Lecture Notes

Health InsuranceI. The demand for Health Insurance

Definitions:Deductible: when the patient pays all the price for a

certain rangeCoinsurance: the insurer pays only part of the price,

the patient pays the rest Limits: coverage up to a maximum amount

Indemnity Insurance: reimbursement to the patient for medical costs (often fixed price per day in hospital)

Service insurance: reimbursement to the provider for medical costs

Impact of these on demand?

An economic theory of demand for health insuranceWhy do individuals choose to buy insurance

and how much? Budget constraint and preferences

Expected utility analysis Expected utility analysis Risk aversion

Suppose we have the following situation:1. an individual has $50,000 in money2. there is a 10% probability that the individual

will become ill and have to pay $25,000 for treatment.

=> 1 = “good” state 2 = “bad” stateLet Mg= money income in good stateMb= money income in bad state

Suppose you can insure against the loss For example: suppose you can buy $10 of insurance

coverage for $1 and that you fully insure against the loss.

10% change of => Mb = $50,000 – $25,000 + $25,000 – $2,500

Mb= $47,500 Mg= 50,000-2,500 = $47,500

Regardless of which state of nature occurs

Let Y = premium cost/dollar of coverageK= dollars of coverage=> in general..

10% change of getting $25,000 + K – YK 90% chance of getting 50,000 – YK

Now, contingent consumption N states of nature and consumption is contingent

upon which state of nature you’re in. If states are just different consumption bundles =>

consumer theory can handle it.

Mg

50,000

50,000-yk

Mb

A

B

$25,00025,000+ k -yk

A= EndowmentB= Full

How do you attain points where Mb > $50,000 –ykBy over-insuringIn essence by selling insurance– if such a choice is

possible which it may not beSlope = ∆Mg /∆Mb = -yk/k-yk = -y/1-y

Now look at utility function and indifference curves to talk about how individuals make choices.

But 1st, how do probabilities enter info utility? They should, shouldn’t they?

If Pg = .9 Pb =.1 (should get a different choice than if Pg= 1 and Pb = 0

Suppose m1, m2, m3 = income in states 1 and 2P1, P2, P3 = probability in states 1, 2, 3

2 definitions:Expected value = P1*M1, + P2*M2 + P3*M3. In

our example EV = (.9) (50,000) + (.1) (25,000) = 47,500

ExplainExpected utility = P1*u(M1) + P2*u(M2) +

P3*u(M3) +….Expected utility hypothesis: you choose that

option with the highest expected utility = weight of ability in difference possible states of nature.

Now when does an individual choose to insure?Assume that the premium is actuarially fair

(book calls pure premium) i.e. reflects the true probabilities so that in our

example must pay ten cents the dollar => premium = $2,500 = EV

1. Risk Aversion

u (m)

$25,000 47.5 50

Now look at two possibilitiesDon’t buy insurance => Euni = .9 u(50K) + .1

u(25K)Buy insurance => Eui = u(97,500)An individual is risk averse for when EU (ins) >

EU (no ins.)Or u (EU (g))

3 possibilities 1. EUNI < EUI => risk averse

2. EU(NI) = EUI => risk neutral

3. EUNI > EUI => risk lover

So depends upon the individuals shape (preferences) of utility of money curve

Risk lover

Risk averse

U

U

25 47.550

U (m)

U (m)

Have shown two things that matter in deciding whether to buy insurance1. Attitudes toward risk2. The insurance premium

U (m)

25 50 m

u

Risk averse individuals always buy insurance when the premium is actuarially fair as it was in our example.

Now, just look at risk averse individualsAnd look at the price or premiumEven with competition, insurance firms can ____

charge an actuarially fair or pure premiumWhy?

Suppose 10,000 individuals--- all the same with the same insurance Each pay $2,500 in premiums for a total of $25,000,000 10% of these individuals will incur losses of 25,000.

