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Chapters 15 and 16: Health Economics and Public and Private Health Insurance


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Title: Chapters 15 and 16: Health Economics and Public and Private Health Insurance

Chapters 15 and 16 Health Economics and Public
and Private Health Insurance
  • Outline
  • Introduction
  • Health insurance
  • Private through employers
  • Public
  • Uninsured
  • (Like other forms of insurance, we trade off)
    consumption smoothing versus moral hazard
  • Payments to providers
  • Health care reform

  • Increases in health spending (from 4 of GDP in
    1950 to 15 of GDP in 2003) have altered the
    delivery of health services. For example,
    treatment for many ailments has improved
  • Knee surgery that used to be very invasive and
    took months to recover is now a quick and easy
  • The number dying from heart attacks has fallen by
  • The infant mortality rate has fallen by 75.
  • Individuals can permanently improve their vision
    with LASIK surgery, that takes less than two
    hours, and be up and running within a day.

  • There are some problems with the health care
    system however. Disparities in health outcomes
    exist by race and income.
  • The white infant mortality rate is 6 per 1000, in
    line with countries like the United Kingdom and
  • The black infant mortality rate is 14 per 1000,
    more than double. It is higher than some
    developing countries.
  • Access to health care also varies.
  • 15.6 of the U.S. population, or 45 million
    people were uninsured in 2003.
  • The number of uninsured has remained high during
    both economic booms and busts.

Spending in the U.S. averages 5,800 per person,
and nearly 15 of GDP.
Countries like the United Kingdom and Japan spend
a much smaller share on health care.
Americans Source of Health Insurance Coverage, 2002 Americans Source of Health Insurance Coverage, 2002 Americans Source of Health Insurance Coverage, 2002
People (millions) Percentage of population
Total population 288.6 100.0
Private 177.8 61.6
Employment-based 161.0 55.8
Individually purchased 16.8 5.8
Public 83.0 28.8
Medicare 40.5 14.0
Medicaid 42.8 14.8
Uninsured 43.3 15.0
Roughly 44 million individuals were uninsured for
the entire 2002 calendar year, or 15 of the
Some Terminology That Arises with Insurance
  • Individuals often pay for part of the cost of
    their actual utilization, whether privately
    (through employers) or publicly provided.
  • These payments by individuals occur in one of
    three ways
  • Deductible A person faces the full cost of care
    to some limit, and the insurance pays for costs
    after that.
  • Copayment A person pays a fixed payment when
    they get a medical good or service.
  • Coinsurance A person pays a percentage of each
    medical bill rather than a flat dollar amount.

Private Insurance
  • A risk pool is a group of individuals to whom an
    insurance plan is offered.
  • One motivation for employers to offer coverage is
    the nature of risk pools.
  • Insurers try to create large insurance pools with
    a predictable distribution of medical risk. Two
    features increase the predictability of medical
    risk distributions
  • The absence of adverse selection
  • Large group sizes
  • Employers have a good chance of meeting these
  • Individuals are not likely to meet these
  • Although large groups of individuals could be
    formed, the concern about adverse selection
  • That is, is the group looking for health coverage
    simply because they are sick.
  • Some administrative costs of running a health
    insurance plan are fixed thus, the larger the
    pool, the smaller the per-enrollee costs.
  • This also reinforces the preference for providing
    insurance through large firms.

Private Insurance
  • Overall, adverse selection, group size, and fixed
    costs lead to vast differences in the odds of
    being offered health insurance.
  • 98 of firms with 200 or more employees offer
    health insurance to at least some of their
  • Only 55 of firms with fewer than 10 employees
    offer health insurance.
  • Even one costly health risk (such as a cancer or
    AIDS patient) can lead to losses for small groups.

Private Insurance
  • The tax subsidy to employer provided health
    insurance refers to the fact that workers are
    taxed on their wage compensation but not on their
    compensation in the form of health insurance,
    leading to a subsidy to health insurance provided
    through employers.
  • This is a second motivation for employers to
    offer health insurance coverage.
  • The effective price of offering 1 of health
    insurance is only (1-J), where J is the
    cumulative federal, state, and payroll tax rate.

