Health Economics FAQ
In this FAQ…
How much do we spend on health care, where does the money come from and where does it go?
Anyone who has ever tried to navigate the health care system knows that it is complex, not only in the types of services that are provided, but also in the way we as a society pay for health care. We have developed a complicated mix of payment sources, including private health insurance, government programs, out-of-pocket expenditures, and in-kind contributions. Totaling all these payments, the United States spends more per person than any other nation (figure 1).
The United States spent almost $1.3 trillion on health care services in 2000.1 The amount the nation spends on health care has increased steadily during the past 40 years and with this growth have come changes in how health care is financed, where the money in the health care system comes from and where it goes. In addition, health care has come to represent an increasingly large portion of the overall U.S. economy.
As figure 2 illustrates, 85 percent of health care spending is financed via third-party payments. Private health insurance finances about one-third of health care spending in the nation, while the largest public health insurance programs (Medicare, Medicaid, and SCHIP) also finance one-third of health care spending. Other public and private health care spending finance approximately 18 percent of health care expenditures. Only about 15 percent of health care expenditures are financed out-of-pocket. The sources of financing for health care expenditures have changed substantially during the course of the past 40 years; several significant shifts are worth noting. First, the proportion of health care expenditures that are out-of-pocket has declined substantially. In 1960, nearly half (48 percent) of the nation’s health care expenditures were financed out of pocket. As noted in figure 2, by 2000 this figure had declined to 15 percent. Does this mean the amount of money we are paying out of pocket for health services has declined? The answer is no. In fact, in constant (inflation-adjusted) 2000 dollars, annual per capita out-of-pocket spending grew from $333 per person in 1960 to $694 per person in 2000. What occurred is that overall health expenditures grew rapidly during the past four decades. A larger share of this increased spending was financed via third party payments than had been the case before 1960. As a result, as the size of the health care expenditure pie grew, proportionately more of the pie was financed by third-party payment, in spite of the fact that out-of-pocket expenditures per capita actually were growing during this period as well.
Of course, the primary reasons that the percentage of health care financed by out-of-pocket payments has declined are the widespread introduction of private health coverage and, more important, the expansion of public health insurance programs, particularly those enacted at the federal level. In 1960, 21 percent of all personal health care expenditures in the nation were financed by private health coverage. By 2000, that figure had grown to 35 percent. More strikingly, in 1960, 21 percent of all personal health expenditures were financed through governmental sources. By 2000, that figure had grown to 43 percent, more than doubling the role of government in financing health care in the United States. Much of this growth was due to the introduction of Medicare, the federal health care program for the elderly and some disabled; and Medicaid, the federal and state program that finances health care for lower-income people and certain categories of elderly and disabled. Both programs were established in 1965. It is important to note that the role of the federal government in financing health care has grown dramatically since 1960. In 1960, only about 9 percent of national personal health care expenditures were financed through federal sources. By 2000, that figure had increased to 33 percent. During the same period, the role of state and local governments remained relatively static at between 10 percent and 12 percent of personal health care spending.
Figure 3 illustrates how the nation’s health care dollar was spent in 2000. As shown, hospital expenditures account for approximately one-third of health spending, with spending on physicians and clinics accounting for 22 percent of health care expenditures. Expenditures for prescription drugs account for approximately 9 percent of the nation’s health care spending, while spending on nursing home care accounts for 7 percent.
Proportionate allocation of the health care dollar between sectors of the health care economy also has changed over time. This change is most evident in hospital expenditures. The proportion of the nation’s health care dollar that goes to hospital expenditures declined from 41 percent in 1980 to 32 percent in 2000. This decline can be attributed to several factors. The introduction of the Medicare Prospective Payment System in the 1980s helped to limit lengths of hospital stays. Technological and treatment advances made it possible for certain conditions to be treated outside the hospital setting. The widespread introduction of managed care in the 1990s placed an emphasis on cost containment by reducing lengths of hospital stays and by moving sources of care to less costly settings. This shift of settings of care is evident: expenditures for professional services such as physician clinics, outpatient surgical centers, and other types of non-hospital providers increased from 27 percent in 1980 to 33 percent by 2000. The other notable change in health care has been in the area of prescription drugs. Driven primarily by rapid increases in the late 1980s and mid-to late 1990s, prescription drugs came to represent 9.4 percent of health care expenditures in 2000, compared to less than 5 percent in 1980. Although drug expenditures remain a relatively small proportion of the overall health care dollar, they have seen the most rapid increase during the past five years.
