1. C HAPTER 9 THE HEALTH CARE MARKET

2. W HY IS THE HEALTH CARE DEBATE SO CONTENTIOUS ? 1. For many, access to health care can be a life or death decision. In any event, it is critical to the well being of people. Emotions run high. 2. There is uncertainty with regard to an individual’s health. A small accident or illness can have catastrophic financial consequences. 3. The US spends approximately ______________ on health care. This has increased over time from roughly 5% in 1960. o Whereas spending on other “critical” categories such as housing, clothing, and food have decreased as a percentage of GDP. See graph on next page.

3. US E XPENDITURES ON H EALTH C ARE (A S A PERCENT OF GDP)

4. US HAS HIGHEST HEALTH CARE EXPENDITURES RELATIVE TO GDP IN THE WORLD

5. W HAT ATTRIBUTES OF HEALTH CARE MAY JUSTIFY GOVERNMENT INVOLVEMENT ? 1. Uncertainty and Risk due to Asymmetric Information Asymmetric information means that one party in the exchange has more or better information than another party in the exchange. With health care some individuals may know if they are in a high risk or low risk category for illness and base decision to buy insurance on relative costs and benefits. The insurance company can’t determine who is high risk and low risk and therefore charges an average premium to all clients.

6. REASONS CONTINUED 2. ________________________________ means the people that choose to buy insurance are typically those in high risk categories who believe the benefits > costs; those that think they are at low risk may not buy insurance expecting to accrue few benefits from health insurance but would have to pay the costs associated with premiums. Hence, insurance companies may end up insuring a pool of proportionately more high risk applicants. 3. __________________________________ ___________________ occurs when someone has an incentive to increase risky behavior because the adverse outcomes of that behavior are covered by insurance. People who have insurance may overuse health care by engaging in more risky behavior or more costly behavior (unnecessary procedures and testing) because they are covered and pay very little in incremental costs.

7. T HE ROLE OF I NSURANCE Buyers pay insurance premiums, to the providers of insurance, which in turn contractually agree to cover the costs associated with health care expenditures should an adverse event or illness occur. In general, higher premiums are associated with greater coverage. What motivates consumers to buy insurance? Consumers like to “smooth the risk” associated with such events occurring so they do not have the potential for large out of pocket expenses associated with an illness. The price a consumer is willing to pay for insurance depends on the probability of an adverse event occurring, the financial impact of such an event (the costs) and the price of the insurance.

8. A CTUARIALLY FAIR INSURANCE PREMIUMS We use the concept of _______________________ to determine the average value over all possible uncertain outcomes with each outcome weighted by the probability of occurring. EV= Probability of Event 1 * Payout in Event 1 + Probability of Event 2 * Payout of Event 2 …. __________________________________________ are insurance premiums set equal to the expected value to compensate exactly the expected expenses. In the real world insurance companies have overhead costs that they must also account for in insurance premiums but for now let’s consider their additional costs of supplying insurance as zero.

9. N UMERICAL EXAMPLE : DETERMINING EXPECTED VALUE AND PREMIUMS Emily is considering two options: Option 1: no insurance and Option 2: full insurance. Assume that Emily has a 90% chance of staying healthy and a 10% chance of getting sick. When healthy, Emily earns an income of $50,000 and has no health care expenses. If she gets sick health expenditures cost $30,000 leaving her with $20,000 income. Determine Emily’s actuarially fair insurance premium: Given this premium of $3,000 should Emily buy insurance (option 2) or not (option1)?

10. S HOULD EMILY BUY INSURANCE AT A PRICE OF $3,000? Calculate the expected value of her payoff in each scenario. EV of option 1: EV of option 2: Her expected payoff is the same? Should she buy?

11. T O BUY OR NOT TO BUY ? Most people will choose insurance because the $47,000 payoff is “certain”. Emily incurs no risk with insurance. Without insurance her actual payoff could be $50,000 or $20,000 but on average it will be $47,000. In general, economic theory suggests there is __________________________________________ such that each incremental dollar provides less and less benefit to the consumer. This means the gain of an incremental dollar is less than the loss of losing a dollar so in general consumers will choose insurance if the EVs are equal.