The company must pay out (25,000)(1,000) = $25,000,000

But it costs more money to provide insurance (i.e. transaction costs of gathering premiums, paying for losses, etc. Even if profit = 0 premium > pure premium

Q: Will a risk averse individual still insure?A: Perhaps

1st look at EV of the gamble = M3 => EU = U3 and willing to pay (M2-M4) at

most to insure the distance M3 – M4 = the additional amount willing to pay above the pure premium if prem >M2 – M4 => don’t insure

M1 M2M3M4

U3

U (m)

Implications of this Analysis1. as the probability of the loss gets larger => M3-

M4 gets smaller => less likely to buy insurance i.e. if you are sure to pay for the expense => not

willing to buy insurance. Why?2. As the probability of the loss gets smaller =>

M3-M4 gets smaller => less likely to buy insurance i.e. as you become more sure that loss will not occur

less likely to buy insurance. Why?3. As the magnitude of the loss decreases less

likely to buy insurance because M4-M3 decreases. 4. As an individual becomes more risk averse=>

more likely to buy insurance.

5. As the price of insurance increases => buy insurance for fewer events (less insurance) where price = amount willing to pay above pure premium.

0 1 line = amount person willing to pay above pure premium

AA = price of insurance (above fair premium (pure))

P1 P2

A

A

P

Rises assuming costs increases as the # of claims increases due to rising transaction costsIndividual only buys for P1 < Prob. < P2

If price increases => this interval gets smaller

6. The starting income of the individual At high income levels => MU low so less willing to pay

above fair premium At low income levels => MU is high again because the

distance between actual and EU is less This is wrong, at least the part about income levels

affecting the distance. It still may be true that lower income people are less likely to buy insurance but this is because of budget constraints not the distances between the curves.

Now look at the evidence: Tables 6.1 and 6.2We see

1. if prob. is low => use is low2. if prob. is high => use is low3. if magnitude is high => use is high4. if magnitude is low => use is low=> model predicts relatively wellThe above assumed that D for M.C. perfectly

inelastic once an illness occurs. Suppose its not. Moral Hazard: the tendency for insurance to

affect the individual’s behavior. i.e. the individual can affect the size of the loss under insurance.

Examples:1. fire insurance => less likely to install fire

alarms, smoke detectors2. Car insurance => may drive faster3. Health insurance => individuals may invest

in less preventative care. Why? Preventative care is not paid for but other care is. Other examples depends upon how the insurance is

set up

Look at 2 impacts of the moral hazard using Demand Analysis

Full Insurance Coverage: P=0 to consumer and buys Q = Q2 > Q*

This is inefficient since time cost is MC = P* at Q2 MB = 0 => MC >MBWith no insurance, individuals consume Q = Q* with P=P*

P*

Q* Q2 Q

MC = S

D

P

Is this behavior rational? Yes, individual is equating MB with MC = 0

Given that Q increases, what happens to the premium? Clearly, it must rise as well. Both because Q increases and because P increase if S is upward sloping.

SupposeP* = 1,000Q* = 10P2+ 2,000Q2 = 20Probability of illness = .2Assume moral hazard does not cause this to change

P2

P*

Q* Q2

D

S

With no moral hazard and no inefficient…Pure Premium = (.2) (1,000)(10) + (.8) (0) =

$2,000With moral hazard: pure premium = (.2)(2,000)

(20) + (.8)(0) = $8,000 Premium rises to pay additional costs

Q: Why don’t individually obserce? Increase insurance premium and stop increase QD?

A: 1st, individuals make choices on the margin. The effect of insurance is to decrease the MC to the individual 2nd: need to understand the concept that insurance

groups people together => by your decrease in QD you get very little benefit.

Implications of the Moral Hazard1. QD increases with insurance ( P increases as

well)2. Premium rises => fewer people insureRecall

P1 P2

A

A

P

P

P*

Q* Q1 Q2

S=MCA

BC

Look at 2 situations: 1st: Q1 < Q* => will always buy the insurance at the

pure premium. Why?2nd: Q1 > Q* => either don’t buy insurance an

consume at Q* or do buy insurance and consume at Q2

How do you decide? If you do buy… Pay P* x Q1 =>

Extra cost = (P*)(Q1-Q*) = area a + area c Extra benefit= Area under from Q* to Qz = Area c + Area

b =>But only if extra benefits > Extra costs OR if a + c < c + b or B > A

=> Deductibles do not reduce the amount of Q purchased if have insurance…just reduces the # of people who buy insurance.