In spite of these shifts in health care system funding and expenditures, one constant has been that an ever increasing proportion of the nation’s economy is being devoted to health care. In 1960, only approximately 5.1 percent of the nation’s economy was devoted to health care services. As shown in figure 4, this percentage has grown steadily, although it stabilized during the 1990s as a result of historically low health care expenditure growth combined with a relatively strong economy.
In 2000, 13 percent of the nation’s economy was devoted to health care expenditures. It is projected that health care will begin to consume larger portions of the economy in coming decades, increasing to approximately 16 percent of the nation’s economy by 2010.
Finally, it is worth noting the important role that health care plays in state budgets. Approximately 27 percent of an average state budget goes for health-related programs and services.2 Medicaid is by far the largest single component of state-based health spending (accounting for 74 percent of total state health-related spending), but state employee health benefits, community-based services, and public health spending also are important components of state budgets.
What are market imperfections and market failures?
The fundamental basis of economics is the fact that the resources we have are scarce, whether economy-wide, or in a sector of the economy such as health care. Economics is the study of the way in which scarce resources are allocated among alternative uses to satisfy the wants of society. Health economics helps us understand how the scarce resources the health care system are allocated among the many competing uses for those resources to satisfy our health care needs. Given scarcity, it is necessary to determine how to allocate resources, and to decide how resources should be used. Although this can be done in a variety of ways, in general the United States relies upon a market-based economy to allocate resources.
When economists talk about a market, they mean a process of voluntary exchange between buyers and sellers of goods or services. Therefore, the market for health care consists of buyers of health care (consumers and purchasers of health insurance) and sellers (health care providers such as hospitals and physicians). Under certain ideal conditions, called perfect competition, a free market will produce the goods and services we want, in the right quantities, at the lowest possible cost. This is called an efficient outcome. Perfect competition requires that a set of conditions be present. Perfect information must be supplied so that all buyers and sellers are aware of price and quality of goods. There must be many buyers and sellers, and none of the sellers must have the ability to set prices; that is, they must be price-takers. They must be selling uniform products, and there must be freedom of entry into and exit from the marketplace. If the market is not structured this way and these conditions are not met, then the market will fail and outcomes will not be efficient.
In the real world, of course, there are no perfectly competitive markets. All markets have failures, and the American health care market structure is fraught with market failures. The health care market is organized such that it fails to meet the conditions for a perfectly competitive market in many ways, three of which are examined below.
Lack of Information
When we wish to purchase a refrigerator, we know we can go to the appliance store, compare the prices of refrigerators and the attributes of various models, and make our purchasing decision based on this information. We also can purchase consumer reports that give us neutral information about which refrigerator is the best quality or represents the best value. Once we have decided on the make and model we wish to purchase, we can go from store to store to find the best price. In health care, however, the situation is different. We usually do not know the cost of the care we are going to consume for several reasons. We do not have sufficient understanding of treatment options, so we do not know exactly what type of care we should receive. Insurance coverage shields us from the direct cost of care. Hospitals and providers negotiate different rates with different health insurers. Very little neutral information about the quality of care is provided, information about services we actually need is usually limited and consumers have no real ability to separate the care needed from unnecessary care. To make a judgment between products, we must be able to judge value. Information from which to make decisions—present in markets for many other goods—is lacking in health care, which makes it difficult to judge value in the health care market.
Information Asymmetries
Health care markets also contain what economists call information asymmetries. When we go to the doctor, we know that we do not feel well or we know we have certain symptoms but, in general, we are unable to diagnose our own ailments. We rely on physicians to do that. We then rely on physicians to prescribe a course of treatment for our condition. In other words, information in the health care market is not equally shared between the buyer and the seller; in this case, the physician—or seller—has far more information than the buyer—the patient. Thus, it is difficult for the buyer to determine value or make an informed purchasing decision, and there is no simple way for the health care buyer to gain sufficient information.
