Graduate Health Economics: Background, Theory and Practice

Transcription

1 Graduate Health Economics: Background, Theory and Practice Pierre Thomas Léger 2013 Abstract In this document I present an overview of demand-side and supplyside topics in Health Economics. More specifically, I examine the different players in the healthcare market (from consumers/patients, to physicians, to insurers, to regulators) and discuss their objectives, their interactions and choices, and ultimately their welfare (along with their empirical counterparts). It is hoped that this broad and concise overview of topics facing Health Economists and policy makers alike may provide a source of useful information for students and newcomers to the subject. Contents 1 Introduction 3 2 Arrow and the Healthcare Markets Healthcare Market Takeaways The Grossman Model of Healthcare Consumption Grossman Model Takeaways:

2 4 Insurance The Cutler and Zeckhauser Model Consequences of the Absence of Information Ex Post Moral Hazard The Blomqvist Model RAND Health Insurance Experiment RAND Health Insurance Experiment Experimental Design RAND HIE Results Limitations of the RAND HIE and Further Work Insurance Takeaways: Healthcare Decision Making and Other Ine ciencies of Healthcare Provision Introduction Concerning Physician Healthcare Decision Making Physician Incentives in Service Provision Excessive Consumption Under Full Information and Limited Competition A Basic Model of Service Provision, Fee-For-Service and Supplier- Induced Demand Empirical Studies of Supplier-Induced Demand Other Issues and Results about Fee-for-Service A Basic Model of Service Provision and Capitation A Mixed-Payment System A Mixed-Payment Model Model Setup A mixed-payment model and competition Healthcare Decision Making Takeaways:

3 6 Conclusion 49 3

4 1 Introduction Today healthcare spending tops 10% of GDP in many countries around the world and continues to grow (both in absolute and percentage terms). These high and rising costs have compelled researcher and policy makers alike to consider ways in which to improve e ciency and ultimately bend the cost curve. Yet the size and growth of healthcare spending is not the only reason this market deserves special examination in the wider economic context. As argued by Nobel Laureate Kennet Arrow in his 1963 paper Uncertainty and the Welfare Economics of Medical Care, healthcare markets are ridden with a series of complexities that may lead competitive markets to be ine cient (i.e., not Pareto Optimal) 1 and hence warrant some sort of government intervention or regulation. 2 In this document, I provide an overview of health and healthcare economic research and findings starting with Arrow s work. Next, I turn my attention to specific players in the healthcare market (from consumers/patients, to physicians, to insurers, to regulators, etc.), their objectives, their interactions and choices, and ultimately their welfare. I then review both theoretical models of patient-provider-hospital-insurance interactions and their empirical counterparts, in order to provide a broad and concise overview of topics facing health economists and policy markers today. 2 Arrow and the Healthcare Markets Central to Arrow s analysis of healthcare is the link between competitive markets and Pareto e ciency. As is well known, under certain established conditions, 1 For example, Rotschild and Stiglitz (1976) show that insurance markets may su er from important problems of adverse selection in the presence of information asymmetry. More specifically, the insurance market may not be able to provide each individual with actuarially fair insurance and may collapse all together. 2 An interesting overview is provided by Reinhardt (2001) 4

5 competitive markets lead to outcomes that are Pareto e cient in the sense that no one can be made better o without making someone worse o - and is known as the The First Theorem of Welfare Economics. 3 Arrow discusses each of these conditions (including perfect and symmetric information, unregulated prices and no barriers to entry), specifically in the context of healthcare and argues that so many of these conditions are likely to be violated that the First Theorem is unlikely to hold. He also carefully points out how non-market mechanisms, such as trust and professionalism, may be used to compensate for potential market failures in healthcare markets. Arrow discusses many of the conditions that are likely to be violated in the healthcare markets, including perfect and symmetric information, unregulated prices and no barriers to entry, while pointing out their likely e ects. Among the most important assumptions unlikely satisfied in the healthcare market is perfect and symmetric information. In fact, both are likely to fail on a variety of dimensions. For example, physicians are likely to have better information about the patient s illness, potential treatments and their likely benefits and side-e ects. Patients, on the other hand, are likely to have private information about their symptoms, medical history, behaviours and willingness to pay for treatments. Hospitals are likely to have private information on the underlying costs of treatments and prices. Finally, patients and physicians may have greater information about the patient s needs for treatment, as well as treatment received, than the insurance provider. In such an environment, patients likely delegate some of their decision making to the provider while insurance providers may be stuck reimbursing on treatment provided (or reported) rather than on the e cient level of care. The lack of information on the consumer side can lead to important de- 3 It is important to note, however, that many Pareto-E cient outcomes may exists and that many of these may be undesirable on equity grounds (which in and of itself may justify government intervention). 5

