Chapter Nine Public policy agenda => Health care is unique Life or death Private mkt alone cannot be trusted to detrmine heath care outcome Why? Remark: Other goods are crucial for survival Large expenditure and increasing Remark: also smartphones expenditures

U.S. Expenditures of Selected Goods and Services as Share of GDP (1960-2010) Source: Centers for Medicare & Medicaid Services, National Health Expenditure Data, and National Income and Product Accounts

Examples Medicaid (low income people) Why Gov’t involvement 1. Uncertainty in life => reduce risk => Social Insurance Social insurance - government programs that provide insurance to protect against adverse events Examples Medicaid (low income people) Medicare (insurance elderly disabled) Social Security Unemployment Compensation

How Health Insurance Works Insurance premium: money paid to an insurance company in exchange for compensation if an adverse event occurs / the greater the more the compensation People are willing to pay for insurance because of -1) Expected Value= (probability of outcome 1)*(Payout in outcome 1) + (probability of outcome 2)*(Payout in outcome 2) +… + (probability of outcome n)*(Payout in outcome n) -2) Risk smoothing: paying money in order to guarantee a certain level of consumption should an adverse event occur

Example of Expected Value Computation Draw cards from deck of cards Draw heart and receive $12 Draw spade, diamond or club and lose $4 Probability of drawing heart = 13/52 = ¼ Probability of drawing spade, diamond or club = 39/52 = ¾ EV = (1/4)($12) + (3/4)(-$4) = $0

Why Buy Insurance? Insurance Options Income Probability of Staying Healthy Probability of Getting Sick Lost Income if She Gets Sick (A) (B) (C) Income if She Stays Healthy Income if She Gets Sick Expected Value Option 1: No Insurance $50,000 9 in 10 1 in 10 $30,000 $20,000 $47,000 Option 2: Full Insurance ($3,000 premium to cover $30,000 in losses Although both yield same EV, Option 2 is preferred due to risk-smoothing.

Expected value: income 0,9 50 45 0,1 20 2 47 Expected value: health expenditure 30 3

Do People Buy Insurance? Actuarially Fair Insurance Policy: Insurance premium = expected payout: => WHY PAYING THEN? CERTAINTY! Risk Aversion: a preference for paying more – a risk premium - in order to guarantee compensation if an adverse event occurs Diminishing marginal utility: more is better but… U is concave… risk adverse: pain from losing larger than utility from gaining

Why People Buy Insurance Utility UB U D UD UC C Expected Utility Risk Smoothing A UA 20,000 47,000 50,000 Income

Do People Buy Insurance with Loading Fees? Actuarially Fair Insurance Policy: Insurance premium = expected payout: Loading fee: the difference between an insurance premium charged by a company and the actuarially fair premium Current average loading ratio for private insurance companies=1.20 9-10

Do People Buy Insurance with Loading Fees Do People Buy Insurance with Loading Fees? Actuarially Fair Insurance Policy: Insurance premium = expected payout Risk Aversion Risk Premium Loading Fee

The Role of Risk Pooling Our risk is endorsed by the insurer Pooling to reduce risk =>o/wise it is stuck w/ individual risk Insurance in a small population Insurance in a large population Law of large numbers More people in=> more predictable the final outcome => charge a fair premium Remark: we are dealing w/ equal individual risk

Asymmetric information Why might Government Intervention be needed in the Health Insurance Market? Asymmetric information Situation in which one party engaged in an economic transaction has better information than the other party An individual knows her own illness risk, but insurer does not Results in Adverse Selection The phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it In charging everyone the same premium, high risk individuals have a higher probability of buying while low-risk individuals do not => DEATH SPIRAL Table 9.2 pag 183 and read pag 185: Switzerland case and footnote on effective relevance of adverse selection

Does Adverse Selection Justify Government Intervention? Experience rating: Private companies can perform some screening offering different premium but… Who will then insure those at high genetical risk? Will they be offered an insurance at all? Scientific progress and equity issue Community rating: Gov’t intervention, mandatory participation and same premium criticism: CR it is not fair while ER not so discriminatory Need to strike the balance b/n fairness and incentive Conclusion: Gov’t intervention justified

Insurance and Moral Hazard Moral hazard: when obtaining insurance against an adverse outcome leads to an increase in the likelihood of the outcome (we cannot monitor the behaviour of the insured) Even if insured would in principle incur the same risk , people are risk adverse and premium is fair=> incentive to increase risky behaviour Or seek out more health care services (not needed ?!) => Efficiency problem (also asymmetric info) Strategies for reducing moral hazard Deductible: out-of-pocket payment of health costs before the insurance company pays Co-payment: a fixed amount paid by the insured for a medical service Co-insurance: a % of the cost of a medical service that the insured must pay

