CHAPTER 9 The Health Care Market McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

U.S. Expenditures of Selected Goods and Services as Share of GDP (1960-2007) Source: US Bureau of the Census [2009, pp. 95, 425], and National Income and Product Accounts

Social Insurance Social insurance - government programs that provide insurance to protect against adverse events Examples Medicaid Medicare Social Security Unemployment Compensation

How Health Insurance Works Insurance premium Expected Value Expected value (EV) = probability of outcome 1) * (Payout in outcome 1) + probability of outcome 2)*(Payout in outcome 2) + … + (probability of outcome n)*(Payout in outcome n)

Expected Value Computation Draw cards from deck of cards Draw heart and receive $12 Draw spade, diamond or club and lose $4 Probability of drawing heart = 13/52 = ¼ Probability of drawing spade, diamond or club = 39/52 = ¾ EV = (1/4)($12) + (3/4)(-$4) = $0

Actuarially Fair Insurance Policy Why Buy Insurance? Insurance Options Income Probability of Staying Healthy Probability of Getting Sick Lost Income if She Gets Sick (A) (B) (C) Income if She Stays Healthy Income if She Gets Sick Expected Value Option 1: No Insurance $50,000 9 in 10 1 in 10 $30,000 $20,000 $47,000 Option 2: Full Insurance ($3,000 premium to cover $30,000 in losses Actuarially Fair Insurance Policy

Why People Buy Insurance UB Utility D UD UC C Expected Utility Risk Smoothing A UA Income 20,000 47,000 50,000

Do People Buy Insurance with Loading Fees? Risk Aversion Risk Premium Loading Fee

The Role of Risk Pooling Insurance in a small population Insurance in a large population Law of large numbers

Adverse Selection in the Health Insurance Market Asymmetric information

Asymmetric Information and Adverse Selection   (A) (B) (C) (D) (E) (F) Expected Benefit Probability of Lost Income Expected Minus Premium Insurance Buyer Getting Sick if Sick (Differential Premiums) (Premium = $3,000) (Premium = $4,500) Emily 1 in 5 (High Risk) $30,000 $6,000 $0 $3,000 $1,500 Jacob Emma Michael Madison Joshua 1 in 10 (Low Risk) -$1,500 Olivia Matthew Hannah Ethan Insurer's Net Profits -$15,000

Does Adverse Selection Justify Government Intervention? Experience rating Experience rating and equity Community rating

Insurance and Moral Hazard Deductible Co-payment Co-insurance

Moral Hazard Flat-of-the-curve medicine Price per unit deadweight loss b Sm Axes and labels 1st click – Dm 2nd click – Sm, 3rd click - brown rectangle 4th click - .2P0 5th click - gray rectangle 6th click – deadweight loss triangle 7th click – “Flat-of-the-curve medicine” P0 h .2P0 Dm M0 M1 Medical services per year

Additional Considerations The Elasticity of Demand for Medical Services Does Moral Hazard Justify Government Intervention? Third Party Payment

Other Market Failures in the Health Care Market Information Problems Externalities

Do We Want Efficient Provision of Health Care? Paternalism The Problem of the Uninsured Who are the uninsured? Does health insurance improve health?

High Health Care Costs Source: Organization for Economic Cooperation and Development [2008a].

Causes of Health Care Cost Inflation The Graying of America Income Growth Improvements in Quality Commodity Egalitarianism