6 viations from desired outcomes. More specifically, if physicians interests are not perfectly aligned with those of their patients (i.e., unless they are a perfect agent to the patient), then they are likely to make choices which increase their own welfare but come at a cost to their patients. The ability for patients to limit this type of behaviour (i.e., deviation from what the patient would chose for themselves if they were perfectly informed) is made di cult by the presence of uncertain illness-treatment-outcome relationships. That is, the variation in treatment outcomes makes it di cult, even post treatment, for the patient to judge the relevance and quality of the treatment they received (and ultimately their physician s quality). 4 Finally, Arrow discusses the role of insurance and how its presence (though welfare enhancing in general) may lead to ine ciently high levels of consumption and costs. Namely, insured consumers will wish to consume healthcare beyond e cient levels as they face a subsidized price at the margin. Ultimately this overuse, known as ex post moral hazard, drives up costs for all health insurance policies making insurance more expensive, less available to consumers, and less welfare-enhancing than it could be. Lastly, because prices are often regulated (and so do not equilibrate demand and supply), substitute means of rationing, from quantity limits to gatekeeping rules, may need to be implemented. 2.1 Healthcare Market Takeaways Competitive Markets are a useful benchmark to consider potential issues that exist in healthcare markets. Healthcare markets exhibit characteristics such as Asymmetric Information, Insurance, regulated prices and barriers to entry. 4 Goods whose characteristics (its value) are di cult to judge even after consumption are known as credence goods. 6

7 These deviations, or market imperfections, blur the line between competitive outcomes and e ciency. These deviations may require government intervention and regulation. In order to delve deeper in these aforementioned issues, one first needs to examine the individual players (or stake-holders) from patients to physicians. It is only by understanding each party s motivation and strategies that one will be able to to speak to whether proposed policies are likely to be welfare-enhancing. 3 The Grossman Model of Healthcare Consumption As a starting point to examining consumer behaviour and consumption in healthcare markets, I present Grossman s (1972) dynamic model of individual health capital and investment. 5 In his seminal paper, Grossman introduces several important concepts to the literature including the central idea that health is, at least in part, an endogenous variable. In his model, consumers continuously make decisions that a ect both their current and future health and consumption. Each decision involves di cult trade-o s which are likely to respond to both the individual s needs but also the economic environment in which they live. Grossman also points out that healthcare services are not, in and of themselves, desirable. Rather, individuals value their health which may be augmented through the purchase of medical goods ( known as derived goods). At the core of Grossman s model is a simple intertemporal utility maximization problem where consumers, who value both their health and consumption, make investments in health. Investments in health, in Grossman s model, serve 5 Unlike other types of human capital which may a ect a person s productivity (whether market or non-market), health capital is thought to determine how much time can be spent producing goods as well as the enjoyment one may yield from consumption in general. 7

8 to counter-act the natural decay to health (or health stock) that occurs with time (or, equivalently, with age). Furthermore, these investments in health can come from two sources: (i) formal investments from medical care consumption which can be in the form of medication or medical interventions, and (ii) time investments such as exercise. Finally, the consumer s ability to transfer these investments into true health is assumed to vary from one individual to another and is a function of such things as age and education. The results of the model should hold few surprises: increasing wealth and education increases healthcare consumption and health. What is novel here is that increasing health has two e ects on well-being: (i) the utility that a healthy person feels (i.e., ceteris paribus, individuals prefer being healthy to sick) and (ii) the e ect that being healthy has on available work time and thus on income and consumption. Grossman s analytical model allows us to untangle these di erent e ects. As will be seen shortly, the model also serves to make predictions about how health and the demand for medical care responds to factors such as wages and education (all of which have empirical counterparts). For instance, Grossman assumes that education is an important determinant of both the demand for health capital and the demand for health services. An increase in education is associated with an increase in the marginal e ciency of health capital and thus an increase in the optimal stock of health but is associated with a lower demand for health services (if the elasticity of demand is less than 1). Now let us formally consider Grossman s model. The consumer s utility is given by: U = U( t H t,z t ), (1) for t =0, 1,...,n and where health stock at time (or, equivalently, age) t is 8

9 denoted by H t with given health endowment H 0. In order to survive into the next period, individuals must maintain a minimum health stock (or H t H min ). An individual s health stock provides flows to utility by. Finally, Z t denotes consumption of a composite good. or The change in health stock over one period is simply investment minus decay, H t = H t+1 H t = I t t H t, (2) where t denotes the time-specific (or age-specific) decay rate (or H t+1 = H t th t + I t ). The gross investment in health I t is given by: I t = I t (M t,th t ; E), (3) where M t denotes medical goods while TH t denotes time-investments in health (such as exercise). How M t and TH t augment health depends, in part, on the patient s stock of human capital (or similarly, education) which is denoted by E. Muurinen (1982) augments the Grossman model to allow for increased health to also increase the individual s capacity to perform tasks. Finally, the production function of the composite (or consumption) good Z is determined by: Z t = Z t (X t,t t ; E), (4) where X t denotes material inputs while T t denotes time inputs. How material goods and time translate into consumable goods is also assumed to depend on the patient s human capital. 9

