Eco 506 health care economics
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ECO 506– Health Care Economics. Lecture Notes. Health Insurance. I. The demand for Health Insurance Definitions: Deductible: when the patient pays all the price for a certain range Coinsurance: the insurer pays only part of the price, the patient pays the rest

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ECO 506– Health Care Economics

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Eco 506 health care economics

ECO 506– Health Care Economics

Lecture Notes

Health insurance

Health Insurance

  • I. The demand for Health Insurance

    • Definitions:

    • Deductible: when the patient pays all the price for a certain range

    • Coinsurance: the insurer pays only part of the price, the patient pays the rest

      • Limits: coverage up to a maximum amount

    • Indemnity Insurance: reimbursement to the patient for medical costs (often fixed price per day in hospital)

    • Service insurance: reimbursement to the provider for medical costs

    • Impact of these on demand?

Eco 506 health care economics

  • An economic theory of demand for health insurance

    • Why do individuals choose to buy insurance and how much?

      • Budget constraint and preferences

    • Expected utility analysis

      • Expected utility analysis

      • Risk aversion

  • Suppose we have the following situation:

    • 1. an individual has $50,000 in money

    • 2. there is a 10% probability that the individual will become ill and have to pay $25,000 for treatment.

Eco 506 health care economics

  • => 1 = “good” state 2 = “bad” state

  • Let Mg= money income in good state

  • Mb= money income in bad state

    • Suppose you can insure against the loss

      • For example: suppose you can buy $10 of insurance coverage for $1 and that you fully insure against the loss.

      • 10% change of => Mb = $50,000 – $25,000 + $25,000 – $2,500

      • Mb= $47,500

      • Mg= 50,000-2,500 = $47,500

      • Regardless of which state of nature occurs

Eco 506 health care economics

  • Let Y = premium cost/dollar of coverage

    • K= dollars of coverage

    • => in general..

      • 10% change of getting $25,000 + K – YK

      • 90% chance of getting 50,000 – YK

      • Now, contingent consumption

        • N states of nature and consumption is contingent upon which state of nature you’re in.

        • If states are just different consumption bundles => consumer theory can handle it.

Eco 506 health care economics








25,000+ k -yk

A= Endowment

B= Full

Eco 506 health care economics

  • How do you attain points where Mb > $50,000 –yk

    • By over-insuring

    • In essence by selling insurance– if such a choice is possible which it may not be

    • Slope = ∆Mg /∆Mb = -yk/k-yk = -y/1-y

    • Now look at utility function and indifference curves to talk about how individuals make choices.

    • But 1st, how do probabilities enter info utility? They should, shouldn’t they?

    • If Pg = .9 Pb =.1 (should get a different choice than if Pg= 1 and Pb = 0

Eco 506 health care economics

  • Suppose m1, m2, m3 = income in states 1 and 2

  • 1 2 3 = probability in states 1, 2, 3

  • 2 definitions:

    • Expected value = 1, M1, + 2, M2, 3, M3. In our example EV = (.9) (50,000) + (.1) (25,000) = 47,500

    • Explain

    • Expected utility = 1, u(M1), + 2 u(M2) + 3 u(M3) +….

    • Expected utility hypothesis: you choose that option with the highest expected utility = weight of ability in difference possible states of nature.

Eco 506 health care economics

  • Now when does an individual choose to insure?

    • Assume that the premium is actuarially fair (book calls pure premium)

      • i.e. reflects the true probabilities so that in our example must pay ten cents the dollar => premium = $2,500 = EV

      • 1. Risk Aversion

u (m)


47.5 50

Eco 506 health care economics

  • Now look at two possibilities

    • Don’t buy insurance => Euni = .9 u(50K) + .1 u(25K)

    • Buy insurance => Eui = u(97,500)

    • An individual is risk averse for when EU (ins) > EU (no ins.)

    • Or u (EU (g))

    • 3 possibilities

      • 1. EUNI < EUI => risk averse

      • 2. EU(NI) = EUI => risk neutral

      • 3. EUNI > EUI => risk lover

Eco 506 health care economics

  • So depends upon the individuals shape (preferences) of utility of money curve


U (m)

Risk averse


Risk lover

U (m)




Eco 506 health care economics


U (m)

  • Have shown two things that matter in deciding whether to buy insurance

    • 1. Attitudes toward risk

    • 2. The insurance premium




Eco 506 health care economics

  • Risk averse individuals always buy insurance when the premium is actuarially fair as it was in our example.

