GS ECO 2301 CH 5 The Economics of Health Care

Fee-for-service

A system under which doctors and hospitals receive a payment for each service they provide.

Canada has a single-payer health care system

A system, such as the one in Canada, in which the government provides health insurance to all of the country's residents. Each of the 10 Canadian provinces has its own system, although each system must meet the federal government's requirement of covering 100 percent of the cost of all medically necessary procedures. Individuals pay nothing for doctor's visits or hospital stays; instead, they pay for medical care indirectly through the taxes they pay to the provincial and federal governments. As in the United States, most doctors and hospitals are private businesses, but unlike in the United States, doctors and hospitals are required to accept the fees that are set by the government. Also as in the United States, doctors and hospitals are typically reimbursed on a fee-for-service basis.

A related question is why a firm would buy health insurance for you rather than increase your wages by the same amount and let you buy your own insurance. We have seen that there are two important reasons so many people receive health insurance from their employers:

(1) The wage an employer pays you is taxable income to you, but the money an employer spends to buy health insurance for you is not taxable; and (2) insurance companies are typically willing to charge lower premiums for group insurance, particularly to large employers, because risk pooling is improved and adverse selection and moral hazard problems are lower than with individual policies.

The United Kingdom In the United Kingdom, the government, through the National Health Service (NHS), owns nearly all hospitals and directly employs nearly all doctors.

(Note that England, Scotland, Wales, and Northern Ireland run their health care systems independently, although their main features are the same.) This system contrasts with those in the United States, Canada, and Japan, where the government employs relatively few doctors and owns relatively few hospitals. Because there are few private insurance plans and private hospitals in the United Kingdom, its health care system is often called socialized medicine

Those in favor of moving toward greater government involvement in health care often raise three arguments:

1. A single-payer system would reduce the paperwork and waste caused by the current system. 2. The current Medicare system—which is essentially a single-payer system for people over age 65—has had lower administrative costs than have private health insurance companies. 3. The systems in most other high-income countries have lower levels of health care spending per person and lower rates of increase in total health care spending, while providing good health outcomes.

Most people who have private health insurance receive it through their employer. According to a survey of employers by the Kaiser Family Foundation, in 2016, 98 percent of firms employing more than

200 workers and 55 percent of firms employing between 3 and 199 workers offered health insurance as a fringe benefit (that is, a type of non-wage compensation) to their employees. Private health insurance companies can be either not-for-profit firms, such as some of the Blue Cross and Blue Shield organizations, or for-profit firms, such as Humana, Aetna, and John Hancock, which typically also sell other types of insurance.

Figure 5.6 shows that out-of-pocket spending on health care as a percentage of all spending on health care has fallen steadily since 1960. In 1960,

48 percent of all health care spending was out of pocket, while today only about 10 percent is. As a result, in recent years, consumers of health care have been directly paying for only a small fraction of the true cost of providing health care, with third-party payers picking up the remainder. As average incomes rise, consumers might be expected to spend a rising share of the increase on health care. But because consumers do not pay the full cost of increases in health care spending, they may not be willing to buy as much health care as they currently receive if they had to pay the full price.

Health insurance

A contract under which a buyer agrees to make payments, or premiums, in exchange for the provider's agreeing to pay some or all of the buyer's medical bills.

Socialized medicine

A health care system under which the government owns most of the hospitals and employs most of the doctors. With 1.4 million employees, the NHS is the largest government-run health care system in the world. Apart from a small copayment for prescriptions, the NHS supplies health care services without charge to patients and receives its funding from income taxes. The NHS concentrates on preventive care and care for acute conditions.

Figure 5.2 shows the sources of health insurance in the United States in 2016.

About 49 percent of people received health insurance through their employer, and about 7 percent directly purchased an individual or family health insurance policy from an insurance company, often using the state health insurance marketplaces Congress established under the Affordable Care Act.

The two key consequences of asymmetric information are adverse selection and moral hazard. It is easy to mix up these concepts. One way to keep the concepts straight is to remember that:

Adverse selection refers to what happens at the time of entering into a transaction. An example would be an insurance company selling a life insurance policy to a terminally ill person because the company lacks full information on the person's health. Moral hazard refers to what happens after entering into a transaction, such as a nonsmoker buying a life insurance policy and then starting to smoke four packs of cigarettes a day.

The market for health care is significantly affected by the problem of

Asymmetric information A situation in which one party to an economic transaction has less information than the other party.

Adverse Selection in the Market for Health Insurance Health insurance companies face a key obstacle to accurately predicting the number of claims policyholders will make:

Buyers of health insurance policies always know more about the state of their health—and, therefore, how likely they are to submit medical bills for payment—than do the insurance companies. In other words, insurance companies face an adverse selection problem because sick people are more likely to want health insurance than are healthy people.