10 When making investment and consumption decisions (both for medical and composite goods), the consumer faces an intertemporal budget constraint which is given by: nx t=0 P t M t + Q t X t (1 + r) t = nx t=0 W t TW t (1 + r) t + A 0. (5) The left-hand side represents the present value of inputs while the right-hand side represents the present value of the stream of revenues. A 0 denotes the present value of non-labor income, while P t and Q t denote the prices of medical (M t ) and composite goods (X t ), respectively. Furthermore, W t stands for the wage rate, TW t denotes the hours of work, and r represents the interest rate. Finally, the patient is endowed with a given amount of time and faces the following time constraint: TW t + TH t + T t + TL t = (6) TL t = h t, (7) where TL t and TW t denote sick and work time, respectively. Finally, h t denotes non-sick time, which is simply total time minus sick time. By substituting in the time constraint, the budget constraint becomes: nx t=0 P t M t + Q t X t + W t (TL t + TH t + T t ) (1 + r) t = nx t=0 W t (1 + r) t + A 0, (8) where the left side represents total consumption while the right-hand side represents the present value of maximum income. More specifically, the budget constraint simply says that ones maximum income (that is, if every minute of time was spent working) can be used to purchase: (i) inputs and time to produce the composite good, (ii) inputs and time to produce health, and (iii) 10

11 sick time. The consumer s maximization problem is simply to purchase composite and medical goods (with corresponding time inputs) in order to maximize lifetime welfare subject to a lifetime budget constraint. Solving for the first order conditions (derivations not shown), the consumer s optimal decision is characterized by the point where the marginal cost of investment in health in period t 1 must equal the present value of marginal benefits, or MC It = G t apple W t (1 + r) t + Uh t, (9) where G t denotes the marginal product of health capital. This marginal benefit of health investments comes from both the ability to purchase more of the composite good (because of less time lost to sick time) as well as the direct benefit of health to utility. In addition to deciding how much to invest in health, the consumer must also decide where to invest! That is, the consumer must decide on how much investment should come from healthy time and how much should come from purchasing medical goods. The optimal choice is given by: MC It = P t 1 W t 1 = t 1 /@M t t 1 /@TH t 1 which simply equates the marginal benefits of the two types of investment to their marginal cost. Note that one of the interesting peculiarities of the Grossman model is that death is, for all intents and purposes, treated endogenously. That is, through investment decisions, consumers may (albeit under less than realistic parametrizations) be able to cheat death indefinitely. Not withstanding this limitation, the model can help one tract investment and health decisions made by individual 11

12 consumers over the life cycle. The model also allows one to compare di erent consumers at a given moment in time. For example, the model can help explain how di erent characteristics, such as a consumer s age or wage rate, can a ect investments in health and health status! To isolate the e ect of di erent exogenous variables (such as age and wage rate) on individual choices over the life cycle, and the channels in which they work, one can separately shut down (i) the direct e ect of health on utility, and (ii) the indirect e ect health has on income and consumption. Pure Investment Model in Grossman (1972) First, consider the pure investment model of health (i.e., where health has no direct e ect on utility) presented in Figure 3. In the figure, the horizontal line represents the cost of capital (which is independent of health stock and, as such, is perfectly elastic). Assuming the marginal-e ciency-of-capital (MEC) curve is downwards sloping, the optimal health stock at time (or age) t is given by H t. Next, I next consider the case where the depreciation rate is increasing in 12

13 0 age (i.e., t > 0). Notice that, if the depreciation rate grows su ciently large (namely, with each year lived, a patient s health degrades more and more), the patient will eventually die. This is simply because the resources necessary to sustain life outgrow resources available. This result does not, however, imply that health investments decrease with age. In fact, health investments are likely to increase with age (as the marginal benefit of health increases as the stock of health decreases). Rather, this simply implies that the necessary investments in health required to maintain a su ciently high level of health stock is outpaced by the degradation of health that naturally occurs as one grows older. 6 Notice that increases in the wage rate or human capital shift-out the MEC curve. That is, all else equal, individuals with more resources or, equivalently, those able to produce more health with a given amount of resources, will demand a greater health stock. The first result is to be expected as the cost of being ill increases with the wage rate. The second is also not surprising as increases in human capital (i.e., increases in E) allow patients to produce health more e ciently. Finally, consider the case where education is positively correlated with human capital and wages. Both higher wages and greater human capital lead to increases in the optimal health stock (i.e., Ht ). This does not imply, however, that it also translates into increases in investments in health. In fact, the net e ect can be either positive or negative. On the one hand, increases in an individual s wage rate increases the amount of resources available to increase health (which is a normal good). On the other, increases in human capital allow individuals to produce more health with fewer resources. So, if the income e ect dominates the human capital e ect then the educated person will consume more care. If, however, the e ciency e ect dominates the income e ect, 6 Older individuals may also invest more on healthcare goods if available resources increase with age. 13