12. R ISK AVERSION We know the expected monetary outcome (Expected Value) of Emily’s insurance options: EV= $47,000. Under Option 1 she incurs risk (no insurance); Under Option 2 she is risk-free (full insurance). Compare the utility from each option: The utility received by an individual from the risky option is called Expected Utility or EU. To determine a consumer’s choice we must compare the utility received from the risky endeavor with no insurance ( Expected Utility) with the utility received from a certain outcome called the certainty equivalent (Expected Value) with insurance.

13. R ISK AVERSION — MORE FORMALLY ______________________: the consumer prefers to avoid risk so that utility received from taking the risk of no insurance is less than the utility of the certain outcome or certainty equivalent (with insurance). Expected Utility (EU) of no insurance < Utility of Expected Value (EV) of $47,000. In this case a consumer would maximize utility by purchasing insurance. Recall From our previous example Option 1 without insurance (risk): results in a $50,000 income if healthy, a $20,000 income if sick with an EV= $47,000. Option 2 full insurance (no risk) : results in a $47,000 income regardless is she’s healthy or sick (premium was $3,000). Compare the utility of these two options: Risk vs. No Risk

14. R ISK AVERSE EXAMPLE

15. U SE GRAPH FROM PREVIOUS SLIDE Compare the Expected Utility of Option 1 with risk (EV=$47,000) compared to Option 2 Utility of $47,000 risk free Graphically, show linear segment between 20 and 50 and at $47,000 she is at point C with utility of 297. This is less than the 305 she receives from insurance. This consumer would pay to avoid risk (willing to pay a risk premium)

16. H OW MUCH OF A PREMIUM WILL SHE PAY ? How much will she be willing to pay as a premium to avoid risk? Move horizontally left onto her utility curve at 297 units of utility. Whatever that income level is, say I=$43,000, shows how much she would pay ($47,000 – $43,000 is $4,000). The more curvature in her utility function the more she is willing to pay to avoid risk. Hence, the more risk averse people are, the more insurance companies can charge

17. R EAL WORLD PREMIUMS In the real world, firms charge higher premiums than the actuarially fair insurance premium: 1. 2. The difference between the fair premium and the actual premium is called the _________________. According to Phelps 2003, the average private insurance company’s loading fee is______________ higher than the actuarially fair premium.

18. W HY CAN ’ T PRIVATE MARKETS EFFICIENTLY PROVIDE HEALTH CARE ? Given the ability to set premiums it seems that private markets for insurance should work without the need for government intervention. However, there is also a problem of asymmetric information in the market for health care. Emily may know her probability of getting sick based on family history, her personal medical history, stress, environmental factors, etc. However, the insurance company will not have access to similar information.

19. T HE ROLE OF ASYMMETRIC INFORMATION Using our previous example to look at asymmetric information. Suppose there are 10 clients each of whom face the same potential income loss of $30,000 if they become ill. Emily’s chance of being sick was 1 in 10. What if some of our clients have higher risk, say 1 in 5 of becoming ill? And what if only the clients know if they are high risk or low risk? How does asymmetric information result in market failure?

20. C ALCULATIONS For low risk clients (1 in 10 chance of getting sick) their expected loss in income is: EV= For high risk clients (1 in 5 chance of getting sick) their expected loss in income is EV=

21. F IRM LOSES MONEY If the firm continued to charge the $3,000 premium to all clients then they would certainly lose money. Expected loss of each low risk person is: Expected loss of each high risk person is: Firm pays out: Firm loses $15,000.