Factors That Do Explain Sustained Increases in Health Care Spending (Cont II) - Distorted Economic Incentive pt 2

Figure 5.8 illustrates this situation. If consumers paid the full price of medical services, their demand would be D1. The marginal benefit to consumers from medical services would equal the marginal cost of producing the services, and the equilibrium quantity would be at the efficient level QEfficient. However, because consumers pay only a fraction of the true cost of medical services, their demand increases to D2. In this equilibrium, the quantity of medical services produced increases to QMarket, which is beyond the efficient level. The marginal cost of producing these additional units is greater than the marginal benefit consumers receive from them. As a result, there is a deadweight loss equal to the area of the yellow triangle. Doctors and other suppliers of medical services receive a price, PMarket, that is well above the price, P, paid by consumers.

Problems with determining consumer preferences. In most markets, we can assume that the quantities and prices we observe reflect the interactions of the preferences of consumers (demand) with the costs to firms of producing goods and services (supply).

Given their incomes and preferences, consumers compare the prices of different goods and services when making their buying decisions. The prices firms charge represent the costs of providing the good or service. In the market for health care, however, the government plays the dominant role in supplying the service in most countries other than the United States, so the cost of the service is not fully represented in its price, which in some countries is zero. Even in countries where consumers must pay for medical services, the prices they pay usually do not represent the cost of providing the service. In the United States, for instance, consumers with private health insurance typically pay only 10 to 20 percent of the price as a copayment.

Health care

Goods and services, such as prescription drugs, consultations with a doctor, and surgeries, that are intended to maintain or improve a person's health. Health care makes up more than one-sixth of the U.S. economy—about the size of the entire economy of France.

What explains increases in life expectancy and declines in death rates over the longer time span since 1850?

Improvements in sanitation and in the distribution of food during the late 1800s and early 1900s led to better health during that period. More generally, the late Nobel Laureate Robert Fogel of the University of Chicago and Roderick Floud of Gresham College, along with coauthors, described a process by which better health makes it possible for people to work harder as they become taller, stronger, and more resistant to disease. Working harder raises a country's total income, making it possible for the country to afford better sanitation, more food, and a better system for distributing the food. In effect, improving health shifts out a country's production possibilities frontier. Higher incomes also allow the country to devote more resources to research and development, including medical research.

Patient Protection and Affordable Care Act (ACA) Health care reform legislation passed by Congress and signed by President Barack Obama in 2010.

Individual mandate. The act requires that, with limited exceptions, every resident of the United States have health insurance that meets certain basic requirements. Individuals who do not acquire health insurance are subject to a fine. In 2017 the fine was $695 or 2.5 percent of income, whichever was greater. State health insurance marketplaces. Each state must establish a marketplace called an Affordable Insurance Exchange. Separate marketplaces were established for individuals and small businesses with fewer than 50 employees. Low-income individuals and small businesses with 25 or fewer employees are eligible for tax credits to offset the costs of buying health insurance. The purpose of the marketplaces is to allow greater risk pooling and lower administrative costs than existed in the market for health insurance policies sold to individuals or small businesses. Employer mandate. Every firm with more than 200 full-time employees must offer health insurance to its employees and must automatically enroll them in the plan. In 2017, firms with 50 or more full-time employees must offer health insurance that meets certain requirements or pay a fee of up to $3,390 to the federal government for every employee who receives a tax credit from the federal government for obtaining health insurance through a health insurance marketplace. A worker is a full-time employee if he or she works at least 30 hours per week.

Japan Japan has a system of universal health insurance under which (cont)

Japanese health insurance does not pay for most preventive care, such as annual physical exams, or for medical expenses connected with pregnancies, unless complications result. Health insurance in the United States and Canada typically does cover these expenses. As in the United States, most doctors in Japan do not work for the government, and there are many privately owned hospitals. The number of government-run hospitals, though, is greater than in the United States.

Moral Hazard in the Market for Health Insurance The insurance market is subject to a second consequence of asymmetric information. Moral hazard

Moral hazard Actions people take after they have entered into a transaction that make the other party to the transaction worse off. Moral hazard in the insurance market occurs when people change their behavior after becoming insured. For example, once a firm has taken out a fire insurance policy on a warehouse, its managers might be reluctant to install an expensive sprinkler system. Similarly, someone with health insurance may visit the doctor for treatment of a cold or other minor illness, which he would not do if he lacked insurance.

In practice, people with health insurance pay a reduced price for vaccinations, and the government often provides further subsidies to the firms that produce vaccines.

One reason for the government subsidies is to overcome the effects of the positive externality.

