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Chapter 9: Health Care Market. Why is the health care debate so contentious?. 1. For many, access to health care can be a life or death decision. In any event, it is critical to the well being of people. Emotions run high.

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why is the health care debate so contentious
Why is the health care debate so contentious?

1. For many, access to health care can be a life or death decision. In any event, it is critical to the well being of people. Emotions run high.

2. There is uncertainty with regard to an individual’s health. A small accident or illness can have catastrophic financial consequences.

3. The US spends approximately _________________. This has increased over time from roughly __________ Whereas spending on other “critical” categories such as housing, clothing, and food have decreased as a percentage of GDP. See graph on next page.

what attributes of health care may justify government involvement
What attributes of health care may justify government involvement?


  • With health care some individuals may know if they are in a high risk or low risk category for illness and base decision to buy insurance on relative costs and benefits.
  • The insurance company can’t determine who is high risk and low risk and therefore charges an average premium to all clients.
  • those that think they are at low risk may not buy insurance expecting to accrue few benefits from health insurance but would have to pay the costs associated with premiums.
  • Hence, insurance companies may end up insuring a pool of proportionately more high risk applicants.
  • People who have insurance may overuse health care by engaging in more risky behavior or more costly behavior (unnecessary procedures and testing) because they are covered and pay very little in incremental costs.
the role of insurance
The role of Insurance
  • Buyers pay insurance premiums, to the providers of insurance, which in turn contractually agree to cover the costs associated with health care expenditures should an adverse event or illness occur. In general, higher premiums are associated with greater coverage.
  • What motivates consumers to buy insurance? To smooth the risk associated with the uncertainty of an adverse event occurring. Consumers like to “smooth the risk” associated with such events occurring so they do not have the potential for large out of pocket expenses associated with an illness.
  • The price a consumer is willing to pay for insurance depends on the probability of an adverse event occurring, the financial impact of such an event (the costs) and the price of the insurance.
actuarially fair insurance premiums
Actuarially fair insurance premiums
  • We use the concept of “expected value”:
  • “Actuarially Fair Insurance Premiums”
  • In the real world insurance companies have overhead costs that they must also account for in insurance premiums but for now let’s consider their additional costs of supplying insurance as zero.
numerical example determining expected value and premiums
Numerical example: determining expected value and premiums

Emily is considering two options: Option 1: no insurance and Option 2: full insurance. Assume that Emily has a 90% chance of staying healthy and a 10% chance of getting sick.

When healthy, Emily earns an income of $50,000 and has no health care expenses. If she gets sick health expenditures cost $30,000 leaving her with $20,000 income.

Determine the actuarially fair insurance premium:

  • Given this premium of $3,000 should Emily buy insurance (option 2) or not (option1)?
should emily buy insurance at a price of 3 000
Should emily buy insurance at a price of $3,000?

Calculate the expected value of her payoff in each scenario.