14 then the more educated individuals will consume less care. Ultimately, the relationship between education and consumption of medical services is an empirical one. 3.1 Grossman Model Takeaways: Grossman presents an intertemporal model of consumer choice, where consumers value both their health and the consumption of other goods. Healthcare investments themselves are not valued, but rather augment health which is valued (both directly and through its e ect on consumption). Health stock continually decays and must be replenished with health investments. The rate of depreciation (or decay) likely increases with age and, as such, ultimately leads to death. Increases in the wage rate and human capital both lead to increases in the optimal level of health stock. Higher levels of education can be theoretically associated with both increases and decreases in investments to health. 4 Insurance One of the simplifying, yet not so innocuous assumption, of the Grossman model is the absence of uncertainty with respect to future health shocks (or illnesses). In reality, individuals face huge variations in disease and illness prevalence and severity, which itself translates into huge variations in medical expenditures within observationally equivalent patients. Furthermore, the distribution of 14

15 such medical spendings is highly skewed in the sense that a very small proportion of the population is responsible for a very large share of total medical expenditures. Thus, although severe illnesses may be quite rare, the potential expenditures associated with such rare events may be prohibitively large. It is, thus, not surprising that such uncertainty may have important implications on a person s optimal investment and consumption decisions over the life cycle. Finally, because individuals tend to dislike such uncertainty, private and public health insurance have developed as a mean to spread risk and improve welfare. I next consider a model of uncertainty, risk-averse consumers and insurance. Before doing so, I first review some of the stylized facts of health risks, consumption of medical services and insurance. First, evidence shows that illnesses (or, more broadly, health shocks) can be extremely costly to consumers. If consumers are lucky and avoid bad health shocks (such as illnesses or accidents), then they can enjoy good health and high consumption. On the other hand, if the consumer is unlucky and gets sick, then he or she will experience low health and lower consumption (as medical services must be paid for out-of-pocket). As consumers are generally risk-averse, reducing this risk is the role of health insurance. Table 1: Distribution of medical spending US 1987 (Berk) Share of distribution Cumulative share of spending (percent) Top 1 percent 30 Top 5 percent 58 Top 10 percent 72 Top 50 percent 98 Insurance reduces exposure from random shocks by spreading the risk across individuals. As mentioned above, this is particularly important for healthcare as the distribution of medical expenditures is not only high-variance, but also is greatly skewed. That is, a small proportion of individuals are responsible for a 15

16 disproportionally large portion of total healthcare expenditures (Refer to Table 1). Similarly, the risk of excessively large medical expenditures increases with age, highlighting the importance of taking dynamics into consideration. 7 Now, in developed countries most health expenditures are financed by health insurance. In the United States, this is accomplished by a mixture of private and public sources (Medicare, Medicaid, private employer-based insurance, etc) (see Table 2). In Canada and many other developed countries, the government plays a much larger role in providing and regulating insurance financed through general taxation. Table 2: Sources of Health Insurance Coverage in the United States Source Population Share % Payment Share % Medicare Medicaid Other Government 1 8 Employer Sponsored/Non-Group Uninsured 17 3 Not only can health insurance have important implications on healthcare consumption and financial resources left for general consumption as well as health, it can also have important implications in the labour market. This is especially true in countries like the US where health insurance is generally tied to employment and workplace. Tying insurance to the place of work may make unemployment especially costly and may limit mobility across jobs or into self-employment. In the next section, I examine specific models of insurance in order to highlight both its benefits and its potentially perverse e ect on behaviour and welfare. 7 Note that insurance may also be justified on equity grounds as a means to transfer income from the rich (and healthy) to the poor (and unhealthy) or to guarantee access to (costly) care independent of financial resources. 16

17 4.1 The Cutler and Zeckhauser Model Consider a simple model of healthcare consumption presented by D.M. Cutler and R.J. Zeckhauser (2000) in the Handbook of Health Economics. More precisely, consider a population of individuals who are ex ante identical, each facing a probability (1 p) of being healthy and p of being sick. Let d =0 if the individual is healthy and requires no care and d = 1 if the individual is sick and requires m amount of care (whose price is normalized to 1). 8 The individual s post-healthcare consumption is given by: h = H[d, m], (11) where: H[1,m] = H[0, 0]. (12) That is, patients are assumed to regain their pre-illness health after appropriate care. The individual s utility function is given by: U[x, h], where x represents general consumption (after healthcare expenditures are paid for) which depends on the presence and generosity of insurance. Referring to Figure 4.1, the uninsured individuals situation is characterized by point E (and its corresponding indi erence curve). By purchasing insurance at an actuarially fair price (i.e., where the consumer pays one dollar for k dol- 8 The amount of care needed and consumed is exogenously given without loss of generalizability. Endogenizing healthcare consumption is, nonetheless, quite simple to do (and it is examined specifically in later on). Setting a fixed amount of care at m when ill, however, abstracts from the possibility of ex post moral hazard (which is discussed in detail below). 17