Patient Protection and Affordable Care Act (ACA) - continued

Regulation of health insurance. Insurance companies are required to participate in a high-risk pool that will insure individuals with preexisting medical conditions who have been unable to buy health insurance for at least six months. All individual and group policies must provide coverage for dependent children up to age 26. Lifetime dollar maximums on coverage are prohibited. Limits are also placed on the size of deductibles and on the waiting period before coverage becomes effective. Changes to Medicare and Medicaid. Eligibility for Medicaid was originally expanded to persons with incomes up to 138 percent of the federal poverty line, although a 2012 Supreme Court decision resulted in the states being allowed to opt out of this requirement. In an attempt to control increases in health care costs, the Independent Payment Advisory Board (IPAB) was established and given the power to reduce Medicare payments for prescription drugs and the use of diagnostic equipment and other technology if Medicare spending exceeds certain levels. Some Medicare reimbursements to hospitals and doctors were reduced. Taxes. Several new taxes help fund the program. Workers earning more than $200,000 pay higher Medicare payroll taxes, and people who earn more than $200,000 pay a new 3.8 percent tax on their investment income. Beginning in 2018, a tax is scheduled to be imposed on employer-provided health insurance plans that have a value above $10,200 for an individual or $27,500 for a family—so-called Cadillac plans. In 2017, Congress was considering proposals to repeal this tax. Pharmaceutical firms, health insurance firms, and firms producing medical devices also pay new taxes.

The equilibrium level of overall compensation in the economy is determined by the supply of and the demand for labor. Fringe benefits (such as health insurance) are just part of that compensation. Consequently, the costs of fringe benefits are borne by workers largely in the form of lower cash wages than they would receive if no such benefits were provided by their employer.

Replacing employment-based health care with a government-run system could reduce employers' payments for their workers' insurance, but the amount that they would have to pay in overall compensation would remain essentially unchanged.

Economists categorize goods on the basis of whether they are rival and excludable.

Rivalry occurs when one person consuming a unit of a good means no one else can consume it. Excludability means that anyone who does not pay for a good cannot consume it.

Data problems. Countries do not always collect data on diseases and other health problems in the same way.

So, there are not enough consistent data available to compare health outcomes for more than a few diseases.

Factors That Do Explain Sustained Increases in Health Care Spending (Cont)

The Aging of the Population and Advances in Medical Technology As people age, they increase their spending on health care. Firms continue to develop new prescription drugs and medical equipment that typically have higher costs than the drugs and equipment they replace. The aging of the U.S. population and the introduction of higher-cost drugs and medical equipment interact to drive up spending on the federal government's Medicare program and on health care generally. People over age 65 disproportionately use many newly introduced drugs and diagnostic tools. Partly as a result, health care spending on people over age 65 is six times greater than spending on people aged 18 to 24 and four times greater than on people aged 25 to 44. In the figure, "effect of excess cost growth" refers to the extent to which health care costs per person grow faster than GDP per person. An aging population and increases in the cost of providing health care are key reasons health care spending is an increasing percentage of GDP.

For example, in the late 1700s, England had the highest level of income per person of any large country. But the average person in England had a short life span, and many people suffered from diseases—such as cholera, yellow fever, dysentery, and smallpox—that have disappeared from high-income countries today.

The average life expectancy at birth was only 38 years, and 30 percent of the population died before reaching age 30. Even people who survived to age 20 could expect to live only an average of 34 more years. Today, the average life expectancy at birth in the United Kingdom and other high-income countries is around 80 years. People in eighteenth-century England were also short by modern standards. The average height of an adult male was 5 feet, 5 inches compared with 5 feet, 9 inches today.

Does competition equalize the prices of medical services?

The evidence indicates that it doesn't. The data in the following table demonstrate that the prices of abdominal MRI scans vary widely. In most cities in the United States, the most expensive MRI scan has a price that is more than double the least expensive scan. And prices for MRI scans also vary widely across cities. How can some providers of medical services charge hundreds or thousands of dollars more than competitors and remain in business? The answer is that most patients are not concerned about prices because they either do not pay them or they pay only a small fraction of them. Patients typically rely on doctors to refer them to a facility for an MRI scan or other procedure and make little or no effort to determine the price the facility charges. A goal of market-based reforms of the health care system is to give patients an incentive to pay more attention to the prices of medical services.

In 1945, President Harry Truman proposed a plan for national health insurance, under which anyone could purchase health insurance from the federal government.

The health insurance would have covered treatment received from doctors and hospitals that agreed to enroll in the system. Congress declined to enact the plan.

One way to think about the basic moral hazard problem with insurance is to note that normally there are two parties to an economic transaction: the buyer and the seller.