2nd: Coinsurance

Pure premium: (P* -Pc)(Q1)(.2) < (P*)(Q2)(.2)Let Pc = coinsurance price => even with insurance

must pay some of the price1- Moral hazard problem is less2-pure premium is lower with coinsurance => more

people buy insurance

P

P*

Q* Q1 Q2

S

Pc

3rd: Prepaid plans like HMOs and PPOs focus on Drs and patient incentives not just patient thru coinsurane or deductibles.

Adverse Selection: Consider 2 groups of people1st group: prob. of illness =.82nd group: prob. of illness =.2Suppose that the insurance company cannot

distinguish between individuals in the 2 groups.Results?Assume equal number of individuals in both

groups=> company observes a group who prob. of illness =.5 and bases its premium upon that.

Let Mg = 10,000 MB = 2,000

Pure premium for Group 1 (high risk) = (.8)(8,000) =6,400 M = 10,000 -6,400 = 3,600

Pure premium for Group 2 (low risk) = (.2)(8,000) =1,600 M= 10,000-1600 = 8,400

u (m)

2,000 3,600

6,000 8400 10,000

u

m

Both would be willing to buy at average premium of $4,000 (m= $6,000)

In our graph, Group 2 does not buy but Group 1 will always buy. Why?

Group 2 may buy dependent upon several factors but most important is how different the risk levels for the 2 groups.

Conclusions:Adverse selection

1. causes fewer low risk individuals to buy insurance and more high risk individuals to buy

2. Premium must rise if this is true, more low risk individuals drop out

Controls?1. experience ratings but perfect experience

rations = no insurance.2. exclusions for pre-existing conditions3. decrease premium the longer insured4. unwillingness to pay deductible and

coinsurance may signal risk status

Conclusions for the Chapter1. forced coverage for all expenses is inefficient.

Both high and low prob. events should likely not be covered. Why? => 100% coverage not optimal

2. moral hazard and adverse selection problems:

3. Public Policy: National health insurance? Coerced coverage for all individuals discrimination

ded Co ins.

Major medical

% of ind.

Size of exp.

Other issues1. Differential Health Insurances

Suppose Health insurance reimburses hospital expenditures but not physician services

If decrease P of H => substitutes hospitals for Drs and inefficient since original iso-cost represented true costs.

This is a service policy => results in overuse of those services which are reimbursed.

Mc = mc*

Drs

Hosp.H* H1

D*

D1

An indemmity policy keeps the relative prices of the two goods the same since it reimburses for all medical expenditures

This does cause D more MC to increase but does not change relative prices => no technological inefficiency

Note: figure 6.9 indicates allocative efficiency but this is incorrect

H

Dr

MC = MC*

MC= MC1

Service benefit insurance creates more problems. i.e. inefficiency while indemmity insurance does not.

3 ProblemsIncreased use of insured servicesPoint where MP = 0Increase demand for quality which is inefficient

Tax AdvantagesHealth insurance as a fringe benefit is not

taxedLook at the individual who has two choices

1. Get a $300/month raise (BL2) 2. Get health insurance benefits (BL3) worth

$300/monthM + 300/PcM/Pe

M/Ph M + 300/Ph Health insurance

Q: Why ever choose (2)? Since it cuts off part of BL?

A: Tax benefits– suppose $300 is taxed but health insurance is not +> for 1 actually face BL4=> Plan 2 Makes everyone better off but does

cause inefficiencies since forces some individuals to use more health insurance…then optimal

Note: there is one type of ___ that may not be better off—the individual would choose no health care and depends on tax rate if ind. A would be better off

The Market for Health InsurancePublic Policy: 2 Questions

1. is intervention justified?2. what type of intervention?Efficiency in 2 senses

Supply Side: 1st- firm technological efficiency (use resources to

min. cost of production)2nd- Industry: does each firm produce at min point

on LRAC? [suppose not any reason why this might be okay?]

Demand SideAllocative efficiency MB=MC?Note: will basically take the same approach for all

the other markets as well.