18 lars when ill and zero otherwise such that p k + 1 = 0 or k = 1/p), the consumer can eliminate some or all risk. By purchasing full insurance, the consumer reaches his or her highest expected utility at point E and corresponding indi erence curve. Basic Model of Health Insurance Now, assume that consumers purchase insurance at an actuarially fair price. That is, individuals can pay a premium equal to expected healthcare expenditures (or = p m) in exchange for medical care when ill without any marginal payment (i.e., free). So, instead of consuming x = y when healthy and x = y m when ill, the insured consumer s consumption is invariant to the presence of illness (i.e., x = y ). Consequently, the individual s expected utility without insurance (and defined appropriate care when ill of m) is given by: V N =(1 p)u(y, H[0, 0]) + pu(y m, H[1,m]), (13) 18

19 or V N =(1 p)u(y)+pu(y m), (14) or, taking a Taylor-series expansion, it approximates to: V N = U(y )+U 0 U 00 2U 0 (m ). (15) The individual s expected utility with insurance (and defined appropriate care when ill of m) is given by: V I = (1 p)u(y,h[0, 0]) + pu(y,h[1,m]) (16) = U(y ), where = pm as before. Taken together, full insurance is better that no insurance if: V I = U(y pm) >V N =(1 p)u(y)+pu(y m). (17) Therefore, the value of insurance (i.e., the additional expected utility provided by insurance) is simply: V I V N = U 0 U 00 2U 0 (m ). (18) Essentially, insurance transfers income from healthy states to sick ones and from states of lower marginal utility of income to states where the marginal utility of income is higher. Referring again to Figure 4.1, the individual can purchase insurance at an actuarially fair price (i.e., according to the fair-odds 19

20 line where the individual pays 1 dollar and receives k dollars where k = 1/p) and achieves a greater utility at E (which is characterized by income which is invariant to illness). That is, the optimal insurance is full and is characterized by a simple state-contingent contract where the patient receives m dollars when ill and 0 otherwise. Finally, notice that the value of insurance increases with (i) the consumer s risk aversion (the first term being the coe cient of absolute risk aversion) and, (ii) the variance in income due to healthcare consumption (i.e., how expensive appropriate care is). 4.2 Consequences of the Absence of Information In contrast to the simple model above, the absence of information (or more specifically information asymmetry) may interfere with the e cient operation of an insurance market. One consequence of information asymmetry is adverse selection (discussed in detail below) where the insurer cannot observe many of the individual s characteristics which may a ect his or her future need for care (and associated costs). Another consequence of information asymmetry is moral hazard. To wit, the ability of consumers to alter their behaviour in an unobservable way to the insurer alters the costs of covering such a consumer with insurance. 9 Two di erent types of moral hazard that are important in the healthcare market setting can be distinguished: ex ante and ex post moral hazard. Ex ante moral hazard refers to the lack of prevention (an unobserved change in behaviour) that occurs when an individual is insured as they do not face the full consequence of becoming ill. Ex post moral hazard refers to the over- 9 One of the major negative e ects of insurance in the healthcare industry is the problem of moral hazard (over consumption because of a decrease in the net price of treatment). However, it may be di cult to di erentiate empirically between this e ect and the adverse selection e ect (the issue that people who anticipate large future consumption of healthcare are more likely to purchase insurance). 20

21 consumption that occurs when consumers face a subsidized price for care when they become ill. Insurance is an important issue as it generates a conflict between risk spreading and appropriate prevention/consumption. More specifically, greater insurance coverage (which is welfare-enhancing as it reduces risk) may lead to over consumption of medical services and less prevention (which is welfare decreasing as it increases the cost of insurance). In the next section I examine in detail the issue of ex post moral hazard formally and its consequence on e ciency in health and insurance markets Ex Post Moral Hazard In the above simple model of healthcare consumption under uncertainty and full information, the first-best insurance contract is a state-contingent one where the individual receives a payment when ill exactly equal to the cost of purchasing the illness-specific appropriate treatment. Augmenting this model to allow for a larger variety of illnesses, each with its optimal level of care, is simple and leads to a comparable results. Namely, under observable illness severities, the first-best insurance policy is an illness-contingent contract where each illness is associated with an insurance payment just equal to the cost of consuming the optimal or appropriate care for that specific illness (Arrow). 10 In order to see this, consider a model where the individual experiences a health shock s taken from a known illness distribution F (s). 11 The health production function is given by: h = H[s, m] whereillnessseveritys determines the optimal level of care m s. Finally, consider the case where the consumer can purchase actuarially fair insurance with co-payment c(m). That is, in exchange 10 By optimal care for a specific illness, one could either mean: (i) the medically appropriate treatment, or (ii) the level of treatment where the marginal benefit is just equal to its marginal cost. 11 Or, equivalently, a population with illness severity distributed by F (s). 21