The insurance company becomes a third party to the purchase of medical services because the insurance company, rather than the patient, pays for some or all of the service. For this reason, economists refer to traditional health insurance as a third-party payer system. Because of this system, consumers of health care do not pay a price that reflects the full cost of providing the service. This lower price leads consumers to use more health care than they otherwise would.

Adverse selection

The situation in which one party to a transaction takes advantage of knowing more than the other party to the transaction. Most used cars offered for sale will be lemons. In other words, because of asymmetric information, the market has selected adversely the cars that will be offered for sale. Notice as well that the problem of adverse selection reduces the total quantity of used cars bought and sold in the market because few good cars are offered for sale.

Supporters of market-based reforms note that employees have to pay federal income and payroll taxes on the wages their employers pay them, but in most circumstances they do not pay taxes on the value of the health insurance their employers provide them.

This feature of the tax laws encourages employees to want generous health care coverage; in fact, if offered the choice between a $1,000 salary increase or increased health care coverage worth $1,000, many people would choose the increased health care coverage because it would be tax free (although someone who was young and healthy and did not expect to have medical bills would probably choose the increase in salary). The size of this tax break is quite substantial—more than $250 billion in 2015. But individuals typically get no tax break when buying an individual health insurance policy or when they spend money on health care out of pocket. Some economists have proposed making the tax treatment of employer-provided health insurance the same as the tax treatment of individually purchased health insurance and out-of-pocket health care spending. They argue that this change could, potentially, significantly reduce spending on health care without reducing the effectiveness of the health care received. Such tax law changes would make it more likely that employer-provided health insurance would focus on large medical bills—such as those resulting from hospitalizations—while consumers would pay prices closer to the costs of providing routine medical care.

Do Information Problems with Health Care Justify More Government Intervention? Information problems are also important in the market for private health insurance. Consumers who buy health insurance often know much more about the state of their health than do the companies selling health insurance.

This information problem may raise costs to insurance companies when the pool of people being insured is small, making insurance companies less willing to offer health insurance to consumers the companies suspect may file too many claims. Economists debate how important information problems are in health care markets and whether government intervention is required to reduce them.

In 1993, President Bill Clinton proposed a health care plan intended to provide universal insurance coverage.

While somewhat complex, the plan was based on requiring most businesses to provide health insurance to their employees and new government-sponsored health alliances that would ensure coverage for anyone who otherwise would not have health insurance. After a prolonged political debate, Congress chose not to enact President Clinton's plan.

Market-based reforms Changes in the market for health care that would make it more like the markets for other goods and services.

With such reforms, the prices consumers pay and suppliers receive would do a better job of conveying information on consumer demand and supplier costs. The expectation is that increased competition among doctors, hospitals, pharmaceutical companies, and other providers of health care would reduce costs and increase economic efficiency. Economists who support market-based reforms as the best way to improve the health care system were disappointed that the ACA did not adopt this approach. Currently, markets are delivering inaccurate signals to consumers because when buying health care, unlike when buying most other goods and services, consumers pay a price well below the true cost of providing the service.

Externalities in the Market for Health Care For most goods and services, we assume that the consumer receives all the benefits from consuming the good and that the firm producing the good bears all of the costs of production. Some goods or services, though, involve an externality, which is

a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. For example, if a utility burns coal to produce electricity, the result will be air pollution, which causes a negative externality because people with asthma or other breathing problems may bear a cost even though they were not involved in buying or selling the electricity that caused the pollution. College education may result in a positive externality because college-educated people are less likely to commit crimes and, by being better-informed voters, are more likely to contribute to better government policies. So, although you receive most of the benefits of your college education, other people also receive some of the benefits.

In addition to having a large role for government, the market for health care differs from most markets in other ways. Most importantly,

a typical consumer of health care doesn't pay the full price for that care. Most people have private health insurance, either provided through their employers or purchased on the government-run health insurance marketplaces, or they are enrolled in the Medicare or Medicaid programs. Consumers who have insurance make different decisions about the quantity of health care they wish to consume than they would if they were paying the full cost of the services.

Or Should There Be Greater Reliance on Market-Based Policies? Many economists believe that market-based policies are the best approach to improving the health care system. As we saw in Table 5.2, the United States has a mixed record on health outcomes. The United States is, however,

a world leader in innovation in medical technology and prescription drugs. The market-oriented approach to reforming health care starts with the goal of improving health care outcomes while preserving incentives for U.S. firms to continue with innovations in medical screening equipment, surgical procedures, and prescription drugs.

In important ways, health insurance is different from other types of insurance. As we discussed earlier, the basic idea of insurance is that the financial risk of an unpredictable, high-cost event—a house fire or a serious car accident—is pooled among the many consumers who buy insurance. Health insurance, though,

also typically covers many planned expenses, such as routine health checkups, annual physicals, and contraceptives, and other low-cost events, such as treatment for minor illnesses. By disguising the true cost of these routine expenses, health insurance encourages overuse of health care services.