  • EV of option 1:
  • EV of option 2:
  • Her expected payoff is the same? Should she buy?
to buy or not to buy
To buy or not to buy?
  • Without insurance her actual payoff could be $50,000 or $20,000 but on average it will be $47,000.
  • In general, economic theory suggests there is diminishing marginal utility to income:
risk aversion
Risk aversion
  • We know the expected monetary outcome (Expected Value) of Emily’s insurance options: EV= $47,000.
  • Under Option 1 she incurs risk (no insurance); Under Option 2 she is risk-free (full insurance).
  • Compare the utility from each option: The utility received by an individual from the risky option is called Expected Utility or EU.
  • To determine a consumer’s choice we must compare the utility received from the risky endeavor with no insurance (Expected Utility) with the utility received from a certain outcome called the certainty equivalent (Expected Value) with insurance. 
risk aversion more formally
Risk aversion—more formally
  • Risk Averse (RA):
  • In this case a consumer would maximize utility by purchasing insurance.
risk averse example
Risk averse example
  • Recall: Option 1 without insurance (risk)
  • Option 2 full insurance (no risk)
  • Compare the utility of these two options:
    • Risk vs. No Risk
use graph from previous slide
Use graph from previous slide
  • Compare the Expected Utility of Option 1 (EV=$47,000) compared to Option 2 Utility of $47,000 risk free
  • Expected utility of no insurance (option 1) is less than the utility of risk free insurance option 2.
  • The consumer must be risk averse! Show linear segment between 20 and 50 and at $47,000 she is at point C with utility of 297. This is less than the 305 she receives from insurance. This consumer would pay to avoid risk (willing to pay a risk premium)
how much of a premium will she pay
How much of a premium will she pay?
  • How much will see be willing to pay as a premium?
    • Move horizontally left onto her utility curve at 297 units of utility.
    • Whatever that income level is, say I=$43,000, shows how much she would pay ($47,000 – $43,000 is $4,000).
  • The more curvature in her utility function the more she is willing to pay to avoid risk. Hence, the more risk averse people are the more insurance companies can charge
real world premiums
Real world premiums
  • In the real world, firms charge higher premiums than the actuarially fair insurance premium, because of overhead costs, and because of risk averse clients. They can earn a normal profit due to risk aversion.
  • Loading fee is estimated by calculating:
  • According to Phelps 2003, private insurance companies loading fee _______________higher than the actuarially fair premium. 
why can t private markets efficiently provide health care
Why can’t private markets efficiently provide health care?

Given the ability to set premiums it seems that private markets for insurance should work without the need for government intervention. However, there is also a problem of asymmetric information in the market for health care. Emily may know her probability of getting sick based on family history, her personal medical history, stress, environmental factors, etc. However, the insurance company will not have access to similar information.

the role of asymmetric information
The role of asymmetric information
  • Using our previous example to look at asymmetric information.
  • Suppose there are 10 clients each of whom face the same potential income loss of $30,000 if they become ill. Emily’s chance of being sick was 1 in 10. What if some of our clients have higher risk, say 1 in 5 of becoming ill? And what if only the clients know if they are high risk or low risk? How does asymmetric information result in market failure?

For low risk clients (1 in 10 chance of getting sick) their expected loss in income is:

For high risk clients (1 in 5 chance of getting sick) their expected loss in income is

firm loses money
Firm loses money

If the firm continued to charge the $3,000 premium to all clients then they would certainly lose money.

Firm loses $15,000.

how should firms cover these losses
How should firms cover these losses?

If the firm knew which clients were at high risk and which were low risk they could theoretically charge different prices. But they don’t have this information.

Suppose the firm knowing its expected payout is $45,000 and wants to spread the risk by making the average premium $4,500 for each of the ten people in an effort to cover costs. Would the firm survive?

what happens to the firm by averaging the premium across different risk groups
What happens to the firm by averaging the premium across different risk groups?
  • The firm is driven out of the market. Why?
    • because the 5 low risk people have an expected loss of income of $3,000 so it is unlikely they would buy insurance at a premium cost of $4,500 (even if risk averse some will opt out)
    • The high risk people are attracted to the program but not the low risk people: adverse selection problem.
    • Note: the insurance company would have to raise premiums to $6,000 to cover actual expenditures causing even more people to potentially drop out of the market. People who would pay the actuarially fair rate with go without insurance leaving the market not functioning. This is called “the death spiral”—killing the market.
a true story harvard university
A true story—harvard university
  • Harvard had 2 health plans: a more generous plan (costs slightly more) and less generous plan. There was a big subsidy on the generous plan for employees.
  • Due to a tight budget situation they changed the system to give each employee an equal contribution to a health plan and then allowed each employee to choose to enroll in the generous or less generous plan. Now, they pay substantially more for the generous plan $700/year.
  • What happened?
    • People opted out of the generous plan for the less generous plan.
    • People who switched were not a random sample. The ones that left were younger, presumably in better health and opted for less insurance.
    • This indicates sorting based on health status as you would expect with adverse selection.
    • With the less healthy now pooled in the generous plan health care expenditures increased and so premiums increased.
    • More young people left and exacerbated the situation.
    • Harvard dropped the generous plan.—“death spiral”