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

Outline Introduction Health insurance

Private through employers Public Uninsured

(Like other forms of insurance, we trade off…) consumption smoothing versus moral hazard

Payments to providers Health care reform

Introduction Increases in health spending (from 4% of GDP in

1950 to 15% of GDP in 2003) have altered the delivery of health services. For example, treatment for many ailments has improved dramatically. Knee surgery that used to be very invasive and took

months to recover is now a quick and easy procedure. The number dying from heart attacks has fallen by

half. The infant mortality rate has fallen by 75%. Individuals can permanently improve their vision with

LASIK surgery, that takes less than two hours, and be up and running within a day.

Introduction There are some problems with the health care

system however. Disparities in health outcomes exist by race and income. The white infant mortality rate is 6 per 1000, in line

with countries like the United Kingdom and Australia. The black infant mortality rate is 14 per 1000, more

than double. It is higher than some developing countries.

Access to health care also varies. 15.6% of the U.S. population, or 45 million people

were uninsured in 2003. The number of uninsured has remained high during

both economic booms and busts.

Health Care Spending in OECD Nations in 2002

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Figure 1

Countries like the United Kingdom and Japan spend a much smaller

share on health care.

Spending in the U.S. averages $5,800 per person, and nearly 15%

of GDP.

Table 1

Americans’ Source of Health Insurance Coverage, 2002

People

(millions)

Percentage of population

Total population 288.6 100.0%

Private 177.8 61.6%

• Employment-based 161.0 55.8%

• Individually purchased

16.8 5.8%

Public 83.0 28.8%

• Medicare 40.5 14.0%

• Medicaid 42.8 14.8%

• TRICARE/CHAMPVA 6.9 2.4%

Uninsured 43.3 15.0%

Roughly 44 million individuals were uninsured for the entire 2002 calendar

year, or 15% of the population.

Some Terminology That Arises with Insurance

Individuals often pay for part of the cost of their actual utilization, whether privately (through employers) or publicly provided.

These payments by individuals occur in one of three ways: Deductible: A person faces the full cost of care to

some limit, and the insurance pays for costs after that.

Copayment: A person pays a fixed payment when they get a medical good or service.

Coinsurance: A person pays a percentage of each medical bill rather than a flat dollar amount.

Private Insurance

A risk pool is a group of individuals to whom an insurance plan is offered.

One motivation for employers to offer coverage is the nature of “risk pools.”

Insurers try to create large insurance pools with a predictable distribution of medical risk. Two features increase the predictability of medical risk distributions:

The absence of adverse selection Large group sizes

Employers have a good chance of meeting these conditions. Individuals are not likely to meet these conditions.

Although large groups of individuals could be formed, the concern about adverse selection remains.

That is, is the group looking for health coverage simply because they are sick. Some administrative costs of running a health insurance plan are fixed;

thus, the larger the pool, the smaller the per-enrollee costs. This also reinforces the preference for providing insurance through large firms.

Private Insurance Overall, adverse selection, group size, and

fixed costs lead to vast differences in the odds of being offered health insurance. 98% of firms with 200 or more employees offer

health insurance to at least some of their employees.

Only 55% of firms with fewer than 10 employees offer health insurance.

Even one costly health risk (such as a cancer or AIDS patient) can lead to losses for small groups.

Private Insurance The tax subsidy to employer provided

health insurance refers to the fact that workers are taxed on their wage compensation but not on their compensation in the form of health insurance, leading to a subsidy to health insurance provided through employers. This is a second motivation for employers to offer

health insurance coverage. The effective price of offering $1 of health

insurance is only ($1-), where is the cumulative federal, state, and payroll tax rate.

Table 2

Illustrating the Tax Subsidy to Employer-Provided Insurance

Marginal product,

wage

Employer health insuranc

e spendin

g

Pre-tax wage

After-tax wage

Personal health

insurance

spending

After-tax, after-health insurance

income

Jim $30,000

0 $30,000

$25,500 $4,500 $21,000

Peter

$30,000

$5,000 $25,000

$21,250 0 $21,250

Although Jim buys less expensive health insurance on his own, his net

income is lower!

Jim and Peter face 15% marginal tax rates. Jim purchases aprivate policy for $4,500. Peter’s employer buys him a more expensive policy for $5,000. Yet, because of tax deductibility,Peter’s after-tax income is larger than Jim’s.