  • Now, just look at risk averse individuals

    • And look at the price or premium

    • Even with competition, insurance firms can ____ charge an actuarially fair or pure premium

    • Why?

      • Suppose 10,000 individuals--- all the same with the same insurance

        • Each pay $2,500 in premiums for a total of $25,000,000

        • 10% of these individuals will incur losses of 25,000.

          • The company must pay out (25,000)(1,000) = $25,000,000

Eco 506 health care economics

  • But it costs more money to provide insurance (i.e. transaction costs of gathering premiums, paying for losses, etc.

    • Even if profit = 0 premium > pure premium

    • Q: Will a risk averse individual still insure?

    • A: Perhaps

Eco 506 health care economics

U (m)


  • 1st look at EV of the gamble =

    • M3 => EU = U3 and willing to pay (M2-M4) at most to insure the distance M3 – M4 = the additional amount willing to pay above the pure premium if prem >M2 – M4 => don’t insure





Eco 506 health care economics

  • Implications of this Analysis

    • 1. as the probability of the loss gets larger => M3-M4 gets smaller => less likely to buy insurance

      • i.e. if you are sure to pay for the expense => not willing to buy insurance. Why?

    • 2. As the probability of the loss gets smaller => M3-M4 gets smaller => less likely to buy insurance

      • i.e. as you become more sure that loss will not occur less likely to buy insurance. Why?

    • 3. As the magnitude of the loss decreases less likely to buy insurance because M4-M3 decreases.

    • 4. As an individual becomes more risk averse=> more likely to buy insurance.

Eco 506 health care economics

  • 5. As the price of insurance increases => buy insurance for fewer events (less insurance) where price = amount willing to pay above pure premium.

  • 0 1 line = amount person willing to pay above pure premium

  • AA = price of insurance (above fair premium (pure))






Eco 506 health care economics

  • Rises assuming costs increases as the # of claims increases due to rising transaction costs

    • Individual only buys for P1< Prob. < P2

    • If price increases => this interval gets smaller

    • 6. The starting income of the individual

      • At high income levels => MU low so less willing to pay above fair premium

      • At low income levels => MU is high again because the distance between actual and EU is less

      • This is wrong, at least the part about income levels affecting the distance. It still may be true that lower income people are less likely to buy insurance but this is because of budget constraints not the distances between the curves.

Eco 506 health care economics

  • Now look at the evidence: Tables 6.1 and 6.2

  • We see

    • 1. if prob. is low => use is low

    • 2. if prob. is high => use is low

    • 3. if magnitude is high => use is high

    • 4. if magnitude is low => use is low

    • => model predicts relatively well

    • The above assumed that D for M.C. perfectly inelastic once an illness occurs. Suppose its not.

    • Moral Hazard: the tendency for insurance to affect the individual’s behavior. i.e. the individual can affect the size of the loss under insurance.

Eco 506 health care economics

  • Examples:

    • 1. fire insurance => less likely to install fire alarms, smoke detectors

    • 2. Car insurance => may drive faster

    • 3. Health insurance => individuals may invest in less preventative care. Why?

      • Preventative care is not paid for but other care is.

      • Other examples depends upon how the insurance is set up

Eco 506 health care economics


  • Look at 2 impacts of the moral hazard using Demand Analysis

  • Full Insurance Coverage: P=0 to consumer and buys Q = Q2 > Q*

  • This is inefficient since time cost is MC = P* at Q2

  • MB = 0 => MC >MB

  • With no insurance, individuals consume Q = Q* with P=P*


MC = S





Eco 506 health care economics

  • Is this behavior rational? Yes, individual is equating MB with MC = 0

  • Given that Q increases, what happens to the premium? Clearly, it must rise as well. Both because Q increases and because P increase if S is upward sloping.