Deductibles and coinsurance also provide policyholders with an incentive to

avoid filing claims, thereby reducing the moral hazard problem. Deductibles have been increasing in many employer-provided health insurance plans. According to a survey by the Kaiser Family Foundation, in 2006 only 10 percent of workers were enrolled in plans with deductibles of $1,000 per year or more, but by 2016, 51 percent of workers were enrolled in such plans.

Notice, though, that deductibles and coinsurance reduce, but do not eliminate, adverse selection and moral hazard. People who anticipate having large medical bills will still have a greater incentive than healthy people to

buy insurance, and people with health insurance are still more likely to visit the doctor even for a minor illness than are people without health insurance.

Because the federal and state governments in the United States pay for just over half of health care spending through Medicare, Medicaid, and other programs, increases in health care spending can

cause problems for government budgets. The Medicare and Medicaid programs began in 1965. By 2017, spending on these programs had grown to 7 percent of GDP. That percentage is expected to double over the next 40 years unless health care costs begin to grow at a slower rate. Congress and the president have been struggling to find ways to pay for the projected increases in Medicare and Medicaid without severely cutting other federal spending or sharply raising taxes.

Many economists believe that several aspects of health care involve externalities. For example, anyone vaccinated against a communicable disease not only protects herself or himself but also reduces the chances that people who have not been vaccinated will contract the disease. The positive externality from vaccinations

causes a difference between the private benefit from being vaccinated and the social benefit. The private benefit is the benefit you receive as a consumer of a good or service. The social benefit is the total benefit from consuming a good or service, and it is equal to the private benefit plus any external benefit, such as the benefit to others from a reduced chance of getting a disease for which you have been vaccinated. Because of the positive externality, the social benefit of vaccinations is greater than the private benefit.

When economists measure changes over time in the standard of living in a country, they usually look first at increases in income per person. However

changes in health are also important because health is an essential part of a person's well-being and, therefore, of his or her standard of living. The health of the average person in the United States improved significantly during the 1800s and 1900s, and by and large, it continues to improve today.

Some low-income people either do not qualify for Medicaid or choose not to participate in that program. More than 70 percent of uninsured people live in families in which at least one member has a job. These individuals either were not offered health insurance through their employers or

chose not to purchase it. Some young people opt out of employer-provided health insurance because they are healthy and do not believe that the cost of the premium their employer charges for the insurance is worth the benefit of having the insurance. More than half the uninsured were younger than age 35. Although most large firms offer their employees health insurance, fewer than two-thirds accept it. The remaining employees are covered by a spouse's policy, are not eligible for coverage, or have decided to go uninsured because they do not want to pay the premium for the insurance. The uninsured must pay for their own medical bills out of pocket, with money from their own income, just as they pay their other bills, or receive care from doctors or hospitals either free or below the normal price.

Prior to the passage of the ACA in 2010, to reduce the problem of adverse selection, insurance companies typically limited

coverage of preexisting conditions, which are medical problems, such as heart disease or cancer, that the buyer already has before purchasing insurance. Critics argue that by excluding coverage of preexisting conditions, insurance companies were forcing people with serious illnesses to pay the entire amount of what might be very large medical bills or to go without medical care. Some people with chronic or terminal illnesses found it impossible to buy an individual health insurance policy. To some extent, the debate over coverage of preexisting conditions is a normative one. Ordinarily, in a market system, people who cannot afford a good or service must do without it. However, many people do not want others to be without health insurance because they cannot afford it. As we will discuss in the next section, Congress included significant restrictions on the ability of insurance companies to limit coverage of preexisting conditions when it passed the ACA.

How Insurance Companies Deal with Adverse Selection and Moral Hazard Insurance companies can take steps to reduce adverse selection and moral hazard problems. For example, insurance companies can use

deductibles and coinsurance (or copayments) to reduce moral hazard. A deductible requires the policyholder to pay a certain dollar amount before the insurance begins paying claims. With coinsurance, the insurance company pays only a percentage of any claim. Suppose you have a health insurance policy with a $200 deductible and 20 percent coinsurance, and you receive a medical bill for $1,000. You must pay the first $200 of the bill and 20 percent of the remaining $800.

Problems with distinguishing health care effectiveness from lifestyle choices. Health outcomes depend partly on the effectiveness of doctors and hospitals in delivering medical services. But they also

depend on the choices of individuals. For example, in the United States, the high rates of obesity and hospitalizations for diabetes—which can be a complication of obesity—may be caused more by the decisions individuals make about diet and exercise than by the effectiveness of the U.S. health care system.

