Chapter 1: Introduction Health Economics

 Can we apply the tools of economics to study the health care sector?

Outline l The 4 basic questions of health economics. l The production possibilities curve l Economic models l Positive and normative analysis l Net Benefit calculus The following slides summarize material in Santerre & Neun, Health Economics: Theories, Insights and Industry Studies, Dryden, 2000.

Health Economics l …studies the supply and demand of health care resources and the impact of health care resources on a population. (Mosby Medical Encyclopedia 1992, p. 361)

The 4 Basic Questions 1) What combination of nonmedical and medical goods and services should be produced in the macroeconomy? a) Should the federal government spend more on missile defense or to reduce the number of uninsured children? b) Should the federal government spend more on education or prescription drugs for the elderly?

The 4 Basic Questions (cont.) 2) What particular medical goods and services should be produced in the health economy? a) Should the federal government spend more on prescription drugs for the elderly or on home health care? b) Should the federal government spend more on research to cure cancer or on cancer screening programs?

The 4 Basic Questions (cont.) 3) What specific health care resources should be used to produce the final medical goods and services? a) Should more ambulatory patients be cared for by nurse practitioners instead of physicians? b) When is medical vs. surgical management of a health condition appropriate? 4) Who should receive the medical goods and services?

The 4 Basic Questions (cont.) 4) Who should receive the medical goods and services? a) Should all of the elderly receive prescription drug coverage from the federal gov’t, or only the low-income elderly? b) Should illegal immigrants receive free care in county clinics and hospitals?

The Production Possibilities Curve (PPC) l A framework for answering the 4 basic questions. l Depicts the availability of resources and indicates what can be produced.

A PPC for the Federal Gov’t: National Defense vs. Health Care Full-proofness of the U.S. against terrorist attacks % of Children covered by health insurance 100% Points inside the PPC represent production inefficiency Points outside the PPC are not achievable with current technological know-how.

A PPC for the Federal Gov’t (cont.) l The federal gov’t must make tradeoffs.  Spending more on health insurance  spending less on defense  Tradeoffs  the PPC slopes downwards. l Tradeoffs imply opportunity costs.  The value resources would yield if they were put to an alternative use.  The opportunity cost of raising health insurance coverage by 1% could be a 2% reduction in the number of armed forces trained to deal w/ terrorist attacks.

A PPC for the Federal Gov’t (cont.) l Resources are allocated optimally if the value obtained from a particular expenditure (e.g. raising health insurance coverage by 1%) is greater than its opportunity cost.  Who’s value? In this case, one must come up with a valid measure of “society’s value”…

A PPC for the Federal Gov’t (cont.) l Resources are imperfectly substitutable Each additional unit of production has a rising opportunity cost. e.g. Raising health insurance coverage from 10 to 20% may reduce the full- proofness of the U.S. defense system from 95% to 94%. But raising insurance coverage from 90% to 100% could reduce the readiness of the U.S. defense system from 10% to 0%.  The PPC is concave.

A PPC for the Federal Gov’t (cont.) : National Defense vs. Health Care Full-proofness of the U.S. against terrorist attacks % of Children covered by health insurance 100% Identical increases in health insurance coverage require larger reductions in defense readiness as more resources are devoted to insurance.

A PPC for the Federal Gov’t (cont.) l All points on the PPC are efficient, and the point which is chosen will depend on society’s preferences. l But is the optimal point “fair”??  To the poor?  To those who would die in a terrorist attack?

A PPC for the Federal Gov’t (cont.) l As we will see in this course, market competition often leads to an efficient allocation of resources. l However, a society which is also concerned with equity can redistribute resources, often using taxation.  However, taxation leads to inefficiencies.  A tradeoff often exists between efficiency and equity.

Economic Models l “Models are abstractions of reality and are used in economics to simplify a very complex world.” l Usually describes a hypothesized relation between two or more variables. l Can be expressed in verbal, graphical, or mathematical form.

Economic Models (cont.) l Example: We hypothesize that health care expenditures are dependent upon an individual’s income. E = f(Y) In stating this hypothesis, we assume that all other likely determinants of E (e.g. prices, tastes, preferences) stay constant.

Economic Models (cont.) We can hypothesize that health care expenditures are linearly related to income. E = a + bY a = expenditures if income is zero. b = slope of the expenditure function. b =  E/  Y

Economic Models (cont.) We can quantify the linear relation between income and health expenditures. E = Y $1000 = expenditures if income is zero. Each $1,000 increase in consumer income raises health care expenditures by.1*(1000) = $100.

Economic Models (cont.) The economic models states that ceteris paribus, E= Y. We can incorporate changes in other factors into the model as well. Suppose that the population has aged, so that yearly medical costs rise by $500 for the typical household.

Economic Models (cont.) We respecify the model as: E = Y In our graphical representation of the model, this represents a shift up in the entire health care expenditure function.

E 1 = Y E 0 = Y We will rely on the results of multiple regression analysis to quantify models like this in this course.

Positive and Normative Analysis l Positive analysis makes statements or predictions regarding economic behavior.  What is?  What happened? l Normative analysis deals with the appropriateness or desirability of an economic outcome or policy.  What ought to be?  Which is better?

Positive and Normative Analysis (cont.) l According to Becker and Murphy (1988), a 10% increase in the price of cigarettes leads to a 6% reduction in the number of cigarettes consumed. l The government should increase the tax on cigarettes to prevent people from smoking.

