1. Health Care; Information Today: More topics to help you think like an economist

2. Today Three more “mini-lectures” Health care The economics of information Asymmetric information

3. Health care “By 2017, total health care spending will double to more than $4 trillion a year, accounting for one of every $5 the nation spends, the federal government projects.” (Source: AP article on CBS’ website, “Health Care Will Cost $4 Trillion by 2017,” posted Feb. 26, 2008; see readings on class website for link)

4. Health care More from the AP article, quoting Centers for Medicare and Medicaid Services economists "Health is projected to consume an expanding share of the economy, which means that policymakers, insurers and the public will face increasingly difficult decisions about the way health care is delivered and paid for"

5. Health care As we will see, there is often too much money spent on health care, relative to the optimal amount of spending We will look at a simple case with constant MC

6. Health care Health care services, like all goods and services, have a demand schedule Demand denoted by MB curve

7. Health care Suppose that Angela has been admitted to the hospital after being in a car accident She has a substantial MB for the first night in the hospital, due to the care that she needs

8. Health care As Angela’s condition improves, her MB declines After Q2 days in the hospital, she is completely better

9. Will Angela pay for the full cost of her hospital stay? Not likely Most Americans have at least some health insurance Insured person usually pays a deductible or co-payment for medical services Some people have complete medical coverage No direct payment made to those that provide medical services

10. Equilibrium length of hospital stay with co-payment Assume that Angela pays X dollars (co- payment) for her hospital stay Let X be small relative to total hospital bill Angela will then decide to stay in the hospital as long as MB for each night exceeds its MC Note that Angela’s private MC is zero under this form of insurance

11. Equilibrium length of hospital stay with co-payment PUBLIC MC is positive Angela’s PRIVATE MC is zero If hospital lets Angela stay in the hospital as long as she wants, equilibrium occurs at Q2 MB and private MC are both zero here

12. What is optimal? Angela’s optimal length of hospital stay occurs when the PUBLIC MC equals MB This occurs at point A

13. What about a percentage co- payment? What if Angela had to pay 20% of her costs while in the hospital Her PRIVATE MC is now two-tenths of MC curve (See dashed line) Equilibrium is at the yellow circle 0.2 MC

14. What are some possible solutions to this problem? Health Maintenance Organizations (HMOs) Patients less likely to receive services with low MB Higher deductibles Closer to optimal outcome, since out-of-pocket payments are higher Reimbursement policies for medical services Review boards Discharge criteria from hospitals

15. Moral hazard With insurance, people are likely to do riskier activities, knowing that insurance will cover them if they get hurt Skydiving Bungee jumping Mountain climbing These activities lead to more medical costs, leading to higher premiums for everyone

16. Health care costs Is there a single solution to lowering health care costs? No: Many approaches will be needed Another issue: Drug costs Research and Development: Often millions of dollars for a single drug Patent protection  Market power

17. Summary: Health care Insurance often leads to more health care being used than what is optimal Co-payments help improve efficiency some, but not completely Some methods to help lower health care costs include the use of HMOs, higher deductibles, and reimbursement policies

18. The economics of information Information is valuable, since the right buyer is more likely to find the right seller Middleman is often knowledgeable about a market, which is valuable This leads to the question: How much information is optimal?

19. Information is typically not complete nor perfect Since firms and customers are usually not fully informed, we lose efficiency Firms are unable to notify every potential customer that her/his business is ready to sell Customers may not know all options of companies that sells a good or service

20. Do we want full information in every market? No Prohibitively costly, if it is even possible In our analysis, we will find the optimal amount of information

21. The middleman A good middleman (or middlewoman) is knowledgeable about the market in question Some customers are willing to pay for this service Some information providers today are not human Google and many other search engines have paid advertising

22. What is optimal? As usual, we will use marginal analysis We will search for information is long as MB > MC The middleman often provides this information, but at a cost

23. More on the middleman Basic information can be provided at low cost, since many people are usually knowledgeable in the topic Very specialized information can be costly Someone may have to do substantial research to get this specialized information  MC of information usually increases at an increasing rate

24. Marginal benefit of information Basic information about a product is usually very valuable Very specialized information usually has little value  MB of information typically gets steeper as the number of units increases

25. Some examples of MC and MB curves of information

26. Optimal amount of information? Find the point where MB = MC Example: Use MC 1 and MB 1 curves Optimal amount of information is 7 units, at a cost of $15 per unit

27. Summary: The economics of information Information is useful, and thus has value MB/MC analysis still applies The “middleman” often provides information, at a price

28. Asymmetric information Some markets have sellers knowing more about their product for sales than buyers This is known as asymmetric information Most common example: Used cars Buyer knows less about the car than the seller Some cars are good: “plums” Some cars are bad: “lemons”

29. Lemons model When buyers do not have information as to which cars are lemons and which cars are plums, sometimes only the lemons go on the market We will go through two examples to show a case where only lemons are available on the market

30. Example 1 A used car dealer has the following information about used Yugo limos: Plums are worth $3,000 to the dealer $1,200 to the owner Lemons are worth $250 to the dealer $100 to the owner 100 Yugo limos owned privately Half of the limos are plums, half are lemons Yugo car Yugo limo

31. What should the used car dealer offer for Yugo limos? Suppose the used car dealer offers $1,201 for used Yugo limos 1,201 > 1,200  Plum owners sell to dealer 1,201 > 100  Lemon owners sell to dealer Profit if all 100 are bought Total value = 50  3,000 + 50  250 = $162,500 Total cost of buying Yugos = 100  1,201 = $120,100 Total profit = $162,500 - $120,100 = $42,400

32. What should the used car dealer offer for Yugo limos? Should the used car dealer offer an amount other than $1,201? Offer a higher price  increased cost for no gain in value Offer a price below $1,200  only the lemon owners would sell their cars Profit if $101 was offered  50  (250 – 101) = $7,450

33. What is the best price to offer? Offer $1,201  profit is $42,400 Offer $101  profit is $7,450 Highest profit occurs if $1,201 is offered

34. Example 2: Everything is the same except the last bullet point A used car dealer has the following information about used Yugo limos: Plums are worth $3,000 to the dealer $1,200 to the owner Lemons are worth $250 to the dealer $100 to the owner 100 Yugo limos owned privately One-quarter of the limos are plums, three-quarters are lemons

35. What should the used car dealer offer for Yugo limos? Suppose the used car dealer offers $1,201 for used Yugo limos 1,201 > 1,200  Plum owners sell to dealer 1,201 > 100  Lemon owners sell to dealer Profit if all 100 are bought Total value = 25  3,000 + 75  250 = $93,750 Total cost of buying Yugos = 100  1,201 = $120,100 Total profit = $93,750 - $120,100 = –$26,350

36. Notice here that the dealer will never offer $1,201 Why? Profits are negative Profits can be zero by not attempting to buy Yugo limos

37. What should the used car dealer offer for Yugo limos? Offer a price below $1,200  only the lemon owners would sell their cars Profit if $101 was offered  75  (250 – 101) = $11,175 Offer $101 to maximize profit

38. What else could the car dealer do? The dealer could hire a mechanic to try to determine if the Yugo limos are lemons or plums Will do it if MB of information exceeds MC

39. Summary: Asymmetric information The Lemons model Under what conditions will plums never enter the market?

40. Wednesday Other topics E-mail me by tonight if you want to see any of the following topics covered Public goods Labor markets (value of work; human capital; more on unions; discrimination; income distribution) Government failure Taxation The internet and information

41. Sick?  lemons are good (Vitamin C) Driving?  lemons are bad