Economics of Health

ECONOMICS OF HEALTH

Health is fundamental to living, but are the choices people make regarding their health fundamentally different from the choices they make in other areas of their life? The economics of health adapts the general study of how people make choices to issues involving health. Much of the focus is on the interaction among individuals, the health care system, and government policy. However, the boundaries of health economics also include topics linking individuals with other parts of the economy, topics such as lifestyle choices, the effect of air and water pollution, and the provision of public services such as drinking water and sewage water treatment.

SCARCITY AND ECONOMIC EFFICIENCY

Economics is built on scarcity. People have many desires, among them good health, but there is a lack of resources to provide all things to all people. In the presence of this scarcity, someone, or some process, must decide what mixture of goods and services to produce, what quantity of each is to be produced, and how to allocate the production to participants in the economy. If the world is such that people are well informed, there are many buyers and sellers, there are no barriers to moving resources from one use to another, and one consumer's or producer's choice does not affect another's outside the market place; economic analysis indicates that a market (or price) system will function well. The market will decide what to produce, including various kinds of medical care; decide the quantity to be produced; and allocate what is produced in a way that no one individual can be made better off without making someone else worse off. This is the economist's notion of an efficient outcome. Economists recognize that many efficient production and allocation combinations are possible, although the results may not always be viewed as equitable. But efficiency, not equity, is the focus of economists.

When the situation differs from the criteria for efficiency, then markets can yield an inefficient outcome. This means that if a change can be made that leaves one person better off without leaving another person worse off, there can be a winning situation for everyone. Consequently, economists advise leaving situations alone where the criteria are met, and changing the situation where the criteria for efficiency are not met.

HEALTH ECONOMICS

The economics of health focuses on real or perceived differences between the economically idealized setting for efficiency and the setting for decisions about health. Such differences would not be important if health-related economic activity were a small part of the economy. However, the health care system in the United States has grown from 5 percent of gross national product (GNP) in 1960 to 13.5 percent in the late 1990s. This figure excludes numerous expenditures not directly related to the health care system, such as the control and treatment of water and air pollution. Expenditures on water and air pollution control and treatment were approximately 2.5 percent of GNP in the late 1990s. Consequently, these two components alone involved over 1.2 trillion dollars in 1997, an amount over three times the amount spent on national defense or almost twice the amount spent by consumers on durable goods such as cars and furniture. In short, if economic behavior differs from the conditions for efficiency, the effects can be enormous.

There are many conditions that may be different for health-related goods and services compared to other products. These include:

• Information: Consumers may not be informed about the nature and quality of health care being purchased.
• Uncertainty: Randomness in the cause and timing of ill health.
• Barriers to competition: Limitations may be placed on health care labor, the use of hospitals, or other resources.
• Externalities: One person's or firm's action can affect those of a third party separately from financial effects in the marketplace.

Furthermore, economists' concern with efficiency ignores a concern for fairness regarding what obligation a society owes to provide health treatment for the poor, the disadvantaged, or other groups.

INFORMATION

Health, for an individual, is a state of being. Economists often think of health as an asset of the individual that is produced through the use of various inputs. This asset can depreciate, improve through investment, or just be maintained. Individuals can undertake a variety of actions to achieve their desired level of health, which is constrained by physical factors and is subject to various risks. People's choices about living location, work, diet, recreation, over-the-counter medication, and formal health care can all affect their health status. Perhaps startlingly, studies of factors that determine health in affluent societies indicate that changes in lifestyle choice and status—such as environment, income, education, and cigarette consumption—outweigh the contribution of changes in health care services.

To the extent that information is public knowledge, a market with costly information can still be efficient. However, if there are barriers to knowledge about health-improving opportunities, then markets may not be efficient. The debate in health economics relates primarily to health care information and the role of the physician, and secondarily to the quality of hospital and other services. For example, most individuals purchase over-the-counter drugs for mild, repetitive problems, such as headaches or a common cold. With such purchases there is little financial loss for a wrong decision. If a consumer is not satisfied with Brand X, he or she can switch to Brand Y. In contrast, when an individual seeks professional health care for serious problems, a wrong choice could be costly, and the specialized knowledge required for resolution may be beyond the reach of the typical consumer at the time that information is needed.