Illustrating the Tax Subsidy to Employer-Provided Insurance Illustrating the Tax Subsidy to Employer-Provided Insurance Illustrating the Tax Subsidy to Employer-Provided Insurance Illustrating the Tax Subsidy to Employer-Provided Insurance Illustrating the Tax Subsidy to Employer-Provided Insurance Illustrating the Tax Subsidy to Employer-Provided Insurance Illustrating the Tax Subsidy to Employer-Provided Insurance
Marginal product, wage Employer health insurance spending Pre-tax wage After-tax wage Personal health insurance spending After-tax, after-health insurance income
Jim 30,000 0 30,000 25,500 4,500 21,000
Peter 30,000 5,000 25,000 21,250 0 21,250
Although Jim buys less expensive health insurance
on his own, his net income is lower!
Jim and Peter face 15 marginal tax rates. Jim
purchases a private policy for 4,500. Peters
employer buys him a more expensive policy for
5,000. Yet, because of tax deductibility, Peter
s after-tax income is larger than Jims.
  • Medicaid serves low-income groups who are
  • Women and children
  • Disabled or elderly
  • Medicaid is administered by the states, but
    financed jointly by the federal government and
    the state.
  • In poor states like Mississippi, the federal
    government pays nearly 4 for every 1 the state
  • In richer states, like Massachusetts, the federal
    government pays 1 for every 1 the state
  • The benefits of Medicaid are similar to private
    plans, except there is little or no patient
    coinsurance or copayments.
  • States must offer a basic set of services, and
    have latitude to add additional services.

The Medicaid program for low-income mothers and
children Eligibility and Coverage
  • The Childrens Health Insurance Program (CHIP)
    was introduced in 1997 to expand eligibility of
    children for public health insurance.
  • Generally covers up to 200 of the poverty line,
    or 36,800 for a family of four in 2004.
  • Some states expand eligibility much higher, such
    as New Jerseys 64,400 limit for children.
  • Federal rules require that the full Medicaid
    program cover major services like physician and
    hospital care.
  • All states have also chosen to cover other,
    expensive, optional benefits almost all cover
    prescription drugs, optometrist services, and
    dental. Often, no copayment is required.
  • As a consequence, Medicaid is much more generous
    than virtually any private plan.

The Medicaid program for low-income mothers and
children How do providers get paid?
  • Although the services are generous, the
    reimbursement to health care providers is not.
  • Medicaid reimburses physicians at a much lower
    level than the private sector. For example,
    childbirth is reimbursed at about half the
    private-sector rate.
  • Physicians are often unwilling to serve Medicaid
    patients. One-third of doctors serve no Medicaid

The Effects of Medicaid on Health Steps to
In reality, crowd-out turns out to be an
important issue.
Expanding Medicaid eligibility affects both the
uninsured and the insured.
Increased Eligibility
Previously Privately Insured
Previously Uninsured
Step 1
Even with crowd-out, however, Medicaid coverage
goes up.
Medicaid Coverage
Step 2
This leads to better access to health care and
greater utilization.
Medical Utilization
Step 3
This is weighed against program costs to
determine cost-effectiveness.
Increased utilization should improve health
Health Outcomes
Step 4
Program costs
What are the effects of the Medicaid program?How
does Medicaid affect health? Evidence
  • Step 1 although eligibility expanded
    dramatically, relatively few of the newly
    eligible enrolled the takeup rate was roughly
  • Roughly 2/3 of children already had private
  • When faced with the free Medicaid option, there
    appeared to be substantial crowd-out of private
  • For every 100 new Medicaid recipients, the number
    on private insurance fell by 20 to 50 persons.
  • Nonetheless, expanding Medicaid still
    substantially reduces the number of uninsured.
  • Step 2 Currie and Gruber find that these
    reductions in the number of uninsured had
    positive effects on health.
  • Utilization of health services increased Early
    prenatal care and preventive medical visits for
    children rose by more than 50.