Because of information asymmetries, the relationship between physicians and patients becomes what is called an agency relationship. We rely on doctors to act on our behalf as our agents. In this case, the physician has become both the seller of goods as well as one who acts on our behalf as the buyer of goods. This has led to concern about what some term “supplier-induced demand.” That is, a situation where the physician, because of the unique position of being both the seller of services and an agent on behalf of the buyer of services, advises more expensive treatment than is truly necessary.
Another prominent example of supplier-induced demand is direct-to-consumer advertising of pharmaceuticals. This has been a very effective way for drug companies to create demand for their products. Pharmaceutical companies take advantage of an information asymmetry—they know more about the effectiveness of their product than you—to create demand. This marketing has been enormously successful. The 50 most heavily advertised-to-consumer prescription drugs, which account for less than 1 percent of the total prescriptions marketed, accounted for nearly half the increase in retail prescription drug sales in 2000.3
Barriers to Entry
For a market to operate efficiently, buyers and sellers must be able to enter and exit markets freely. If physicians, for example, are earning excessive profits, it is likely that more people will enter into the medical profession until the price of doctors’ services is bid down. However, many aspects of health care limit movement into and out of the market. The extensive schooling and training required to meet the certifications to become a physician, for instance, serve as a barrier to entry to the medical field. Hospital certificate of need laws also serve as a barrier to entry by requiring state approval before hospitals can be constructed. Laws such as those that require a certain level of capital reserves or require nonprofit status of health plans or providers also may serve as barriers to entry for potential competitors. Because they prevent potential competitors from entering the marketplace, barriers to entry lead to higher health care prices than otherwise would exist in a free market.
States have attempted to address some of these market failures in several ways. In particular, states have undertaken a number of initiatives aimed at reducing information asymmetries. These initiatives include state efforts such as provider and health plan report cards that attempt to give consumers information about the quality of care and access to care for various providers and health plans. States also generally require hospitals and health plans to report financial and service utilization information, which is often compiled by states and made available to health care purchasers and consumers. It is challenging, however, to present information on quality of care and access to care so that it is understandable to and useable by the average health care consumer, and the success of efforts to date to reduce information asymmetries have generally fallen short.
Why do we need health insurance?
A substantial shift has occurred during the past 50 years in how we pay for health care. The percentage of expenditures paid out-of-pocket has declined, and the use of third-party payment through health insurance has become the primary method of payment for health care services. Why has health insurance become our primary financing tool and why do we need it?
Certain goods and services account for the majority of household expenditures: food, clothing, health care, housing, transportation, and utilities. Yet, health care is the only item on this list for which we purchase insurance coverage. Why do we not purchase insurance for food or housing? The answer is that we know each month, with relative certainty, how much these services will cost. The same is not true for health care. We cannot predict when we will get sick, and health care is expensive when we do get sick. If everyone spent the average amount on health care services, we would not need health insurance. We would simply budget for it, the same way we budget for food or housing. But that is not the case. Although most people are healthy most of the time and, therefore use very few resources (the lowest-using 50 percent of the population uses only about 3 percent of the health care resources), a small proportion of people use the majority of health care resources. The highest-using 1 percent of the population uses 27 percent of the health care resources and the highest-using 10 percent of the population uses 69 percent of the health care resources.4
As a result of this skewed distribution—and because health care is enormously expensive for those who are ill—an insurance market developed to remove this risk and uncertainty. It is important to remember that some people in the highest-user group (the 1 percent of the population that uses 27 percent of the health care resources) are people who have a one-time catastrophic event. Someone may incur injuries in a serious car accident but fully recover and the next year will again be in the non-user group. Others in the high-user group have chronic and expensive health conditions that place them in this group year after year. It is important, therefore, that policymakers carefully craft policy that distinguishes between these two groups. For example, many states have developed high-risk insurance pools for people with chronic health conditions. These high-risk pools stabilize the overall private health insurance market by placing certain individuals with high-service needs into a separate pool, usually subsidizing the cost of their insurance coverage.
Insurance takes advantage of the fact that, at any given time, most people are healthy and not using services. When we buy health insurance, we agree to pay premiums each month (or year) and contribute to the pool of resources available to pay for health services, whether or not we need health care. Then, when we need care, the insurer pays the bill, however large it is. Through our payment of a health insurance premium and the subsequent pooling of individuals, most of whom will be healthy most of the time, insurance transfers the risk of above-average illness costs from the individual to the pool.