Has the high level of health care spending in the United States resulted in better health outcomes? Are people in the United States healthier, and do they have their medical problems addressed more rapidly than do people in other countries? Table 5.2 compares several health outcomes for the countries that are members of the Organization for Economic Co-operation and Development (OECD), a group of 35 high-income countries. The table shows that the United States

does relatively poorly with respect to infant mortality, while it does somewhat below average with respect to life expectancy at birth but about average with respect to life expectancy at age 65. People in the United States are significantly more likely to be obese than are people in other high-income countries, which can lead to developing diabetes and other health problems.

Externalities interfere with the

economic efficiency of a market equilibrium. A competitive market achieves economic efficiency by maximizing the sum of consumer surplus and producer surplus (see Chapter 4, Section 4.1). But when there is a negative externality in production, as with air pollution, the market will produce more than the efficient quantity. When there is a positive externality in consumption, as with college educations, the market will produce less than the efficient quantity.

Japan Japan has a system of universal health insurance under which

every resident of the country is required to enroll either in one of the many nonprofit health insurance societies that are organized by industries or professions or in the health insurance program provided by the national government. The system is funded by a combination of premiums paid by employees and firms and a payroll tax similar to the tax that funds the Medicare program in the United States. Unlike the Canadian system, the Japanese system requires substantial copayments, under which patients pay as much as 30 percent of their medical bills, while health insurance pays for the rest.

Equilibrium in this labor market occurs where the quantity of labor demanded equals the quantity of labor supplied. On the vertical axis, we measure the wage, so the graph shows the determination of the equilibrium wage. When choosing among jobs, however, workers don't just consider the wages firms offer; they also take into account

fringe benefits, such as employer contributions to retirement accounts or employer-provided health insurance. It would therefore be more accurate to describe the intersection of the labor demand and labor supply curves as determining the equilibrium compensation rather than the equilibrium wage.

Aspects of the delivery of health care have convinced some economists that government intervention is justified. For example, consuming certain types of health care

generates positive externalities. Being vaccinated against a communicable disease, such as influenza or meningitis, reduces not only the chance that the person vaccinated will catch the disease but also the probability that an epidemic of the disease will occur. Therefore, the market may supply an inefficiently small quantity of vaccinations unless vaccinations receive a government subsidy.

Notice that for the insurance company to cover all of its costs, the total amount it receives in premiums must be

greater than the amount it pays out in claims to policyholders. To survive, insurance companies have to predict accurately the amount they are likely to pay out to policyholders. For instance, if an insurance company predicts that the houses of only 2 percent of policyholders will burn down during a year when 5 percent of houses actually burn down, the company will suffer losses.

Private health insurance companies sell

group plans to employers to cover all of their employees and individual plans directly to the public. Some health insurance plans reimburse doctors and hospitals on a fee-for-service basis

The U.S. Health Care System One important difference among health care systems in different countries is the way people pay for their health care. Most people in the United States

have health insurance that helps them pay their medical bills.

The number of medical procedures performed in the United States has been continually increasing. Many doctors argue that the increasing number of medical procedures is not the result of third-party payer health insurance. Instead, the increase is due to the

improved effectiveness of the procedures in diagnosing illness and the tendency of some doctors to practice "defensive medicine" because they fear that if they fail to correctly diagnose an illness, a patient may file a malpractice lawsuit against them.

Figure 5.5 illustrates a key fact underlying the debate over health care policy in the United States: Health care's share of gross domestic product (GDP), which is the total value of output in the economy, is increasing. Panel (a) shows that spending on health care was

less than 6 percent of GDP in 1965 but had risen to nearly 18 percent in 2017 and is projected to continue rising in future years. In other words, an increasing percentage of total production in the United States is being devoted to health care. Panel (b) shows increases in health care spending per person in the United States and 10 other high-income countries. Spending on health care has grown faster in the United States than in other countries.

Health care outcomes and the amounts countries spend on health care are also quite different. In Figure 5.3, each green diamond represents a combination of health care spending per person and income per person for 35 high-income countries. The figure shows that, typically, the higher the

level of income per person in a country, the higher the level of spending per person on health care. This result is not surprising because health care is a normal good. We know that as income increases, so does spending on normal goods (see Chapter 3, Section 3.1). The line in the figure shows the average relationship between income per person and health care spending per person. The diamonds for most countries are fairly close to the line, but note that the diamond representing the United States is significantly above the line. Being well above the line indicates that health care spending per person in the United States is higher than in other countries, even taking into account the relatively high income levels in the United States.

