Health Care Systems and Institutions

Health Care Systems and Institutions. The General Model of a Health Care System

 

 

This topic introduces and explains the structure and purpose behind various institutions and payment systems that typically compose a health care system. The knowledge gained will help you better understand how the different parts of a health care system are interrelated. In addition, the material will provide you with a greater appreciation for the remaining topics of the book and help make you a more informed consumer or producer of health care services. Specifically, this topic:

•              constructs a general model of a health care system

•              discusses the reasoning for and responsibilities of third-party payers

•              introduces and explains some of the different reimbursement methods used by third-party payers

•              identifies some structural features associated with the production of medical services and the role of health care provider choice

•              uses the general model to describe the health care systems in Canada, Germany, and the United Kingdom

•              provides an overview of the U.S. health care system.

 

 

PPOs, HMOs, and DRGs are just a few of the many health care acronyms bandied around in the popular press. To the uninformed, they are simply the ingredients in an alphabet soup. Those familiar with them know that they stand for preferred provider organizations, health maintenance organizations, and diagnosis-related groups. They, like many other health care institutions, have evolved over the last several decades and have greatly contributed to the ongoing and wide-sweeping transformation of the U.S. health care system.

 

 

Elements of a Health Care System

A health care system consists of the organizational arrangements and processes through which a society makes choices concerning the production, consumption, and distribution of health care services. How a health care system is structured is important because it determines who actually makes the choices concerning the basic questions, such as what medical goods to produce and who should receive medical care. At one extreme, the health care system might be structured such that choices are decided by a centralized government, or authority, through a single individual or an appointed or elected committee. At the other extreme, the health care system might be decentralized. For example, individual consumers and health care providers, through their interaction in the marketplace, may decide the answers to the basic questions.

From a societal point of view, it is difficult to determine whether a centralized or decentralized health care system is superior. A normative statement of that kind entails value judgments, and trade-offs are inevitably involved. On the one hand, a centralized authority with complete and coordinated control over the entire health care system may be more capable of distributing output more uniformly and have a greater ability to exploit any large-sized economies. At the same time, a single centralized authority may lack the competitive incentive to innovate or respond to varied consumer-voter demands. A central authority may also face high costs of collecting information about consumer needs.

On the other hand, a health care system with a decentralized decision-making process, such as the marketplace (or a system of local governments), may provide more alternatives and innovation but may result in high costs in the presence of economies of size, nonuniformity, or lack of coordination. Determining the best structure for a health care system involves quantifying the value society places on a number of alternative and sometimes competing outcomes, such as choice, innovation, uniformity, and production efficiency, among other things. A study of that kind is difficult at best because it involves so many normative decisions. Indeed, alternative health care systems exist throughout the world because people place different values on each of the various outcomes (Reinhardt, 1996). Reflecting the trade-offs involved, most health care systems today are neither purely centralized nor decentralized but rather take on elements of both systems of decision making. In any case, as we discuss the elements of various health care systems, it is important to keep in mind that understanding how and at what level decisions are made is critical to grasping how any health care system works.

Health care systems are huge, complex, and constantly changing as they respond to economic, technological, social, and historical forces. For example, the structure of the U.S. health care system involves a seemingly endless list of participants, some of which were foreign to us only a decade ago, such as preferred provider organizations. The list includes more than 800,000 physicians and dentists, about two milliourses, nearly 7,000 hospitals, and more than 80,000 nursing homes and mental retardation facilities, not to mention the millions of people who purchase medical care, the thousands of health insurers, and the multitude of government agencies involved in health care issues.

Because of the vastness and complexity of health care systems, many people have trouble understanding how they function. With that problem in mind, Figure 4-1 presents a general model of a health care system. Notice that the diagram possesses a triangular shape reflecting the three major players in any health care system: patients or consumers, health care providers or producers, and insurers or third-party payers. Sponsors, such as employers or the government, are also included in the general model because they act as intermediaries or brokers. As brokers, sponsors structure coverage, manage enrollment, contract and negotiate risk-sharing arrangements, and collect and submit the contributions of insured (Van de Ven and Ellis, 2000). Contributions show up as forgone wage income resulting from either taxes or premium payments. The figure also illustrates the three elements common to all health care systems: financing, reimbursement, and production or delivery of medical care.

 

 

For a typical market transaction, the individual consumer and producer are the only ones involved in the exchange as shown in the bottom flow of the diagram. In that instance, the consumer’s out-of-pocket price equals the full cost of the service provided. Buyer and seller are equally well informed, and the buyer pays the seller directly for the good or service. For example, the purchase of a loaf of bread at a local convenience store involves a normal market transaction. Both consumer and seller have the same information regarding the price and quality of the bread, and the transaction is anticipated and planned by the consumer. An unexpected outcome is not likely to occur, and, if it did, it could be easily rectified (for example, stale bread can be easily returned).

In a medical market, the corresponding situation is a prespecified patient fee paid directly to a doctor or a hospital for some predetermined and expected quantity and quality of medical services. In the case of medical services, however, the transaction is ofteot anticipated, and the price, quantity, and quality of medical services are unknown until after the medical event occurs. The transaction is unanticipated because medical illnesses occur irregularly and unexpectedly (Arrow, 1963). The price, quality, and quantity of medical services are not known initially because much uncertainty surrounds the diagnosis and proper treatment of a medical problem. In addition, health care providers possess a greater amount of information relative to patients regarding the provision of medical services, giving rise to an asymmetry of information. Because no simple relation exists between diagnosis and treatment, and much is left to the discretion of health care providers, possibilities for opportunistic behavior arise. That is, health care providers may produce more treatments or a higher-quality treatment than economic considerations warrant.

 

 

The Role and Financing Methods of Third-Party Payers

Because the timing and amount of medical treatment costs are uncertain from an individual consumer’s perspective, third-party payers, such as private health insurance companies or the government, play a major role in medical care markets. Third-party payers often serve as intermediaries between the consumer and the health care producer and monitor the behavior of health care providers as a means of controlling medical costs.

Also, third-party payers are responsible for managing the financial risk associated with the purchase of medical services. A third-party payer faces a much lower level of risk than an individual consumer because it can pool its risk among various subscribers by operating on a large scale. The law of large numbers implies that whereas single events may be random and largely unpredictable, the average outcome of many similar events across a large population can be predicted fairly accurately. For example, it is difficult for one individual to predict whether he or she will experience a heart attack. An insurance company, on the other hand, can be reasonably sure about the heart attack rate by judging from past experiences involving a large number of individuals. Third-party payers can use indicators such as occupational and demographic averages to forecast expected medical claims for a large group of individuals. A risk-averse consumer is better off by making a certain preset payment to an insurer for coverage against an unforeseen medical event rather than facing the possibility of paying some unknown medical costs. Essentially, consumers receive a net benefit from the financial security that third-party payers supply. Health insurance principles are developed more fully in Topics 5 and 6.

Third parties make the health care system much more complex because the source of third-party financing and the method of reimbursement must be worked into the model. If the third-party payer is a private health insurance company, the consumer pays a premium in exchange for allotted medical insurance coverage. As part of the health insurance plan, the consumer may be responsible for paying a deductible portion as well as a copayment or coinsurance. The deductible provision requires the consumer to pay the first $X of medical costs, after which the health insurance company is responsible for reimbursement. With a coinsurance provision, the consumer pays a fixed percentage of the cost each time he or she receives a medical service. A copayment refers to a fixed amount per service.

When a government agency (or a public health insurance company) acts as a third-party payer, the financing of medical care insurance usually comes from taxes. Premiums and taxes differ in the way risk is treated and the voluntary nature of the payment. See Raffel (1997) for discussion on the health care systems in various industrialized countries. For manageability, we confine the discussion to the insurance, physician, and hospital services industries. No mention is made of the existing systems in the pharmaceutical and long-term care markets, for example. Premiums are paid voluntarily and often depend on the risk category of the buyer of health insurance. Tax payments are mandatory and represent a single fee without reference to risk category.

Some alternative ways to finance health care can be gleaned by examining the different methods used in Canada, Germany, and the United Kingdom. See Bodenheimer and Grumbach (1992) for an in-depth comparison of taxes and premiums for financing universal health insurance. We chose these particular countries because their health care systems possess unique features. In addition, most proposals for health care reform in the United States are based to some extent on the health care systems of these three countries.

Canada has a compulsory national health insurance (NHI) program administered (somewhat differently) by each of its 10 provinces. The NHI program provides first-dollar coverage, and no limit is imposed on the level of medical benefits an individual can receive during his or her lifetime. First-dollar coverage means complete health insurance coverage; the health insurer reimburses for the first and every dollar spent on medical services (that is, there is no deductible or copayment amount). For all practical purposes, taxes finance the NHI program in each province. Three provinces charge insurance premiums that are related to family size rather than risk. These premiums are not compul­sory for coverage and will be paid by the province if individuals are unable to pay. Because these premiums are not adjusted for risk, they are essentially taxes. In addition, the Canadian government provides up to 40 percent in direct cost sharing and makes hospital construction grants available to provinces. Private insurance is available for some forms of health care in Canada, although private coverage is prohibited for services covered by the NHI plan. Because the public sector (rather than the private sector) insures against medical costs, there are no marketing expenses, no administrative costs of estimating risk status or determining whom to cover, and no allocation for profits.

The socialized health insurance (SI) program in Germany is based on government-mandated financing by employers and employees. The premiums of unemployed individuals and their dependents are paid by former employers or come from various public sources (the Federal Labor Administration and public pension funds). Private not-for-profit insurance companies, called Sickness Funds, are responsible for collecting funds from employers and employees and reimbursing physicians and hospitals. The statutory medical benefits are comprehensive, with a small copayment share for some services. Affluent and self-employed individuals are allowed to go outside the system and purchase private health insurance coverage.

Mechanic (1995) and others refer to the health care system in the United Kingdom as a public contracting model because the government contracts with various providers of health care services on behalf of the people. The U.K. health care system, under the auspices of the National Health Service (NHS), offers universal health insurance coverage financed through taxation. The NHS provides global budgets to district health authorities (DHAs). Each DHA is responsible for assessing and prioritizing the health care needs of about 300,000 people and then purchasing the necessary health care services from public and private health care providers. Hospital services are provided by nongovernmental trusts, which compete among themselves and with private hospitals for DHA contracts. Community-based primary care givers also contract with the DHAs. In addition, general practitioner (GP) fundholders apply for budgets from the DHAs, and, with the budgets, service a minimum group of 5,000 patients by providing primary care and purchasing elective surgery, outpatient therapy, and specialty nursing services on their behalf. There is some limited competition among GP fundholders for patients.

 

 

Risk Management, Reimbursement, and Consumer Cost Sharing

Another important element of a health care system concerns the manner in which health care providers are reimbursed and the share of medical costs paid by consumers. Reimbursement is important because some payment methods shift much more financial risk onto health care providers than others. As Figure 4-1 indicates, insurers may reimburse health care providers with either a fixed or variable payment, although in practice the payment methods are sometimes combined. A fixed payment is set independent of the amount of medical services actually provided to patients for a given and defined treatment episode. If the actual costs of delivering services to patients are less than the level of the fixed payment, health care providers are normally allowed to keep the surplus. However, health care providers also face the possibility that actual costs are greater than the fixed payment. Thus, some financial risk is shifted to health care providers when reimbursement takes place on a fixed-payment basis. A prospectively set fixed annual budget to a hospital or nursing home or a fixed annual salary for an employee are examples of fixed-payment systems. Regardless of how many resources a hospital or nursing home employs, or the number of hours an employee works during a given period, the payment remains the same.