A) Demand Market: Recall that market demand is determined by: 1. price of insurance 2. prob. of loss 3. magnitude of loss Income of the consumer Risk aversion

Price elasticity ~ -1 => increase P of 10%, decrease QD by 10%

Firm DemandLook at 3 different types of insurance

1. Blue Cross/Blue Shield= non profit2. other commercial plans= profit3. Independent plans= prepaid plans (HMOs); self

insurance; service contracts

Look at the changes embodied in table 11-2, p. 237

Trends: 1. increas in % of Pop. covered but slight especially in

later years 2. decrease in BC/BS and big increase in Independent =>market demand is relatively inelastic but firm

demand is elastic due to substitutes and competition

Differences in1. type of benefit2. price3. extent of coverage (Coinsurance,

Deductibles)4. reimbursement5. reputation

Predictions: 1. price will vary as the product varies 2. the product will change over time as pref. change

(or as costs change)

Now look at efficiencyIs there an information argument that

consumers find buying insurance inefficient since costly to gain information about competing co’s?

Probably not.1. large benefit item=> pays individuals to gain

info2. insurance often bought by groups and

cost/person of gaining information is less. => information probably not a problem (note

table 8-2 suggests it is for individual policies)

Now look at Benefit/Premium RatioBenefit = average benefit paid for by groupPremium= price of insurance for that group

If B/P ratio = 1 => premium = pricePremium:

If B/P ratio < 1 => price > pure premium as B/P ratio decreases, price increases

If industry competitive expect to see B/P ratio close to 1If monopoly=> B/P ratio would be lowLook at table 8-2 to see how this has workedNote: book concludes that a fair amount of competition

exists in the health insurance market, especially in the later years.

Community RatingWhy don’t we just put everyone into the same

basket, charge them the same premium and get the same benefit? = community ratingThis is what Blue Cross did

Problems:Suppose we have 2 large goals

1. efficiency 2. redistribution so low income individuals can afford

medical care Look at how community rating affects both of these

goals

Assume 2 groups: High risk and low riskWhat you are trying to do is cross subsidize the high risk

group. But 3 problems:1) Inefficiency: low risk will be paying too high a price

=> may choose to self-insure even though for cost they should not.

2) Is the high risk group the one that we want to subsidize?Blue Cross subsidized the old but are they low income?Evidence suggests that Blue Cross actually subsidized

the middle to high income. 3) Is community rating the efficient method of

subsidizing?No, because it distorts choices by others => just use

direct subsidies to achieve the goal. Competition ensured the demise of community rating.

Low risk groups would leave the Blue Cross system with more options and this is what happened.

The uninsuredLook at table 11.3 / 11.4 (p. 241-42)Why do people choose no insurance? What

does our theory tell us?P increase or decrease (prob.)Loading costsLack of competition

Working uninsuredBook discusses 3 major reasons

1. see figure 11.4 (p. 242)—Basically firm has limited exp. Rating => must pay i1 not i0 => can’t compete

2. Pre-existing conditions may keep out certain industries with high % of such people—Book discusses beauty shop workers (temporary, young, etc.)

3. AttitudesSolutions—mandated coverage?

Separate insurance from work

Conclusion:D relatively competitive especially in recent years =>

allocatively efficient2 points to support this: price is close to pure premium

and demise of community rating is probably a result of increased competition in the market.

B) Supply: look at 2 issues n determining the technological efficiency of production of health insurance 1. economies of scale = right # of firms in industry 2. each firm produces at min. cost

Note: in normal model, competition ensures these 2 things but may have (1) information problems and (2) non-profit firms like BC BS.

(1) Economies of Scale: book notes that there are many firms (> 1,000) in the insurance industry

Empirical evidence seems to suggest that costs/claim decreases as the insurance firm gets larger. This appears to be true for commercial firms and BC BS.

ProblemsHow do you measure costs?

General problems with all these quality and type of service varies => may get bias.

The type of policy matters as well For example: group v. individual policies. 2nd is likely to

be more costly to administer => may get additional bias.