Although health insurance coverage plays an important role in removing the risk and uncertainty of the costs associated with having an illness, it also breaks the link between the buyer (the consumer or patient) and the seller (the health care provider) of health care services. Insurance removes the burden of the cost of health care from consumers, so that the patient no longer needs to worry about whether a visit to the doctor or emergency room is necessary or whether an extra visit is worth the additional cost, since the consumer is shielded from these costs under the third-party payment model introduced by insurance. Once the insurance premium is paid, everything costs the same; there is no need or ability to differentiate between providers based on price, and therefore, no ability to judge value. There is an incentive to over-consume health care, since the price of the next unit of health care consumed is the same as the previous unit of care consumed—zero. Competition based on things other than price then occurs. Our decisions on the consumption of health care are based on things such as the level of technology a given health care provider has, which provider group has the broadest range of specialists, or other things that we perceive to be relevant to health care quality.
Finally, the tax treatment of health insurance provided through an employer affects our demand for health insurance coverage. Health insurance premiums paid by the employer are excluded from the taxable income of the employee. As a result, the tax-free nature of employer paid health benefits lowers the price of health insurance to the employee and leads to larger demand for health insurance. Since these benefits are available tax-free, we prefer them to other benefits. Because the marginal tax for those with higher incomes is larger, the tax-free nature of employer provided health benefits tends to benefit those in higher income brackets more than those with lower incomes Overall, this exclusion of employer contributions for health insurance premiums and medical care is expected to result in foregone federal tax revenue of approximately $384 billion in 2002.5
What are moral hazard, adverse selection and risk segmentation and why are they important to the health insurance market and policymakers?
An earlier FAQ addressed why we need health insurance coverage: we do not know when we will get sick and health care is expensive, so we have developed an insurance market to remove uncertainty by using health insurance premiums and risk pooling. Unfortunately, health insurance markets, like all markets, can fail because of moral hazard, adverse selection and risk segmentation.
Moral Hazard
Having insurance coverage can change the way we act. For example, if people have comprehensive insurance for the belongings of their houses, they may be less likely to lock the door when they go to the store than if they did not have such insurance. The attitude they have about locking the door has changed because they have insurance, and this is known as moral hazard. Although moral hazard is present in all types of insurance markets, it is a particular problem in health insurance markets.
People who have health insurance coverage know that if they become ill, they will not be paying for the health care services consumed. As a result, they may be less likely to lead a healthy lifestyle or to obtain preventive care; therefore, the cost of care when they do become ill may be higher. After all, insurance will cover the cost of treating any acquired illness or condition. People also may go to the doctor more frequently or demand treatments they otherwise would not choose if they were paying directly for them. As a result, people may over-consume health care due to the existence of health insurance.
Similarly, providers of health care can be affected by moral hazard. Providers may know a patient has health insurance coverage and, therefore, the cost of the services they provide will be paid for. Thus, providers more often may over-treat or over-prescribe because they know the patient is not paying for services directly.
Many elements of the current health care system have evolved to offset the effects of moral hazard. For example, many elements of managed care—such as the use of gatekeepers—are intended to limit the effect of moral hazard on patients’ use of services. Similarly, managed care tools such as prior authorization and utilization review are intended to prevent inappropriate use or overuse of services due to moral hazard at the provider level. The development of practice guidelines and parameters for physicians and other providers in health care networks also are attempts to guard against over-treatment induced by moral hazard.
Adverse Selection
As noted earlier, a relatively small number of people consume the majority of health care resources. Most people are healthy most of the time and generally know more about their health status than a prospective insurer. Because of the large expense involved when people use health care services, we have an incentive to have insurance if we know we have a condition that is likely to require medical care or if we expect to use health care services. As a result, it is likely that people who need health care services will be those most likely to purchase health insurance. Although insurers attempt to predict the health care expenditures of those they insure, they do not have complete information about those covered. Therefore, insurers tend to price health insurance at the average of the expected risk. However, for those who are at low risk of using health care (for example, younger people), this average may be more than they wish to pay, and they may choose not to buy health coverage. Adverse selection, then refers to the process wherein those with higher health care needs are the most likely to purchase health coverage, while those with lower risks select themselves out of the market. Adverse selection is important because it can affect both the risk pool and how insurers approach the pooling of risk.