22. H OW SHOULD FIRMS COVER THESE LOSSES ? If the firm knew which clients were at high risk and which were low risk they could theoretically charge different prices. o Firms typically don’t have this information. o If firms have evidence of “pre-existing conditions” that signal higher expenditures in the future then firms often don’t cover those medical expenses. Suppose the firm knowing its expected payout is $45,000 and wants to spread the risk by making the average premium $4,500 for each of the ten people in an effort to cover costs. Would the firm survive?

23. W HAT HAPPENS TO THE FIRM BY AVERAGING THE PREMIUM ACROSS DIFFERENT RISK GROUPS ? The firm is driven out of the market. Why? Since the 5 low risk people have an expected loss of income of $3,000 it is unlikely they would buy insurance at a premium cost of $4,500 (even if risk averse some will opt out) The high risk people are attracted to the program but not the low risk people: adverse selection problem. Note: the insurance company would have to raise premiums to $6,000 to cover actual expenditures causing even more people to potentially drop out of the market. People who would pay the actuarially fair rate will go without insurance leaving the market not functioning. This is called: ___________________________________________

24. A TRUE STORY — HARVARD UNIVERSITY Harvard had 2 health plans: a more generous plan (costs slightly more) and less generous plan. There was a big subsidy on the generous plan for employees (it did not cost that much more than the other plan). Due to a tight budget situation they changed the system to give each employee an equal contribution to a health plan and then allowed each employee to choose to enroll in the generous or less generous plan. Now, they pay substantially more for the generous plan --$700/year. What happened? People opted out of the generous plan for the less generous plan. People who switched were not a random sample. The ones that left were younger, presumably in better health and opted for less insurance. This indicates sorting based on health status as you would expect with adverse selection. With the less healthy now pooled in the generous plan health care expenditures increased and so premiums increased. More young people left and exacerbated the situation. Harvard dropped the generous plan.—“death spiral”

25. IS THERE A WAY FOR PRIVATE MARKETS TO DEAL WITH ASYMMETRIC INFORMATION WITHOUT GOVERNMENT ? Use of “ experience ratings ” can reduce or eliminate problems associated with asymmetric information. Commonly done for life insurance where a battery of blood tests must be undertaken in addition to questionnaire regarding use of tobacco, alcohol, etc. Experience ratings are also common practice in auto insurance.

26. P ROBLEM WITH HEALTH CARE AND EXPERIENCE RATINGS Improving efficiency by reducing problems associated with asymmetric information has serious equity consequences. Those people who are genetically at a higher risk for adverse health events will pay higher premiums and may be priced out of the market. Potential solution of “community rating”—pooling a community of people into one plan. employer-mandated coverage in which large employers with a pool of many people with different risks are combined into one insurance plan with uniform premium rates. Government provided mandatory health care coverage for the entire population setting uniform rates for premiums.

27. A DVANTAGES AND DISADVANTAGES OF COMMUNITY RATINGS Advantage: reduces inequities in the market and allows a larger risk pool spreading out the risk and perhaps lowering average premiums. Disadvantage: this “community rating” means that some people may have to pay premiums above the plan’s worth to them individually (not rewarding those with healthy lifestyles that have little or no need for insurance), while others would prefer to pay more money in order to buy more insurance.

28. H EALTH I NSURANCE AND M ORAL H AZARD Another consequence of insurance is moral hazard or the tendency to engage in risky or costly behavior because you are insured against adverse events. With health insurance plans, the more a plan smoothes the risk to individuals of lost income by covering health care costs, the more it leads to inefficient overconsumption of health care through an increase in risky and/or costly behavior. Risky behavior includes: Costly behavior includes:

29. D EGREE OF MORAL HAZARD AND TYPE OF INSURANCE The degree of moral hazard depends on the type of insurance. Insurance with a copayment: Co-insurance:

30. M ORAL HAZARD GRAPHING

31. M ORAL HAZARD GRAPHING CONTINUED

32. M ORAL HAZARD AND “ FLAT OF THE CURVE MEDICINE ” Moral hazard results in overconsumption of medical services. This overconsumption occurs even to the point when the marginal benefit of services becomes close to zero. “ Flat of the Curve Medicine ”: In other words, the additional health gains from greater spending on health care are very limited. Does the US health care system on the flat of the curve? Many health economists say yes in light of GDP per capita expenditures are 2 ½ times more than the OECD average and health outcomes are not better. Average infant mortality rates and life expectancy rates for the US are average among OECD countries.