  • Suppose

    • P* = 1,000

    • Q* = 10

    • P2+ 2,000

    • Q2 = 20

    • Probability of illness = .2

    • Assume moral hazard does not cause this to change







Eco 506 health care economics

  • With no moral hazard and no inefficient…

  • Pure Premium = (.2) (1,000)(10) + (.8) (0) = $2,000

    • With moral hazard: pure premium = (.2)(2,000)(20) + (.8)(0) = $8,000

      • Premium rises to pay additional costs

    • Q: Why don’t individually obserce? Increase insurance premium and stop increase QD?

    • A: 1st, individuals make choices on the margin. The effect of insurance is to decrease the MC to the individual

      • 2nd: need to understand the concept that insurance groups people together => by your decrease in QD you get very little benefit.

Eco 506 health care economics

  • Implications of the Moral Hazard

    • 1. QD increases with insurance ( P increases as well)

    • 2. Premium rises => fewer people insure

    • Recall






Eco 506 health care economics

  • 3 methods to decrease moral hazard problem

    • 1. Deductibles

      • Assume MC constant for simplicity

    • Let Q1 = deductible amount of services

      • Actually, deductibles are usually in dollar amounts










Eco 506 health care economics

  • Look at 2 situations:

    • 1st: Q1 < Q* => will always buy the insurance at the pure premium. Why?

    • 2nd: Q1 > Q* => either don’t buy insurance an consume at Q* or do buy insurance and consume at Q2

    • How do you decide? If you do buy…

      • Pay P* x Q1 =>

        • Extra cost = (P*)(Q1-Q*) = area a + area c

        • Extra benefit= Area under from Q* to Qz = Area c + Area b

        • =>But only if extra benefits > Extra costs

        • OR if a + c < c + b or B > A

        • => Deductibles do not reduce the amount of Q purchased if have insurance…just reduces the # of people who buy insurance.

Eco 506 health care economics

  • 2nd: Coinsurance

  • Pure premium: (P* -Pc)(Q1)(.2) < (P*)(Q2)(.2)

  • Let Pc = coinsurance price => even with insurance must pay some of the price

  • 1- Moral hazard problem is less

  • 2-pure premium is lower with coinsurance => more people buy insurance








Eco 506 health care economics

  • 3rd: Prepaid plans like HMOs and PPOs focus on Drs and patient incentives not just patient thru coinsurane or deductibles.

  • Adverse Selection: Consider 2 groups of people

    • 1st group: prob. of illness =.8

    • 2nd group: prob. of illness =.2

    • Suppose that the insurance company cannot distinguish between individuals in the 2 groups.

    • Results?

    • Assume equal number of individuals in both groups=> company observes a group who prob. of illness =.5 and bases its premium upon that.

Eco 506 health care economics

  • Let Mg = 10,000MB = 2,000

  • Pure premium for Group 1 (high risk) = (.8)(8,000) =6,400

    • M = 10,000 -6,400 = 3,600

  • Pure premium for Group 2 (low risk) = (.2)(8,000) =1,600

    • M= 10,000-1600 = 8,400


u (m)


2,000 3,600

6,0008400 10,000

Eco 506 health care economics

  • Both would be willing to buy at average premium of $4,000 (m= $6,000)

  • In our graph, Group 2 does not buy but Group 1 will always buy. Why?

  • Group 2 may buy dependent upon several factors but most important is how different the risk levels for the 2 groups.

  • Conclusions:

    • Adverse selection

      • 1. causes fewer low risk individuals to buy insurance and more high risk individuals to buy

      • 2. Premium must rise if this is true, more low risk individuals drop out

Eco 506 health care economics

  • Controls?

    • 1. experience ratings but perfect experience rations = no insurance.

    • 2. exclusions for pre-existing conditions

    • 3. decrease premium the longer insured

    • 4. unwillingness to pay deductible and coinsurance may signal risk status

Eco 506 health care economics

  • Conclusions for the Chapter

    • 1. forced coverage for all expenses is inefficient. Both high and low prob. events should likely not be covered. Why? => 100% coverage not optimal

    • 2. moral hazard and adverse selection problems:

    • 3. Public Policy:

      • National health insurance?

      • Coerced coverage for all individuals

      • discrimination

% of ind.