Under a variable-payment system, the reimbursement amount varies with the quantity of services actually delivered to patients. Retrospective reimbursement, in which the health care provider bills for actual costs incurred, and fee-for-service, in which a price is paid for each unit of a medical service, are two common examples of a variable-payment system. A few state governments still reimburse nursing homes on a retrospective basis for caring for Medicaid patients. The price paid for each physician office visit is an example of a fee-for-service payment. When reimbursement takes on a variable-payment basis, health care providers face much less risk from cost overruns.

Similarly, the share of medical costs paid by consumers is important because a greater amount of cost sharing puts more financial risk on them. For example, take the extreme cases. The typical consumer faces very little financial incentive, if any, to care about the costs associated with his or her medical treatment if fully insured with no out-of-pocket expenses. Even if the medical costs equal $100, $1,000, or $10,000, the consumer pays a zero out-of-pocket price if fully insured. Conversely, that same consumer faces much more financial incentive to be concerned with the cost if required to pay the entire bill (that is, 100 percent out-of-pocket price) associated with the medical treatment. No one disagrees that the opportunity cost of paying $200 for an office visit is much greater than paying $100.

The matrix in Figure 4-2 helps illustrate the importance of risk sharing. The matrix shows how the two reimbursement schemes previously discussed and the consumer’s out-of-pocket price interact and affect the likelihood that a large volume of medical services will be supplied and demanded. The probability of a high volume of medical services is given inside each cell of the matrix for each combination of reimbursement method and consumer out-of-pocket price.

We can identify the opportunity for a large volume of medical services per patient by considering how the different provider reimbursement schemes and consumer payment plans affect the incentives of health care providers and consumers. For example, a health care provider that is reimbursed on a fixed-payment basis is very unlikely to supply a large volume of medical services to a patient unnecessarily. The cost of additional medical services immediately subtracts from the fixed payment and puts the health care provider at risk for cost overruns. In contrast, for the variable-payment schemes, health care providers do not absorb the financial risk of the higher costs associated with additional services.

 

 

We can conduct a similar analysis for the consumer. Consumers who face a low out-of-pocket price of obtaining medical services are more likely to seek out additional medical services (this is referred to as the moral hazard problem in Topic 5). On the other hand, consumers who face a high out-of-pocket price are less inclined to seek out medical services given the greater opportunity cost of their money.

Combining the reimbursement and out-of-pocket payment schemes, the likelihood of a large volume of medical services per patient is the greatest in cell 2, where a variablepayment scheme interacts with a low consumer out-of-pocket plan. Neither party loses much financially in the exchange of dollars for medical services. Conversely, a large volume of medical services is least likely in cell 3, where a fixed-payment plan coexists with a large consumer out-of-pocket scheme. Both parties in the exchange lose financially. Cell 4 offers a moderate likelihood of a large volume of medical services, because the provider is not made financially worse off by providing additional services. For this to happen, however, either the consumer’s out-of-pocket price must not be too high or the consumer must be relatively insensitive to price (that is, highly inelastic demand). Finally, in cell 1, the health care provider is made worse off while the consumer is relatively unaffected by additional medical services, so the probability of a large volume of medical services is low.

A major current concern of health care policy makers is that a variable reimbursement system, when combined with a modest consumer out-of-pocket plan, results in excessive medical services that provide low marginal benefits to patients but come at a high marginal cost to society. For example, medical care providers may offer expensive diagnostic tests to low-risk patients. The tests come at a high marginal cost to society but yield only small marginal benefits to patients given their low-risk classification. Small marginal medical benefits coincide with the “flat-of-the-curve” medicine observed in several empirical studies, as discussed in Topic 2.

As a result, many health policy analysts believe that fee-for-service or retrospective payments and small consumer out-of-pocket payments are responsible for high-cost, low-benefit medicine. Policy makers typically argue that some cost sharing is needed on the supply and/or demand side of the market to reduce the potential for excess medical services (Ellis and McGuire, 1993). That is, they believe that fixed-payment reimbursement plans and nontrivial consumer payments are required to control unnecessary medical services.

We can appreciate the importance of the reimbursement method by examining and contrasting the countrywide reimbursement schemes practiced in Canada, Germany, and the United Kingdom. In Canada, everyone is eligible for the same medical benefits, and there are no copayments for most medical services. Patients essentially drop out of the reimbursement picture, and reimbursement exclusively takes place between the public insurer (the government) and the health care provider. In terms of Figure 4-1, this means that the monetary exchange is virtually nonexistent between patient and health care provider. The ministry of health in each province is responsible for controlling medical costs. Cost control is attempted primarily through fixed global budgets for hospitals and predetermined fees for physicians. Specifically, the operating budgets of hospitals are approved and funded entirely by the ministry in each province, and an annual global budget is negotiated between the ministry and each individual hospital. Capital expenditures must also be approved by the ministry, which funds the bulk of the spending.

Physician fees are determined by periodic negotiations between the ministry and provincial medical associations (the Canadian version of the American Medical Association). With the passage of the Canada Health Act of 1984, the right to extra billing was removed in all provinces. Extra billing or balance billing refers to a situation in which the physician bills the patient some dollar amount above the predetermined fee set by the third-party payer. For the profession as a whole, negotiated fee increases are implemented in steps, conditional on the rate of increase in the volume of services. If volume per physician rises faster than a predetermined percentage, subsequent fee increases are scaled down or eliminated to cap gross billings – the product of the fee and the volume of each service – at some predetermined target. The possible scaling down of fee increases is supposed to create an incentive for a more judicious use of resources. Physicians enjoy nearly complete autonomy in treating patients (for example, there is no mandatory second opinion for surgery) because policy makers believe there is no need for intrusive types of controls given that the hospital global budgets and physician expenditure targets tend to curb unnecessary services.

The Sickness Funds in Germany, which collect employer and employee insurance premiums, pay negotiated lump-sum funds equal to the product of a capitation (per-patient) payment and the number of insured individuals to regional associations of ambulatory care physicians. These regional associations, in turn, reimburse individual physicians for services on the basis of a fee schedule. The fee schedule is determined through negotiation between the regional associations of Sickness Funds and physicians. To determine the fee schedule, each physician service is assigned a number of points based on relative worth. The price per point is established by dividing the lump-sum total budget by the actual number of points billed within a quarter by all physicians. The income to an individual physician equals the number of points billed times the price per point.

The Sickness Funds that operate in a given state also negotiate fixed prices for various procedures (based on the diagnosis-related group, or DRG) with local hospitals. Because hospitals can make profits or incur losses because of the fixed prices, there is an incentive for hospitals to save resources and specialize in certain procedures. For some procedures, hospital accommodations are reimbursed on a per diem basis but funds are limited by an overall budget. Hospital-based physicians are paid on a salary basis. Most of the hospital funds for capital acquisitions come from state and local governments and are reviewed and approved through a state planning process.

In the United Kingdom, the district health authorities are allocated funds by the NHS on a weighted capitation basis, which considers age, sex, and health-risk factors as well as geographical cost differences. Independent community-based family practitioners contract with the NHS and are uniformly paid throughout the United Kingdom, primarily on a capitation basis. The DHAs prospectively reimburse individual hospital trusts based on the actual cost of providing the services. All hospital-based physicians and consultants are paid on a fixed salary basis by the trusts. Trusts are required to earn a 6 percent return on assets and the residual is returned to the DHA. Capital funding for the trusts is determined by the DHA and is based on its regional allocation.

Any funds allocated to GP fundholders are deducted from the DHA’s allocation. GP fundholders annually negotiate funds to purchase elective and nonemergency services for their subscribers. About 41 percent of the population in England is served by GP fundholders. Any savings made by a fundholder may be reinvested in the practice or new services but cannot directly increase the GP’s personal income. GP fundholders are not at personal financial risk as they are protected against any legitimate cost overruns by the DHAs.

In sum, these three countries have shied away from relying on an uncontrolled fee-for-service reimbursement scheme because of the concern that it creates incentives for high-cost, low-benefit medicine. The payment is on either a per diem, per-person, or negotiated fee-for-service basis. In addition, the payment for medical services is determined by a single payer – the government in Canada and the United Kingdom and representatives of the Sickness Funds in Germany. Policy makers in these countries believe that a single-payer, controlled-payment system can reduce the incentive to provide high-cost, low-benefit medicine and better contain health care costs.

 

The Production of Medical Services

The mode of production also differs across health care systems. Several distinguishing features of production are worth mentioning. We normally think of health care services as being produced on an inpatient care basis in hospitals or nursing homes or on an outpatient (ambulatory) care basis at physician clinics or in the outpatient department of a hospital. However, health care services are also produced in the home. Preventive care (such as exercise, dieting, and flossing) and first aid are two prime examples of home-produced health care services. In addition, long-term or chronic care services are often produced in the home rather than in an institution, such as a nursing home. Although acute care services can also be produced in the home, the cost of producing these services is usually prohibitive for the individual consumer because of the high per-person labor and capital expenses. According to the Mosby Medical Encyclopedia (1992), long-term care is “the provision of medical care on a repeated or con­tinuous basis to persons with chronic physical or mental disorders” (p. 471). Acute care is “treatment for a serious illness, for an accident, or after surgery. . . . This kind of care is usually for only a short time” (p. 11). As a result, it is almost always cheaper for the individual consumer to purchase acute care services at a hospital because such an organization can exploit various large-size economies.

Outside the home, health care providers may be organized in a number of ways. For example, a hospital may be a freestanding, independent institution or part of a multihospital chain. Similarly, a physician may operate in a solo practice or belong to a group practice. Usually the size and scope of the medical organization depend on whether any economies exist from operating on a small or large scale. In addition, some physicians, such as radiologists and anesthesiologists, may be employees of the hospital. In contrast, some physicians on the medical staff may not be employees of the hospital but instead are granted admitting privileges.

Health care services may be produced in the private or public sector by health care providers in the medical services industry. If produced in the private sector, the health care provider may offer medical services on a not-for-profit or a for-profit basis. A not-for-profit organization is required by law to use any profits exclusively for the charitable, educational, or scientific purpose for which it was formed. For example, a hospital may use profits to lower patient prices or finance medical equipment or hospital expansion.

 

 

Institutional Differences between For-Profit and Not-for-Profit Health Care Providers

Because not-for-profit institutions are so prevalent in the health care sector, it is important that we examine the institutional differences between for-profit and not-for-profit firms. There are five basic institutional differences between these two classes of organizations.