Certain elements of the insurance system were developed to help minimize the effect of adverse selection. For example, preexisting condition limitations were developed to prevent people with certain conditions from seeking coverage only after the condition has developed or only when they need care for an existing condition. Open enrollment periods for employer health coverage usually are limited to one month of the year, and employees who do not elect coverage at the time of their employment generally are restricted from enrolling in coverage until the next open enrollment period (or only with underwriting) in order to prevent employees from enrolling in health insurance only when they have a medical condition that requires attention.
Risk Segmentation
Any form of voluntary health insurance market is likely to suffer from adverse selection. If the likelihood that people will become sick is low and they have alternative uses for their money, they may choose not to purchase health insurance coverage. On the other hand, if they need services, they will want to have insurance to protect against the cost of paying for those services. Insurance companies understand that adverse selection is likely to occur and, therefore, have an incentive to try to attract the healthiest individuals to their risk pools. They do this by offering lower premiums to those groups that are likely to be healthier. (This process is often called “cherry picking” or “cream skimming.”) If an insurer is able to attract the lowest risk individuals who are least likely to consume care and to avoid the higher risk individuals or groups, that insurer can make a profit. Risk segmentation, then, refers to this process of dividing pools of individuals and charging different premiums based on their risk of using health services.
The most stable health insurance markets are those with the broadest possible spread of risk. In this way, significant medical costs are spread out across many people in the pool. When risk segmentation occurs, pools are broken into smaller pools where differential premiums can be charged. If healthier people are segmented from a large pool into a smaller pool and charged lower premiums, the premiums of the less healthy people remaining in the higher risk pools will necessarily increase. As a result, insurance coverage for those who need it the most is will become more expensive.
Moral hazard, adverse selection and risk segmentation can lead to failure in health insurance markets. Moral hazard can lead to higher health care costs; adverse selection may mean that people who are most likely to need care are also those most likely to purchase health coverage (which might make the cost of coverage less attractive to those with lower risk), and risk segmentation occurs when insurance companies divide risk pools to attract individuals or groups with lower health risks.
What are the RAND Health Insurance Experiments, and what do they tell us about the economics of health care?
Health care is a unique product because most Americans are protected against the uncertainty of incurring medical expenses through health insurance coverage. As a result, the true cost of the care consumed often is not visible to the consumer. However, health insurance frequently does not completely cover the cost of medical expenses. People often are required to pay out-of-pocket coinsurance for services, usually up to some maximum amount, or have a copayment for prescription drugs or emergency room use. In theory, the existence of copayment or coinsurance requires people to consider the value of the services they consume so that they are less prone to overuse unnecessary health care. Do the real world actions of people match with theory? The RAND Health Insurance Experiment was designed and conducted to help answer this and other questions.
The RAND Health Insurance Experiment was one of the largest and longest running social science projects ever completed, and the information gathered during the experiment has been invaluable in understanding how people respond to cost-sharing. The experiment, a randomized field trial of alternative health insurance plans, ran from late 1974 until 1982. Although a variety of reasons existed for conducting the experiments, the primary objective was to ascertain the consequences of alternative cost-sharing levels in health insurance on both cost and health outcomes. Thus, the experiment’s primary goal was to shed light on whether and to what degree different levels of cost-sharing in an insurance product affected the amount of health care consumed and the health outcomes of individuals.
In the experiment, approximately 2,000 families were randomly assigned to one of 14 health plans, which varied by the level of coinsurance (some plans had 0 percent coinsurance, or free care, while others had 25 percent, 50 percent, or 95 percent coinsurance) and by the maximum out-of-pocket expenditure (either 5 percent, 10 percent, or 15 percent of family income, up to a maximum of $1,000). The goal was to measure whether differences existed in the medical expenditures and health outcomes of people assigned to different levels of cost-sharing.