What are the effects of the Medicaid program?How
does Medicaid affect health? Evidence
  • Step 3 Health care outcomes improved.
  • Infant mortality declined by 8.5 due to the
    expansions in Medicaid for pregnant women.
  • Other work using the introduction of national
    health insurance in Canada and the termination of
    public assistance in California find health
    results consistent with these findings, too.
  • Step 4 Currie and Gruber (1996) estimated that
    it cost Medicaid roughly 1 million per infant
    life saved through the expansions.
  • This is much lower than typical estimates from
    other policies, including food regulation and
    seat-belt safety.

The Other Major Public Insurance Program
Features of Medicaid and Medicare Features of Medicaid and Medicare Features of Medicaid and Medicare
Medicaid Medicare
Eligibles Families on welfare Low-income children, pregnant women Low-income elderly, disabled Retirees and spouses 65 Certain disabled individuals People with kidney failure
Premiums None Hospital coverage None Physician coverage 66.60/mo
Deductibles/ copayments None (or very small) Hospital coverage 876 deductible for first 60 days Physician coverage 100 deductible, 20 coinsurance
Services excluded None (or very minor) Prescription drugs (at least until 2006) Routine checkups, dental care, nursing home care, eyeglasses, hearing aids, immunization shots
Provider reimbursement Very low Moderate (but falling)
Medicare puts more cost-sharing on the
patient-side, and excludes some services.
Medicaid features very little patient-side
cost-sharing arrangements.
The Medicare programHow Medicare works
  • To qualify for Medicare, a worker (and his
    spouse) must have worked and paid payroll taxes
    for ten years.
  • Medicare Part A is the part of the Medicare
    program that covers inpatient hospital costs and
    some costs of long-term care
  • Financed by a total payroll tax of 2.9.
  • Medicare Part B is the part of the Medicare
    program that covers physician expenditures,
    outpatient hospital expenditures, and other
  • One-fourth of costs are financed from enrollee
    premiums, and the rest from general revenue.

The Medicare programHow Medicare works
  • Medicare has high patient costs.
  • The copayments and deductibles are fairly high.
  • For example, Part A has an 876 deductible for
    the first 60 days of a hospital stay, and high
    per-day patient costs thereafter. Part B has a
    20 coinsurance rate.
  • The benefits are relatively lean.
  • For example, it does not cover dental or vision
    care, and until 2006, it does not cover
    prescription drugs.
  • These features undermine the consumption
    smoothing value of Medicare.

The Uninsured
  • 44 million individuals in the U.S. are without
    any insurance coverage at all.
  • They tend to have below-average incomes. Nearly
    two-thirds of the uninsured are in families with
    incomes below 200 of the poverty line.
  • 70 of the uninsured are in families with a head
    of household who is a full-time, full-year
  • Over one-fifth of the uninsured are children.

The Uninsured
  • Why should we care about the uninsured?
  • Physical externalities associated with
    communicable diseases.
  • Financial externalities Uncompensated care is
    the costs of delivering health care for which
    providers are not reimbursed.
  • 35 billion delivered in uncompensated care,
    roughly 2 of total spending.
  • Inappropriate delivery of care (e.g., through
    emergency rooms).
  • Paternalism and equityindividuals may
    irrationally underinsure themselves by
    miscalculating the odds of getting sick.
  • Becoming uninsured is a concern for many.
  • This is an issue because of the great reliance on
    employer-provided health insurance.
  • Job lock is the unwillingness to move to a better
    job for fear of losing health insurance.
  • Job lock can lead to a mismatch between workers
    and jobs, and can lower overall productivity.

  • As with other insurance, the optimal generosity
    will be determined by the trade off between
    consumption-smoothing and moral hazard.
  • Generosity represents the share of medical
    spending that will be reimbursed by the health
  • This generosity can be measured with respect to
    the patients and with respect to the providers.