First, when for-profit firms are established, they acquire initial capital by exchanging funds for ownership with the private sector. Ownership gives the private sector a claim on future profits. Not-for-profit firms must rely on donations for their initial capital because they are not privately owned. In a broad sense, they are owned by the community at large. Second, for-profit providers are capable of earning accounting profits and distributing cash dividends to their owners, whereas not-for-profit firms face a non-distribution constraint and are prohibited from distributing profits to employees, managers, or company directors. A non-distribution constraint means that not-for-profit firms cannot legally distribute any revenues in excess of costs to individuals without regard to the charitable purpose for which the organization was formed. Third, for-profit organizations can easily be sold or liquidated for compensation by their owners, whereas it is very difficult to sell a not-for-profit organization. Fourth, not-for-profit providers are exempt from certain types of taxes and are eligible to receive subsidies from the government. In fact, it has been argued that the tax exemption and subsidies give not-for-profit firms an unfair advantage over for-profit firms. Finally, not-for-profit providers are restricted by law in the types of goods and services they can provide.

 

Why Are Not-for-Profit Health Care Providers So Prevalent?

Now that we understand the differences between for-profit and not-for-profit providers, the next item to address is why not-for-profit providers are so prevalent in the health care sector. Weisbrod (1988) discusses the issue in general terms, but his analysis can easily be applied to the health care sector. Not-for-profit firms exist primarily as a result of market failure in the private sector. The market failure results from three factors.

First, the private sector works best when all market participants are perfectly informed. However, given the complexity of medical technology and the difficulty of assessing the appropriateness of medical care, consumers typically possess imperfect information about the health care sector. As a result, many consumers believe they are in a vulnerable situation and can easily be exploited by medical providers for the sake of profits. For that reason, they prefer to deal with not-for-profit providers, which presumably are driven by more altruistic motives because of the nondistribution constraint.

The second reason for market failure concerns equity. Society as a whole believes that each citizen has a right to some minimum level of medical care that would not be provided if health care resources were allocated by the for-profit sector. The profit motive ensures that health care is allocated based on the ability to pay and not oeed. As a result, some argue that not-for-profit providers are necessary to meet the needs of those who cannot pay for medical care.

The third reason for market failure involves the presence of externalities as discussed further in Topic 9. When externalities exist, resources are not efficiently allocated because the for-profit sector does not consider all the costs and benefits associated with production. Thus, for these three reasons, the for-profit sector may fail to address the collective need for health care.

The next question that comes to mind is why the public sector does not simply take over the allocation of health care resources in the presence of market failure. The answer, Weisbrod contends, is that consumer needs are heterogeneous. Wheeeds are widely diverse, the government has difficulty developing an appropriate overall policy that meets the desires of all consumers in a cost-effective manner. For example, “one-size-fits-all” medicine most likely would not appeal to everyone. Hence, a multitude of not-for-profit health care providers, such as hospital and nursing homes, are required to satisfy heterogeneous demands. Each institution can be tailored to fit the individual demands of its constituents. For example, the Shriners run not-for-profit hospitals aimed at orthopedic pediatric care, while some religious organizations operate nursing homes specifically for elderly members of their own religion.

One last question deserves some discussion. If these market failures are substantial, why is the for-profit sector allowed to operate at all in the health care field? Consumer knowledge and preferences provide the answer to this question. Although some consumers lack the information they need to make informed decisions, others are much more informed. Informed consumers may “have no institutional preferences” and “prefer to deal with any organization, regardless of ownership form, that provides the wanted outputs at the lowest price” (Weisbrod, 1988, p. 124). Thus, the for-profit sector exists in the health care market primarily to satisfy the demands of these types of consumers.

 

 

Production of Health Care in the Three Systems

The organizations of production in the three health care systems we have been discussing have some slight differences. In Canada, medical services are produced in the private sector. Most hospitals in the private sector are organized on a not-for-profit basis and are owned by either charitable or religious organizations. In Germany, medical services are produced primarily in the private sector, because most physicians operate in private practices. Public hospitals control about 51 percent of all hospital beds in Germany. The remaining beds are managed by not-for-profit (35 percent) and for-profit hospitals (13 percent). Office-based physicians are normally prohibited from treating patients in hospitals, and most hospital-based physicians are not allowed to provide ambulatory care services in Germany.

The structure of production in the United Kingdom now largely takes place in the private, although mostly not-for-profit, sector. The present situation in the United Kingdom is in stark contrast to the method of production that prevailed before the passage of the National Health Service and Community Act of 1990. Up to 1990, almost all hospitals were publicly owned and operated and most doctors were employees of the NHS. Even before 1990, however, family practitioners were community-based in solo or small group practices and simply contracted with the NHS.

 

Physician Choice and Referral Practices

Important differences in the availability and utilization of medical services can also result from the degree of physician choice the health care consumer possesses and the types of referral practices used within the health care system. More choice typically provides consumers with increased satisfaction (Schmittdiel et al., 1997). However, greater choice may come at a cost if it leads to a large number of fragmented health care providers that are unable to sufficiently coordinate care or exploit any economies that come with large size (Halm et al., 1997).

In some health care systems, patients have unlimited choice of and full access to any physician or health care provider within any type of setting (such as a clinic or hospital). For example, at one time in the United States, insured individuals could directly seek out any general practitioner or specialist without financial penalty. Moreover, at one time in the United States, it was not unusual for a general practitioner to review the care of a patient referred for hospital services. We will see later that conditions regarding physician choice and referral practices have changed a great deal in the United States.

Other countries have adopted different referral practices. Although the Canadian and German health care systems allow free choice of provider, general practitioners in the United Kingdom act as “gatekeepers” and must refer patients to a specialist or a hospital. Once the patient is referred to a hospital, the patient-general practitioner relationship is severed for any particular illness in both the United Kingdom and Germany. Unlike in Germany, however, patients are allowed to go directly to a family practitioner or a hospital for primary care in the United Kingdom, unless they are registered with a GP fundholder.

 

 

The Three National Health Care Systems Summarized

Based on our generalized model of a health care system, Table 4-1 provides a capsulized summary of the current national health care systems in the three countries we have been discussing. Each national health care system is differentiated according to the degree of health insurance coverage, type of financing, reimbursement scheme, consumer out-ofpocket price, mode of production, and degree of physician choice. The essential features of the Canadian health care system are national health insurance, free choice of health care provider, private production of medical services, and regulated global budgets and fees for health care providers. The dominating features of the German health care system include socialized health insurance financed through Sickness Funds, negotiated payments to health care providers, free choice of provider, and private production of health care services. In the case of Great Britain, the distinguishing characteristics include restrictions on choice of provider, public contracting of medical services, global budgets for hospitals, fixed salaries for hospital-based physicians, and capitation payments to family practitioners.

 

 

The U.S. health care system is discussed in detail in the next section, and the last column in Table 4-1 gives a quick preview. The pluralistic U.S. health care system contains some structural elements found in most of the other three systems (such as private production) but relies more heavily on a fee-for-service reimbursement scheme. In addition, health care providers are reimbursed through multiple payers, including the government and thousands of private insurance companies, in contrast to the single-payer system in Canada (government), Germany (Sickness Funds), and the United Kingdom (government).

 

 

An Overview of the U.S. Health Care System

Some analysts argue that the multifaceted nature of the health care system accounts for the relatively high expenditures devoted to medical care in the United States. Although this may be true and is a topic of discussion throughout this book, it most certainly is true that this diversity makes it very difficult to describe the U.S. health care system in sufficient detail. This section presents a brief overview of the current system in the United States based on the generalized model of a health care system. The remainder of the book discusses the operation and performance of the U.S. health care system in much greater detail, albeit on a piecemeal basis.

 

 

Financing of Health Care in the United States

The United States has no single nationwide system of health insurance. Health insurance is purchased in the private marketplace or provided by the government to certain groups. Private health insurance can be purchased from various for-profit commercial insurance companies or from nonprofit insurers, such as Blue Cross/Blue Shield. About 84 percent of the population is covered by either public (27 percent) or private (68 percent) health insurance. U.S. Census Bureau, “Income, Poverty, and Health Insurance Coverage in the United States: 2006,” http://www.census.gov/prod/2007pubs/p60-233.pdf. The figures for private and public insurance coverage do not sum to 84 percent because of double­counting. For example, some people receiving public insurance coverage also purchase private health insurance.

Approximately 60 percent of health insurance coverage is employment related, largely due to the cost savings associated with group plans that can be purchased through an employer. Employers voluntarily sponsor the health insurance plans. Nearly all privately insured individuals belong to some type of managed care plan. As we discuss in Topic 6, managed care plans are designed to practice cost-effective medicine and place varying degrees of restrictions on consumer choices.

In addition to private health insurance, some portion of the U.S. population is covered by public health insurance. The two major types of public health insurance, both of which began in 1966, are Medicare and Medicaid. See Topic 10 for a more detailed discussion on the Medicare and Medicaid programs. The federal government is also responsible for providing health insurance to individuals in the military and to federal employees. Medicare is a uniform, national public health insurance program for aged and disabled individuals (such as those with kidney failure). Administered by the federal government, Medicare is the largest health insurer in the country, covering about 14 percent of the population, and is primarily financed through taxes. The Medicare plan consists of two parts. Part A is compulsory and provides health insurance coverage for inpatient hospital care, very limited nursing home services, and some home health services. Part B, the voluntary or supplemental plan, provides benefits for physician services, outpatient hospital services, outpatient laboratory and radiology services, and home health services. Part D, the Medicare coverage of prescription drugs is discussed in Topic 10.

The second type of public health insurance program, Medicaid, provides coverage for certain economically disadvantaged groups. Medicaid is jointly financed by the federal and state governments and is administered by each state. The federal government provides state governments with a certain percentage of matching funds ranging from 50 to 83 percent, depending on the per capita income in the state. Individuals who are elderly, blind, disabled, or members of families with dependent children must be covered by Medicaid for states to receive federal funds. In addition, although the federal government stipulates a certain basic package of health care benefits (hospital, physician, and nursing home services), some states are more generous than others. Consequently, in some states individuals receive a more generous benefit package under Medicaid than in others. Medicaid is the only public program that finances long-term nursing home care. Approximately 13 percent of the population is covered by Medicaid.

In summary, the financing of health care falls into three broad categories: private health insurance, Medicare, and Medicaid. However, another category of individuals exists: those who are uninsured. Approximately 16 percent of the U.S. population is estimated to lack health insurance coverage at any point in time. This does not mean these individuals are without access to health care services. Many uninsured people receive health care services through public clinics and hospitals, state and local health programs, or private providers that finance the care through charity and by shifting costs to other payers. Nevertheless, the lack of health insurance can cause uninsured households to face considerable financial hardship and insecurity. Furthermore, the uninsured often find themselves in the emergency room of a hospital, sometimes after it is too late for proper medical treatment. We take up this discussion in later topics.

 

 

Reimbursement for Health Care in the United States

Unlike in Canada and Europe, where a single-payer system is the norm, the United States possesses a multipayer system in which a variety of third-party payers, including the federal and state governments, commercial health insurance companies, and Blue Cross/Blue Shield, are responsible for reimbursing health care providers. Naturally, reimbursement takes on various forms in the United States, depending on the nature of the third-party payer. The most common form of reimbursement is fee-for-service, although most health care providers accept discounted fees from private health insurance plans.