33. M ORAL H AZARD Medical services per year Price per unit DmDm SmSm M1M1 M0M0 0 P0P0.2P 0 a b h deadweight loss Flat-of-the-curve medicine

34. US SPENDING PER CAPITA IS MUCH HIGHER THAN OTHER COUNTRIES

35. US HEALTH EXPENDITURES --% GDP

36. R ICH COUNTRIES SPEND MORE — BUT US SPENDS PROPORTIONATELY MORE !

37. R EADING C HART 3 ABOVE : ( TAKEN DIRECTLY FROM OECD PUBLICATION ) If per capita income is around $20,000, a country is ‘expected’ to spend about $1,500 per person on health (and indeed this is the case for countries like Slovakia and Hungary), whereas if per capita income is $40,000, health spending of a bit more than $3,500 would be predicted. The relationship is simply an empirical observation: it does not imply that a country should be spending at or near the line, but it is a convenient way of thinking about national health spending levels. There are significant differences across countries: Canada spends a lot more than Australia, for example, though income levels are similar. But the United States is the biggest outlier, by a wide margin. A country with the income level of the United States would be expected to spend around $2,500 less per capita than it actually does – equivalent to $750billion per year.

38. C OMMON EXPLANATIONS AND MYTHS ABOUT HEALTH CARE COST INCREASES There are many common explanations for the rising health care costs in the US. 1. o Empirical evidence suggests that the change in age structure accounts for a small fraction of increased costs. o Additionally, life expectancies in all countries are increasing with medical technology and other countries have not experienced the same rapid increase in costs.

39. I NCREASES IN HEALTH COSTS CONTINUED 2._____________________ many suggest that health care is a “normal good” indicating that with higher income growth we see higher demand for medical services thereby increasing costs. o o o Newhouse estimates that increases in US income account for less than 10% of the increase in health care expenditures.

40. 3. ____________________________________________ improvements in medical training, services, equipment are costly and therefore positively impact health care costs. o Newhouse finds that “quality” is the most important explanatory factor in increasing health care costs. o Examples include cardiac care (medical treatment of heart attacks, strokes, drug therapy), care for premature and/or low birth weight babies, cancer research, etc. o One major problem with comparing health care systems internationally is accounting for differences in health care quality across countries.

41. S OURCES OF H EALTH C ARE F UNDS IN THE U.S. (2007) Source: Centers for Medicare and Medicaid Services [2008c].

42. U.S. HEALTH CARE FUNDS (2007) Source: Centers for Medicare and Medicaid Services [2008c].

43. I NTERNATIONAL COMPARISONS : C ATEGORIES OF HEALTH SPENDING In what categories of cost is the US relatively high relative to OECD countries? (taken from “Written Statement to the Senate Committee on Aging” by Mark Pearson) 1. In-patient spending: is health care spending for treatment of patients staying in the hospital. In-patient spending in the US is higher than in other OECD countries. Part of this is due to: physicians’ salaries in the US being much higher than in other countries—particularly specialty doctors. There is a pervasive shortage of doctors in the US. Part of this is due to the vast number of medical procedures being done in US not done in the same quantity in other countries (cesearan sections, knee replacements, diagnostic testing like MRIs, CAT scans, etc). Part of this is due to the practice of: In patient spending has been growing somewhat less rapidly than other categories of spending.