The United States rates well in the availability of

medical equipment that can be used in diagnosing and treating illness. Table 5.2 shows that the United States has more than twice as many MRI units per person and over 50 percent more CT scanners per person than the average of high-income countries, although the United States has relatively fewer of these machines than does Japan. The United States also appears to do well in cancer treatment, with a lower rate of cancer deaths, particularly given that people in the United States are more likely to develop cancer, and a relatively low mortality ratio from cancer. The mortality ratio measures the rate at which people die from cancer relative to the rate at which they are diagnosed with cancer. A low cancer mortality ratio indicates that the U.S. health care system does a relatively good job of reducing the death rate among people diagnosed with cancer.

Problems with measuring health care delivery. The easiest outcomes to measure are deaths because a specific event has occurred. So, measures of life expectancy, infant mortality, and mortality rates from some diseases, such as cancer, are available across countries. But

much of health care involves treatment for injuries, simple surgeries, writing of pharmaceutical prescriptions, and other activities for which outcomes are difficult to measure. For example, although the United Kingdom does well in many of the measures shown in Table 5.2, patients often have long waiting times for elective surgeries, such as joint replacements, that can be arranged much more quickly in some other countries, including the United States. Economists have difficulty measuring the cost to patients of these waiting times.

Both critics of the ACA who favor greater government involvement in health care and those who favor market reforms raise questions about the act's individual mandate, which requires every U.S. resident to have health insurance. The mandate was considered

necessary because otherwise healthy people might avoid buying insurance until they become ill. Because insurance companies would not be allowed to deny coverage for preexisting conditions, they would end up paying large medical bills for people who had not been paying premiums to support the system while they were healthy. People who do not buy insurance are subject to fines under the act, but there were questions about how effective the fines would be in pushing people to buy insurance. In 2016, several million people paid the fine rather than buy insurance.

Table 5.1 compares three indicators of health in the United States in 1850 and 2016. Individuals in the United States today are taller, live much longer, and are much less likely to die in the first months of life than was true 165 years ago. Economists often use height as a measure of long-run changes in the average well-being of a population. A person's height depends partly on genetics—that is, tall parents tend to have tall children—but also on a person's

net nutritional status. Net nutritional status depends on a person's food intake relative to the work the person has to perform, whether the person is able to remain warm in cold weather, and the diseases to which the person is exposed. Over time, people in the United States and other high-income countries have, on average, become taller, which is an indication that their nutritional status has improved.

A public good is both

nonrival and nonexcludable. Public goods are often, although not always, supplied by a government rather than by private firms. The classic example of a public good is national defense. Your consuming national defense does not interfere with your neighbor consuming it, so consumption is nonrival. You also cannot be excluded from consuming it, whether you pay for it or not. No private firm would be willing to supply national defense because everyone can consume national defense without paying for it.

Because public goods must be both nonrival and nonexcludable, health care does

not qualify as a public good under the usual definition. More than one person cannot simultaneously "consume" the same surgical operation performed by a particular doctor in a particular hospital. And someone who will not pay for an operation can be excluded from consuming it.

Third-party payer health insurance can also lead to another consequence of moral hazard, known as the

principal-agent problem, because some doctors may be led to take actions that are not necessarily in the best interests of their patients, such as increasing their incomes by prescribing unnecessary tests or other treatments for which the doctors receive payment.

Other health insurance plans are organized as health maintenance organizations (HMOs), which typically

reimburse doctors mainly by paying a flat fee per patient rather than paying a fee for each individual office visit or other service provided.

The principal-agent problem

results from agents—in this case, doctors—pursuing their own interests rather than the interests of the principals—in this case, patients—who hired them. If patients had to pay the full price of lab tests, MRI scans, and other procedures, they would be more likely to question whether the procedures were really necessary. Because health insurance pays most of the bill for these procedures, patients are more likely to accept them. Note that the fee-for-service aspect of most health insurance in the United States can make the principal-agent problem worse because doctors and hospitals are paid for each service performed, whether or not the service was necessary or effective.

Insurance companies provide the service of

risk pooling when they sell policies to households. or example, if you own a $150,000 house but do not have a fire insurance policy, a fire that destroys your house can be a financial catastrophe. But an insurance company can pool the financial risk of your house burning down by selling fire insurance policies to you and thousands of other homeowners. Homeowners are willing to accept the certain cost represented by the premium they pay for insurance in return for eliminating the uncertain—but potentially very large—cost should their house burn down.

One way to deal with the problem of adverse selection is for the government to require every person to buy insurance. Doing so would increase the ability of insurance companies to engage in

risk pooling. Most states require all drivers to buy automobile insurance so that both high-risk and low-risk drivers will carry insurance. The Patient Protection and Affordable Care Act (ACA), passed in 2010, requires residents of the United States to buy health insurance or pay a fine. This provision of the law is known as the individual mandate and has been controversial.

