Free market Supply and demand work to allocate resources and distribute goods and services Through prices
Independence of supply and demand Supply is the sum of the decisions of sellers Demand is the sum of the decisions of buyers
Supply curve Shows the relationship between the quantity that sellers want to sell and the price Depends on costs (Costs Supply ) – Opportunity costs of resources And competition (Competition Supply ) – Number of sellers – Freedom of entry
Demand curve Shows the relationship between the quantity that buyers want to buy and the price Depends on – Budgets (Budgets Demand ) Opportunity cost of the good to the buyer – Preferences, wants, needs (Wants Demand ) – Alternatives and their prices (Alternatives Demand ) Cross-price elasticities – Competition (Competition Demand ) Number of buyers
Equilibrium Bubbles – When expected future prices affect today’s supply and demand – Momentum of demand and price Fueled by debt Next slide http://www.calculatedriskblog.com/2009/08/house- prices-real-prices-price-to-rent.html
Supply elasticity and housing (and commercial real estate) Columbia: Elastic supply – Higher demand led to more houses South Florida: Inelastic supply – Higher demand led to higher prices
What makes health care special in economic theory HSPM J712
Is health care special? Does the free market give good results? – What are good results?
Free trade makes things better, if certain conditions hold As individuals pursue their self-interest in the market, they work for the benefit of others, “as if guided by an invisible hand.” – Adam Smith (1776) Prices guide people to use their resources in ways that most benefit others.
Reinhardt’s diagram to illustrate Pareto Optimality and the Kaldor-Hicks criterion (which is behind cost-benefit analysis) If a dictator puts you at X, free trade will move you to between Y and Z.
What is “optimal?” What is “efficient?” Pareto criterion (strong): No one can be made better off without making someone else worse off. Kaldor-Hicks criterion (weaker): If the gains to the winners total more than the losses to the losers.
Free Trade and Optimality or Efficiency Free trade will get you to an optimum If and only if … – Buyers and sellers have full information about quality and price – No outside subsidies or penalties – No external costs or benefits – Everything that affects well-being can be bought. (The exclusion of externalities is a subset of this.) – No collusion or entry barriers
How this works with Pareto optimality If there were a way for you to be better off without making me worse off, Then we’d both know about it (perfect info) And we could engineer a trade in which you’d gain the extra and give me some (free trade) And no one else would be hurt (no external costs) And we wouldn’t be hurt indirectly (because everything is for sale)
1 st and 2 nd optimality theorem 1 st is that those conditions lead to an optimum 2 nd is that, if those conditions hold, society can get to any particular optimum by manipulating the distribution of wealth – So, OC’s (objects of compassion) should be given money, not programs
For health care and the free market, let’s start with … 1)Consumers must – Know prices of all alternatives – Know qualities of all alternatives Qualities = benefits to them
Arrow: Information uncertainty in health care Consumers are uncertain about qualities and prices. Much of what consumers buy from health professionals is information. Buying and selling information – a problem for free market theory How do you know how much you’re going to benefit from information without knowing the information?
How do these deals sound? “I have some information that it will benefit you to know. Pay me $35 and I’ll tell you the information.” “I have some information that it will benefit you to know. Agree in advance to pay me whatever I’ll ask and I’ll tell you the information.”
Professionalism Trust Arrow: Society develops solutions when market is not optimal. Not necessarily government solutions. Professionalism = Behave unlike unfettered business. Professionalism encourages trust – That the information will be worth what you are paying for it.
This is an efficiency problem, not an equity problem It’s not about fairness, or what to do about the medically indigent. It’s about a free market not being able to provide the right amount of medical care to people who can pay. – Without some substitute for consumer sovereignty, which fails in health care
Professionalism in medicine Knowledge and training Agency – The patient is the “principal.” – The physician or other professional or the hospital or other institution is the principal’s “agent.” Agents are supposed to apply their abilities on behalf of their principals, not themselves.
Professionalism in medicine Serves a social purpose Moves away from the unfettered, anything goes, market … … to make the outcome closer to optimal … to make the outcome more efficient
But violates other free market optimality requirements Collusion Entry barriers
For health care and the free market, let’s continue with … 2)No outside subsidies or penalties – Subsidies unhook the relative prices that individuals face from the relative costs of their choices
Moral hazard Is a consequence of insurance But insurance is a rational market response to the uncertainty of health care expense.
Insurance and expense uncertainty Consumers are uncertain about how much they will be spending on health care. They may have a catastrophe and want to spend more than they can raise. So they buy insurance.
Insurance and risk Insurance is a financial transaction You (the insured) pay the insurer to assume risk for you. You pay more than the expected value of the insurance payout. The difference is your risk premium. The risk premium covers the cost of administering the insurance.
Risk pool A way to think about it instead of expected value You and a bunch of others agree that if any of you suffer a loss, you will all chip in to pay for it. Mutual insurance
Insurance leads to moral hazard Theory says that you will use any service to the point where the marginal value to you equals the price to you. If there are diminishing returns to using more service, and the price to you is a fraction of the cost, you will use services that have a higher opportunity cost to society than their benefit to you... … and you won’t bother to shop for a lower price.
Moral hazard When having insurance makes it more likely that a claim-triggering event will happen. – Example: The expectation of a rescue by the government may induce a bank to take bigger risks.
Health insurance and the demand curve Insurance increases the demand And makes it less elastic 100% coverage pivots the demand curve around the point where it meets the Quantity axis, and makes the demand curve a vertical line.