Physician services under Medicare (and most state Medicaid plans) are also reimbursed on a fee-for-service basis, but the fee is set by the government based on the time and effort involved in providing the care. Since 1983, the federal government has reimbursed hospitals on a prospective basis for services provided to Medicare patients. This Medicare reimbursement scheme, called the diagnosis-related group (DRG) system, contains 500 or so different payment categories based on the characteristics of the patient (age and sex), primary and secondary diagnosis, and treatment. The DRGs are based on 23 major diagnostic groups centered on a different organ of the body. A prospective payment is established for each DRG. The prospective payment is claimed to provide hospitals with an incentive to contain costs (cells 1 and 3 of Figure 4-2).

Beginning in the early 1980s, many states, such as California, instituted selective contracting, in which various health care providers competitively bid for the right to treat Medicaid patients. In fact, much of the favorable experience with selective contracting in the United States led to the adoption of the public contracting model in the United Kingdom (Mechanic, 1995). Under selective contracting, recipients of Medicaid are limited in the choice of health care provider. In addition, to better contain health care costs and coordinate care, the federal government and various state governments have attempted to shift Medicare and Medicaid beneficiaries into managed care organizations (MCOs). About 66 percent of all Medicaid recipients and roughly 12 percent of all Medicare beneficiaries were enrolled in MCOs.

 

 

Production of Health Services and Provider Choice in the United States

Like the financing and reimbursement schemes, the U.S. health care system is very diversified in terms of production methods. Government, not-for-profit, and for-profit institutions all play an important role in health care markets. For the most part, primary care physicians in the United States function in the private for-profit sector and operate in group practices, although some physicians work for not-for-profit clinics or in public organizations. In the hospital industry, the not-for-profit is the dominant form of ownership. Specifically, not-for-profit hospitals control about 70 percent of all hospital beds. The ownership structure is the reverse in the nursing home industry, however. More than 70 percent of all nursing homes are organized on a for-profit basis. One should also keep in mind that mental retardation facilities, dialysis facilities, and even insurance companies possess different ownership forms. The variety of ownership forms helps make health care a very difficult, but challenging and interesting, industry to analyze.

We previously mentioned that provider choice matters. Consumers typically receive greater satisfaction from facing more choices. We also discussed, however, that more choices may come at greater costs if small, differentiated providers are unable to fully exploit any economies associated with size. Hence, it is important to know how much choice consumers have over health care providers in the United States.

Up to the early 1980s most insured individuals had full choice of health care providers in the United States. Consumers could choose to visit a primary care giver or the outpatient clinic of a hospital, or see a specialist if they chose to. The introduction of restrictive health insurance plans and such new government policies as selective contracting have limited the degree to which consumers can choose their own health care provider. For example, some health care plans require that patients receive their care exclusively from a particular network; otherwise they are fully responsible for the ensuing financial burden. Furthermore, the primary care giver acts as a gatekeeper and must refer the patient for additional care. Of course, the lower premiums of a restrictive plan compensate consumers at least to some degree for the restriction of choice. There are arguments for and against free choice of provider, and once again trade-offs are involved. This issue will be discussed throughout the text in more depth. For now let us just say that these tradeoffs must be given serious thought when determining what degree of consumer choice is best from a societal point of view.

 

the production of adult health. However, the results also indicate that quantitatively, the impact is relatively small. For example, Hadley (1982) finds that a 10 percent increase in per capita medical care expenditures results in only a 1.5 percent decrease in the adult mortality rate. His result confirms those of an earlier study conducted by Auster et al. (1969), who estimate that a 10 percent increase in medical services leads to a 1 percent drop in the age-adjusted mortality rate. Sickles and Yazbeck (1998) find that a 10 percent increase in health-related consumption leads to about a 0.3 percent improvement in health as measured by a comprehensive health index that considers a number of quality-of-life variables. Finally, based upon a random assignment of households to different health plans, Newhouse et al. (1993) find that households in low coinsurance plans received more medical care yet possessed virtually the same level of health as those households in high coinsurance plans, ceteris paribus. Enthoven (1980) has referred to the small marginal impact of medical care services on the health status of adults as “flat-of-the-curve” medicine. In the context of Figure 2-3, this means the typical adult consumes medical services at the point where the slope of the total product curve or marginal product of medicine is near zero. Except for the RAND study, which represents a social experiment, the other studies mentioned above are observational studies. Appendix A-1 points out that an observational study may only show an association rather than causation between two variables. Freeman et al. (2008) survey the literature and find fourteen studies analyzing the “causal” effect of health insurance on the utilization of medical services and health outcomes among nonelderly adults. Causality is likely because these studies use fixed effects, instrumental variables, or quasi-experimental approaches. Their review consistently shows that health insur­ance increases physician and preventive services, improves self-reported health status, and lowers mortality conditioned on injury and disease. Thus, these studies clearly show that the marginal product of medical care is positive. Unfortunately, the studies offer no direct estimates of the magnitudes of the marginal productivity of medical care among nonelderly adults.

If, as the empirical evidence indicates, the overall contribution of medical care to health is rather modest at the margin, what determines marginal improvements in health? The answer lies in the other factors associated with the production of health, with education, income, lifestyle, and the environment being the major contributing factors. A discussion of the impact of technology on health is postponed until Topic 3.

Education and Health

The positive relation between education and health is well documented in the literature. For example, Elo and Preston (1996) find that education had a significant impact on mortality for both men and women in the United States during the early 1980s, with the impact of education greater for men and those of working age than for women and the elderly. Lleras-Muney (2001) finds a significant relation between education levels and health. In particular, she finds that one more year of schooling decreases the probability of dying within 10 years by 3.6 percent. More recently, Cutler and Lleras-Muney (2006) estimate that an additional year of education increases life expectancy by between 0.18 and 0.6 years.

Income and Health

Empirical studies have also documented a positive connection between income and health. Ettner (1996) finds that increases in income enhance both mental and physical health, while Lantz et al. (2001) find that income and education are both associated with improved health. More specifically, they find that people with less than a high school education and incomes below $10,000 are between two and three times more likely to have functional limitations and poorer self-rated health than their more advantaged counterparts.

While the positive relation between income and health is well established in the literature, a question remains concerning how temporary changes in the macroeconomy impact health. In other terms, what is the relationship between cyclical changes in the macroeconomy and overall health? Your first inclination is to assume that a procyclical relationship holds between the state of the economy and health. In other words, as an economy emerges from a recession and the unemployment rate begins to fall, overall health should improve. You might argue that higher per capita incomes should translate into improved health as people have more discretionary income to spend on medical care. In addition, as more people acquire jobs with employer-financed health insurance, the out-of-pocket price of medical care should drop, causing people to consume more health care. An improved economy may also be associated with healthier lifestyles because as unemployed workers find employment, stress levels are likely to fall along with alcohol consumption and smoking.

Ruhm (2000, 2003) argues that just the opposite may occur: an improved economy may be linked to poorer health. He cites three reasons why health may decline during a cyclical economic expansion. First, the opportunity cost of time is likely to increase with an improved economy. As workers find employment, the amount of leisure time they have to perform what Ruhm refers to as health-producing activities (such as exercise and eating right) diminishes. Second, the act of work may adversely impact the production of health. As the economy improves and more workers find employment, the number of work-related accidents and work-related stress cases increases. Third, an economic expansion may cause an increase in other causes of mortality such as traffic fatalities, homicide, and suicides.

To test the relationship between cyclical conditions and health, Ruhm estimates the impact that various economic indicators such as unemployment and personal income have on a number of health indicators. The author utilizes a state-based data set for the years 1972 through 1991 and estimates a number of equations utilizing a variety of health measures. Among the measures of health included in the analysis were overall mortality rates, age-based mortality rates, and deaths due to specific causes such as cardiovascular diseases, chronic liver disease and cirrhosis of the liver, motor vehicle accidents, and suicide.

The results are illuminating and suggest an inverse relationship between the strength of the economy and health in the short run. Overall, Ruhm finds that a 1 percent drop in the unemployment rate, relative to the state historical average, results in an increase in the total mortality rate of between 0.5 and 0.6 percent. In addition, Ruhm finds that the impact of changes in the unemployment rate on mortality rates appears to concentrate among the relatively young, between ages 20 and 44. This makes intuitive sense given they are the ones likely to be hit hardest by temporary changes in economic conditions.

The author also finds fluctuations in state unemployment rates to be inversely related to a number of specific causes of death. For example, Ruhm finds decreases in state unemployment rates to be associated with increased fatalities from auto accidents, other types of accidents, homicides, cardiovascular disease, and influenza. Ruhm (2003) also finds that a one-percentage-point decrease in the unemployment rate is associated with acute morbidity and ischemic heart disease increases of 1.5 and 4.3 percent, respectively. Ruhm’s empirical results are compelling because they suggest that cyclical, or temporary, changes in economic activity inversely impact health.

Income Inequality and Health

Lynch et al. (2004) and Wagstaff and van Doorslaer (2000) provide two excellent reviews of the literature regarding the relation between income inequality and health. Both papers agree that there is significant support in the literature for the absolute income hypothesis. The same cannot be said for the other alternative hypotheses, however. According to Wagstaff and van Doorslaer, there is “no support for the relative-income hypotheses and little or no support for the income-inequality hypothesis” (p. 543). They conclude that there is no empirical support for the relative position hypothesis. These results were largely reaffirmed by Lynch et al. (2004) and Lorgelly and Lindley (2008). However, Lynch et al., (2004) find some support for the hypothesis that greater income inequality worsens health outcomes at the state level in the United States.

Lifestyle and Health

The literature abounds with studies that illustrate the important role lifestyle plays in determining health. Among the risky lifestyle behaviors found to negatively impact health are smoking, excessive alcohol consumption, lack of physical activity, and poor diet. For example, Leigh and Fries (1992) estimate that the typical one-pack-a-day smoker experiences 10.9 more sick days every six months than comparable nonsmokers, while a person who consumes two or more drinks a day has 4.6 more sick days than a comparable light drinker (one or fewer drinks a day). Strum (2002) analyzes the impact of obesity, being overweight, smoking, and problem drinking on health and the consumption of health care for a sample of adults between ages 18 and 65 in 1997-1998. He finds that all four risk behaviors impact health to some degree, with obesity having the greatest impact. In fact, Strum estimates that obesity has the same impact on health as 20 years of aging when health status is measured by the number of seventeen common chronic conditions present. Finally, Balia and Jones (2008) find that lifestyle, particularly smoking and sleep patterns, play a significant role in predicting mortality. Using some rather sophisticated modeling and econometric techniques that focus on the distribution of health inequality, they estimate that predicted mortality rates may be much more sensitive to lifestyle factors, and less sensitive to socioeconomic factors and aging, than previously thought.

In the context of Figure 2-6, these results collectively suggest that adverse lifestyles cause the total product curve for medical care to shift downward and possibly flatten out. To compensate for the loss in health, a person may opt to slide up the total product curve by consuming more medical care. For example, Strum (2002) finds that obesity is related to an average increase in expenditures on inpatient and ambulatory care of $395 per year.

Environment and Health

The relation between environmental factors and health is mixed and, as a result, it is difficult to draw overall conclusions from the literature. Auster et al. (1969) included two variables in the regression equation to capture the impact of environmental factors on health: an index of industrialization and a variable that measured the extent of urbanization. Both measures were hypothesized to be positively associated with such factors as air and water pollution, and therefore negatively related to health. The index of industrialization was found to cause higher mortality, but the level of urbanization had no influence.