This nonstandard form of economic service is one type of what is called a merit good in economics. A merit good leads to a situation where an agent, say a physician, is working on the consumer's behalf to choose the appropriate remedy. In that sense, physicians are asymmetrically informed compared to patients. Doctors are high on a scale of expertise that can also include services such as those of automobile mechanics, plumbers, carpenters, teachers, travel agents, lawyers, and so on. Each has expertise whose quality is difficult for a consumer to evaluate in advance, and each involves a skill that the consumer may purchase infrequently. Several difficulties exist for the efficient working of a health care market in such a situation. The consumer has difficulty choosing, and the agent can have incentives to add unnecessary services that may not be in the consumer's best interests—a problem called "supplier-induced demand" in the health literature. While research tends to reject a large impact for this problem, it can be exacerbated or reduced depending on the financial terms of the contract between patient and physician. Professional certification is one method used to signal a minimum level of quality to patients, while malpractice suits are an after-the-fact quality-reinforcing mechanism. Professional certifications are typically necessary to work in medicine in the developed world. Finally, some argue that a tradition of medical ethics serves as a counterbalance to these information asymmetries.

A relatively new topic in this discussion is the role of quality information for medical care providers. Important differences in frequency and outcome of treatment, called "small area variations," have lead to suggestions that either patients or physicians, or both, are relatively uninformed. One method to improve the functioning of health care markets is to make information more available. In particular, various ranking methods for hospitals and doctors have been developed to identify those of apparently lower (and higher) quality, while restrictions on advertising have been struck down as illegal. There is economic incentive in providing the rational consumer, whether an individual or organization providing insurance, with information to improve the efficiency of economic choices in the medical marketplace.

Information also plays a key role in government programs related to health risks from food and drugs. From meat and other food inspection to the certification of drugs, government certification programs are targeted at overcoming consumer difficulties in evaluating product quality. While some certifications could be handled by market processes, as through a credible third-party seal of approval or the threat of litigation, the safety of food and drugs is an established part of government regulation. The debate regarding genetically altered food products is only one example that combines both information issues and the potential for indirect, third-party effects, discussed as externalities later in this section.

UNCERTAINTY AND HEALTH INSURANCE

While the search for information can reduce some aspects of uncertainty about quality or price, the random aspect of illness is another type of uncertainty. From an individual's viewpoint, one's health state may change due to a large variety of health problems related to aging, accidents, disease, and so on. Individuals can "take their chances" and, if an accident or illness occurs, obtain what treatment is available within their budgets. This "self-insurance" option is risky, however, since individuals would not be able to afford care for serious health problems. In the early 1990s about 15 percent of the U.S. population was self-insured, or, more accurately, uninsured. If such individuals choose to access the health care system, they must either pay for services directly or seek free treatment.

In fact, various types of medical insurance are widespread in developed countries. In the United States, employer-provided medical insurance expanded rapidly during World War II, while Medicaid and Medicare (both begun in 1966) provide a form of medical insurance for the poor and the elderly, respectively. Insurance works as a market concept because health uncertainty is large for an individual but can become quite stable across a large population, a statistical result of the law of large numbers. Thus, the number of cardiovascular problems in a large population may be similar year to year, although to an individual it is a very uncertain event. By pooling resources through insurance, each person at risk pays a smaller guaranteed payment in exchange for more expensive conditional coverage if a health problem occurs. While individuals can, and often do, pay for their own health insurance, the tax-free status of employer-provided health benefits in the United States provides an incentive to businesses to expand coverage in place of wage or salary increases.

As with the potential problem of asymmetric information between physician and patient, various asymmetry problems arise with regard to insurance. Those individuals with potentially more health demands have an incentive not to reveal such information, a problem known as "moral hazard" or "adverse selection." If this occurs too frequently, insurance premiums are incorrectly charged or insufficient. A second problem can occur if medical care is free to those insured. In such cases the care may be overused in comparison to the benefit received.

Insurance plans in the United States, including Blue Cross/Blue Shield and Medicare and Medicaid, focused for many years on administering bill-paying systems that implemented fee-for-service types of contracts to reimburse the health care provider. This contractual form places all the financial risk with the insurance company or government and is thought to be a significant contributor to rapid increases in health care costs. In contrast, health maintenance organizations (HMOs) combine the three roles of insurer, administrator, and health care provider. Consequently, they are potential competitors in both the insurance market and in the provider market. HMOs receive income through a steady stream of periodic payments per enrollee, a form of revenue called "capitation." As HMOs, which are increasingly for profit organizations, retain any cost savings from improved case management, they are said to internalize the incentive to reduce cost. A variety of other types of organizations mix and match the roles of insurer, plan administrator, and health care provider, with the result of increasing competition in both the insurance and provider markets. Other details of insurance, including deductibles (a fixed amount paid before insurance coverage begins), co-payments (a monetary fee paid by the patient per service), co-insurance (a fixed percentage paid by the patient), and coverage of in-patient (hospital) or out-patient claims, have all been studied for their economic incentives on various parties. For example, some form of consumer payment reduces the number of small claims, which require more administrative effort, or transaction costs, and also provides some impetus to search for low-cost providers.