Moral hazard makes market inefficient = not optimal Insurance with free choice induces people … … to get society to provide them with services – Society = pubic or private insurance … such that there are other things that the person is not getting that would be more valuable to the person than the medical service – Violates the Pareto criterion
To reduce moral hazard within the free market, conservatives advocate: Catastrophic insurance – Insurance that only pays for big, bad, surprises.
Catastrophic-only insurance For Less inducement to moral hazard – Because less is covered Less administrative cost – Because fewer bills paid Selection – Risky people want to avoid it, – So low-risk people will pay a premium closer to their expected value. Against Tilts incentive away from primary care – Discourages prevention Bargaining power and market knowledge – Insurer as monopsonist Individual payment has administrative cost, too. Risk-adjusted premium can stop selection.
The case for catastrophic-only insurance part 1 Less inducement to moral hazard – Because less is covered
The case for catastrophic-only insurance part 2 Administrative cost – Through your premium, you pay the insurance company to do the paperwork for your bills. – If the insurance company handles fewer bills, the administrative cost is less. – The insurance company can supply a catastrophic policy at a higher medical loss ratio. That’s more value relative to cost for you.
The case for catastrophic-only insurance part 3 Selection makes catastrophic insurance a better deal – Comprehensive insurance attracts people who expect to have more health care. It’s premium will rise accordingly. (Assumes competitive market for insurance.) – Catastrophic-only insurance will have a less risky pool, so the cost per member will be less, and the premium will closer to an average person’s expected payout plus administrative cost.
Irony of pre-existing condition exclusions Selection by the company overcomes buyer selection and enables lower-risk people to buy comprehensive insurance at an appropriate price.
The case against catastrophic-only insurance, part 1 Bargaining power and market knowledge – The administrative cost argument assumes the insurance company will pay the same prices for services that you will. As a mass buyer, however, the insurer (private or public) may get a better prices than you can. This should mean a lower premium for you, and lower total expected health care costs for you. – The doctor, as your agent, as supposed to charge you a fair price. The insurance company handles lots of bills and knows what’s customary. “Trust, but verify.”
The case against catastrophic-only insurance, part 2 Billing individuals has administrative cost, more per bill than billing a big insurer. Big savings if you don’t bill patients. – In Canada, hospitals operate on lump-sum annual payments from government. There are no patient copayments. Hospitals there have tiny billing departments, only to charge foreigners. The paperwork cost reduction is substantial.
The case against catastrophic-only insurance, part 3 Tilts incentive away from primary care – If you have to pay for your car’s oil changes, but will get a new engine for free if needed, will you stop changing your oil? – Do people think like that regarding medical care? Getting a new tooth or new lungs is a lot of trouble, even if you don’t have to pay. – On the other hand, it’s tempting to be short- sighted When the big dollars flow, moral hazard is back.
The case against catastrophic-only insurance, part 4? The selection problem can be solved two ways: 1.Make insurance mandatory and community rated – Which is a further departure from the free market 2.Fine tune risk adjustment of premiums to each person’s riskiness – Provide information to make the free-market work better (but that has costs – like people avoiding getting diagnosed)
… which leads to another free market optimality condition violated 3)… that you can buy anything you need
In a free market for insurance … … there will be a range of coverage options – high or low copayments – stricter or looser exclusions People with risks will pay more for their insurance – By flocking to more comprehensive plans, which raises the average cost of those plans – By paying risk adjusted premiums
Non-marketability of risk insurance You can’t buy insurance against having a risk – in a free competitive market Having a risk identified is a financial catastrophe You might be willing to pay to cover that risk, but you can’t.
Risk insurance example You can buy: Insurance that pays for treatment if you get cancer. You can’t buy: Insurance that will pay you if you need more money to pay for your health insurance because you have a family history of cancer.
Solving the lack of risk insurance? Put everyone on Medicare Mandate that everyone buy insurance – While prohibiting risk adjustment of premiums or coverage (no “pre-existing conditions” conditions) Either takes us further from the free market
Mike Huckabee at the Value Voters Summit – Sept. 17, 2010 “… from a common sense perspective …” = “unencumbered by the thought process” http://sambaker.com/Econ/Clips/Huckabee.m p3 http://sambaker.com/Econ/Clips/Huckabee.m p3 Fries 1993 and Richter 2009 – distractions in the health reform debates
External benefits of health care Another free market condition violated 4)No external costs of benefits Already talked about external benefits of immunizations – the herd effect – In a free market, too few people might get immunized
External benefit of health care – Normative and positive economics intertwined People (except Rush Limbaugh) have “concern for the health of others.” If you can’t buy the health care that I think you need, I get sad. If you get the health care that I think you need, I’m happier. A free market would provide less health care than what would make everybody happy
External benefit of health care – Normative and positive economics intertwined A free rider problem: – I’m happier if others get health care, but I’m also happier if someone else pays than if I pay. – The external benefit to me justifies taxing me to help pay for others’ health care – But what about Rush Limbaugh, who doesn’t care. He gains no external benefit, so should he be taxed anyway?
Can there be market justice in health care? – Information – Moral hazard – Impossibility of risk insurance – External benefits These are all efficiency issues Not just fairness issues
Conclusion: There will be a healthy dose of societal intervention in health care. No society can tolerate leaving health care to the free market. Providers developed our health care system. It has evolved since, through market forces, into a mess that is not efficient or equitable.