Public Insurance: THE MEDICAID PROGRAM FOR LOW-

INCOME MOTHERS AND CHILDREN

Medicaid serves low-income groups who are largely: Women and children Disabled or elderly

Medicaid is administered by the states, but financed jointly by the federal government and the state. In poor states like Mississippi, the federal government pays nearly

$4 for every $1 the state contributes. In richer states, like Massachusetts, the federal government pays

$1 for every $1 the state contributes. The benefits of Medicaid are similar to private plans, except

there is little or no patient coinsurance or copayments. States must offer a basic set of services, and have latitude to add

additional services.

The Medicaid program for low-income mothers and children:

Eligibility and Coverage The Children’s Health Insurance Program (“CHIP”)

was introduced in 1997 to expand eligibility of children for public health insurance. Generally covers up to 200% of the poverty line, or $36,800 for a

family of four in 2004. Some states expand eligibility much higher, such as New Jersey’s $64,400

limit for children. Federal rules require that the full Medicaid program

cover major services like physician and hospital care. All states have also chosen to cover other, expensive, optional

benefits – almost all cover prescription drugs, optometrist services, and dental. Often, no copayment is required.

As a consequence, Medicaid is much more generous than virtually any private plan.

The Medicaid program for low-income mothers and children: How

do providers get paid?

Although the services are generous, the reimbursement to health care providers is not.

Medicaid reimburses physicians at a much lower level than the private sector. For example, childbirth is reimbursed at about half the private-sector rate.

Physicians are often unwilling to serve Medicaid patients. One-third of doctors serve no Medicaid patients.

Increased Eligibility

Previously Privately InsuredPreviously Uninsured

Medicaid Coverage

Medical Utilization

Health Outcomes

Cost-Effectiveness

Crowd-out

Access

Take-up

Step 1

Step 2

Step 3

Step 4

Figure 2

Program costs

Expanding Medicaid eligibility affects both the

uninsured and the insured.

In reality, crowd-out turns out to be an important

issue.

Even with crowd-out, however, Medicaid coverage goes up.This leads to better

access to health care and greater utilization.

Increased utilization should improve health

outcomes.

This is weighed against program costs to determine cost-effectiveness.

The Effects of Medicaid on Health: Steps to Consider

What are the effects of the Medicaid program?

How does Medicaid affect health? Evidence

Step 1: although eligibility expanded dramatically, relatively few of the newly eligible enrolled – the takeup rate was roughly 25%. Roughly 2/3 of children already had private coverage. When faced with the “free” Medicaid option, there appeared to be

substantial crowd-out of private insurance. For every 100 new Medicaid recipients, the number on private

insurance fell by 20 to 50 persons. Nonetheless, expanding Medicaid still substantially reduces the number of

uninsured. Step 2: Currie and Gruber find that these reductions in the

number of uninsured had positive effects on health. Utilization of health services increased: Early prenatal care and

preventive medical visits for children rose by more than 50%.

What are the effects of the Medicaid program?

How does Medicaid affect health? Evidence

Step 3: Health care outcomes improved. Infant mortality declined by 8.5% due to the

expansions in Medicaid for pregnant women. Other work using the introduction of national health

insurance in Canada and the termination of public assistance in California find health results consistent with these findings, too.

Step 4: Currie and Gruber (1996) estimated that it cost Medicaid roughly $1 million per infant life saved through the expansions. This is much lower than typical estimates from

other policies, including food regulation and seat-belt safety.

Table 2

Features of Medicaid and MedicareMedicaid Medicare

Eligibles Families on welfareLow-income children, pregnant womenLow-income elderly, disabled

Retirees and spouses 65+Certain disabled individualsPeople with kidney failure

Premiums None Hospital coverage: NonePhysician coverage: $66.60/mo

Deductibles/ copayments

None (or very small) Hospital coverage: $876 deductible for first 60 daysPhysician coverage: $100 deductible, 20% coinsurance

Services excluded

None (or very minor) Prescription drugs (at least until 2006)Routine checkups, dental care, nursing home care, eyeglasses, hearing aids, immunization shots

Provider reimbursement

Very low Moderate (but falling)

Medicaid features very little patient-side cost-sharing arrangements.

Medicare puts more cost-sharing on the patient-

side, and excludes some services.

The Other Major Public Insurance Program: Medicare

The Medicare programHow Medicare works

To qualify for Medicare, a worker (and his spouse) must have worked and paid payroll taxes for ten years.

Medicare Part A is the part of the Medicare program that covers inpatient hospital costs and some costs of long-term care Financed by a total payroll tax of 2.9%.

Medicare Part B is the part of the Medicare program that covers physician expenditures, outpatient hospital expenditures, and other services. One-fourth of costs are financed from enrollee

premiums, and the rest from general revenue.

