1. How insurance affects the demand for medical care
Richard Hirth

2. Ideal health insurance structure
Insurer observes health state
Cash payment based on health state
Set to equate marginal utility of income across all possible health states; thus, large payments made (income transfers) for health states in which expensive care is highly productive
Insured can spend the payment on whatever they please; thus, no distortion of prices
Not feasible because health state cannot be perfectly observed; thus, insurance contracts “pay off” by lowering price of care and dollar value of the pay off depends on amount of care

3. How insurance affects the demand for medical care
Demand is influenced by incentives created by the insurance-
induced reduction in the price of care to the consumer
“Traditional” FFS insurance:
 Can impose cost-sharing
 Does not directly “manage” care (UR,
selective contracting, provider incentives)
 Examining the potential and limitations of
traditional insurance helps clarify the rationale
for managed care

4. A. Many HI plans (both traditional and managed)
employ copayments (coinsurance)
 Enrollees pay a fraction of the price of care
 Encourages some cost-sensitivity when seeking
care or choosing a provider
 Higher copayment  more incentive to remain
cost-conscious, but more financial risk. Thus,
the fundamental trade-off in traditional insurance
is incentives versus risk sharing.

5. For coinsurance rate c:
 Patient pays cpm for a unit of care
 Insurer pays (1-c) pm
 Slides the consumer down her demand curve from
A to B. Consumer behaves as if the price of care
had fallen to cpm.
For coinsurance rate c: P Pm
cPm • A B Q D
Figure 1

6. Translating “sliding down” the uninsured D curve
into a “with insurance” D curve:
1) Start with the no insurance D curve. This shows which
P (actually paid by the consumer) leads to any particular Q.
2) For each Q, find the P where out-of-pocket price with
insurance = P on the no insurance D curve
 Uninsured consumer buys Q=10 units at P=$20
 If C=.2, she would buy Q=10 at P=$100
 This is one point on the insured D curve
3) Connect the “with insurance” Ps and Qs to get the “with
insurance” D curve

7. • • Translating “sliding down” the uninsured D curve
into a “with insurance” D curve (cont’d.): P •
$100
D with insurance •
$20
D no insurance 10
Figure 2

8. An alternative way of translating an uninsured
D curve to an insured D curve:
 Uninsured D curve represents 100% coinsurance (c=1)
 With full insurance (c=0), demand for care would be
perfectly price inelastic (vertical)
 D curves with 0<c<1 can be determined by rotating the
no insurance D curve around the Q intercept towards
the full insurance D curve. Insured D curve becomes
steeper (less P elastic) as the copayment falls.
If health care markets are not perfectly competitive, how will insurance influence prices and profits?

9. • • Creating a “with insurance” D curve P D full insurance $100
D no insurance
$20 • A 10 15 Q
Figure 3

10. B. Indemnity insurance pays a fixed $ amount per
unit of care
 To see the effect on the D curve:
• Suppose an uninsured consumer buys 10 units of care
at p=$40
• Indemnity pays $80 per unit regardless of the price of
care
• If p=$120, consumer faces out-of-pocket p=$40 and
demands Q=10;
• Insured D curve shifts up by the amount of the
indemnity payment
How do incentives to “price shop” differ under an indemnity
Policy vs. a policy with coinsurance?

11. B. Indemnity insurance pays a fixed $ amount per
unit of care (cont’d): P
$120
$100
D indemnity
$40
D no insurance
$20 10 20 Q
Figure 4

12. C. Deductibles imply that the consumer faces
different prices at different quantities:
 e.g., $500 deductible and 20% coinsurance; p=$100
 Effects of deductible depend on the level of illness:
• For minor illness, deductible > expenditures, so the
consumer faces the full price of $100
• For serious illness, expenditure > deductible, so the
price of the marginal unit of care is only $20
 Effects of deductibles also depend on time (January 1
vs. December 31) and health status

13. C. Deductibles imply that the consumer faces
different prices at different quantities (cont’d.): P D
Minor illness D
Severe illness
$100
$20
Out-of-pocket price 5 Q
Figure 5

14. D. Maximum payment provisions are the opposite of deductibles
 If policy limits coverage to $100,000 (or to
30 days of inpatient care), I face a low price for
small amounts of care, but a high price for high
levels of care

15. Why should we care about the demand for
Medical care? (or “Demand” vs. “Need”)
If we’re concerned about utilization by a population, it is
important to understand how demand is determined
 A policy analysis based on the concept of ‘demand” can
yield different results than one based on the concept of
“need” (“need” = amount of care that “experts” believe
some person or population should have)

16. Several policies have been shaped by
need-based analyses:
1) Hill-Burton Act
 Subsidies for hospital construction predicated
on a standard of 4.5 beds per 1000 population
 Since “need” is independent of price, it is
represented by the vertical line at 4.5 beds/1000
 Residents of an area with D1 would have to be paid
to consume as much inpatient care as they “need;”
subsidies to build capacity to 4.5/1000 would be
wasted

17. Hill-Burton Act (cont’d.)
 Residents of an area with D2 would only consume what
they “need” at a price of p*
“need” P* D1 D2
4.5
beds/1000 pop.
Figure 6

18. Hill-Burton Act (cont’d.)
2) Health workforce policies
Step 1: Forecasts of physicians needed to serve the
population (based on expected #s of people with
various diseases and assumptions about optimal care)
Step 2: Compare to actual # of physicians (given existing
trends) to calculate future surplus or shortage
 These forecasts were important determinants of
policies such as subsidization of medical schools
 In response to errors generated by a need-based
approach, recent workforce forecasts have been
based at least partly on the concept of demand

19. The moral of the story: Even if you believe that people’s preferences
(as expressed through D curves) should be over-
ridden in favor of expert opinion about “need,”
you’ll still need to know about the determinants
of D to get them to consume what you think
they need

20. Empirical studies of the demand for medical care
P elasticity of D for medical care determines how insurance
affects the quantity of care demanded:
 Price faced by the consumer is pc = pm*c
 1% increase in either pm or c results in a 1% increase in
out-of-pocket price
 Many attempts to estimate the price elasticity of D:
• Estimates all over the place (0 to -3)

21. Methodological limitations:
 Need to observe consumers who face different Ps
• Same person, P changes over time
• Different people facing different Ps at one point
in time
 Studies often use insurance coverage as the source of
P variation
 Biased elasticity estimates (people who expect to
consume more medical care enroll in more generous
health plans, causing the observed relationship
between insurance coverage and utilization to include
both the pure response to price and a “selection effect”)

22. RAND Health Insurance Experiment (HIE)
 Patients randomly assigned to different levels of coverage
to allow estimation of the pure price effect
 6 sites including one with a staff model HMO
 Enrollment ; 3-5 year follow-up
 C varied from 0 to 0.95, $1000 out-of-pocket maximum

23. (see handout for details):
RAND HIE: Key results
(see handout for details):
 Cost-sharing matters (expenses fell 30% when c went
from 0 to 0.95)
 Few health consequences of marginal utilization
 P elasticity of demand overall in the range of -0.1 to -0.2
 Income elasticity 0.2 for outpatient, 0 for inpatient
 Cost-sharing reduced utilization of care deemed “effective”
as much as care deemed “ineffective;” are patients
good rationers?