Hadley (1982) undertook one of the more comprehensive assessments of the impact of environmental factors on health. Included in the regression analysis were variables representing water quality, air quality, climate, and occupational hazards. The results are inconclusive, which Hadley attributes mainly to “the lack of good quality data” (p. 73).

Other Determinants and Health

Other variables found to contribute to health are age and marital status. The impact of marital status on health is interesting and merits a brief discussion. Married adults appear to experience better health than their single counterparts, everything else held constant. Most likely, this is because a spouse augments the production of health within the home. Marriage may also have a positive effect on health by altering preferences for risky behavior. Manor et al. (2000) find the mortality rate of married women to be lower than unmarried women for a sample of Israeli adult women, while more recently Kravdal (2001) finds that married people have a higher chance of survival of twelve common forms of cancer in Norway than their unmarried counterparts.

 

The Determinants of Health among Children

Numerous studies have investigated the factors that influence health among children. This body of literature is important because it illustrates the lasting impact of childhood health into adulthood. For example, Case et al. (2005) find that childhood health has a long-term impact on adult health, education, and social status. Such information is valuable when crafting public policies aimed at improving overall health.

Employing county-level data, Corman and Grossman (1985) regress the neonatal mortality rates for blacks and whites on a host of factors including education of the mother, the prevalence of poverty (a measure of income), and the availability of public programs. The infant mortality rate equals the number of deaths from the first to the 364th day of life per 1,000 live births. The neonatal mortality rate represents the number of deaths from the first to the 27th day of life per 1,000 live births. Some of the public programs included in the analysis are the existence of neonatal intensive care facilities, the availability of abortion services, organized family planning, and Medicaid. Overall, the results are robust and enlightening. Lack of schooling and the existence of poverty are found to raise the neonatal mortality rate for both white and black infants. Together, they account for an increase ieonatal mortality rates by 0.950 and 0.786 per 1,000 live births for whites and blacks, respectively. Access to health care also plays a role, as the presence of neonatal intensive care has caused the neonatal mortality rate to fall by 0.631 and 0.426 per 1,000 live births for white and black infants, respectively. Moreover, the results indicate that various government programs are associated with a reduced mortality rate for black as well as white infants. For example, Medicaid accounts for a decrease in the mortality rate by 0.632 per 1,000 live births for white children and 0.359 per 1,000 live births for black children.

Two recent articles point to the significance of environmental factors on infant health. Chay and Greenstone (2003) use county data from 1981-1982 to estimate the impact of total suspended particulates (TSPs) on infant mortality. TSPs are minute pieces of dust, soot, dirt, ash, smoke, liquid vapor, or other matter in the atmosphere that can cause lung and heart disease. The authors find that a 1 percent reduction in TPS causes the infant mortality rate to fall by 0.35 percent at the county level. Currie and Neidell (2005) find that reductions in carbon monoxide also impact infant mortality. In particular, they find that reductions in carbon monoxide in California throughout the 1990s saved approximately 1000 infant lives. These studies are part of a growing body of literature that illustrates the importance of environmental factors in determining health.

Case et al. (2002) focus on the impact of socioeconomic status on children’s health. Consult Case and Paxson (2002) for a nontechnical overview of the study. To no one’s surprise, the authors find a strong positive relation between the education of the parents and the health of their children. For example, the health of children is positively related to the education of mothers for children living with a mother. Education, in this case, is measured by whether the mother did not complete high school, had a high diploma, or had more than a high school education. The education of fathers is also found to positively contribute to improved health among children, implying that parental education positively impacts the production of a child’s health at all age levels.

The study also finds that household income is a strong predictor of children’s health. More specifically, the authors find that when household income doubles, the probability that a child 3 years old or younger is in excellent or very good health increases by 4 percent. Comparable improvements for children between ages 4 and 8, 9 and 12, and 13 and 17 are 4.9 percent, 5.9 percent, and 7.2 percent, respectively. Just as interesting, the authors find that permanent income is a strong determiner of children’s health. In particular, they find that family income before a child is born is positively related to the child’s health for all ages.

Finally, the authors find that healthier parents tend to have healthier children. Why that is the case, however, remains to be determined. However, the authors do estimate a series of equations for children with adoptive and biological parents and find that the impact of income on health is not significantly different across the two populations. While this evidence is not definitive, it does suggest that genetics may explain only part of the reason why healthier parents have healthier children. Could it be that the production of health takes place at the household level and that healthier parents are simply more efficient producers of health for all members of the household? Clearly, more research needs to be done before we fully understand how parental behavior coupled with socioeconomic factors impacts children’s health.

The literature concerning uninsured versus insured status and health outcomes offers additional insights into the effect of medical care on infant health as well as on other groups. However, we couch the discussion in terms of the relation between medical care and health because the only plausible pathway from insurance to health outcomes is through medical care (Levy and Meltzer, 2001). In a series of articles, Currie and Gruber (1996a, 1996b, and 1997), using a quasi-experimental design, examine the expansion of Medicaid eligibility by Congress on birth-related health outcomes. The authors exploit the fact some states expanded Medicaid eligibility more than others did and at different times. By correlating the magnitude and timing of eligibility expansions with the magnitude and timing of changes in health outcomes, it is possible to determine if a causal effect of insurance on health holds. Currie and Gruber conclude that a significant increase in health inputs and a corresponding reduction in low infant birth weight and child mortality relative to a baseline results from an expansion in Medicaid eligibility. They also find that the magnitude of the Medicaid expansion’s impact on infant mortality depends upon the proximity of high-tech hospitals.

As another example, Hanratty (1996) examines the impact of Canada’s national health insurance program on infant health outcomes. Her identification strategy involves the fact that Canadian provinces adopted national health insurance at different times between 1962 and 1972. She observed changes in the mortality and birth weights of infants across Canadian counties at different introduction dates for the national health insurance program while controlling for other nonmedical determinants of infant health. Her results suggest a significant reduction in the infant mortality rate and a smaller reduction in the low birth weight rate after the introduction of national health insurance in the various provinces of Canada.

 

The Determinants of Health among the Elderly

Several studies have examined the medical care utilization and health of individuals who suddenly become Medicare-eligible at age 65 but previously uninsured to otherwise comparable individuals who were continuously insured. Lichtenberg (2002) analyzes the effect of Medicare on the health of elderly individuals by looking for sudden discontinuities in medical care utilization and health outcomes at age 65, when people typically become eligible for the federal program. Notice that chronological age is an external factor that cannot be altered by the nonmedical determinants of health or influenced by health status. He finds evidence that the utilization of ambulatory and inpatient care increases sharply at age 65. Lichtenberg also finds evidence that people spend less time in bed and face a reduced probability of dying compared to what would have occurred in the absence of Medicare. His results suggest a relatively large marginal productivity of medical care on the health of elderly individuals.

These results are reaffirmed by Card et al. (2007). Using data between 1992 and 2002, they examine the mortality rates of 400,000 elderly patients who were discharged from California hospitals before and after their 65th birthday when they become eligible for Medicare. To control for the possibility that some of the elderly may postpone medical care until they become eligible for Medicare, the authors compare Medicare-eligible people to uninsured individuals who were admitted to the emergency room for medical conditions that require immediate attention. Card et al. find that Medicare eligibility is associated with more medical spending and procedures and a reduction in the mortality rate of elderly individuals.

Using a nationally representative data set, McWilliams et al. (2007) provide a quasiexperimental analysis of longitudinal data for 5,006 adults who were continuously insured and 2,227 adults who were persistently or intermittently uninsured. Individuals ranged from 55 to 64 years of age. The authors find that acquisition of Medicare coverage is associated with improved trends in self-reported health for previously uninsured adults, particularly for those with cardiovascular disease or diabetes. However, Finkelstein and McKnight (2005) find that the introduction of Medicare in 1965 had no measurable impact on elderly mortality during the first decade of the program. That is probably because many high-powered medical technologies such as angioplasty and stents were not available at that time. Finkelstein and McKnight did find the Medicare substantially reduced the exposure of the elderly to the out-of-pocket costs of medical care. Thus, while not initially reducing mortality, Medicare did offer a substantial amount of utility for elderly individuals because of the greater financial security.

 

The Role of Public Health: An Historical Approach

Thus far our discussion has revolved around the production of good health at the micro, or individual, level. Recall that the health production function, as specified in equation 2-2, is taken from the perspective of the individual in terms of the various inputs needed to produce health. We cannot ignore, however, the tremendous impact improvements in public health have had on health over time through an impact on the environmental and technology factors in equation 2-2. Public health places the emphasis on improving health at the community level and looks to such things as improving health education, controlling communicable diseases, improving sanitation, and monitoring and controlling environmental hazards. The fact that almost every municipality, county, and state in the country has a department of public health attests to the importance of public health on our everyday lives.

To illustrate the importance of public health, we discuss two very important public health interventions in the United States. The first health intervention deals with the development of clear water in the United States during the first half of the twentieth century. It coincides in our history with a number of improvements iutrition and public health that caused infectious-disease mortality rates to decrease significantly. The second intervention deals with the development of a polio vaccine, which corresponds with the growth in modern medicine in United States starting in the 1930s with the development of sulfa drugs, or antibiotics. (Cutler, 2006)

During the first part of the twentieth century the United States witnessed an almost unprecedented advancement in health as measured by a drop in the overall mortality rate. Cutler and Miller (2005) provide a compelling case that a majority of this decrease in the mortality rate can be attributed to improvements in water quality brought about by public investments in clean water technologies. Their study uses historical data for thirteen cities where dates were available for four clean water interventions: water filtration, water chlorination, sewage treatment, and sewage chlorination. The dependent variables in the study include alternative measures of mortality. The empirical results suggest that improvements in water quality could explain 43 percent of the reduction in mortality rates from 1900 through 1936 across the cities in the sample. Even more convincing, cleaner water explained 62 percent of the drop in infant mortality and 74 percent of the decline in child mortality over the same time period.

Poliomyelitis, or polio, was one of the most dreaded epidemics to hit the United States in the mid-twentieth century. It is a highly infectious virus that generally afflicts children and can lead to paralysis or death. The most celebrated case occurred in 1921 when Franklin Delano Roosevelt, then a relatively unknown politician from New York, contracted polio while vacationing with his family. The disease left his legs paralyzed and he was largely wheelchair bound for the remainder of his life. While his disability was not hidden from the public, reporters were discouraged from taking pictures of him in his wheelchair while he was the governor of New York and later the president of the United States.

While polio had been around for many years, the number of new polio cases began to accelerate in the United States in the 1940s and early 1950s, reaching epidemic proportions in 1952 with 21,000 new cases. In 1955 the American public received news that Jonas Salk had developed a polio vaccine. The news was received nationally with much fanfare and Salk became a national hero overnight. With the support from the federal government and the March of Dimes, a plan was developed to distribute the vaccination across the country with priority given to young children. Within two years the number of reported polio cases fell by approximately 90 percent (Oshinsky, 2005).