Major medical

Co ins.


Size of exp.

Eco 506 health care economics

  • Other issues

    • 1. Differential Health Insurances

      • Suppose Health insurance reimburses hospital expenditures but not physician services

      • If decrease P of H => substitutes hospitals for Drs and inefficient since original iso-cost represented true costs.

      • This is a service policy => results in overuse of those services which are reimbursed.




Mc = mc*


H* H1

Eco 506 health care economics

  • An indemmity policy keeps the relative prices of the two goods the same since it reimburses for all medical expenditures

  • This does cause D more MC to increase but does not change relative prices => no technological inefficiency

  • Note: figure 6.9 indicates allocative efficiency but this is incorrect



MC = MC*


Eco 506 health care economics

  • Service benefit insurance creates more problems. i.e. inefficiency while indemmity insurance does not.

  • 3 Problems

    • Increased use of insured services

    • Point where MP = 0

    • Increase demand for quality which is inefficient

Eco 506 health care economics

  • Tax Advantages

  • Health insurance as a fringe benefit is not taxed

    • Look at the individual who has two choices

      • 1. Get a $300/month raise (BL2)

      • 2. Get health insurance benefits (BL3) worth $300/month

M + 300/Pc


Health insurance

M/PhM + 300/Ph

Eco 506 health care economics

  • Q: Why ever choose (2)? Since it cuts off part of BL?

  • A: Tax benefits– suppose $300 is taxed but health insurance is not +> for 1 actually face BL4

    • => Plan 2 Makes everyone better off but does cause inefficiencies since forces some individuals to use more health insurance…then optimal

    • Note: there is one type of ___ that may not be better off—the individual would choose no health care and depends on tax rate if ind. A would be better off

The market for health insurance

The Market for Health Insurance

  • Public Policy: 2 Questions

    • 1. is intervention justified?

    • 2. what type of intervention?

    • Efficiency in 2 senses

    • Supply Side:

    • 1st- firm technological efficiency (use resources to min. cost of production)

    • 2nd- Industry: does each firm produce at min point on LRAC? [suppose not any reason why this might be okay?]

Eco 506 health care economics

  • Demand Side

    • Allocative efficiency MB=MC?

    • Note: will basically take the same approach for all the other markets as well.

    • A) Demand

      • Market: Recall that market demand is determined by:

      • 1. price of insurance

      • 2. prob. of loss

      • 3. magnitude of loss

      • Income of the consumer

      • Risk aversion

      • Price elasticity ~ -1 => increase P of 10%, decrease QD by 10%

Eco 506 health care economics

  • Firm Demand

  • Look at 3 different types of insurance

    • 1. Blue Cross/Blue Shield= non profit

    • 2. other commercial plans= profit

    • 3. Independent plans= prepaid plans (HMOs); self insurance; service contracts

    • Look at the changes embodied in table 11-2, p. 237

    • Trends:

      • 1. increas in % of Pop. covered but slight especially in later years

      • 2. decrease in BC/BS and big increase in Independent

      • =>market demand is relatively inelastic but firm demand is elastic due to substitutes and competition

Eco 506 health care economics

  • Differences in

    • 1. type of benefit

    • 2. price

    • 3. extent of coverage (Coinsurance, Deductibles)

    • 4. reimbursement

    • 5. reputation

    • Predictions:

      • 1. price will vary as the product varies

      • 2. the product will change over time as pref. change (or as costs change)

Eco 506 health care economics

  • Now look at efficiency

    • Is there an information argument that consumers find buying insurance inefficient since costly to gain information about competing co’s?

    • Probably not.

    • 1. large benefit item=> pays individuals to gain info

    • 2. insurance often bought by groups and cost/person of gaining information is less.

    • => information probably not a problem (note table 8-2 suggests it is for individual policies)

Eco 506 health care economics

  • Now look at Benefit/Premium Ratio

  • Benefit = average benefit paid for by group

  • Premium= price of insurance for that group

  • If B/P ratio = 1 => premium = price

  • Premium:

    • If B/P ratio < 1 => price > pure premium as B/P ratio decreases, price increases

    • If industry competitive expect to see B/P ratio close to 1

    • If monopoly=> B/P ratio would be low

    • Look at table 8-2 to see how this has worked

    • Note: book concludes that a fair amount of competition exists in the health insurance market, especially in the later years.