(2) Internal efficiencyTheoreticalSmall information problems => Competition

and profit-max will result in internal efficiencyCurrently doesn’t exist in a large sector

especially w.r.t. BC & BS for 2 reasons: 1. BC & BS (BC est. by hospitals directly) have some

monopoly power (competitive advantages) due to: BC & BS non-profit => favorable tax treatment but

premium increases are regulated. [note: lost federal tax exempt status in 1986]

Blues do not compete with each other => legal collusive arrangement between them.

BC (hospital portion) receives a discount on hospital charges that most commercial insures do not. Why?

One possibility is that hospitals are trying to increase utilization of their expense services. BC provides more comprehensive coverage than most hospital plans. => monopoly power for BC & BSWhy don’t they just drive other, less

competitive firms out of the industry? Because they are not profit-max. They use their

competitive advantage to benefit others (by increased costs of production => inefficient)

Possibilities: Consumers - not much support for this Hospitals - some support for this Physicians - fair turnout of empirical support for this

Conclusion

1. Economies of scale exist

2. BS/BC may be internally tech. inefficient

3. However, increased competition in the past decade, especially by HMOs, etc. has decreased the ability of BC & BS to be inefficient => prospect for the future looks good.

Market Competition in Health CareBasically want to look at 2 issues

Why did competition evolve now and not before? What is the nature of the new competition?

I. Why did competition evolve?A. Impetus from several sectors of the market for

increased competition (+) Federal initiatives fueled by concern with rising

expenditures on Medicare => implemented several plans Increased supply of physicians by:

Subsidizing construction of new medical schools Subsidizing medical education for physicians and all

health professions => Increase competition among physicians by

increasing supply.

HMO acts decreased expenditures by stimulating HMOs1973 HMO Act

Employers with more than 25 employees had to offer HMO option in area

Federally qualified HMOs exempt from restrictive state practices

1979 amendment to CON legislation Loosened restrictions on building hospitals => HMOs

found it easier to build their own hospitals if desired. => increased comp. especially when hospitals

began to have excess capacity

Medicaid Changes- basically eliminated the patients right of provider choice => states could negotiate with “efficient” providers

New hospital reimbursement: DRGs talked about before. => decrease occupancy rates in hospitals, etc.Note: by this time, comp. already taking effect.

(2) private sector Basically business wanted to decrease costs of health

ins. Benefit programs for a number of reasons: recession, foreign competition, etc.

Solutions: self-insurance, deductibles and coinsurance, pressure on insurers for efficiency, insurance coverage for low cost substitutes for hospital care.

Impact:Business concerns translated into insurance

concerns. Why?Hospital utilization decrease => excess

capacity in hospitals developed [occupancy rate decreases]

=> hospitals became more willing to participate in alternate delivery systems

Note: the same kind of things had happened before but had not resulted in increased comp. Why? Anti-competitive practices by physicians.

=> of even more importance

(3) Application of anti-trust laws to health sectorPreviously not applied to health sector=> before

when above conditions held competition by such things as:Denying hospital privileges to participating

physiciansDenying licencesLimit advertisingWhy? Service industry exemption => decisions which

changed this recently. Goldberg vs. Virginia State Bar: price fixing not legal for

service industries 1978 Supreme Court denied the use of anti-competitive

behavior by engineers => service industry exemptions lifted or at least decreased

Advertising has 2 impacts on the market:1st- decrease price of medical care…Why?2nd- decrease variance of price of medical

care…Why?

1st: increase information available to the public => increase elasticity of any individual suppliers D Curve

Pna

Pa

MRA

Da

MC

P is higher with no advertising and lower with advertising

2nd- recall our theory of how consumer’s search for best quality and best buy.

Do it by spending resources. Get more variation in price for: large budget vs. small budget goods; when search costs are higher

=> advertising (as long as it contains info decrease search costs => get less variation in the price between difference producers)

2 impacts of Advertising1. consumers have info on different products price

and quality=> Decrease price in market because n increases/

2. decreased consumers search costs => decreased variation in prices

3rd possible impact is to remove barriers to entry for competing firms includes: new Drs and new HMOs/PPOs.