This public health intervention is rather extraordinary because for the first time in our history a private philanthropic organization played a vital role in eradicating a major health problem. Much of the medical research and distribution of the vaccine was funded by the National Foundation for Infantile Paralysis, or the March of Dimes, which was started in 1938. Support for the foundation in terms of volunteers and funds was unprecedented and in 1954 alone the foundation raised an excess of $66 million. Some of our readers may remember as a young school child being asked to donate a shiny new Roosevelt dime to the March of Dimes to help eradicate polio.

The polio vaccine has improved over the years. Today states require students in licensed day care or kindergarten to be immunized for polio, with few exceptions. In many communities, local public health departments, or school clinics, provide vaccinations free of charge for those families who cannot afford to be vaccinated by a private health care provider.

These two examples illustrate the significant impact public health has had on reducing infectious diseases in the United States in the twentieth century. In the context of the total product curve, both public health initiatives caused the curve to shift and rotate upward as illustrated in Figure 2-5. Enhanced water sanitation improved the physical environment, while the polio vaccination is an example of a new medical technology. Needless to say, public health can impact the production of health in a variety of ways. Other examples may include a state-wide anti-smoking campaign aimed at improving lifestyle or a teenage pregnancy prevention program in the local high schools directed at enhancing sex education.

 

The Ten Major Causes of Death in the United States in 2005

As mentioned previously, individual choices, socioeconomic status, and environmental factors play a significant role in the production of health. If so, one might suspect that national disease-specific mortality rates would reflect the importance of these variables. That is, mortality rates should be high for diseases that are more sensitive to adverse lifestyles, low socioeconomic status, or unhealthy environments. With this in mind, Table 2-1 lists the top ten causes of death in the United States for 2005. Over the course of the year, more than 2.4 million individuals died in the United States. Of this number, approximately 77 percent succumbed to the ten most common causes of death listed in the table. By far the number one cause of death is diseases of the heart, accounting for almost 27 percent of all deaths in the United States in 2005. Although researchers are still unclear as to what determines an individual’s risk for heart disease, they are certain that the blood level of cholesterol, smoking, level of physical activity, stress, and obesity play a major role in determining the risk of heart disease. Each of these factors is influenced by lifestyle choices, socioeconomic status, and environmental settings.

 

 

The second leading cause of death is malignant neoplasms, or cancers. Lifestyle choices often have an impact on this type of illness as well. For example, Edlin and Golanty (1988) point out that approximately 80 percent of all lung cancer deaths, the most common form of cancer, can be attributed to smoking. Socioeconomic status and environmental factors also come into play in determining the likelihood of contracting lung cancer through exposure to such items as asbestos and radon. The third leading cause of death is stroke and the medical community is in agreement that lifestyle, such as whether a person follows a proper diet and exercises, impacts the chances of having a stroke.

The fourth leading cause of death is chronic lower respiratory diseases, which includes chronic obstructive pulmonary disease, emphysema, and chronic bronchitis. Air pollution plays a critical role in the progression of these diseases. The next leading cause of death is unintentional injuries, which deals with deaths directly related to individual behavior such as automobile and industrial accidents rather than natural causes.

Finally, the list is interesting for what it does not include. In 1995 the human immunodeficiency virus (HIV) was the eighth leading cause of death and accounted for 32,655 deaths. By 2005 that number had dropped to 12,543. This dramatic decrease in the number of deaths can be attributed to a series of factors including improved therapies and changes in lifestyle brought about by great public awareness of the disease.

This rather simple exercise underscores the importance that lifestyle choices, socioeconomic status, and environmental factors play in determining deaths in the United States. It is worth noting that the information in Table 2-1 can also be used to illustrate the importance that an individual’s mental and physical profile play in the making of health. For example, age is a critical factor in determining the onset of Alzheimer’s disease, while the environment, genetics, and age contribute to development of diabetes.

 

Empirical Evidence on the Production of Health: A Summary

Health production theory suggests that medical care, lifestyle factors, environmental surroundings, and socioeconomic status all influence health conditioned upon the state of medical technology and an individual’s medical profile. Clearly, the total impact of medical care on health is significant and many people would die without proper medical care attention. But from a practical economic perspective, it is important to know which factors contribute more to improved health at the margin so cost-effective policies can be designed. Given limited resources, society’s goal is to implement least-cost methods of improving population health.

In terms of adult health, evidence seems to suggest that nonmedical factors generate greater improvements in health at the margin than medical care. A better lifestyle and improved socioeconomic and environmental conditions seem to matter more than the consumption of additional medical care. Medical care appears to be more important at the margin for infants than adults, especially for low-income infants. But as we saw in this topic, socioeconomic and environmental conditions are also important for infant health. In fact, even lifestyle is important for infants. While at first blush that statement may sound odd, low birth weight and greater infant mortality have been linked to adverse maternal lifestyle behaviors such as tobacco, alcohol and drug abuse. For the elderly, particularly those without health insurance prior to becoming Medicare-eligible, medical care is also important at the margin. But even in this case, nonmedical factors, such as exercise and diet, play an important role.

These empirical findings have some rather interesting policy implications. They suggest that any public policy initiative aimed at improving health should first consider raising education levels, reducing the amount of poverty, and encouraging improved lifestyles rather than simply providing additional medical care. Naturally, the specifics of any policy should be based on sound cost-benefit analysis.

 

 

 

Medical Care Access

Medical care access, another leg of the medical stool, relates to the distribution question. That is: Does everyone have reasonable access to medical care on a timely basis? Timely access is often measured by the percentage of individuals with health insurance. For most people the cost of catastrophic care, such as organ transplants and cariovascular surgery, lies beyond their financial means. But, as explained fully in Topic 6, for a relatively small payment or premium, insurance provides access to high-cost, life-saving interventions if and when people experience severe illnesses. Thus, health insurance may be an important factor in terms of ensuring timely access to medical care. Figure 1-5 offers some information on the percentage of people without health insurance in the United States since 1940.

Before discussing the data in Figure 1-5, it should be noted that the health insurance product has changed considerably over time. Prior to the 1970s most people purchased only hospital insurance. Today people purchase health insurance for other types of medical care, as mentioned previously. Also, the amount of medical care expenditures covered by insurance has increased over the years. Thus, for the sake of consistency, it may be best to think of Figure 1-5 as showing the percentage of the U.S. population without hospital insurance.

In any case, the data in the figure show that great strides have been taken in terms of more people insured in the United States. In 1940, only 10 percent of the U.S. population possessed health insurance purchased almost entirely in the private marketplace. Even before public health insurance programs, beginning with the Medicare and Medicaid Acts of the mid-1960s, many people began purchasing private health insurance in the United States following the 1940s. By 1975 the uninsured rate in the United States dipped to about 13 percent because of both private purchases and public expansions.

 

 

 

 

However, beginning around 1980, further persistent declines in the uninsured rate have not materialized. In 2006 the uninsurance rate in the United States stood at nearly 16 percent. While we take up the causes, types, and social costs of uninsurance in Topics 6 and 11, it suffices to note that a sizeable percentage of the U.S. population lacks timely access to medical care because of their uninsured status. In addition, severe racial disparities exist with respect to uninsured status, as noted in Topic 11. Clearly, these are two additional areas where the tools of health economies are needed to shed better light and bring about improvements in the health economy and society.

 

 

Medical Care Quality

The final leg of the medical stool we consider is medical care quality. As discussed more fully in Topic 2, quality represents a complex and multidimensional concept. In keeping with the other two legs of the medical stool we confine our discussion to a single measure of quality that is easily understandable and important from a societal point of view, and for which data can be obtained over time for comparative purposes. The chosen measure is the infant mortality rate that tells us the number of children below one year of age that died as a percentage of all live births in that same year. The infant mortality rate for the United States from 1960 to 2006 is reported in Figure 1-6.

 

 

Like the uninsured rate, the infant mortality rate has improved significantly over time in the United States falling from a height of over 25 infant deaths per 1,000 live births in 1960. Although it stands to reason that rising health care spending and increased insurance coverage contributed to the decline, Topic 2 discusses the theoretical framework and empirical findings regarding the many factors influencing health status outcomes such as infant mortality. Despite the vast improvements that have taken place over time, Figure 1-6 suggests that nearly 7 out of every 1,000 live babies in the United States do not live beyond 1 year of age. Also, the United States lags far behind when compared to other industrialized countries like Belgium, France, Italy, Japan, and the United Kingdom, which have infant mortality rates below 5 deaths per 1,000 live births. Finally, the figure does not capture the vast variations in health outcome measures, such as infant mortality, among different income, racial, and ethnic groups. Once again, the tools of health economics can prove useful for analyzing health outcomes and proposing ways of improving societal health.

 

 

A Note on the Relation between System Structure and Performance

Many theories and empirical findings pertaining to health economics are introduced and developed in this text. Sometimes theories and empirical findings are of interest for their own sake, particularly for academicians such as the authors. But the main reason for their introduction and development is that we wish to obtain a better grasp of the operation and performance of the real-world health economy around us. If the health economy does not perform in a socially efficient and equitable manner, then we would hope that solutions could be proposed and policies could be changed to alter that undesirable performance.

 

 

An understanding of the link between structure and performance is essential when crafting new policies. Structure plays a role in determining how people behave or conduct themselves in the health economy. Figure 1-7 shows the complex interaction between structure and performance. A health economy is structured in a particular way, and this health economy structure is discussed in great detail in Topic 4. Structure shows up in the ways various organizations are designed in terms of their size and scope, the mix of market activities and government involvement in the health economy, and financing and reimbursement mechanisms, among others.

This underlying structure helps to establish the prevailing incentives in a health economy and thereby influences how people, organizations, and government itself, behave. If incentives are distorted because of structural defects, then suboptimal performance likely results in terms of inefficient and inequitable outcomes. Given the suboptimal performance, solutions can be proposed and public policies can be designed to remedy the situation. In particular, policies can be changed to either indirectly affect behavior through a restructuring of the system or directly by introducing conduct remedies.

 

 

 

 

The Utility-Maximizing Rule

Given market prices at a point in time, consumers must decide which combination of goods and services, including medical care, to purchase with their fixed incomes. According to microeconomic theory, each consumer chooses the bundle of goods and services that maximizes utility. Without working through the mathematics underlying the process, logic dictates that consumer utility is maximized when the marginal utility gained from the last dollar spent on each product is equal across all goods and services purchased. That is, assuming all prices are known, income is spent over the period in question, and all products are subject to the law of diminishing marginal utility.

The shape of the utility curve illustrates that total utility increases at a decreasing rate with respect to the level of medi­cal care consumed. The curve has a bow shape for two reasons. First, each additional unit of medical care consumed results in a smaller increase in health than the previous unit because of the law of diminishing marginal productivity. Second, each additional improvement in health generates a smaller increase in utility because of the law of diminishing marginal utility.

 

The shape of the utility curve illustrates that total utility increases at a decreasing rate with respect to the level of medical care consumed. The curve has a bow shape for two reasons. First, each additional unit of medical care consumed results in a smaller increase in health than the previous unit because of the law of diminishing marginal productivity. Second, each additional improvement in health generates a smaller increase in utility because of the law of diminishing marginal utility.