Expenditures in the absence of insurance Overconsumption of medical services due to insurance coverage: Moral Hazard Expenditures in the absence of insurance Price per unit Additional expenditures induced by insurance a b Sm Axes and labels 1st click – Dm 2nd click – Sm, 3rd click - brown rectangle 4th click - .2P0 5th click - gray rectangle 6th click – deadweight loss triangle 7th click – “Flat-of-the-curve medicine” P0 h .2P0 Dm M0 M1 Medical services per year

Deadweight Loss Expenditures in the absence of insurance Price per unit Deadweight Loss a b Sm Axes and labels 1st click – Dm 2nd click – Sm, 3rd click - brown rectangle 4th click - .2P0 5th click - gray rectangle 6th click – deadweight loss triangle 7th click – “Flat-of-the-curve medicine” P0 h .2P0 Dm M0 M1 Medical services per year

Additional Considerations Flat-of-the-curve medicine: US 2.5 as much as others, however difficult to compare (R&S ) Quality: different life style /difficult comparison (O’ Neil 2007) The elasticity of demand for medical services => drawing this curve… medical advise? Vertical curve? No inefficiencies from M.H. Why? Discretional expenditure /Ethical integrity of physicians Empirical study by Anderson, Dobkin and Gross (2010) quasi experimental: losing insurance implies substantial reduction in health care utilisation => expanding coverage to curretly uninsured people => increase in demand for health service

All third party payment systems generate moral hazard Does moral hazard justify government intervention in health insurance market? All third party payment systems generate moral hazard there is a trade off, a generous system, reducing risk, more protection and more MH. Paying out of the pocket Public no better than private (unlike A.S.) 9-19 19

Information problems by patients Other Market Failures in the Health Care Market that might Justify Government Intervention Information problems by patients Lack of information by consumers about the needed treatment and competency of physician Full reliance / No other mkt is like that => It is a rationale for many government regulations? Accreditation granted by American Medical Association Externalities of Health Care Negative (excess antibiotics) and positive (flu vaccine)

Efficient but also equitable provision of Health Care Equity Considerations Paternalism Health care decisions are too complicated to be left in people’s own hands: Wrong expectations or wrong tastes (not sufficiently risk adverse) The Problem of the Uninsured: Is health insurance too expensive? - Who are the uninsured? 16% population of which 32 % age group 18-24 Of which 39% earn more than 50,000 $ => Are people buying enough insurance? Are premium too expensive? 32% of those below poverty line do not have it Much anxiety about them in US

High Health Care Costs Source: Organization for Economic Cooperation and Development [2012a].

Causes of Health Care Cost Inflation The Graying of America Income Growth Improvements in quality and medical technology Commodity Egalitarianism view: some special commodities should be distributed to everyone. There is in fact a strong consensus in the society that everyone should have access to at least basic medical services.

The Health Care Market – main issues/points Government-provided insurance (known as social insurance) makes up a large and increasing proportion of the federal budget. The U.S. spends a large percent of its GDP on health – 17.9% in 2010. Government-provided health insurance has been an increasing percentage of the U.S. federal budget Reasons for growth include aging of population, growth in income, third-party payments, and technological change For a risk-averse person, an insurance plan that charges an actuarially fair premium increases expected utility because it allows risk smoothing. The more risk averse an individual is, the more he or she is willing to pay for an insurance policy.

By pooling individuals into one insurance program, an insurance company can lower risk from a societal point of view. Adverse selection arises when those being insured know more about their risk than the insurance company. This prevents the insurance company from charging premiums that are in line with each individual's expected losses. If the insurance company instead charges an average premium across all customers, the low-risk people will tend to drop out of the plan, and the insurer makes less money. In theory, government can address adverse selection by providing universal health insurance coverage and charging uniform premiums. This is inefficient but would eliminate sorting by risk.

Moral hazard arises when obtaining insurance leads to changes in behavior that increase the likelihood of the adverse outcome. There is a trade-off in providing insurance: the more generous the insurance policy, the greater the protection from the financial risks of illness but the greater the moral hazard as well. Efficient insurance balances the gains from reducing risk against the losses associated with moral hazard. This can be accomplished by requiring high out-of-pocket payments for low-cost medical services and more generous benefits for expensive services. Justifications for government intervention in the health insurance market include adverse selection, moral hazard, commodity egalitarianism, and health care externalities About 16 percent of the US population at any given time lacks health insurance. The proportion of the uninsured population under 65 years old has been growing over time. US health care expenditures as a percentage of Gross Domestic Product have been growing rapidly over time. They currently make up 18 percent of GDP. Possible reasons include the aging of the population, growth in income, the prevalence of third-party payments, and technological change. The evidence points to technological change as a primary factor.

About 16 percent of the US population at any given time lacks health insurance. The proportion of the uninsured population under 65 years old has been growing over time. US health care expenditures as a percentage of Gross Domestic Product have been growing rapidly over time. They currently make up 18 percent of GDP. Possible reasons include the aging of the population, growth in income, the prevalence of third-party payments, and technological change. The evidence points to technological change as a primary factor.

HMWK 5 (assess the insurance plan) and 6 and 9 (!) page 199 http://www.ahrq.gov/