  • Risk-averse individuals will value health
    insurance as a means of smoothing their
    consumption with respect to the cost of medical
  • Some events, like a check-up, are minor and
    predictable, while others, like a heart attack,
    are more expensive and unpredictable.
  • Expected utility theory suggests that insurance
    is much more valuable for expensive,
    unpredictable events.
  • The consumption smoothing benefits of first
    dollar coverage for minor and predictable events
    is small because
  • Risk-averse individuals gain little utility from
    insuring small risks.
  • And individuals are easily able to self-insure
    (against small risks).

  • Offsetting the consumption-smoothing benefits of
    health insurance to individuals is the risk of
    moral hazard.

Price of each visit
The right amount of health care is where DS.
Deadweight Loss
Health insurance shifts the consumers demand,
leading to more consumption.
This over-consumption leads to deadweight loss.
Number of visits to doctors office
  • The fundamental trade-off of health insurance,
    then, is the gains in terms of consumption
    smoothing versus
  • the costs in terms of the overuse of medical

  • Moral hazard and flat of the curve medicine.

Initially, dollars of spending lead to high
Further spending has diminishing returns.
of Marginal Health Benefits
of Medical Spending
Moral Hazard Costs of Health Insurance for
  • Productivity dwindles as spending on health care
    rises. From a societal perspective, spending
    should stop when the additional health benefit is
    smaller than the additional health cost.
  • If individuals paid the full cost of their health
    care, the socially optimal amount, point B would
    be chosen.
  • If individuals do not pay much for their
    additional health care, they will demand health
    care as long as the effectiveness curve is not
    perfectly flat. The flat of the curve area is
    therefore beyond point B, where each 1 of
    medical care buys less than 1 in improved
  • The existence of insurance creates Moral Hazard,
    where people over-consume medical services since
    the do not pay the marginal costs of additional

Optimal Health Insurance
  • The evidence (from the Rand Health Insurance
    Experiment) is that the elasticity of medical
    care utilization with respect to price is
    non-zero (e.g., moral hazard).
  • This implies there there is a significant
    deadweight loss associated with first-dollar
    insurance coverage.
  • This suggests that the optimal health insurance
    policy is one in which,
  • Individuals bear a large share of the medical
    costs within some affordable range, and
  • Individuals are fully insured when costs become

  • There is also moral hazard on the provider side.
  • Patient-side moral hazard refers to the extra
    care demanded for illness because insurers cover
    the cost of medical treatment.
  • Provider-side moral hazard refers to the extra
    care provided for illness because insurers
    reimburse health care providers based on costs.
  • Even if an insurer could perfectly assess a
    patients true level of illness, the cost to
    treat that illness can vary considerably.
  • Thus, insurers have often reimbursed medical
    providers according to their reported costs of

  • Retrospective reimbursement is a payment
    arrangement reimbursing physicians for the costs
    they have already incurred.
  • This system removes any incentive for providers
    to treat their patients cost-effectively.
  • If a physicians objective is to maximize health
    of the patients, then this system will likely
    yield flat of the curve medicine.
  • In addition, if physicians are also concerned
    about income maximization, this sort of
    reimbursement only exacerbates the moral hazard.

Managed Care and Prospective Reimbursement
  • Patient cost-sharing did not slow the growth in
    health care spending, so the private market
    turned to managed care in the late 1980s and
  • Managed care is a private market approach to
    controlling costs using supply-side controls.
  • Manage care comes in two forms PPOs and HMOs.
  • Preferred provider organizations (PPOs) are
    health care organizations that lower care costs
    by shopping for health care providers on behalf
    of the insured.
  • Health maintenance organizations (HMOs) are
    health care organizations that integrate
    insurance and delivery of care.
  • HMOs may pay its own doctors and hospitals a
    salary independent of the amount of care they

Managed Care and Prospective Reimbursement
  • Prospective reimbursement is the practice of
    paying providers based on what treating patients
    should cost, not on what the provider actually
  • Many HMOs use prospective reimbursement to
    counteract provider moral hazard.
  • Prospective reimbursement reverses the financial
    incentives of physicians.
  • Now when physicians deliver less care,
    profitability goes up.
  • This could create financial incentives to give
    insufficient care.
  • The HMO often gives incentives for a physician to
    limit the care he/she delivers, and to restrict
    the use of specialists as well.