In many countries, such as Canada, Japan, and the United Kingdom, the government either

supplies health care directly by operating hospitals and employing doctors and nurses or pays for most health care expenses, even if hospitals are not government owned and doctors are not government employees. In this section, we look briefly at the health care systems in these three countries.

In the United States, private firms provide most health care, through either doctors' practices or hospitals. The main exception is

the care the government provides through the network of hospitals operated by the federal government's Veterans Health Administration, although some cities also own and operate hospitals. Governments in most countries outside the United States have a more substantial direct role in paying for or providing health care.

In addition, there is evidence that as people's incomes grow

their demand for health care grows faster than their demand for most other goods and services. The average age of the U.S. population is also increasing, and older people have a greater demand for health care. Finally, the Affordable Care Act has increased the demand for health care among low-income people in two ways: by providing subsidies to buy health insurance for people whose incomes fall below a certain level and by expanding the Medicaid system.

Currently, the U.S. health care system is a world leader in innovation in medical technology and prescription drugs. About two-thirds of pharmaceutical patents are issued to U.S. firms and about two-thirds of research on new medicines is carried out in the United States. One goal of market-based reforms would be

to ensure that U.S. firms continue with innovations in medical screening equipment, surgical procedures, and prescription drugs. Executives of U.S. pharmaceutical firms have voiced concern over whether aspects of the ACA will affect their ability to profitably bring new prescription drugs to market. In particular, managers at these firms worry that the new Independent Payment Advisory Board (IPAB) might reduce the payments Medicare would make for new prescription drugs.

The NHS concentrates on preventive care and care for acute conditions. Nonemergency care, also called elective care—such as hip replacements, knee surgery following a sports injury, or reconstructive surgery following a mastectomy—is a low priority. The NHS's goals result in

waiting lists for elective care that can be very long, with patients sometimes waiting a year or more for a procedure that would be available in a few weeks or less in the United States. To avoid the waiting lists, more than 10 percent of the population also has private health insurance, frequently provided by employers, which the insured use to pay for elective care. The NHS essentially trades off broader coverage for longer waiting times and performing fewer procedures, particularly nonemergency surgeries.

An insurance company faces a financial problem if the premiums it is charging are too low to cover the costs of the claims being submitted. The company might try to increase the premiums it charges, but this may make the adverse selection problem

worse. If premiums rise, then younger, healthier people who rarely visit the doctor may respond to the increase in premiums by dropping their insurance. The higher premiums make the adverse selection problem worse for the insurance company because it will have fewer healthy policyholders than it had before the premium increase.

Factors That Do Explain Sustained Increases in Health Care Spending

• Cost Disease Some economists argue that health care suffers from a problem often encountered in service industries. In the sectors of the economy that produce goods, such as the manufacturing sector, productivity, or the amount of output each worker can produce in a given period, increases steadily. By contrast, in service-producing industries, increasing output per worker is more difficult. In medicine, MRI units, CT scanners, and other medical technology have improved diagnosis and treatment, but most medicine still requires a face-to-face meeting between a doctor or medical technologist and a patient. As wages rise in industries in which productivity is increasing rapidly, service industries in which productivity is increasing less rapidly must match these wage increases or lose workers.

How Useful Are Cross-Country Comparisons of Health Outcomes? Here are some factors that make cross-country comparisons in health outcomes difficult:

• Data problems. • Problems with measuring health care delivery. • Problems with distinguishing health care effectiveness from lifestyle choices • Problems with determining consumer preferences

Factors That Do Explain Sustained Increases in Health Care Spending (Cont II)

• Distorted Economic Incentives As we noted earlier, some part of the increase in health care spending over the years results from consumers' choosing to allocate more of their incomes to health care as their incomes rise. But as we have also seen, consumers usually pay less than the true cost of medical treatment because a third party—typically an insurance company or the government—often pays most of the bill. For example, once they have satisfied their insurance plan's deductible, consumers who have health insurance provided by their employers usually pay only a small amount—perhaps $20—for a visit to a doctor's office, when the true cost of the visit might be $80 or $90. The result is that consumers demand a larger quantity of health care services than they would if they paid a price that better represented the cost of providing the services.

Factors That Do Not Explain Sustained Increases in Health Care Spending

• For example, because the U.S. health care system relies on many independent hospitals, medical practices, and insurance companies, some observers argue that it generates more paperwork, duplication, and waste than systems in other countries. • Unlike in most other countries, it is relatively easy in the United States for patients who have been injured by medical errors to sue doctors and hospitals for damages. The Congressional Budget Office (CBO) estimates, though, that the payments to settle malpractice lawsuits plus the premiums doctors pay for malpractice insurance amount to less than 1 percent of health care costs. • Somewhere between 1 and 4 percent of health care costs are due to uninsured patients receiving treatments at hospital emergency rooms that could have been provided less expensively in doctors' offices.