Eco 506 health care economics

  • Community Rating

  • Why don’t we just put everyone into the same basket, charge them the same premium and get the same benefit? = community rating

    • This is what Blue Cross did

  • Problems:

    • Suppose we have 2 large goals

      • 1. efficiency

      • 2. redistribution so low income individuals can afford medical care

      • Look at how community rating affects both of these goals

Eco 506 health care economics

  • Assume 2 groups: High risk and low risk

    • What you are trying to do is cross subsidize the high risk group. But 3 problems:

  • 1) Inefficiency: low risk will be paying too high a price => may choose to self-insure even though for cost they should not.

  • 2) Is the high risk group the one that we want to subsidize?

    • Blue Cross subsidized the old but are they low income?

    • Evidence suggests that Blue Cross actually subsidized the middle to high income.

  • 3) Is community rating the efficient method of subsidizing?

    • No, because it distorts choices by others => just use direct subsidies to achieve the goal.

    • Competition ensured the demise of community rating. Low risk groups would leave the Blue Cross system with more options and this is what happened.

Eco 506 health care economics

  • The uninsured

  • Look at table 11.3 / 11.4 (p. 241-42)

  • Why do people choose no insurance? What does our theory tell us?

    • P increase or decrease (prob.)

    • Loading costs

    • Lack of competition

Eco 506 health care economics

  • Working uninsured

    • Book discusses 3 major reasons

  • 1. see figure 11.4 (p. 242)—Basically firm has limited exp. Rating => must pay i1 not i0 => can’t compete

  • 2. Pre-existing conditions may keep out certain industries with high % of such people—Book discusses beauty shop workers (temporary, young, etc.)

  • 3. Attitudes

    • Solutions—mandated coverage?

      • Separate insurance from work

Eco 506 health care economics

  • Conclusion:

    • D relatively competitive especially in recent years => allocatively efficient

    • 2 points to support this: price is close to pure premium and demise of community rating is probably a result of increased competition in the market.

    • B) Supply: look at 2 issues n determining the technological efficiency of production of health insurance

      • 1. economies of scale = right # of firms in industry

      • 2. each firm produces at min. cost

      • Note: in normal model, competition ensures these 2 things but may have (1) information problems and (2) non-profit firms like BC BS.

Eco 506 health care economics

  • (1) Economies of Scale: book notes that there are many firms (> 1,000) in the insurance industry

  • Empirical evidence seems to suggest that costs/claim decreases as the insurance firm gets larger. This appears to be true for commercial firms and BC BS.

  • Problems

    • How do you measure costs?

      • General problems with all these quality and type of service varies => may get bias.

    • The type of policy matters as well

      • For example: group v. individual policies. 2nd is likely to be more costly to administer => may get additional bias.

Eco 506 health care economics

  • (2) Internal efficiency

    • Theoretical

    • Small information problems => Competition and profit-max will result in internal efficiency

    • Currently doesn’t exist in a large sector especially w.r.t. BC & BS for 2 reasons:

      • 1. BC & BS (BC est. by hospitals directly) have some monopoly power (competitive advantages) due to:

        • BC & BS non-profit => favorable tax treatment but premium increases are regulated. [note: lost federal tax exempt status in 1986]

        • Blues do not compete with each other => legal collusive arrangement between them.

        • BC (hospital portion) receives a discount on hospital charges that most commercial insures do not. Why?

Eco 506 health care economics

  • One possibility is that hospitals are trying to increase utilization of their expense services. BC provides more comprehensive coverage than most hospital plans.

    • => monopoly power for BC & BS

    • Why don’t they just drive other, less competitive firms out of the industry?

      • Because they are not profit-max. They use their competitive advantage to benefit others (by increased costs of production => inefficient)

      • Possibilities:

        • Consumers - not much support for this

        • Hospitals - some support for this

        • Physicians - fair turnout of empirical support for this

Eco 506 health care economics

  • Conclusion

    • 1. Economies of scale exist

    • 2. BS/BC may be internally tech. inefficient

    • 3. However, increased competition in the past decade, especially by HMOs, etc. has decreased the ability of BC & BS to be inefficient => prospect for the future looks good.