 

This condition is known as the utility-maximizing rule, and it basically states that total utility reaches its peak when the consumer receives the maximum “bang for the buck” in terms of marginal utility per dollar of income from each and every good. In mathematical terms, the rule states that utility is maximized when

 

(5-1)                                       MUq/Pq = MU_Z/P_Z,

 

where MU_q represents the marginal utility received from the last unit of medical care purchased, q, and MU_z equals the marginal utility derived from the last unit of all other goods, z. The latter good is often referred to as a composite good in economics. To illustrate why the utility-maximizing rule must hold, suppose that

The Law of Demand

The equilibrium condition specified in Equation 5-1 can be used to trace out the demand curve for a particular medical service, such as physician services. For simplicity, assume the prices of all other goods and income remain constant and initially the consumer is purchasing the optimal mix of physician services and all other goods. Now assume the price of physician services increases. In this case, MU_q/P_q is less than MU_z/P_z (where MU_q and P_q represent the marginal utility and price of physician services, respectively). Consequently, the consumer receives more satisfaction per dollar from consuming all other goods. In reaction to the price increase, the consumer purchases fewer units of physician services and more units of all other goods. This reallocation continues until MUq/Pq increases and MUz/Pz decreases and the equilibrium condition of Equation 5-1 is again in force such that the last dollar spent on each good generates an equal amount of utility. Thus, an inverse relation exists between the price and the quantity demanded of physician services.

If the price of physician services continually changes, we can determine a number of points representing the relation between the price and the quantity demanded of physician services. Using this information, we can map out a demand curve like the one depicted in Figure 5-2, where the horizontal axis indicates the amount of physician services consumed (as measured by the number of visits, for example) and the vertical axis equals the price of physician services. The curve is downward sloping and reflects the inverse relation between the price and the quantity demanded of physician services, ceteris paribus. For example, if the price of physician services equals P₀, the consumer is willing and able to purchase q₀. Notice that if the price falls to P₁, the consumer purchases q₁ amount of physician services.

 

In this case, price represents the per-unit out-of-pocket expense the consumer incurs when purchasing medical services from a physician. As such, it equals the amount the consumer must pay after the impact of third-party payments has been taken into account. Naturally, if the visit to the physician is not covered by a third party, the actual price of the visit equals the out-of-pocket expense.

The substitution and income effects associated with a price change offer another theoretical justification of the inverse relationship between price and quantity demanded. Both of these effects predict that a higher price will lead to a smaller quantity demanded and, conversely, a lower price will result in a greater quantity demanded. According to the substitution effect, a decrease in the price of physician services causes the consumer to substitute away from the relatively higher-priced medical goods, such as hospital outpatient services, and purchase more physician services. That is, lower-priced services are substituted for higher-priced ones. As a result, the quantity demanded of physician services increases as price decreases.

According to the income effect, a lower price also increases the real purchasing power of the consumer. Because medical care is assumed to be a normal good (that is, the quantity demanded of medical services increases with income), the quantity demanded of physician services increases with the rise in purchasing power. That also generates an inverse relation between price and quantity demanded because as price falls, real income increases and quantity demanded rises. Taken together, the substitution and income effects indicate that the quantity demanded of physician services decreases as price increases.

In summary, Figure 5-2 captures the inverse relationship between the price the consumer pays for medical care (in this instance, physician services) and the quantity demanded. The curve represents the amount of medical care the consumer is willing and able to purchase at every price. Utility analysis, or the income and substitution effects, can be used to generate this relationship. This inverse relationship is sometimes referred to as the law of demand. It is important to note that the demand for medical care is a derived demand, because it depends on the demand for good health. A visit to a dentist illustrates this point. An individual receives no utility directly from having a cavity filled. Rather, utility is generated from an improvement in dental health.

Of course, other economic and noneconomic variables also influence the demand for health care. Unlike price, which causes a movement along the demand curve, other factors influence the quantity demanded by altering the position of the demand curve. These other economic and noneconomic determinants of demand are the topic of the next section.

 

 

Other Economic Demand-Side Factors

Income is another economic variable that affects the demand for medical services. Because medical care is generally assumed to be a normal good, any increase in income, which represents an increase in purchasing power, should cause the demand for medical services to rise. Figure 5-3 illustrates what happens to the demand for physician services when income increases. The increase in income causes the demand curve to shift to the right, from d₀ to d₁, because at each price the consumer is willing and able to purchase more physician services. Similarly, for each quantity of medical services, the consumer is willing to pay a higher price. This is attributable to the fact that at least some portion of the increase in income is spent on physician services. Conversely, a decrease in income causes the demand curve to shift to the left. Some goods are referred to as inferior goods. This is because the demand for these goods decreases as income increases. A classic nonmedical example is hamburger. As real income increases, the consumer may prefer to buy more expensive cuts of meat and purchase less hamburger. In the medical sector, hospital outpatient services may be an example of an inferior good. As income increases, the consumer may prefer to visit a private physician to receive individual care rather than outpatient services. As a result, the demand for outpatient services may decrease as income increases. Some researchers have found that tooth extractions represent an inferior dental service.

 

 

The demand for a specific type of medical service is also likely to depend on the prices of other goods, particularly other types of medical services. If two or more goods are jointly used for consumption purposes, economists say that they are complements in consumption: Because the goods are consumed together, an increase in the price of one good inversely influences the demand for the other. For example, the demand for eyewear (that is, glasses or contact lenses) and the services of an optometrist are likely to be highly complementary.

Normally, an individual has an eye examination before purchasing eyewear. If these two goods are complements in consumption, the demand for optometric services should increase in response to a drop in the price of eyewear. As a result, the demand curve for optometric services shifts to the right. Another example of a complementary relation exists between obstetric and pediatric services. An increase in the price of pediatric services should inversely influence the demand for obstetric services. If, for example, a woman postpones pregnancy because of the high cost of pediatric services, her demand for obstetric services also falls. The demand curve for obstetric services shifts to the left.

It is also possible for two or more goods to satisfy the same wants or provide the same characteristics. If that is the case, economists say that these goods are substitutes in consumption: The demand for one good is directly related to a change in the price of a substitute good. For example, suppose physician services and hospital outpatient services are substitutes in consumption. As the price of outpatient services increases, the consumer is likely to alter consumption patterns and purchase more physician services because the price of a visit to the doctor is cheaper in relative terms. That causes the demand curve for physician services to shift to the right. Generic and brand-name drugs provide another example of two substitute goods. The demand for brand-name drugs should decrease with a decline in the price of generic drugs. If so, the demand curve for brand-name drugs shifts to the left. Finally, eyeglasses and contact lenses are likely to be substitutes in consumption.

Time costs also influence the quantity demanded of medical services. Time costs include the monetary cost of travel, such as bus fare or gasoline, plus the opportunity cost of time. The opportunity cost of an individual’s time represents the dollar value of the activities the person forgoes when acquiring medical services. For example, if a plumber who earns $50 an hour takes two hours off from work to visit a dentist, the opportunity cost of the time equals $100. The implication is that the opportunity cost of time is directly related to a person’s wage rate. Given time costs, it is not surprising that children and elderly people often fill doctors’ waiting rooms. Time costs can accrue while traveling to and from a medical provider, waiting to see the provider, and experiencing delays in securing an appointment. In other words, travel costs increase the farther an individual has to travel to see a physician, the longer the wait at the doctor’s office, and the longer the delay in getting an appointment. It stands to reason that the demand for medical care falls as time costs increase (that is, as the demand curve shifts to the left).

 

 

The Relationship between Health Insurance and the Demand for Medical Care

The growth of health insurance coverage is one of the most significant developments in the health care field over the past several decades. It has had a profound influence on the allocation of resources within the medical care market, primarily through its impact on the out-of-pocket prices of health care services. Out-of-pocket payments for health care dropped from almost half of total expenditures in 1960 to approximately one-seventh in 2003. Even more striking, out-of-pocket payments for hospital care fell from 20.7 percent in 1960 to a mere 3.2 percent in 2003. Given that various features are associated with health insurance policies, it is impossible to discuss the economic implications of each one. Here we will focus on three of the more common features of health insurance policies: coinsurance, copayments, and deductibles.

Coinsurance and Copayments. Many health insurance plans, particularly private plans, have a coinsurance component. Under a coinsurance plan, the consumer pays some fixed percentage of the cost of health care and the insurance carrier picks up the other portion. For example, under a plan with a coinsurance rate of 20 percent (a common arrangement), the consumer pays 20 cents out of every dollar spent on health care and the carrier picks up the remaining 80 cents. As you can imagine, an insurance plan like this one has a significant impact on the demand for health care because it effectively lowers the out-ofpocket price of health care by 80 percent.

Let’s begin our discussion of coinsurance coverage by looking at the demand curve for medical care from an alternative perspective. We normally think of the demand curve as revealing the amount of a good that a consumer is willing and able to buy at various prices. However, a demand curve also shows the consumer’s willingness to pay (or marginal benefit) for each unit of a good. The negative slope of the curve indicates that the willingness to pay falls as more of the good is consumed due to the law of diminishing marginal utility.

For example, the demand curve d_WO (WO = without insurance) in Figure 5-4 represents the consumer’s demand or willingness to pay for office visits in the absence of health insurance coverage. This “effective” demand curve reveals that the consumer is willing to pay $50 for the fifth office visit. If $50 is the market price paid by the consumer, she visits the physician five times during the year in the process of maximizing utility because any additional office visits do not yield benefits that compensate for their higher out-of-pocket costs. Notice that the consumer’s willingness to pay for the first four visits, as revealed by the effective demand curve, exceeds the market price of $50. The difference between the willingness to pay and the market price paid is referred to as a customer surplus and, in this example, reflects the net benefits received from visiting the doctor the first four times.

As discussed in Topic 8, market price considers both supply and demand conditions. The demand curves in Figure 5-4 represent the effective and nominal demands of an individual. Individual demands must be horizontally summed to arrive at a market demand and then interacted with supply to determine the market price.

Now suppose the consumer acquires a health insurance plan that requires her to pay a certain fraction, C₀, of the actual price, P. In this case, the insurance coverage drives a wedge between the willingness to pay, or effective demand, and the actual price, or “nominal” demand, for the office visits. Because the utility-maximizing consumer determines the optimal number of times to visit the physician by equating her willingness to pay (or marginal benefit) to the out-of-pocket price (marginal cost), the relationship between the actual and out-of-pocket price can be specified by the following equation:

 

(5-3)                              Pw = CoP.

 

Here P_w stands for the consumer’s willingness to pay for the last visit, and C₀ represents the coinsurance amount. If we solve Equation 5-3 for the actual price, we get

 

(5-4)                              P = Pw/Co.

 

Because the coinsurance, C₀, is less than 1, it follows that the actual price paid, or nominal demand, for office visits is greater than the out-of-pocket price the consumer pays. For example, if she is willing to pay $50 for five visits to a doctor and the coinsurance is 20 percent of the full price, the actual price equals $250 per visit, or $50/0.2.

 

 

The graph illustrates how a coinsurance health plan impacts the individual demand curve for physician visits. The demand curve labeled dwo is the individual’s effective demand without coinsurance while the demand curve labeled c/wi is with coinsurance. The nominal demand curve dwi traces out the total price for various physician visits and cap­tures that portion paid by consumers as out-of-pocket payments as well as that portion paid by the insurance carrier. If you draw a vertical line from any point on the nominal demand curve to the horizontal axis, you can break down the amount paid by consumers (from the horizontal axis to the dwo curve) and the amount paid by the insurance carrier (the wedge between the dwi and dwo curves). As the coinsurance rate falls, dwi rotates upward and pivots off the point where the two curves cross the horizontal axis.