What did the experiment find? Although all the findings could fill, and have filled,6 an entire book, the primary findings showed:
- The more people have to pay for health services, the fewer services they consume. Although this may seem obvious, it has important implications for the design of public policy and health insurance. Per capita health expenditures for those enrolled in the most expensive health plan were 25 percent to 30 percent lower than for those enrolled in free care. This reduction in health expenditures remained true for all types of services, including physician, hospital, prescription drugs, dental care, and mental health care.
- Reduced service use under cost-sharing plans had little or no net adverse effect on health outcomes for the average person. The researchers found that, for a person of average health and average income, the imposition of cost sharing—and the subsequent reduction in use of health services—did not produce worse health outcomes.
- However, health outcomes for sick, lower-income people were adversely affected by the existence of cost sharing. Although the average person did not have worse outcomes in spite of cost-sharing, poor people, particularly those in less-than-average health, had worse outcomes when cost-sharing was imposed. This is an important finding to consider in examining various methods Medicaid and SCHIP program design and implementation.
- People with lower incomes were more responsive to cost sharing for ambulatory services than were those with higher incomes. That is, those with lower incomes used relatively less ambulatory care than those with higher incomes at the same levels of cost-sharing.
What the RAND Health Insurance Experiment helped to show is that, for the average person, the imposition of cost sharing could produce some level of cost savings without a reduction in health outcomes. However, it is important to note that for those with lower incomes, particularly those in poor health, the imposition of cost-sharing did produce poorer outcomes. In addition, lower-income people were more sensitive to cost-sharing for ambulatory care, an important consideration when considering whether preventive care measures under Medicaid or SCHIP should have cost-sharing.
How fast are health insurance premiums growing and what is driving underlying health care cost growth?
The mid-1990s brought about a health care inflation miracle. At a time when the economy was prospering and employment was high, health care cost inflation was low and actually grew at a slower rate than the overall economy. However, starting in 1999, health insurance premiums again began to escalate. In 2001, health insurance premiums increased by 11.0 percent, the largest single-year increase since 1991. Health insurance premium growth was high in the early 1990s, declined during the course of the decade, became virtually flat in 1996, and then increased thereafter (figure 5).7
Two reasons exist for the increase in health insurance premiums: the underwriting cycle and an increase in the rate of growth of underlying health care costs. The underwriting cycle begins when health plans experience what are called “underwriting profits.” The early 1990s were such a period for health plans. Premium revenue exceeded cost growth for health plans; therefore, plans gained profits and increased their reserves (area A on figure 6). With these profits in hand, insurers then attempted to gain market share. They moved into new markets and lowered premiums in an attempt to under-price competitors and gain members for their health plans. During this time, premiums were suppressed and health care cost growth exceeded the growth in health insurance premiums. Therefore, insurers experienced “underwriting losses” (area B on figure 6). By the late 1990s, in response to these financial losses, health plans moved to make up for the losses of the past several years and to restore profitability by increasing the premiums charged for health coverage to a level above the growth of health care costs (area C of figure 6). This process—of higher- than-average profits, leading to a reduction in premiums to gain market share, followed by an increase in premiums to regain profitability—is called the underwriting cycle. In the current stage of the underwriting cycle, premium growth is exceeding cost growth.
The second reason that health insurance premiums are increasing again is that the costs of health care services have increased. The underlying costs or expenses that health plans have incurred for services to their members have increased considerably during the past several years. In 2001, underlying health care costs grew 7.7 percent, the highest growth in underlying costs of the past decade. This growth built upon underlying growth of 7.1 percent in 1999 and 7.2 percent in 2000.
Figure 7 shows the relative contributions to health care cost growth by the major categories of expenditures in 2000. It shows that hospital services have emerged as a key component. Although prescription drugs remain the fastest growing overall component, hospital outpatient spending grew in double digits (11.2 percent ), while hospital inpatient spending grew 2.8 percent. Together, these components contributed to nearly half (43 percent) of the overall health care expenditure growth. As shown, prescription drugs and physician services contributed similar proportions to underlying health care cost increases (29 percent and 28 percent, respectively).
