317_L12, Feb 1, 2008, J. Schaafsma 1 Review of the Last Lecture discussed the effect of proportional health insurance on the healthcare market => showed that price and quantity increase showed that part of the increased expenditure (from P and Q both going up) is accounted for by increased producer surplus and some increased benefit to the patient there is also a welfare loss (deadweight loss) today look at indemnity insurance then look at some other insurance concepts: the economics of deductibles, maximum payment limits, stop loss then look at estimates of the price elasticity of demand then begin our discussion of market failures

317_L12, Feb 1, 2008, J. Schaafsma 2 Indemnity Insurance and Demand Indemnity insurance reimburses for a loss at a pre-specified unit rate, e.g., $50 for a GP visit, $20 for a flu shot if the actual unit price is greater, the consumer pays the difference if the actual unit price is less, the consumer keeps the difference assume DC without the indemnity is Q = a - bP e P e = effective price with indemnity P e = P-I ~> DC is Q = (a+bI) - bP P = product price indemnity insurance shifts the DC  by the amount of the indemnity, or to the right by bI (see diagram) equilibrium P & Q , extent depends on slopes of the S & D curves (show) Indemnity insurance also creates a welfare loss and additional producer surplus (show).///

317_L12, Feb 1, 2008, J. Schaafsma 3 The Economic Effect of an Annual Deductible three cases: 1. Annual deductible large relative to expected expenditure, believe deductible will never be exceeded ~> consumption decision based on the full price 2. Annual deductible small relative to expected expenditure, believe deductible will be exceeded ~> already from Jan 1 consumption decision based on P(1-ir). 3.Problem area ~> initially believe deductible won’t be exceeded ~> consumption based on the full price. However, as deductible used up ~> may come to believe it will be exceeded after all ~> switch to consumption based on P(1-ir). Why a problem? ~> don’t know if (when), this switch will be made.

317_L12, Feb 1, 2008, J. Schaafsma 4 Maximum Payment Limits some insurance policies have insurance limits ~> maximum payout maximum payout could be per person by type of treatment e.g. orthodontic work could be a maximum lifetime payout, e.g. extended health benefits covered to a maximum of $1,000,000 over the insured’s lifetime. Problem: lose catastrophic coverage, i.e., very large losses may not be covered, however, these are the very losses you want to insure for. max payment limits ~> place an upper limit on the insurance company’s losses.///

317_L12, Feb 1, 2008, J. Schaafsma 5 Stop Loss a stop loss is the opposite of a maximum insurance limit => a stop loss places an upper limit on the loss a consumer can incur e.g., B.C. Pharmacare limits total personal liability for approved prescription drug costs For example, suppose a family’s income tested deductibles are as follows: if expenditures on pharmaceutical drugs are: $0 – 1000 the family pays 100% pharmacare pays 0% $1001 – 2000 the family pays 30% pharmacare pays 70% $2001+ the family pays 0% pharmacare pays 100% Stop loss here is $1300 per annum (max amount paid by family).///

317_L12, Feb 1, 2008, J. Schaafsma 6 Price Elasticity of Demand for HC Key issue: how responsive is Q d to P? ~> P elasticity of demand? % change in Q d in response to a % change in P (show on diagram) Expect: demand is P inelastic since HC is a necessity P elasticity of demand for HC has been extensively analyzed for: aggregate HC expenditures, and by component (see table 8.2, Text, p. 177) General agreement: P matters to the consumer Also, elasticity estimates are generally less than 1 (demand is price inelastic) but vary substantially across studies, and some estimates show elastic demand. Not clear why.///

317_L12, Feb 1, 2008, J. Schaafsma 7 Section 5: Market Failures A market failure occurs when the interaction between supply and demand fails to maximize social welfare given the distribution of income underlying the demand curve. begin by looking at how, under certain conditions, perfect competition maximizes social welfare given the existing income distribution

317_L12, Feb 1, 2008, J. Schaafsma 8 The Efficiency Condition for Optimal Output (given the distribution of income) The efficiency condition for optimal output (the condition that must be met to maximize welfare given the income distribution) is: MB = MC If MB > MC are foregoing consumer surplus (diagram) If MB < MC are wasting resources (diagram)

317_L12, Feb 1, 2008, J. Schaafsma 9 Competitive Markets and Efficiency in the Absence of Externalities in a competitive market all consumers and firms are price takers and pay/receive the same price, P (Assume same info available to all, unrestricted entry & exit, no externalities, no insurance, all are price takers, i.e., no market power) profit maximizing firm produces to the point where MC = MR = P utility maximizing consumer consumes to the point where MB = P since all face the same market P ~> MB = MC thus, in the absence of market imperfections, a competitive market achieves efficiency => maximizes welfare given the income distribution

317_L12, Feb 1, 2008, J. Schaafsma 10 Four Sources of Market Failure in the Healthcare Sector 1.Risk 2.Externalities 3.Information asymmetry 4.Monopoly power each results in the inefficient output of HC (too much or too little) => welfare loss Consider first Risk as a source of market failure

317_L12, Feb 1, 2008, J. Schaafsma 11 Risk difference between uncertainty and risk? risk ~> can attach a probability to the occurrence of an event uncertainty ~> event may or may not occur ~> can’t compute a probability can insure against risks, not against uncertain events: reason ~> for risks can compute the expected loss ~> qL, where q is the probability of the event occurring, and L is the loss if the event occurs, can’t do this for uncertain events (no q available) incidence of illness generally known for a given period of time, thus can compute the probability of getting ill ~> can compute qL for the illness, can thus insure for the loss. Not true for all illnesses

317_L12, Feb 1, 2008, J. Schaafsma 12 Why Does Health Insurance Create Market Failure? health insurance drives a wedge between the price received by the producer and the price paid by the consumer producer price = P Consumer effective price = (1 – irP, where ir is the insurance rate, ir ≤ 1 since P > (1 – ir)P ~> MC > MB ~> inefficient ~> over production ~> market failure (Diagram) have already shown this earlier in our discussion of insurance and demand