The Impacts of Managed Care
  • There is no clear evidence that quality of care
    has suffered, even though prospective
    reimbursement might lead to the under provision
    of care in HMOs.
  • There is not a consensus one way or another.
  • Roughly equal numbers of studies find that HMOs
    deliver care that is better, worse, or the same
    as traditional health insurance.

Lessons for health care reform in the United
States Rising health care costs
  • What drives the ever-increasing health care
  • The answer appears to be quality-improving
    technological change in the delivery of health
  • For example, even though the cost of particular
    heart attack treatments has fallen (e.g., bypass
    surgery), there has been substitution from
    less-intensive to more-intensive procedures.
  • Thus, the costs tend to rise over time.
  • These treatments, however, are associated with
    dramatically improved health outcomes.
  • Thus, it is not clear whether society actually
    wants health care costs to be controlled.
  • Would you rather buy 1950s health care at 1950s
    prices, or todays health care at todays prices?

Lessons for health care reform in the United
States Rising health care costs
  • If technology is improving health care, on the
    surface this appears inconsistent with flat of
    the curve medicine.
  • The key, however, is distinguishing between the
    average value and marginal value of a medical
  • On average, the technological advances are
    extremely valuable, but on the margin, they may
    be inappropriate and ineffective.
  • It is difficult to target away from those who are
    on the flat of the curve. It is easy to look
    backward and see that a procedure was wasteful,
    but it much harder to look forward and know this
    for sure.
  • Thus, statistics like 30 of medical spending is
    done in the last 6 months of life are not
    terribly insightful. This is an ex-post

Lessons for health care reform in the United
States The uninsured
  • Another key problem is the high number of
    uninsured in the United States. It currently
    numbers around 45 million.
  • Many of the uninsured do not have access to a
    pooling mechanism (e.g., group rates).
  • Creating a large pool, which could lower the
    administrative costs, could help. But adverse
    selection still remains a concern.
  • Another concern is that not all workers are
    offered insurance, and not all workers take-up
    the employer insurance they are offered.
  • A mandate is a legal requirement for employers to
    offer insurance or for individuals to obtain some
    type of insurance coverage.
  • They tend to be politically unpopular, however.

Lessons for health care reform in the United
States Incremental reforms
  • Other incremental reforms could help with rising
    costs and the number of uninsured.
  • Controlling fraud and waste could save money in
    the short-run, it is not a long-run cost-control
  • Lowering physician fees can control costs, but
    restricts access to care.
  • State laws to guarantee access of small firms and
    individuals to insurance markets have not been
    successful in reducing the number of uninsured.
  • Continuing to expand the social safety net, yet
    this raises the prospect of crowd-out.
  • Finally, tax subsidies could make insurance more
    affordable, but prices in the non-group market
    are still exceptionally high.

Lessons for health care reform in the
USFundamental reform National health insurance
  • National health insurance is a system whereby the
    government provides insurance to all its
    citizens, without involvement of a private
    insurance industry.
  • Canadas system follows this model.
  • Fully solves the problem of the uninsured.
  • Reduces administrative costs.
  • Has comprehensive cost controls, not piecemeal
    controls like Medicares PPS.
  • Solves some inefficiencies like job lock.
  • National health insurance has drawbacks, however.
  • Massive government expenditures.
  • National budgeting may not allow doctors to use a
    technology that is worth its high cost.

Fundamental reform Private-sector solutions
  • Alternatively, build on the existing hybrid of
    private and public sector insurance.
  • The government could create new pools of private
    insurance plans, impose an individual mandate,
    and subsidize the poor.
  • Less new public financing.
  • Preserves consumer choice.
  • More politically feasible.
  • This approach has some disadvantages relative to
    public national health insurance.
  • High administrative costs remain.
  • Inequities and inefficiencies of patchwork health
    system remain.
  • Tension between cost-conscious decision making
    and adverse selection death spirals. The sick
    could end up in much more expensive plans.
  • Creates two-tier medical care, which may be
    undesirable from an equity perspective.