheaply using the same method, or find a different way to produce the good.

Costs are counted in many different ways. We focus here on average costs and marginal costs.

Average cost is the cost of producing one product over a specific period of time. For example, if it costs a manufacturer $2 million to produce 2,000 hospital beds in one year, the average cost is $1,000 per bed during that year.

Average Cost (AC)=Total Cost/QuantityAC=$2,000,000/2,000 hospital bedsAC=$1,000 per hospital bedAverage Cost (AC)=Total Cost/QuantityAC=$2,000,000/2,000 hospital bedsAC=$1,000 per hospital bed

Marginal cost refers to the price of producing one more unit of the output, or, in our example, one more hospital bed. Whatever additional labor, equipment, and supplies are needed to produce one more hospital bed is the marginal cost of production. As a general matter, the marginal cost increases as output increases.

Supply Changers

Other factors in addition to sale price and cost can increase or decrease the supply of a product. Two common factors are number of sellers and changes in technology:

Number of sellers: As the number of sellers of a good increases, the supply of the good will increase as well because there are more companies producing the good. As long as the market is profitable, new sellers will be enticed to enter the market. This occurs until the market reaches equilibrium, where the quantity demanded equals the quantity supplied.

Change in technology: New technology may mean a new way to produce a desired outcome, which may alter the supply of a good or service. For example, fiberglass has replaced plaster in most casts and the production of each material has shifted accordingly (fiberglass up, plaster down). New technology can also make a product more accessible than before. For example, many surgeries once handled on an inpatient basis may now be performed on an outpatient basis or in a physician’s office due to new technology, such as arthroscopy. In addition, evolving technology has led to brand new fields, such as robotic surgery. Technological improvements can increase demand for some services and reduce it for others, leading to a change in the production of these goods and services.

Profit Maximization

Although consumers are driven by the desire to maximize their satisfaction, suppliers are driven by their desire to maximize revenues. For-profit companies seek to make profits to pass on to their shareholders, while not-for-profit companies face a variety of requirements regarding disposing of the revenue they generate in excess of expenses and the cost of acquiring capital to run the company. For ease of explanation, the term profit will be used here to discuss supplier incentives, even though the healthcare field includes a large share of not-for-profit companies.

Profit is the price per unit sold less the production cost per unit. In a competitive market, profit is maximized at the level of output where the marginal cost equals the price. If a hospital bed costs $1,000 to produce and is sold for $1,500, the profit per bed is $500. If the marginal cost of producing one more bed is $1,400, the producer will make that additional bed because it can be sold for $1,500, a $100 profit; however, if the marginal cost of producing an additional bed is $1,600, the producer has no incentive to produce that additional bed because it can only be sold at a loss of $100. Due to the profit maximization goal, if the price of a product increases and a competitive market exists for the product, manufacturers will increase production of the product until the output level again reaches the point where the marginal cost equals the price.

When a profitable market exists, new producers will be drawn into the market so they can reap financial benefits. The new producer may price its hospital bed for less than $1,500 to attract consumers, or the new producer may think there is a niche for a higher-priced bed that has additional features. Assume the new producer chooses to market a similar bed as the $1,500 bed but sells it for $1,250. If a consumer can purchase the bed from the competing company for $1,250 with no additional opportunity costs, demand for the $1,500 hospital bed is likely to fall. The manufacturer of the $1,500 bed will have to lower its price or improve the product (or the perception of the product) to increase demand for a higher-priced bed. At the point where there is a balance between the quantity supplied and the quantity demanded and the price is set to the marginal cost of production, there is equilibrium in the market.