BARRIERS TO COMPETITION

A bewildering array of policies have evolved over the years that both encourage and retard competition in health care. Many of these policies involve barriers to entry for those who provide health care services. When these barriers are lowered the number of health care providers tends to increase, encouraging competition. Also important has been the role of large buyers of health care services, such as governments and large employers. Such buyers have been able to change the market conditions where there are organized sellers of health services.

The economic analysis of competition requires the definition of closely related markets. The broad health care market can be identified as producing goods or services using inputs such as specialized labor services like doctors and nurses, medical equipment and drugs, and buildings and facilities. In 1997, hospitals received 34 percent of health expenditures and physicians received just under 20 percent, with smaller fractions going to other providers. Major subjects for the economic analysis of competition have included the impact of barriers to entry in the labor markets for physicians and nurses, the institutional structure of health insurance and provider markets, and research and development for medicinal drugs.

The economic analysis of medical labor markets has generally been one of analyzing barriers to entry. These restrictions, first taking the form of state licensing of physicians, can be a response to concerns about quality that are based on the lack of information of the consumer. However, economists have also analyzed the various restrictive practices promoted by medical organizations as serving primarily to increase the income of physicians, and less consistently to preserve or improve quality. Among these restrictive practices were apparent limits on the number of U.S. medical schools and increasingly long training or "residency" times after graduation. This appeared to restrict the supply of new physicians without retraining existing physicians, which could also address concern for quality. Government policy linking funding to expanded medical school enrollment started in 1965 and seems to have reduced the shortage of physicians.

In addition to direct barriers to entry for labor, various practices contributed to limitations on competition. These include collusive behavior among physicians—including boycotting specific insurers, the denial of hospital privileges to physicians joining competitive organizations, and restrictions on advertising. While similar actions in industry would be considered anticompetitive and illegal based on federal anti-trust laws, it was not until the mid-1970s that these laws were applied to professionals such as doctors, lawyers, and engineers. A series of anti-trust cases on these topics reduced barriers to entry and increased information, thus opening the way to increased competition.

The fee-for-service form of health care financing has been much studied as a system that does not minimize costs. While federal expenditures do not dominate the system, providing about one-third of health care expenditures in 1997, increases in government health care costs have led to various efforts at reform. In 1973 the federal government passed the Health Maintenance Organization Act, which opened another door to increased competition. Through various amendments and related legislation, the government changed hospital planning requirements (certificates of need); changed hospital payments under Medicare to diagnostic-related groupings in order to establish fixed prospective payments; and eliminated a requirement that Medicaid provide "free choice" of medical provider to its constituents. Simultaneously, large employers became increasingly concerned with the cost of health insurance and undertook actions to modify contracts and provide incentives to providers to reduce costs, often under the umbrella of managed care. These changes, taken together, appear to have increased the competitiveness of the health care system and slowed down cost increases.

An important part of improved health, both in the United States and worldwide, is attributed to medical advances in the pharmaceutical industry. The research and development emphasis of this industry is another important issue in competitiveness. When research and development provides a new treatment, economic efficiency would dictate that such advances be distributed at the cost of production. However, the large sunk (precommitted) costs of research and development cannot be recovered at production-based prices, and profit-seeking firms will not invest in such efforts. Patents, which provide a monopoly or sole right to produce for a limited period of time, are a compromise between providing an incentive for research and development and the long-term economic interest of providing new treatments at low prices. In addition to providing patents, the federal government, through the Food and Drug Administration, also reviews new drugs for safety and effectiveness. This review adds time and expense, which in turn affects the incentives to conduct research and development. This problem was addressed in 1984 by providing an extension of the effective life of drug patents by taking into account part of the time taken for research and development and clinical trials. Issues about dynamic efficiency (efficiency over time), such as the role of research and development, remain at the forefront of economic research.

EXTERNALITIES

What constitutes public health has evolved over the years. In the nineteenth century it was more focused on sanitation projects, and later on medical science. The economics of health provides a common thread for why "public" health is seldom left to a free market. When a market transaction between two parties affects another that is unconsidered in the transaction, this indirect or external effect causes a market to fail to achieve economic efficiency. The concept of "public goods" is based on the concept of "externalities." Whatever the historical failings of sanitary engineers and public health officials in understanding the exact science of diseases, the indirect effects caused by people disposing of personal and industrial wastes in a detrimental manner is one justification for some form of government action, although not necessarily government provision of the specific goods or service. Government action can, and has, taken a variety of specific forms, including publicly owned water supply and treatment works, technological requirements, taxes, or numerically limited but tradable rights to pollute.