22 for a premium, the consumer who purchases m dollars of care must cover c(m) while the insurance provider must cover m c(m). Given this, the insured consumer s expected utility is given by: Z V I = U(y c(m(s)),h[s, m(s)])f(s)ds, (19) where m(s) tells us how much care is consumed/purchased given illness severity severity s and where c(m(s)) and m c(m(s)) describe the costs borne by the consumer and insurance company at the time of illness, respectively. If illness severity is observable or costlestly verifiable, then one can simply define for each s the appropriate level of care m s (i.e., a state-contingent contract providing the optimal illness-severity dependent amount of care). This is perfectly equivalent to a state-contingent contract where each illness severity s is associated with a payment exactly equal to the amount required to purchase m s after which the patient can purchase care directly. Formally, if s is observable to the insurer, one can write contacts based on s rather than m(s). As such, the maximization problem simplifies to: Z max m(s) U(y c(s),h[s, m(s)])f(s)ds (20) subject to actuarially fair insurance = Z (m(s) c(s))f(s)ds, (21) with corresponding first-order condition: U H H m = Z U x (y c(s),h[s, m])f(s)ds (22) = E[U x ], (23) 22

23 or, equivalently, for every illness s, choose m s such that U H H m = U X. Although a first-best state-contingent contract is simple in theory, it depends on an assumption which is surely not to hold in practice, that is, that illness severity is observable to all parties and thus can form the basis of a contract. In reality, illness severity is not observable to third parties such as insurers (at least not costlestly). As such, writing state-contingent contracts based on illness severity s would be either unfeasible or prohibitively expensive. Because illness severity is unobservable, insurance providers must base their reimbursements on things that are observable such as the quantity of treatment provided or, even more simply, on the total cost of care consumed. However, reimbursing costs (partial or whole) yields equilibrium consumption of healthcare services which are not first-best. More precisely, reimbursing on costs (instead of based on the illness severity) will lead to excessive consumption of medical services (i.e., beyond the point where their marginal benefit equals their marginal cost) and correspondingly higher insurance rates. In order to highlight the issue, consider an insured patient who (i) purchases m care, and (ii) must pay c(m) for it. Once s is revealed to the individual, the patient chooses m(s) to solve: max m(s) U(y c(m),h[s, m]) (24) given s, which yields the following illness-specific first order condition: U h H m = c 0 (m)u x. (25) That is, conditional on illness severity s (which is observable to the patient and/or his physician), the patient should consume medical services up to the point where its marginal benefit is just equal to the consumer s marginal cost 23

24 (not the true marginal cost) of care. The e ect on insurance on over-consumption of medical services (through a subsidized price at the time of purchase) is known as ex post moral hazard. Now, I consider the case where s remains unobservable, but where the goal is, through an optimally chosen co-payment rate, to maximize the patient s expected utility taking into account consumer incentives at the time of purchase (i.e., subject to the presence of ex post moral hazard). E[U ] = Z max c(m MH ) U(y c (m MH ),H[s, m MH ])f(s)ds, (26) where = Z (m MH (s) c(m MH (s)))f(s)ds. (27) The optimal co-payment must balance the benefits from insurance with the costs associated with moral hazard. That is, by increasing the co-payment rate, excessive consumption is limited and insurance rates are lower (which is a good thing). However, increasing the co-payment rate decreases the benefits of insurance (which is a bad thing). The solution turns out to be non-linear. Namely, the level of reimbursement is a function of the level of expenditures (i.e., not a fixed proportion) and is mapped out in a related model by Blomqvist (1997) The Blomqvist Model Blomqvist recognizes that a large co-payment may be optimal for a majority of illnesses or cases (with corresponding small expenditures and potentially large moral hazard e ects), while a small co-payment may be optimal for the minority of illnesses or cases (with corresponding large expenditures, little moral hazard, 24

25 and issues of a ordability). That is, insurance generosity should depend on the level of expenditures - kicking in more generous reimbursements for severe and expensive cases where there may be little room for moral hazard, while providing less generous reimbursements for cases that are less expensive and where there is more room for excessive consumption. In order to show this, Blomqvist constructs a model where the patient s utility for a given illness severity is given by: u( ) =u(c, h ), (28) where c denotes consumption and h healthcare expenditures. The patient s consumption is given by: c = y m + z(h) h, (29) where y denotes state-independent income, m the premium and z(h) the reimbursement based on expenditures h. The F.O.C. w.r.t. h is: u h = u c [1 z 0 (h)] (30) which shows that the utility maximizing level of consumption of medical services is (i) illness-dependent and (ii) characterized by simply equating the marginal benefit of care to its marginal cost. What is novel here is the fact that reimbursements (and consequently out-of-pocket expenses in real and proportional terms) are non-linear and dependent on the level of expenditure. 25