The Medicare programHow Medicare works

Medicare has high patient costs. The copayments and deductibles are fairly

high. For example, “Part A” has an $876 deductible for

the first 60 days of a hospital stay, and high per-day patient costs thereafter. “Part B” has a 20% coinsurance rate.

The benefits are relatively lean. For example, it does not cover dental or vision care,

and until 2006, it does not cover prescription drugs. These features undermine the consumption

smoothing value of Medicare.

The Uninsured

44 million individuals in the U.S. are without any insurance coverage at all. They tend to have below-average incomes.

Nearly two-thirds of the uninsured are in families with incomes below 200% of the poverty line.

70% of the uninsured are in families with a head of household who is a full-time, full-year worker.

Over one-fifth of the uninsured are children.

The Uninsured Why should we care about the uninsured?

Physical externalities associated with communicable diseases. Financial externalities: Uncompensated care is the costs of delivering

health care for which providers are not reimbursed. $35 billion delivered in uncompensated care, roughly 2% of total

spending. Inappropriate delivery of care (e.g., through emergency rooms). Paternalism and equity–individuals may irrationally underinsure themselves

by miscalculating the odds of getting sick. Becoming uninsured is a concern for many.

This is an issue because of the great reliance on employer-provided health insurance.

Job lock is the unwillingness to move to a better job for fear of losing health insurance.

Job lock can lead to a mismatch between workers and jobs, and can lower overall productivity.

HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS?

As with other insurance, the optimal generosity will be determined by the trade off between consumption-smoothing and moral hazard. Generosity represents the share of

medical spending that will be reimbursed by the health insurer.

This generosity can be measured with respect to the patients and with respect to the providers.

HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS?

Risk-averse individuals will value health insurance as a means of smoothing their consumption with respect to the cost of medical events.

Some events, like a check-up, are minor and predictable, while others, like a heart attack, are more expensive and unpredictable.

Expected utility theory suggests that insurance is much more valuable for expensive, unpredictable events. The consumption smoothing benefits of first dollar coverage

for minor and predictable events is small because: Risk-averse individuals gain little utility from insuring small risks. And individuals are easily able to self-insure (against small risks).

S=MC

$10

A B

C

D

Q1 Q2

Deadweight Loss

Number of visitsto doctor’s office

Price ofeach visit

$100

Figure 2

The “right” amount of health care is where D=S.

Health insurance shifts the consumers’ demand, leading

to more consumption.This over-

consumption leads to deadweight loss.

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

The fundamental trade-off of health insurance, then, is the gains in terms of consumption smoothing versus the costs in terms of the overuse of medical care.

$ of Marginal Health Benefits

$ of Medical Spending

$1,000 $2,000 $5,000

$1

$0.10

$5A

B

C

Figure 3

Initially, dollars of spending lead to

high benefits.

Further spending has diminishing

returns.

Moral hazard and “flat of the curve” medicine.

Moral Hazard Costs of Health Insurance for Patients

Productivity dwindles as spending on health care rises. From a societal perspective, spending should stop when the additional health benefit is smaller than the additional health cost.

If individuals paid the full cost of their health care, the socially optimal amount, point B would be chosen.

If individuals do not pay much for their additional health care, they will demand health care as long as the effectiveness curve is not perfectly flat. The “flat of the curve” area is therefore beyond point B, where each $1 of medical care buys less than $1 in improved health.

The existence of insurance creates Moral Hazard, where people over-consume medical services since the do not pay the marginal costs of additional services.

Optimal Health Insurance The evidence (from the Rand Health Insurance

Experiment) is that the elasticity of medical care utilization with respect to price is non-zero (e.g., moral hazard). This implies there there is a significant deadweight

loss associated with first-dollar insurance coverage. This suggests that the optimal health

insurance policy is one in which, Individuals bear a large share of the medical costs

within some affordable range, and Individuals are fully insured when costs become

unaffordable.

HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL

PROVIDERS? There is also moral hazard on the provider side.

Patient-side moral hazard refers to the extra care demanded for illness because insurers cover the cost of medical treatment.

Provider-side moral hazard refers to the extra care provided for illness because insurers reimburse health care providers based on costs.

Even if an insurer could perfectly assess a patient’s true level of illness, the cost to treat that illness can vary considerably.

Thus, insurers have often reimbursed medical providers according to their reported costs of treatment.

HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL

PROVIDERS?

Retrospective reimbursement is a payment arrangement reimbursing physicians for the costs they have already incurred.

This system removes any incentive for providers to treat their patients cost-effectively. If a physician’s objective is to maximize health of

the patients, then this system will likely yield “flat of the curve” medicine.

In addition, if physicians are also concerned about income maximization, this sort of reimbursement only exacerbates the moral hazard.