If such a balance does not occur, there is disequilibrium in the market. The disequilibrium could represent a surplus of a good or service due to excess supply or sudden drop in demand, or it could result from a product shortage due to inadequate supply or a sharp increase in demand. Surpluses occur when the market price in a competitive market is higher than the marginal cost of production; as a result, producers lower their prices to increase sales of their product. This will keep happening until market equilibrium is reached. For example, there could be a sudden drop in demand for a food product due to a news report that eating the product more than three times a week may put people’s health at risk. Due to the sudden drop in demand, excess product will be available. Producers will, in turn, lower the price of the product until equilibrium is reached. Shortages occur when the market price is lower than the marginal cost of production. As a result of the shortage, consumers might be willing to pay more for the product, so producers increase their prices until demand stops increasing and market equilibrium is reached. If an opposite news story appeared, hailing the food product as improving health if eaten at least four times a week, there may be a sudden surge in demand. As a result, consumers will likely be willing to pay more for the product and producers will raise the price until equilibrium is reached. Because producers often cannot make significant changes to their production schedule or products in a short amount of time, market equilibrium positions may take some time to achieve.

Health Insurance and Supply

Just as the presence of health insurance affects a consumer’s demand for medical goods and services, it also may impact a healthcare provider’s willingness to supply goods and services. This is a complicated issue because, on the one hand, a provider is expected to act as her patient’s agent and thus should act in her patient’s best interests. If providers encourage only appropriate care, insurance is working in a positive way. On the other hand, providers may have a financial incentive to encourage or discourage the consumption of healthcare goods and services. Providers could recommend against treatment because of financial incentives resulting from the presence or absence of health insurance. For example, financial incentives found in managed care may discourage providers from recommending a particular treatment. Additionally, if a patient is both uninsured and unable to pay for services out-of-pocket, providers have a financial incentive not to provide potentially necessary services due to their inability to receive payment.

On the other hand, a provider may seek to increase her income by encouraging inappropriate or excessive care. This problem—the provider version of moral hazard—is referred to as supplier-induced demand. Supplier-induced demand is the level of demand that exists beyond what a well-informed consumer would have chosen. The theory behind supplier-induced demand is that instead of consumer demand leading to an increase in suppliers (healthcare providers), the suppliers create demand in the consumers (patients), often by relying on information only available to the supplier. However, economists debate whether supplier-induced demand actually exists because it is difficult to study empirically and because behavior consistent with supplier-induced demand may also be consistent with appropriate medical treatment.5(pp237–242)

ECONOMIC BASICS: MARKETS

To this point, we have reviewed many basic aspects of economic theory—how consumers behave, how suppliers behave, what drives and shifts demand, and what drives and shifts supply. To understand how these theories work in the healthcare industry, it is necessary to explore how health insurance affects markets, what kind of market exists for health care, how market structure relates to the production and distribution of goods and services, and why markets fail and what can be done to alleviate the problems associated with market failure.

Health Insurance and Markets

Before delving into the basics of economic markets, it is necessary to highlight how the presence of health insurance alters the dynamics of a standard economic transaction. In a typical market transaction, such as buying food at the grocery store, there are only two parties involved—the consumer who buys the food and the supplier who sells the food. The cost to the consumer is the cost of the food; the consumer bears full responsibility for paying that cost and pays that cost directly to the supplier, the grocery store.

The typical medical transaction, however, does not follow these rules, both because of the types of events that lead to a medical transaction and the presence of health insurance. In health care, there are both routine and expected events (e.g., an annual physical) and unanticipated needs due to an unpredictable illness or injury. The exact diagnosis and treatment are often unknown initially and the patient’s response to treatment is not guaranteed, resulting in an inability to predict exactly what resources will be needed. Without knowing what goods and services are required, it is impossible to estimate the cost to be incurred. This makes it very difficult for the consumer to weigh her preferences for medical care as compared to other goods and services, and makes it difficult for suppliers to know which goods and services will be demanded and at what price they can sell their goods and services.

Another reason healthcare transactions often do not follow the typical market exchange is because the presence of health insurance means that healthcare transactions involve three players, instead of two; these three players are (1) patients (the consumer), (2) healthcare providers (the supplier), and (3) insurers (who are often proxies for employers). Insurers are also known as “third-party payers” because they are the third party involved in addition to the two customary parties. In the public insurance system, the third-party payer is the government, whereas in the private sector the third-party payers are private health insurance companies. Having the health insurance carrier as a third party means that consumers do not pay the full cost of healthcare resources used and therefore may be less likely to choose the most cost-effective treatment option, to reduce the information gap between them and providers, or be as vigilant against supplier-induced demand as they might in other circumstances.

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