26 4.3 RAND Health Insurance Experiment At the heart of the ex post moral hazard issue is to what extent individuals actually react to price changes when making healthcare consumption decisions. If consumers don t react much, then a low co-payment will be optimal. This is simply because the benefits of insurance can be had without the costs associated with ex post moral hazard (i.e., the unsubsidized price leads to similar consumption as the subsidized one). If, however, consumers do react to price changes, then co-payment will have to strike the right balance between riskprotection and e cient consumption. Ultimately, the question is an empirical one and answering it is far from trivial. In order to see if individual choice of medical care consumption is price sensitive, one could consider estimating the following log-level healthcare consumption (or, equivalently, expenditures) regression: ln(cons i )= X i + 2 Ins i + " i, (31) where X denotes a vector of risk-adjustors and Ins denotes the presence or generosity of insurance and " a standard error term. 2, thecoe cient of the variable of interest, represents the price/insurance elasticity of consumption of medical services. Running the above model using almost any cross-sectional data will yield positive estimates for 2. That is, individuals who purchase healthcare insurance (or who purchase more of it) spend more on healthcare than those who do not (or who purchase less of it). Although this may lead some to conclude that insurance generosity leads to more consumption, the relationship could go the other way. Namely, individuals who are at greater risk of large expenditures (i.e., and anticipate these large expenditures) may be more likely to purchase insurance or purchase a more generous policy. More accurately, estimating the 26

27 above regression will be problematic if individuals base their insurance decisions at least in part on factors that (i) are unobservable to the econometrician and (ii) are related to future care consumption. If one is unable to control for these unobservable factors, then one cannot credibly interpret of demand or a measure of moral hazard as the price elasticity In order to estimate a causal link between insurance generosity and healthcare consumption (or the presence and extent of ex post moral hazard) the RAND health insurance experiment (HIE) randomized individuals across different generosities of insurance in order to break the link between insurance generosity and the aforementioned unobservable factors. (See Manning et al. (1987) for details and Newhouse (1993) for summary of all of the results). The experiment had five major goals: 1. To estimate the price elasticity of demand for healthcare services. 2. To see if and how price elasticities are a ected by such things as income. 3. To see if and how price elasticities varied across di erent services (elective, emergency, pediatrics). 4. To estimate the link between price elasticities and health outcomes. 5. To see if and how results change in the presence of managed care RAND Health Insurance Experiment Experimental Design From 1974 to 1977, a large group of Americans were randomly sorted into one of fourteen fee-for-service (FFS) programs and one managed care (MC) pre-paid plans. FFS plans di ered in their co-payments (the percentage of medical costs 12 Another problem with many non-experimental studies is that, even in the presence of an exogenous shock on insurance status, they tend to estimate the e ect of average prices rather than marginal prices on consumption. 27

28 patients paid) and in their maximum out of pocket expense (stop-loss). 13 The experiment ran in six di erent cities with some programs running for three years and others five. Because patients were compensated up-front for their maximum out-of-pocket expenses, estimates are net of any potential income e ects. Although endogeneity issues are eliminated by the random assignment of di erent insurance generosities (i.e., di erent co-payments), several other issues are worth considering. Among these is the fact that many individuals do not consume any medical services, while a small number consumes a large part (i.e., the distribution of consumption has a mass-point at zero and is highly skewed). The initial RAND HIE Study is estimated using a four-equation model: (i) a probit equation on positive expenditures, (ii) a probit equation on expenditures of in-hospital care, (iii) a linear probability model of non-hospital expenditures (conditional on positive expenditures), and (iv) a linear probability model of in-hospital expenditures (conditional on positive hospital expenditures) RAND HIE Results Results from the RAND HIE show that higher co-pays (i.e., less generous insurance) lead to less inpatient and outpatient care and less expenditures in general. For example, moving from the the Free Plan to the 25% Plan (with stoploss of $1000) resulted in 27% less visits, 18% less inpatient admissions, and 15% lower expenditures for the average consumer The results also show that the co-payment amount a ects the decision to seek 13 Astop-lossprovisionissimplythemaximumout-of-pocketexpendituresduringagiven period (typically a year) a consumer is responsible for. 14 Note that the experiment did not look at the e ect of a change in the marginal cost of healthcare (from the patient s perspective) but rather average cost (i.e., they were not able to separate the marginal cost e ect from the stop-loss). 15 Results are somewhat di erent for children where increases in co-payments did not change the likelihood of a hospital admission, suggesting that parents are quite price inelastic when it comes to hospitalization decisions for their children. 16 Estimates show that consumers are less elastic when it comes to emergency care than for other types of care (possibly in part because the decisions are essentially out of their hands). 28