A variety of factors are contributing to this surge in underlying health care costs. First, in the late 1990s and early 2000, there was a shift from heavily managed care. Consumers objected to restrictive networks, and providers objected to utilization review and other tools of managed care. As a result, employers have demanded health plans with broader networks of providers and more direct access to specialty services. This has led consumers to use more health care and providers to gain better negotiating leverage with health plans, simultaneously driving up the quantity of health care consumed and the price of that care.8 Health care payroll also is a key component of recent health care cost increases. Health care is a relatively labor intensive industry, and workforce shortages among certain key professions, most notably nursing, have driven up overall wages, with underlying wage growth for hospitals doubling between 2000 and 2001.
In addition, various other underlying factors continue to contribute to the overall rise of health care costs. Most prominent among these is the continued advancement of technology within the health care system. During the past 30 years, remarkable new procedures and machines have been developed. However, these advancements are very costly. In addition, unlike in many other sectors of the economy where technology frequently is used to substitute for labor, the face-to-face nature of health care (one doctor, one patient) means that technology is likely to add cost to health care without necessarily saving on labor. This is not to say that the technological advances in health care have not been worth the extra investment, just that they have come with a large price tag.
Why should policymakers care about elasticity?
Common sense tells us that when the price of a good falls, all other things being equal, people will purchase more of that good; that is, the demand for the good rises. How much demand increases depends on how “elastic” that good is. Elasticity of demand measures how responsive changes in demand are to changes in price. Similarly, elasticity of supply measures how responsive changes in supply are to changes in price. When a good is demand-inelastic, it means that changes in price have only a minor effect on the amount of the good demanded. By contrast, goods that are demand-elastic have significant responses to changes in price.
Why should policymakers care about the concept of elasticity? One reason is that different goods have different levels of demand elasticity, and this has important implications for tax policy. For certain items, such as tobacco products or alcohol, demand is inelastic. This means that an increase in the price of these goods (through additional taxation, for example) will have a relatively limited effect on the amount of goods demanded, and tax revenues will rise. Policymakers often use “sin taxes” to raise funds to finance public health insurance programs or public health initiatives, and taxation of demand-inelastic goods is generally more successful in raising substantial tax revenue. Alternatively, placing taxes on relatively elastic goods will not be as effective in terms of increasing tax revenue (the decrease in demand will offset the increase in price), but could be useful in discouraging the demand for a given good, should policymakers determine there is a socially desirable reason for doing so.
It is also important for policymakers to include elasticity in their consideration of changes to the health insurance market. Studies show that small businesses are demand-elastic (and, therefore sensitive to the price of health insurance). Increases in the price of insurance may cause some small businesses to drop coverage or choose not to offer insurance at all. Policymakers therefore will want to carefully examine the potential costs of such things as benefit mandates, insurance taxes, or other items that potentially raise the price of insurance to small employers. Although several reasons may make it desirable implement some of these policies, the potential effect on elastic items such as small business demand for health insurance also should be considered.
Notes
1. Most of the information contained in this FAQ is from the Centers for Medicare and Medicaid Services, Office of the Actuary, National Health Statistics Group. See, for example, “Inflation Spurs Health Spending in 2000,” Katherine Levit, et al., Health Affairs 21, no. 1 (Jan./Feb. 2002), 172-181.
2. 1998-1999 State Health Care Expenditure Report, (New York: Milbank Memorial Fund, 2001).
3. Prescription Drugs and Mass Media Advertising, 2000 (Washington, DC: National Institute for Health Care Management, 2001).
4. Marc L. Berk and Alan Monheit, “The Concentration of Health Care Expenditures, Revisited,” Health Affairs 20, no. 2 (March/April 2001), 9-18.
5. U.S. House of Representatives Committee on Ways and Means, 2000 Green Book (Washington, D.C.: U.S. Government Printing Office, 2000).
6. See “Free for All? Lessons from the RAND Health Insurance Experiment,” Joseph P. Newhouse and the Insurance Experiment Group, Harvard University Press, Cambridge, MA, 1993.
7. Bradley C. Strunk et al., “Tracking Health Care Costs: Hospital Care Surpasses Drugs as the Key Cost Driver,” Health Affairs, September, 2001, Web Exclusive.
8. Ibid.
Staff Contacts: updated 7/2009
Dick Cauchi
Program Director, Health Program
National Conference of State Legislatures
(303) 856-1367
Author: Kala Ladenheim (2005)
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