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

9-2 U.S. Expenditures of Selected Goods and Services as Share of GDP ( ) Source: US Bureau of the Census [2009, pp. 95, 425], and National Income and Product Accounts

9-3 Social Insurance Social insurance - government programs that provide insurance to protect against adverse events Examples –Medicaid –Medicare –Social Security –Unemployment Compensation

9-4 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)

9-5 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

9-6 Why Buy Insurance? Insurance Options IncomeProbability 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 $50,0009 in 101 in 10$30,000$50,000$20,000$47,000 Option 2: Full Insurance ($3,000 premium to cover $30,000 in losses $50,0009 in 101 in 10$30,000$47,000 Actuarially Fair Insurance Policy

9-7 Why People Buy Insurance Income Utility 20,000 47,00050,000 UAUA UCUC UDUD UBUB D C B A Expected Utility Risk Smoothing

9-8 Do People Buy Insurance with Loading Fees? Risk Aversion Risk Premium Loading Fee

9-9 The Role of Risk Pooling Insurance in a small population Insurance in a large population Law of large numbers

9-10 Adverse Selection in the Health Insurance Market Asymmetric information

9-11 Asymmetric Information and Adverse Selection (A)(B)(C)(D)(E)(F) Expected Benefit Probability ofLost IncomeExpectedMinus Premium Insurance BuyerGetting Sickif SickLost Income (Differential Premiums)(Premium = $3,000)(Premium = $4,500) Emily1 in 5 (High Risk)$30,000$6,000$0$3,000$1,500 Jacob1 in 5 (High Risk)$30,000$6,000$0$3,000$1,500 Emma1 in 5 (High Risk)$30,000$6,000$0$3,000$1,500 Michael1 in 5 (High Risk)$30,000$6,000$0$3,000$1,500 Madison1 in 5 (High Risk)$30,000$6,000$0$3,000$1,500 Joshua1 in 10 (Low Risk)$30,000$3,000$0 -$1,500 Olivia1 in 10 (Low Risk)$30,000$3,000$0 -$1,500 Matthew1 in 10 (Low Risk)$30,000$3,000$0 -$1,500 Hannah1 in 10 (Low Risk)$30,000$3,000$0 -$1,500 Ethan1 in 10 (Low Risk)$30,000$3,000$0 -$1,500 Insurer's Net Profits $0-$15,000$0

9-12 Does Adverse Selection Justify Government Intervention? Experience rating Experience rating and equity Community rating

9-13 Insurance and Moral Hazard Moral hazard Deductible Co-payment Co-insurance

9-14 Moral Hazard Medical services per year Price per unit DmDm SmSm M1M1 M0M0 0 P0P0.2P 0 a b h deadweight loss Flat-of-the-curve medicine

9-15 Additional Considerations The Elasticity of Demand for Medical Services Does Moral Hazard Justify Government Intervention? –Third Party Payment

9-16 Other Market Failures in the Health Care Market Information Problems Externalities

9-17 Do We Want Efficient Provision of Health Care? Paternalism The Problem of the Uninsured –Who are the uninsured? –Does health insurance improve health?

9-18 High Health Care Costs Source: Organization for Economic Cooperation and Development [2008a].

9-19 Causes of Health Care Cost Inflation The Graying of America Income Growth Improvements in Quality Commodity Egalitarianism