Positive and Normative Analysis (cont.) l It is in our country’s best interests that the federal government take a more active role in the prevention of AIDS. l A study by Hellinger (1991) estimates that the average yearly cost of treating someone with AIDS is $38,300, while the lifetime costs equal $102,000.

Positive and Normative Analysis (cont.) l To control health care expenditures, the United States should adopt a national health insurance program similar to Canada’s. l National health care expenditures per capita in the U.S. equaled $4,094 in 1998.

The Net Benefit Calculus l Economic models assume that individuals are rational.  People can rank their preferences from high to low, or best to worst.  People never purposely choose to make themselves worse off.  If expected benefits>expected costs for a given choice, it is in the agent’s best interest to make that choice.

The Net Benefit Calculus (cont.) NB*(X) = B*(X) – C*(X) X = choice or activity under consideration NB* = expected net benefits B* = expected benefits C* = expected costs B*(X) = Pr(X)B(X) 1  Pr(X)  0

The Net Benefit Calculus (cont.) l Health care providers, government agencies, and individual consumers use such cost-benefit analysis to make decisions.  Explicitly or implicitly.

Conclusion l Because resources are limited, health economists are concerned with determining what medical services to produce, how they should be produced, and who should receive them. l As we will see in this course, the tools of economics can be applied to the health care sector to derive valuable insights about our health care system.

Industry Overview Health Economics

Health Care Expenditures in the United States, * Nominal health expenditures$ (billions of dollars) Annual rate of growth % (average annual % change from previous period shown) Nominal per capita health$ ,0522,6903,6864,3585,043 expenditures Health expenditures as5.1% percentage of GDP *Projected Source: Health Care Financing Administration Homepage:

The Health Care Industry is Rapidly Evolving. l Advances in medical technology and drugs are dramatically improving patient care.  But, these improvements are costly. l Aging U.S. population. % 65 years

l Increased cost containment efforts.  Changes in government reimbursement of health care providers.  Private insurers are exercising more control over patient care. l Increased competitive pressures.  Mergers of existing providers.  Entry of new competitors. é Where are the most promising business opportunities? The Health Care Industry is Rapidly Evolving.

HOSPITAL CARE l 32% of all health care expenditures in l But insurers moved from cost-based reimbursement to fixed price reimbursement in the 1980’s.  Slower revenue growth l In order to attract patients, many hospitals overspent on high-tech equipment.

HOSPITAL CARE l Improved surgical techniques led to shorter stays in hospital after surgery, more outpatient surgery.  Lower demand for hospital beds and operating room time.  1998 community hospital occupancy rate = 62.5% l A glut of hospital beds and high-tech services has led to too many hospitals competing for too few patients.

NYT 10/25/96

Modern Healthcare 2/8/99

If hospital revenues are shrinking, which sectors of the industry are growing?

America’s Top 100 Fastest-Growing Companies FORTUNE, September 4, RANK COMPANY EPS GROWTH RATE REVENUES (millions) WHAT THEY DO 16 VISX 100% $266.8 Holds 150 patents for laser technology, charges a per- procedure licensing fee. 23 Advance 78% $ Prescription-drug benefit Paradigm manager 23 Forest 105 % $959.9 Licenses drugs developed by Laboratoriesother companies & markets them. 28 Minimed 71% $252.1 Infusion pump worn like a pager for diabetes patients to avoid injections. 30 Polymedica 48% $156.9 Sells diabetes-testing equipment to seniors covered by Medicare. 30 Sunrise 124% $280.6 Assisted Living Homes Assisted Living 69 Biogen 60% $881.1 Biotech drug company, leader in MS drugs. 92 Impath 38% $99.0 Collects and interprets Cancer data

PHARMACEUTICAL INDUSTRY l U.S. prescription drug expenditures reached $99.6b in l Industry highly dependent on research and development (R&D).  $300m to bring a new drug to market. l Aggressive marketing to physicians, hospitals, pharmacists, and even the patient.

PHARMACEUTICAL INDUSTRY l Merck  $40.4b in sales in 2000  50% of sales come from Merck-Medco (pharmaceutical benefits management)  50% of human health sales come from 5 drugs: Vioxx, Zocor, Fosamax, Cozaar/Hyzaar, and Singulair

WSJ 2/10/99

MANAGED CARE l Systems which manage the quality and cost of patient care. l Most common:  Health Maintenance Organization (HMO) l Consumer pays a fixed annual capitation fee, for which HMO agrees to provide comprehensive medical services. l 60% of U.S. population (66.8m) enrolled in 2000.

MANAGED CARE l ADVANTAGE: If capitation fee > costs, HMO keeps the profit. l DISADVANTAGE: HMO responsible for cost overruns.  Subject to lawsuits if provides sub-optimal care.

WSJ 2/17/98

Integration and Disintegration

On One Hand... Between 1995 and 1998, over 2,800 hospitals were involved in mergers, acquisitions, joint ventures, long-term leases, and other partnerships. Source:Modern Healthcare. January 11, “Deals” include mergers, acquisitions, joint operating companies, joint ventures, long term leases, and system affiliations.

On the Other...

LONG-RUN KEY TO SURVIVAL v Be an efficient provider of high- quality patient care.