Managed Care and Prospective Reimbursement

Patient cost-sharing did not slow the growth in health care spending, so the private market turned to managed care in the late 1980s and 1990s.

Managed care is a private market approach to controlling costs using supply-side controls. Manage care comes in two forms: PPOs and HMOs.

Preferred provider organizations (PPOs) are health care organizations that lower care costs by shopping for health care providers on behalf of the insured.

Health maintenance organizations (HMOs) are health care organizations that integrate insurance and delivery of care.

HMOs may pay its own doctors and hospitals a salary independent of the amount of care they deliver.

Managed Care and Prospective Reimbursement

Prospective reimbursement is the practice of paying providers based on what treating patients should cost, not on what the provider actually spends. Many HMOs use prospective reimbursement to counteract

provider moral hazard. Prospective reimbursement reverses the financial

incentives of physicians. Now when physicians deliver less care, profitability goes up. This could create financial incentives to give insufficient care. The HMO often gives incentives for a physician to limit the care

he/she delivers, and to restrict the use of specialists as well.

The Impacts of Managed Care

There is no clear evidence that quality of care has suffered, even though prospective reimbursement might lead to the under provision of care in HMOs. There is not a consensus one way or

another. Roughly equal numbers of studies find that

HMOs deliver care that is better, worse, or the same as traditional health insurance.

Lessons for health care reform in the United States: Rising health

care costs What drives the ever-increasing health care costs?

The answer appears to be quality-improving technological change in the delivery of health care.

For example, even though the cost of particular heart attack treatments has fallen (e.g., bypass surgery), there has been substitution from less-intensive to more-intensive procedures.

Thus, the costs tend to rise over time. These treatments, however, are associated with dramatically

improved health outcomes. Thus, it is not clear whether society actually wants health

care costs to be controlled. Would you rather buy 1950s health care at 1950s prices, or

today’s health care at today’s prices?

Lessons for health care reform in the United States: Rising health

care costs If technology is improving health care, on the surface this

appears inconsistent with “flat of the curve” medicine. The key, however, is distinguishing between the average value

and marginal value of a medical technology. On average, the technological advances are extremely valuable,

but on the margin, they may be inappropriate and ineffective. It is difficult to target away from those who are on the

flat of the curve. It is easy to look backward and see that a procedure was wasteful, but it much harder to look forward and know this for sure. Thus, statistics like “30% of medical spending is done in the last

6 months of life” are not terribly insightful. This is an ex-post rationalization.

Lessons for health care reform in the United States: The uninsured

Another key problem is the high number of uninsured in the United States. It currently numbers around 45 million.

Many of the uninsured do not have access to a pooling mechanism (e.g., group rates). Creating a large pool, which could lower the administrative costs,

could help. But adverse selection still remains a concern. Another concern is that not all workers are offered

insurance, and not all workers take-up the employer insurance they are offered. A mandate is a legal requirement for employers to offer

insurance or for individuals to obtain some type of insurance coverage.

They tend to be politically unpopular, however.

Lessons for health care reform in the United States: Incremental

reforms

Other incremental reforms could help with rising costs and the number of uninsured. Controlling “fraud and waste” could save money in the

short-run, it is not a long-run cost-control strategy. Lowering physician fees can control costs, but restricts

access to care. State laws to guarantee access of small firms and individuals

to insurance markets have not been successful in reducing the number of uninsured.

Continuing to expand the social safety net, yet this raises the prospect of crowd-out.

Finally, tax subsidies could make insurance more affordable, but prices in the non-group market are still exceptionally high.

Lessons for health care reform in the US

Fundamental reform: National health insurance

National health insurance is a system whereby the government provides insurance to all its citizens, without involvement of a private insurance industry.

Canada’s system follows this model. Fully solves the problem of the uninsured. Reduces administrative costs. Has comprehensive cost controls, not piecemeal controls like

Medicare’s PPS. Solves some inefficiencies like job lock.

National health insurance has drawbacks, however. Massive government expenditures. National budgeting may not allow doctors to use a technology

that is worth its high cost.

Fundamental reform: Private-sector solutions

Alternatively, build on the existing hybrid of private and public sector insurance.

The government could create new pools of private insurance plans, impose an individual mandate, and subsidize the poor. Less new public financing. Preserves consumer choice. More politically feasible.

This approach has some disadvantages relative to public national health insurance. High administrative costs remain. Inequities and inefficiencies of patchwork health system remain. Tension between cost-conscious decision making and adverse selection

“death spirals.” The sick could end up in much more expensive plans. Creates “two-tier” medical care, which may be undesirable from an equity

perspective.