The concept of externalities opens a wide range of topics, some solidly within the economics of health, others at its boundary. There is little ambiguity about the presence of health-related externalities in the diffusion of gastrointestinal diseases such as typhoid fever, which caused an average of 53.5 deaths per 100,000 people in 1900 for fifteen large cites located on U.S. waterways. Its diffusion largely depends on the method of disposal of human and animal waste, and on the interaction of that disposal with sources of drinking water—a link broken in the United States with the advent of drinking water treatment or source control. Industrial pollution can have similar indirect impacts through the disposal of waste into the air, land, or water. Some programs of the Environmental Protection Agency are entirely or partially justified on health grounds. Finally, social problems such as violence and drug use have implications for the economics of health. Crime victims are, by definition, unwilling participants, and the causes of crime are therefore causes of "external effects." The impacts of this are not only health related but extend to a variety of defensive economic activities.

The economic analysis of external effects, and of health programs in general, typically involve identifying and quantifying the cause and size of the problem and designing institutional responses, often involving government action, to restore the efficiency of the marketplace or to provide for the public good. Identifying the externality typically involves some form of risk analysis, followed by economic valuation of that risk. As many risks are not bought and sold in the marketplace, a variety of indirect estimation tools have been developed. Efforts to put a value on a statistical life, a quality-adjusted life year, or even direct health endpoints, such as an asthma attack, are challenging and controversial. Policy design and evaluation are the next steps, with economic concerns about designs that are cost-effective (providing a given level of service at the minimum cost) or efficient (balancing the additional costs with the additional benefits). Benefit–cost analysis is one tool by which economists formally evaluate alternative policies, taking into account risk, valuation, program costs, and timing.

EQUITY

Issues of fairness, or equity, receive only modest attention in economics. Economists associate equity with the distribution of income—who gains and who loses in particular actions. In a market exchange between two individuals, each person believes he or she will be better off after the exchange or else the transaction would never take place. Each transaction depends not only on the preferences of the individual but also on each individual's available income. In the standard economic view, if society does not like the result of voluntary transactions between individuals, then society should redistribute wealth in some way and then let the individual transactions take place. Either market solution—before or after redistributing wealth—would be viewed as efficient according to economists. Since economists have no particular expertise in what is the right or wrong distribution of wealth, they have generally focused on efficiency and ignored equity.

This hands-off approach stumbles in the face of numerous demands to provide advice on what actions are better or worse for the economy, technically called "welfare economics." Such advice requires adding up the welfare of all the individuals in the economy, and there is no objective method for knowing if the economy is better off so long as an action increases the welfare of someone at the expense of another. The economist's standard solution to this, exemplified in benefit–cost analysis, is to add up the value of benefits and costs no matter who receives them. If the benefits outweigh the costs (appropriately adjusted for time) then the winners can potentially compensate the losers and society is judged to be (potentially) better off.

Such prescriptions are criticized on equity grounds, with critics often pointing to the poor or to minority groups as the losers in this system. While various suggestions have been made to weigh the impacts of such groups differently, or to require actual instead of potential compensation to those who lose, such approaches were not widespread as of the 1990s.

In practice, health care is an area importantly influenced by equity concerns. The Medicare and Medicaid programs effectively insure large parts of the elderly and poor populations. In addition, free or reduced price treatment for the poor or otherwise disadvantaged is another long-standing feature of the ethics and practice of the health care system and was, in fact, the original basis for the development of hospitals. These applications of community values to provide in-kind services and to achieve distributional objectives are another version of a merit good, which is considered by some economists as sufficient justification for government involvement. Concerns for equitable access to health care continue to prompt reviews of who has and who does not have health insurance coverage. Economists contribute to this debate by estimating the costs and implications of extended coverage and by evaluating alternative policy designs.

Each society must answer the economic questions of how much health care is to be produced and how health care will be distributed. The way in which these allocations are made in practice in the United States mixes market forces with a large influence of direct and indirect government intervention. The work of economists is to highlight the efficiency aspects of this marriage of the marketplace and the statehouse.

SCOTT FARROW

(SEE ALSO: Benefits, Ethics, and Risks; Cost-Effectiveness; Equity and Resource Allocation; Ethics of Public Health; Inequalities in Health; Urban Social Disparities)

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