Eco 506 health care economics

  • Market Competition in Health Care

    • Basically want to look at 2 issues

      • Why did competition evolve now and not before?

      • What is the nature of the new competition?

  • I. Why did competition evolve?

    • A. Impetus from several sectors of the market for increased competition

      • (+) Federal initiatives fueled by concern with rising expenditures on Medicare => implemented several plans

        • Increased supply of physicians by:

          • Subsidizing construction of new medical schools

          • Subsidizing medical education for physicians and all health professions

          • => Increase competition among physicians by increasing supply.

Eco 506 health care economics

  • HMO acts decreased expenditures by stimulating HMOs

    • 1973 HMO Act

      • Employers with more than 25 employees had to offer HMO option in area

      • Federally qualified HMOs exempt from restrictive state practices

    • 1979 amendment to CON legislation

      • Loosened restrictions on building hospitals => HMOs found it easier to build their own hospitals if desired.

      • => increased comp. especially when hospitals began to have excess capacity

Eco 506 health care economics

  • Medicaid Changes- basically eliminated the patients right of provider choice => states could negotiate with “efficient” providers

  • New hospital reimbursement: DRGs talked about before. => decrease occupancy rates in hospitals, etc.

    • Note: by this time, comp. already taking effect.

    • (2) private sector

      • Basically business wanted to decrease costs of health ins. Benefit programs for a number of reasons: recession, foreign competition, etc.

      • Solutions: self-insurance, deductibles and coinsurance, pressure on insurers for efficiency, insurance coverage for low cost substitutes for hospital care.

Eco 506 health care economics

  • Impact:

    • Business concerns translated into insurance concerns. Why?

    • Hospital utilization decrease => excess capacity in hospitals developed [occupancy rate decreases]

    • => hospitals became more willing to participate in alternate delivery systems

    • Note: the same kind of things had happened before but had not resulted in increased comp. Why? Anti-competitive practices by physicians.

    • => of even more importance

Eco 506 health care economics

  • (3) Application of anti-trust laws to health sector

  • Previously not applied to health sector=> before when above conditions held competition by such things as:

    • Denying hospital privileges to participating physicians

    • Denying licences

    • Limit advertising

    • Why? Service industry exemption => decisions which changed this recently.

      • Goldberg vs. Virginia State Bar: price fixing not legal for service industries

      • 1978 Supreme Court denied the use of anti-competitive behavior by engineers

      • => service industry exemptions lifted or at least decreased

Eco 506 health care economics

  • Advertising has 2 impacts on the market:

  • 1st- decrease price of medical care…Why?

  • 2nd- decrease variance of price of medical care…Why?

  • 1st: increase information available to the public => increase elasticity of any individual suppliers D Curve






Eco 506 health care economics

  • P is higher with no advertising and lower with advertising

  • 2nd- recall our theory of how consumer’s search for best quality and best buy.

  • Do it by spending resources. Get more variation in price for: large budget vs. small budget goods; when search costs are higher

  • => advertising (as long as it contains info decrease search costs => get less variation in the price between difference producers)

Eco 506 health care economics

  • 2 impacts of Advertising

    • 1. consumers have info on different products price and quality=> Decrease price in market because n increases/

    • 2. decreased consumers search costs => decreased variation in prices

    • 3rd possible impact is to remove barriers to entry for competing firms includes: new Drs and new HMOs/PPOs.





Eco 506 health care economics

  • Empirical Results appear to support the theory

    • (1) P decreases (2) elasticity increases => more substitutes. (3) variation decreases

    • Also concern with negative effects of advertising i.e. not informative but induces individually to buy more low quality services

    • But empirical work finds no reduction in quality of services with increased advertising (may even increase Quality)

    • Spillover effects on non-advertisers => P decrease in markets where some advertise even though all do not

    • P decreases even though quality does not => appears to be with reason for concern.

Eco 506 health care economics

  • B) Competition from alternate forms of health care providers. Like HMOS/PPOs

  • Large increase in two market share.