Pa Pna

Frequency

Price

Empirical Results appear to support the theory(1) P decreases (2) elasticity increases => more

substitutes. (3) variation decreasesAlso concern with negative effects of advertising

i.e. not informative but induces individually to buy more low quality services

But empirical work finds no reduction in quality of services with increased advertising (may even increase Quality)

Spillover effects on non-advertisers => P decrease in markets where some advertise even though all do not

P decreases even though quality does not => appears to be with reason for concern.

B) Competition from alternate forms of health care providers. Like HMOS/PPOs

Large increase in two market share. Serve app. 15% of the population in 1987.

Average annual % increases = 19.6%From 1980-87=> large impact on the marketWant to look at: advantages of HMOs, problems

with HMOs, empirical evidence on HMO performance

Advantages of HMOSPatients do not choose the provider at the time of

illness- long term relation impact. Hospital efficiencyL for FFs (cost based) hospital

reimbursement => Drs had no incentive to be concerned about hospital costs.

HMO Advantages (cont’d)Now dr. does have an incentive either as owner of HMO

or given incentives by HMO. ExplainCost minimization: HMO has an obvious incentive to

min costs since fee does not depend on the amount of services provided

Dr. productivity increases since HMOs use more complementary services like Dr. assistants and more of an incentive to lobby for damages in state practice acts

Preventative care- since HMO as an insurer and has a long term relationship => cost effective preventative care will be provided by HMO. Explain

No incentives to duplicate facilities unless cost effective

Incentive to use cost effective generic drugsIncentives to innovate in care: technology, location,

benefits,etc.

HMO Problems:Biggest problem is with quality of care. To illustrate

assume: patient has no info on qty of services provided =>no info on quality of treatment. (fee HMO = flat monthly fee, no other impact)

HMOs incentive? Max profit or minimize private costs? Private costs: Wx X; where X = # of services provided Wx= C

(cost of) => HMO minimizes costs by decrease in Quality (x) to zero. Just as in analysis of medical malpractice. Are there any

problems with the analysis? Yes: consider the following reasons why this might be a

problem. Assume that the HMO does not have the ability to set x=0.

Why not? Repeat dealings or reputation: if HMO is in business for long

term, then 2 effects: patients may have repeat dealings and leave with inadequate care, or patients may be able to gain info easily from old patients.

Impact of both?

Consumer ChoiceAssume 2 kinds of consumers well and ill

informed. Well: consumers cause competition and increase

quality even for ill informed as long as the HMO can not distinguish between the 2 types.

Medical Malpractice System: if x < x* => sue and obtain judgment => gives incentive. Explain.

Insurance Incentives: Suppose decreased care now (say preventative) increase in needed services later and services with large info.

=> HMO bears the cost of insuring against this => will provide such cost effective care. Explain.

Spillover effects in For-Profit HMOsThe book claims that for profit HMO Drs owned

by Drs => each Dr has an incentive to monitor other Dr in

organization since decrease in their profits due to lost reputation => control own quality due to profit incentive

Problem: suppose large # of Drs in HMO => benefit to any Dr of monitoring is low (extra profit is split up as a large #) cost high => not likely to do it. This is a typical moral hazard problem

Solution: HMO, who has better info, needs to control Dr’s actions since it has a large incentive. Explain.

(3) Empirical EvidenceLook at 3 issues: quality, expenditures/utilization,

biased selection (a) quality: little empirical research (b) Expenditures/utilization

Utilization decreases: length of stay, hospital admissions Expenditures: per day decrease, per admission decrease Table 12. 3 (p. 270)

HMO = GHC Admission rates decrease, hospital days decrease,

visits increase, preventative visits increase. Discuss But, per capital expenditures appear to increase. May

be a short-term impact only.

C) Bias due to Selection Problems3 possible kinds of problems

1. Healthier patients with lower expenses may be more likely to join HMOs => get lower utilization, lower exp and higher quality only because of self-selection.

2. Sicker patients may be more likely to choose HMO since coverage is more comprehensive.

3. HMOs may locate in areas with higher exp, higher utilization, and lower quality since they can be more competitive.

Empirical evidence suggests that self-selective bias is not a large problem. Some get + bias and other get – bias Some get significant bias in correction procedures