 

The nominal demand curve labeled d_WI (_WI = with insurance) in Figure 5-4 reflects the total price paid for medical services that takes into account the coinsurance paid by the insured. The vertical distance between d_WI and the horizontal axis represents the total price for office visits, which can be broken down into the amount the consumer pays and the amount the insurance carrier pays. The portion of the total price the con­sumer pays as an out-of-pocket payment equals the distance between the horizontal axis and the d_WO demand curve. The remaining distance between the two curves represents the amount the insurance carrier pays. It represents the wedge that coinsurance drives between the consumer’s willingness to pay, or effective demand, and the total price paid, or nominal demand.

It is easy to see from this analysis that a reduction in the coinsurance rate causes the nominal demand curve d_WI to rotate clockwise and pivot off the point where d_WO crosses the horizontal axis. At a zero willingness-to-pay price, insurance has no bearing on quantity demanded because medical care is a free good to the individual. In addition, the nominal demand curve d_WI becomes steeper as the coinsurance, C₀, decreases in value as indicated by Equation 5-4. That makes intuitive sense, because we expect the consumer to become less sensitive to changes in the total price as the coinsurance declines.

In the case where the consumer has full coverage (C₀ = 0), the nominal demand curve d_WI rotates out to its fullest extent and becomes completely vertical. This is shown in Figure 5-5. Because the consumer faces a zero price, she consumes medical care as though it were a free good, when in reality it has a nonzero price. Equation 5-4 can be used to illustrate that point. As C₀ approaches zero, the total price is potentially infinity even when P_w equals zero.

Coinsurance should not be confused with a copayment. A copayment represents a fixed amount paid by the consumer that is independent of the market price or actual costs of medical care. For example, a person may be required to pay $10 for each office visit regardless of the actual fee negotiated by the health insurer with the physician. Like a lower coinsurance rate, a reduced copayment results in a movement down the effective demand curve and typically leads to greater quantity of care demanded. But unlike a change in the coinsurance rate, a change in the copayment does not cause a rotation of the nominal demand because the consumer’s portion of the bill is independent rather than proportional to nominal demand (that is, the actual price paid).

 

 

 

 

The graph illustrates the situation in which the individual has complete medical coverage and the coinsurance rate is zero. Notice that the nominal demand curve is vertical because the individual faces a zero out-of-pocket price and visits the physician without regard to the actual price.

 

Also unlike coinsurance, a copayment does not automatically change with an adjustment in the costs of providing medical care. For example, suppose, in response to higher production costs, a physiciaegotiates a higher price with the insurer for each office visit so that the market price increases from $100 to $150. An insured individual who is responsible for paying 20 percent of the cost now faces a $10 increase in his coinsurance from $20 to $30 per office visit. However, an insured individual who is required to pay a copayment of $10 per office visit is unaffected by the higher negotiated price for an office visit (at least until the insurance policy is renegotiated). Thus, compared to a copayment, coinsurance makes consumers more sensitive to the actual market price of medical care.

Deductibles. Many insurance policies have a deductible whereby the consumer must pay out of pocket a fixed amount of health care costs per calendar year before coverage begins. For example, the plan may call for the individual to pay the initial $200 of health care expenses with a limit of $500 per family per year. Once the deductible is met, the insurance carrier pays all or some portion of the remaining medical bills, depending on how the plan is specified. From the insurance carrier’s perspective, the purpose of a deductible is to lower costs. This is accomplished in two ways.

First, the deductible is likely to lower administrative costs because fewer small claims will be filed over the course of a year. Second, the deductible is likely to have a negative impact on the demand for health care. The extent to which this is true, however, is difficult to determine and depends on such factors as the cost of the medical episode, the point in time when the medical care is demanded, and the probability of needing additional medical care for the remainder of the period. To illustrate, assume a new deductible is put in place at the beginning of each calendar year. Once the deductible is met, the consumer has full medical coverage. It is easy to see that the extent to which a deductible influences the demand for medical services for any one medical episode is likely to be inversely related to the cost of the medical services involved. For example, if the consumer faces a potentially large medical bill for an operation, the existence of a deductible is likely to have little impact on demand. This is because, in relative terms, the deductible represents very little money. On the other hand, a deductible may play a crucial role in the decision to purchase medical care if the cost of such care is relatively inexpensive. In this case, the out-of-pocket cost is substantial relative to the total cost, and the consumer may elect not to purchase the medical care or postpone the purchase to a later date.

It is slightly more difficult to understand how the health of the individual, along with the time of the year, influences the impact of a deductible on demand. The best way to explain this is with an example. Consider a normally healthy individual who contracts the flu late in November and has incurred no medical expenses up to this point. Under these circumstances, he may be less inclined to visit the doctor. This is because he will have little opportunity to take advantage of the fact that health care is a free good after he makes his initial visit to the physician and fulfills the deductible. On the other hand, this same individual is much more likely to visit the physician if he catches the flu early in February and his overall health is such that he can expect to visit the physician three or four more times over the remainder of the year. By visiting the doctor and meeting the deductible, he lowers the cost of any future visits to zero for the rest of the year. Therefore, a deductible is likely to have the greatest negative impact on the demand for medical care when the cost of the medical episode is low, the need for care is late in the calendar year, and the probability of needing future care is slight because the person is in good health.

 

 

Moral Hazard

Before we leave the subject of the impact of insurance on the demand for medical care, we need to introduce the concept of moral hazard. Moral hazard refers to the situation in which consumers alter their behavior when provided with health insurance. For example, health insurance may induce consumers to take fewer precautions to prevent illnesses or to shop very little for the best medical prices. In addition, insured consumers may purchase more medical care than they otherwise would have without insurance coverage. Let’s illustrate this point by referring to Figure 5-4. According to the graph, a consumer without insurance purchases five units of medical services at a price of $50 per unit. If that consumer acquires full medical coverage such that the insurer’s coinsurance rate, C₀, equals zero, the quantity demanded of medical care increases to the point where the demand curve crosses the horizontal axis. At this point, the consumer consumes medical care as though it were a free good because she faces a zero price. Thus, any extension of medical insurance coverage has the potential to increase the consumption of medical care because consumers no longer pay the full price. The availability and extensiveness of health insurance may have a profound effect on medical care expenditures. Topic 6 examines the implications of moral hazard in more detail.

 

 

 

Summary

Every health care system must answer the four basic questions concerning the allocation of medical resources and the distribution of medical services. Some systems rely on centralized decision making whereas others answer the basic questions through a decentralized process. Health care systems are complex largely because third-party payers are involved. Third-party payers help reduce the financial risk associated with the irregularity and uncertainty of many medical transactions. Third-party payers also help monitor the behavior of health care providers.

The financing, reimbursement, and production methods and the degree of choice over the health care provider are important elements that make up a health care system. Medical care is financed by out-of-pocket payments, premiums, and/or taxes. Medical care providers are reimbursed on a fixed or variable basis. The production of medical care may take place in a for-profit, a not-for-profit, or a public setting, and medical care providers may operate in independent or large group practices. Choice of provider may be limited. All these features are important because they affect incentives and thereby often influence the operation and performance of a health care system. For example, many economists predict that fee-for-service insurance plans provide an incentive for medical care providers to produce a large volume of services.

The U.S. health care system is very pluralistic. For instance, considerable variation exists in the financing, reimbursement, and production of medical care. The remainder of this book provides a better understanding about how each of these elements affects the functioning of the U.S. health care system.

 

 

Review Questions and Problems

1.                Answer the following questions pertaining to health care systems.

A.                 Why isn’t the market for health care services organized according to a typical consumer (patient) and producer (health provider) relationship?

B.                  What are the basic differences between insurance premiums and taxes as sources of medical care financing?

C.                 How might the reimbursement method differ among health care providers? Why might the reimbursement method make a difference?

D.                 Identify the four basic kinds of health care systems discussed in this topic.

E.                  Point out some unique institutions (compared to the United States) associated with the health care systems of the various countries discussed in this topic.

2.                Suppose you had the opportunity to organize the perfect health care system. Explain how you would organize the financing method, reimbursement scheme, mode of production, and physician referral procedure.

3.                Which of the following reimbursement and consumer copayment schemes would have the greatest and lowest likelihood of producing high-cost, low-benefit medicine? Explain your answers.

A.                 Fee-for-service plan with 40 percent consumer copayment.

B.                  Prepaid health plan with 40 percent consumer copayment.

C.                 Fee-for-service plan with no consumer-cost sharing.

D.                 Fixed-salary plan with no consumer-cost sharing.

E.                  Prepaid health plan with no consumer-cost sharing.

F.                  Fixed-salary plan with 40 percent consumer-cost sharing.

4.                Answer the following questions regarding the U.S. health care system.

A.                 What are the basic differences between conventional health insurance and managed care health insurance in terms of type of insurance offered and reimbursement practice?

B.                  What is the difference between Medicare and Medicaid? How is Medicare financed? How is Medicaid financed?

C.                 What is the DRG system? How are physicians currently reimbursed under the Medicare system?

 

 

References

 

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Bodenheimer, Thomas, and Kevin Grumbach. “Financing Universal Health Insurance: Taxes, Premiums and the Lessons of Social Insurance.” Journal of Health Politics, Policy and Law 17 (fall 1992), pp. 439-62.

Cutler, D. M., and M. McClellan. “Is Technological Change in Medicine Worth It?” Health Affairs 20, no. 5 (2001), pp. 11-29.

Ellis, Randall P., and Thomas G. McGuire. “Supply-Side and Demand-Side Cost Sharing in Health Care.” Journal of Economic Perspectives 7 (fall 1993), pp. 135-51.

Halm, Ethan A., Nancyanne Causino, and David Blumenthal. “Is Gatekeeping Better Than Traditional Care?” Journal of the American Medical Association 278 (November 1997), pp. 1677-81.

Mechanic, David. “Americanization of the British NHS.” Health Affairs 14 (summer 1995), pp. 51-67.

Mosby Medical Encyclopedia. New York: C. V. Mosby, 1992.

Raffel, Marshall W., ed. Health Care and Reform in Industrial Countries. University Park: Pennsylvania State University Press, 1997.

Reinhardt, Uwe. “Economics.” Journal of the American Medical Association 275 (June 1996), pp. 23-25.

Schmittdiel, Julie, Joe V. Selby, Kevin Grumbach, and Charles P. Quesenberry. “Choice of Personal Physician and Patient Satisfaction in a Health Maintenance Organization.” Journal of the American Medical Association 278 (November 1997), pp. 1596-99.

Van de Ven, Wynand, P. M. M., and Randall P. Ellis. “Risk Adjustment in Competitive Health Plan Markets.” In Handbook in Health Economics, eds. A. J. Calger and J. P. Newhouse. Amsterdam: North-Holland, 2000, chap. 14, pp. 755-845.

Weisbrod, Burton A. The Nonprofit Economy. Cambridge, Mass.: Harvard University Press, 1988.