ECONOMICS OF HEALTH

Health is fundamental to living, but are the choices people make regarding their health fundamentally different from the choices they make in other areas of their life? The economics of health adapts the general study of how people make choices to issues involving health. Much of the focus is on the interaction among individuals, the health care system, and government policy. However, the boundaries of health economics also include topics linking individuals with other parts of the economy, topics such as lifestyle choices, the effect of air and water pollution, and the provision of public services such as drinking water and sewage water treatment.
SCARCITY AND ECONOMIC EFFICIENCY
Economics is built on scarcity. People have many desires, among them good health, but there is a lack of resources to provide all things to all people. In the presence of this scarcity, someone, or some process, must decide what mixture of goods and services to produce, what quantity of each is to be produced, and how to allocate the production to participants in the economy. If the world is such that people are well informed, there are many buyers and sellers, there are no barriers to moving resources from one use to another, and one consumer’s or producer’s choice does not affect another’s outside the market place; economic analysis indicates that a market (or price) system will function well. The market will decide what to produce, including various kinds of medical care; decide the quantity to be produced; and allocate what is produced in a way that no one individual can be made better off without making someone else worse off. This is the economist’s notion of an efficient outcome. Economists recognize that many efficient production and allocation combinations are possible, although the results may not always be viewed as equitable. But efficiency, not equity, is the focus of economists. When the situation differs from the criteria for efficiency, then markets can yield an inefficient outcome. This means that if a change can be made that leaves one person better off without leaving another person worse off, there can be a winning situation for everyone. Consequently, economists advise leaving situations alone where the criteria are met, and changing the situation where the criteria for efficiency are not met.
HEALTH ECONOMICS
The economics of health focuses on real or perceived differences between the economically idealized setting for efficiency and the setting for decisions about health. Such differences would not be important if health-related economic activity were a small part of the economy. However, the health care system in the United States has grown from 5 percent of gross national product (GNP) in 1960 to 13.5 percent in the late 1990s. This figure excludes numerous expenditures not directly related to the health care system, such as the control Expenditures on water and air pollution control and treatment were approximately 2.5 percent of GNP in the late 1990s. Consequently, these two components alone involved over 1.2 trillion dollars in 1997, an amount over three times the amount spent on national defense or almost twice the amount spent by consumers on durable goods such as cars and furniture. In short, if economic behavior differs from the conditions for efficiency, the effects can be enormous. There are many conditions that may be different for health-related goods and services compared
to other products. These include:
• Information: Consumers may not be informed about the nature and quality of health care being purchased.
• Uncertainty: Randomness in the cause and timing of ill health.
• Barriers to competition: Limitations may be placed on health care labor, the use of hospitals, or other resources.
• Externalities: One person’s or firm’s action can affect those of a third party separately from financial effects in the marketplace.
Furthermore, economists’ concern with efficiency ignores a concern for fairness regarding what obligation a society owes to provide health treatment for the poor, the disadvantaged, or other groups.

UNCERTAINTY AND HEALTH INSURANCE
While the search for information can reduce some aspects of uncertainty about quality or price, the random aspect of illness is another type of uncertainty. From an individual’s viewpoint, one’s health state may change due to a large variety of health problems related to aging, accidents, disease, and so on. Individuals can “take their chances” and, if an accident or illness occurs, obtain what treatment is available within their budgets. This “selfinsurance” option is risky, however, since individuals would not be able to afford care for serious health problems. In the early 1990s about 15percent of the U.S. population was self-insured, or, more accurately, uninsured. If such individuals choose to access the health care system, they must either pay for services directly or seek free treatment. In fact, various types of medical insurance are widespread in developed countries. In the United States, employer-provided medical insurance expanded rapidly during World War II, while Medicaid and Medicare (both begun in 1966) provide a form of medical insurance for the poor and the elderly, respectively. Insurance works as a market concept because health uncertainty is large for an individual but can become quite stable across a large population, a statistical result of the law of large numbers. Thus, the number of cardiovascular problems in a large population may be similar year to year, although to an individual it is a very uncertain event. By pooling resources through insurance, each person at risk pays a smaller guaranteed payment in exchange for more expensive conditional coverage if a health problem occurs. While individuals can, and often do, pay for their own health insurance, the tax-free status of employer- provided health benefits in the United States provides an incentive to businesses to expand coverage in place of wage or salary increases. As with the potential problem of asymmetric information between physician and patient, various asymmetry problems arise with regard to insurance.Those individuals with potentially more health demands have an incentive not to reveal such information, a problem known as “moral hazard” or “adverse selection.” If this occurs too frequently, insurance premiums are incorrectly charged or insufficient. A second problem can occur if medical care is free to those insured. In such cases the care may be overused in comparison to the benefit received. Insurance plans in the United States, including Blue Cross/Blue Shield and Medicare and Medicaid, focused for many years on administering bill-paying systems that implemented fee-forservice types of contracts to reimburse the health care provider. This contractual form places all the financial risk with the insurance company or government and is thought to be a significant contributor to rapid increases in health care costs. In contrast, health maintenance organizations (HMOs) combine the three roles of insurer, administrator, and health care provider. Consequently, they are potential competitors in both the insurance market and in the provider market. HMOs receive income through a steady stream of periodic payments per enrollee, a form of revenue called “capitation.” As HMOs, which are increasingly for profit organizations, retain any cost savings from improved case management, they are said to internalize the incentive to reduce cost. A variety of other types of organizations mix and match the roles of insurer, plan administrator, and health care provider, with the result of increasing competition in both the insurance and provider markets. Other details of insurance, including deductibles (a fixed amount paid before insurance coverage begins), co-payments (a monetary fee paid by the patient per service), co-insurance (a fixed percentage paid by the patient), and coverage of in-patient (hospital) or out-patient claims, have all been studied for their economic incentives on various parties. For example, some form of consumer payment reduces the number of small claims, which require more administrative effort, or transaction costs, and also provides some impetus to search for low-cost providers.

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