29 care but has little e ect on the amount of care received conditional on having sought care. This suggests that, once patients are under the care of a physician, they have little e ect on the quantity of care provided and consumed. E.B. Keeler and J.E. Rolph separate the e ect of the co-payment from the stop-loss and find a pure price-e ect elasticity of demand of approximately -0,2 (i.e., going from zero insurance to free care leads to about a doubling of expenditures). Although these results suggest that individuals are somewhat price elastic and ex post moral hazard may be a problem (although not a huge one), increasing prices (or, equivalently, increasing the co-payment patients face) may come with unwanted consequences. More specifically, these reductions in healthcare may have negative consequences on health and, as such, may lead to greater need and expenditures in the future. The study considered only a few outcomes and only for a five-year window. 17 Consequently, the results remain mixed. On the one hand, higher co-payments (and subsequently lower consumption) do not appear to have much e ect on the health outcomes - although only a small number of outcomes were examined and only for a five year period. On the other hand, evidence suggests that individuals reduce e ective types of care as much as ine ective (or less valuable) types of care, which may have important long-term health e ects. The results also suggest certain specific groups were a ected negatively (in terms of their health) by the increased co-payments The RAND study also showed that decreases in outpatient services did not lead to increases in inpatient care (i.e., inpatient and outpatient appear to behave as complements not as substitutes). 18 Feldman and Dowd (1991) examines the possibility of over-insurance in the United-States (the idea that the moral hazard e ects are so large that its e ect on premiums outweigh their benefit). Blomqvist (1997) shows that the welfare implications of the level of insurance may be over-estimated by Feldman and Dowd s use of a constant co-insurance. 29

30 4.3.3 Limitations of the RAND HIE and Further Work As valuable as the RAND HIE has been, it nonetheless only provides a partial picture of the e ects of health insurance on consumption. That is, results from the RAND HIE only examine the e ect of changes in co-payment rates in an environment with no income e ect and a maximum out-of-pocket expense (stop-loss). As a result, it cannot speak to the e ect of providing insurance to individuals that are not covered (both on consumption of medical services and health outcomes). In order to investigate the true e ects of insurance, Finkelstein (2005) looks at how the introduction of Medicare insurance increased heatlhcare expenditures in a general equilibrium framework. More precisely, she examines the introduction of Medicare, a vast program applicable to a large portion of the population (age 65+), to compare the e ect it had on states that had di erent initial healthinsurance conditions (i.e., across states whose elderly population varied in their insurance status and generosity prior to the introduction of Medicare). Finkelstein explicitly considers the e ects that the introduction of Medicare had on the supply-side of the market (in the form of hospital entry) and on the already insured individuals (i.e., spillovers). She finds that the introduction of Medicare leads to large increases in hospital expenditures (37%) - half of which are due to hospital entry. Aggregately, her results show that half of the increased spending in healthcare from 1950 to 1975 is precisely due to the insurance expansion (i.e., Medicare). Another limitation of the HIE is its weak ability at identifying health improvements due to insurance. Although the HIE found only modest (to no) health benefits to insurance, the analysis was limited to only a small variety of conditions and outcomes. Futhermore, consumers in the HIE faced no income risk! In order to really get at the link between insurance coverage and 30

31 health outcomes, Decker (2005) uses the exogenous change in insurance status, that occurs at 65 when Americans become eligible for Medicare, in a regression discontinuity framework. More specifically, she looks at breast cancer in populations likely to be uninsured at 64 and compares them to a similar group of individuals who are 65 and covered by Medicare. She finds that insurance (i.e., Medicare) increases the use of mammography and has a modest negative impact on the probability of a late-stage breast cancer diagnosis for certain sub-groups (more precisely, whites and hispanics). A further limitation of the RAND HIE is its timeliness or lack there of. A new randomized health insurance experiment that recently took place in 2008 in Oregon where insurance was randomly assigned (by lottery) to certain poor noninsured individuals (i.e., to its Medicaid program). Striking preliminary results from Finkelstein et al. (2012) show that Medicaid increased the likelihood of a hospital admission by 30 per cent (mostly driven by non-emergency room admissions). It also increased the likelihood of outpatient care and pharmaceutical use by 30 and 15 per cent, respectively (but no e ect on the use of emergency care). Although results suggest important improvements in self-assessed health and depression. It also increased the likelihood of diabetes screening and diagnosis. It did not, however, appear to have any e ect on a series of objective health measures like blood pressure and cholesterol levels. Finally, it did have some e ect on preventive screening suggesting positive health e ects may appear in the long-term. 4.4 Insurance Takeaways: Health insurance finances the majority of healthcare consumption in the developed world and often provides access to expensive forms of care. Asymmetrical information may results in two kinds of distortions in the 31

32 insurance market: Adverse Selection and Moral Hazard. Adverse selection occurs when the insurer cannot observe the consumers characteristics (i.e., hidden characteristics) which are related to future healthcare expenditures and thus is unable to risk adjust appropriately. Moral hazard occurs when the individual modifies his or her consumption of medical services (i.e., hidden behaviour) in the face of insurance. Moral Hazard can come in two forms: ex ante and ex post. Ex ante moral hazard refers to the reduced level of prevention that occurs when individuals do not pay the full cost of care. Ex post moral hazard refers to the increased consumption of healthcare that occurs when consumers face a subsidized price. The RAND experiment suggests that high co-pays reduce patient expenditures by reducing the decision to seek care (and not the amount of care consumed conditional on having sought care). The RAND study suggests that reductions in expenditure from higher copays do not appear to have major health e ects (but failed to consider many conditions and long-term e ects.) Newer studies suggest that insurance increases healthcare consumption and prevention and may have important implications on several dimensions of health (like self-assessed and mental health) but not significant short-term e ects for several objective measures. 32