44. US RANKING ON EXPENSIVE PROCEDURES

45. S PENDING CATEGORIES CONTINUED 2. Out-patient care spending: is health care procedures and treatment done in a hospital or clinic where the patient goes home after the procedure (does not stay overnight in the hospital). o Out patient spending is also highest in the United States, being more than three-times greater than in France, Germany and Japan, and growing very rapidly indeed. The growth rate is high in other countries as well, but from a lower basis. o Much of the out-patient spending in the US is for elective (non-necessary) surgical procedures. o Elective procedures accounted for ___________ of the increase in growth in US health care costs between 2003 and 2006, compared to Canada’s ___________.

46. S PENDING CATEGORIES CONTINUED 3. Administrative costs are high. o medical regulations, bureaucratic systems of complicated insurance programs mixed with government programs increases administrative costs 4. Pharmaceutical spending is higher in the US than in any other country, but it accounts for a smaller share of total health spending than in other countries. o Branded drug costs in the US: o Generic drugs in US are:

47. S PENDING CATEGORIES CONTINUED 5. Long-term care spending: includes spending for those in nursing homes, skilled nursing centers, assisted living centers, home health care, etc. o long term care spending is a little higher than in other countries, but proportionally accounts for less spending than elsewhere.

50. US HEALTH OUTCOMES —Q UALITY OF C ARE US has lower life expectancy than most OECD countries and the US is below average in infant mortality rates (two key indicators of quality) However, US health system delivers care in a timely manner relative to other systems The US system has a great deal of choice in terms of doctors, hospitals, procedures, etc. The US system delivers new products to consumers more quickly than other countries. The US is a major innovator in medical procedures and products (medical innovation) US has the best 5-year survival rate for breast cancer and is ranked high in survival rates for other cancers However, the US does not perform as well in preventing costly hospital admissions for chronic illnesses such as asthma, diabetes, etc.

51. H EALTH C ARE C OSTS AND H EALTH O UTCOMES : U.S., C ANADA, U NITED K INGDOM

52. C URRENT HEALTH CARE REFORM BILL Mandatory Health Care will expand coverage to approximately 32 million Americans currently uninsured increasing the insurance pool and spreading risks. Additionally, insurance companies will not be allowed to deny children coverage based on pre- existing conditions (begins 6 months from now) Insurance providers will no longer be able to deny anyone coverage based on pre-existing conditions (beginning in 2014) Children may stay on their parent’s health plan until the age of 26.

53. “ MANDATES ” OF THE BILL Individual mandate: everyone must purchase health insurance or face a $695 annual fine (there are some exceptions for low-income people). This does not apply to illegal immigrants (approximately 11 million people). Effective January 2014. Employer-mandate: “medium sized businesses” are employers with more than 50 employees and must provide health insurance or pay a fine of $750 per worker, per year. If employees receive federal subsidies for purchase of health insurance this fine may be increased to $2,000 per worker, per year. “small businesses” with 25 or fewer employees will earn a tax credit up to 50% of their employees health care coverage expenses. Otherwise, these employees may buy into the Health Exchange in their state.

54. W HAT IS A HEALTH EXCHANGE ? Each state will create a health exchange in which those uninsured citizens and self- employed citizens can purchase health insurance. A separate exchange is to be created for small businesses to purchase coverage. Subsidies will be available for those qualifying based on income. General rule will be that individuals and families with income between 133% and 400% of the poverty level will receive subsidies to reduce the cost of health insurance. For those families earning below the 133% poverty level ($29,327 for a family of four), Medicaid will provide coverage.

55. F UNDING FOR THE BILL -- TAXES A new Medicare payroll tax on investment income (unearned income) starting in 2010. 3.8% tax on investment income for families earning more than $250,000 per year. New Medicare tax on the wealthy earning over $250,000. Medicare tax of 0.9%. Excise tax on “Cadillac insurance plans” –high end insurance plans worth over $27,500 for families will result in a 40% tax on insurance companies. Excise tax of 10% on indoor tanning.

56. O THER SOURCES OF FUNDING Annual fee on manufacturers and importers of some medical devices. Annual fee on certain makers of branded prescription drugs. Increases medical tax deduction threshold from 7.5% to 10% of adjusted gross income.