  • Serve app. 15% of the population in 1987. Average annual % increases = 19.6%

  • From 1980-87=> large impact on the market

  • Want to look at: advantages of HMOs, problems with HMOs, empirical evidence on HMO performance

  • Advantages of HMOS

    • Patients do not choose the provider at the time of illness- long term relation impact.

    • Hospital efficiencyL for FFs (cost based) hospital reimbursement => Drs had no incentive to be concerned about hospital costs.

Eco 506 health care economics

  • HMO Advantages (cont’d)

    • Now dr. does have an incentive either as owner of HMO or given incentives by HMO. Explain

    • Cost minimization: HMO has an obvious incentive to min costs since fee does not depend on the amount of services provided

    • Dr. productivity increases since HMOs use more complementary services like Dr. assistants and more of an incentive to lobby for damages in state practice acts

    • Preventative care- since HMO as an insurer and has a long term relationship => cost effective preventative care will be provided by HMO. Explain

    • No incentives to duplicate facilities unless cost effective

    • Incentive to use cost effective generic drugs

    • Incentives to innovate in care: technology, location, benefits,etc.

Eco 506 health care economics

  • HMO Problems:

    • Biggest problem is with quality of care. To illustrate assume: patient has no info on qty of services provided =>no info on quality of treatment. (fee HMO = flat monthly fee, no other impact)

    • HMOs incentive? Max profit or minimize private costs?

      • Private costs: Wx X; where X = # of services provided Wx= C (cost of)

      • => HMO minimizes costs by decrease in Quality (x) to zero.

      • Just as in analysis of medical malpractice. Are there any problems with the analysis?

      • Yes: consider the following reasons why this might be a problem.

      • Assume that the HMO does not have the ability to set x=0. Why not?

      • Repeat dealings or reputation: if HMO is in business for long term, then 2 effects: patients may have repeat dealings and leave with inadequate care, or patients may be able to gain info easily from old patients.

      • Impact of both?

Eco 506 health care economics

  • Consumer Choice

    • Assume 2 kinds of consumers well and ill informed.

    • Well: consumers cause competition and increase quality even for ill informed as long as the HMO can not distinguish between the 2 types.

    • Medical Malpractice System: if x < x* => sue and obtain judgment => gives incentive. Explain.

    • Insurance Incentives: Suppose decreased care now (say preventative) increase in needed services later and services with large info.

    • => HMO bears the cost of insuring against this => will provide such cost effective care. Explain.

Eco 506 health care economics

  • Spillover effects in For-Profit HMOs

  • The book claims that for profit HMO Drs owned by Drs

    • => each Dr has an incentive to monitor other Dr in organization since decrease in their profits due to lost reputation => control own quality due to profit incentive

  • Problem: suppose large # of Drs in HMO => benefit to any Dr of monitoring is low (extra profit is split up as a large #) cost high => not likely to do it.

    • This is a typical moral hazard problem

  • Solution: HMO, who has better info, needs to control Dr’s actions since it has a large incentive. Explain.

Eco 506 health care economics

  • (3) Empirical Evidence

    • Look at 3 issues: quality, expenditures/utilization, biased selection

      • (a) quality: little empirical research

      • (b) Expenditures/utilization

        • Utilization decreases: length of stay, hospital admissions

        • Expenditures: per day decrease, per admission decrease

        • Table 12. 3 (p. 270)

          • HMO = GHC

          • Admission rates decrease, hospital days decrease, visits increase, preventative visits increase.

          • Discuss

          • But, per capital expenditures appear to increase. May be a short-term impact only.

Eco 506 health care economics

  • C) Bias due to Selection Problems

    • 3 possible kinds of problems

      • 1. Healthier patients with lower expenses may be more likely to join HMOs => get lower utilization, lower exp and higher quality only because of self-selection.

      • 2. Sicker patients may be more likely to choose HMO since coverage is more comprehensive.

      • 3. HMOs may locate in areas with higher exp, higher utilization, and lower quality since they can be more competitive.

      • Empirical evidence suggests that self-selective bias is not a large problem.

        • Some get + bias and other get – bias

        • Some get significant bias in correction procedures

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