Health Economics

Advancing medical and pharmaceutical technology has allowed us to lengthen human life spans and reduce suffering, but has also increased the health sector’s use of scarce economic resources. Health economics studies the evaluation techniques and institutional arrangements that can be employed to promote efficient use of health resources and to control aggregate health care costs, as well as the social policy objective of guaranteeing that sick people have access to needed health care regardless of ability to pay.


Since the turn of the century, health care has continued to take up an increasing share of total economic resources in most countries in the world. In 1997, health care spending as a share of GDP fell in the range 6.7–13.6% for the G7 countries; by 2010, the range was 9.5–17.6%. The health economics literature has expanded apace. In 2011–12 alone, just over 10 years after the appearance of the first two-volume handbook in the field (Culyer and Newhouse, 2000), three new major survey works were published: Glied and Smith, 2011; Danzon and Nicholson, 2011; Pauly et al., 2012. Readers looking for recent references to any of the topics discussed in this article should look to these volumes in the first instance.

Health care remains one of the economic sectors in which views on the proper role of government intervention, as opposed to reliance on markets and competition, continue to be hotly debated. In some European countries, government has assumed responsibility for both the funding and production of health services; in others, funding is through government plans but production of services is mostly by private agents, while in the U.S. and a few other countries private insurance plays a large role on the funding side as well.

Much of the early literature in health economics focused on the reasons why unregulated private markets are unlikely to perform well in health care, including uncertainty and imperfect information. The demand for health services is state-contingent (most health services are demanded only when people have fallen ill), and while markets for private health insurance offer consumers an opportunity to protect themselves against the financial risk of costly health care, they accomplish this only imperfectly. In his classic article which some characterize as the origin of health economics, Arrow (1963) argues that inadequate medical knowledge and imperfect state-contingent markets put consumers in a very weak position relative to providers when they need to buy health services. As medical and pharmaceutical technology has advanced and more and more resources have been devoted to health care, economic analysis has contributed to the design of regulatory approaches to deal with this problem, and has interacted with the development of new institutional arrangements in private health care and insurance markets that have evolved as a response to it.

Insurance Protection versus Moral Hazard Effects

Under ideal conditions, efficient health insurance would consist of state-contingent lump-sum payments that would depend only on the nature of the consumer’s health problem (Goddeeris, 1984b). In practice, however, it is not possible to write insurance contracts that cover all possible health problems, so benefits under conventional insurance contracts typically are specified instead as a share of the cost of the health services that the insured has used. Implicitly, such contracts therefore act as a subsidy on ill consumers’ utilization of health services. As with other subsidies, this tends to make them use more than the economically efficient quantity (Pauly, 1968). This effect (referred to in the literature as ‘moral hazard’) implies some degree of waste in the conventional microeconomic sense, in an amount that is larger the higher is the share of cost that is covered by the insurer. The resulting trade-off between the objectives of more complete insurance coverage and avoidance of overutilization of health services has been a central topic in much of the health economics literature, beginning with Zeckhauser (1970) and in the multimillion dollar-controlled trial of differing degrees of insurance carried out by the Rand Corporation in the early 1970s (Newhouse and The Insurance Experiment Group, 1993). While the issue of patient cost-sharing (‘user fees’) remains controversial, the results of the Rand study supported the idea that some degree of patient cost-sharing could lead to substantial payoffs in the form of reduced overutilization of health services. Although there are exceptions in which patients pay nothing out of pocket for hospital and physician services (the U.K. National Health Service (U.K. NHS), Canada’s provincial insurance plans), most private and government insurance plans today require patients to pay at least a share of the cost, subject to an annual maximum of some kind.

An approach to the moral hazard problem that has become popular in places like Singapore and China, as well as in the U.S., is that of Medical Savings Accounts (MSAs). When an insurance plan includes MSAs, enrolees must, in addition to paying the regular insurance premium, also contribute an amount to an individual account (the MSA), the balance in which they can only use to pay for their own health services in the future. In the U.S., the popularity of MSAs is due largely to the fact that contributions to MSAs are considered a nontaxable benefit, so designating part of employees’ compensation as MSA contributions reduces the income tax they must pay. The rationale for compulsory MSA contributions in other places (such as Singapore) is less easy to understand, since their only effect is to restrict the way citizens can use some of their income. However, the growing evidence from behavioral economics that individuals do not appear to make rational decisions in the face of risk and uncertainty can perhaps also be used to justify the gentle ‘nudging’ that is inherent in compulsory MSA contributions (Thaler and Sunstein, 2009).

Information Asymmetry, Agency, and Supplier-Induced Demand (SID)

Imperfect information on the part of insurance plans regarding the exact nature and severity of the consumers’ health problems is the reason why health insurance typically pays all or part of actual health care costs, rather than lump-sum indemnities that depend on the consumers’ diagnoses. But imperfect information is also a problem for patients. Sick individuals often do not know what is wrong with them, or to what extent their pain and suffering will be alleviated by different treatment approaches or drugs. Although patients today are becoming more adept at finding information about their treatment options, they still have to rely to a large extent on the advice of their doctors in deciding what services to buy. Much of the literature in health economics has focused on this asymmetry of information between doctors and patients: Coupled with the fact that it is difficult for sick people who need care urgently to compare the terms offered by competing sellers, consumers are in a weak bargaining position relative to providers in health services markets.

If doctors can influence patients’ demand for their services through the advice they provide, as suggested in the literature on SID, and competition among providers is weak, the result may be both high prices and larger-than-efficient volumes of services in markets where doctors can set their own fees. The empirical evidence on the extent to which SID exists remains fragmentary and ambiguous. However, markets of this kind have become much less common over time. Levels of medical fees in most countries with government funding of health care are not market-determined but regulated or negotiated between governments and provider groups. In the U.S., they are increasingly determined in advance of treatment under contracts between providers and insurance plans who obviously have more bargaining power than individual patients. Moreover, other methods of paying providers than fee for service are becoming more common; often these alternative payment methods are structured in such a way that providers have less incentive to supply large volumes of services. These trends are consistent with the suggestion that SID is a significant problem under the conventional market forms.

As the focus has shifted from demand-side incentives (patient cost-sharing) to those that are inherent in the methods used to compensate providers (supply-side incentives), health economics has drawn on agency theory, which analyzes efficient contracts in situations where an agent with better information (in this case, the doctor) is paid to make decisions that affect the welfare of a principal (the patient) with less information. An early application of agency theory related to compensation of corporate managers; in that case the principals are the shareholders, who have less information than the managers who act as their agents. In health care, however, a key feature of the principal–agency relationship is the fact that most of the costs are paid by third parties, so that the doctors’ decisions affect not only the well-being of the patients, but also of the collective that bears most of the cost (taxpayers, members of private insurance plans). To be efficient, the contracts under which the agents provide health care must give them incentives to take account both of the interests of the individual patients, and the costs borne by the collective (Blomqvist, 1991).

Compensation methods that imply enhanced incentives on providers to take cost into account include capitation in primary care (the backbone of the U.K. NHS), and episode-based payments (such as those based on Diagnosis-Related Groups (DRG)) for hospitals. Both are examples of prospective funding models, meaning that the payment is fixed in advance of treatment and does not depend on what volume of services the patient actually received. Under capitation (which is often combined with partial fee for service in ‘blended’ systems), primary care providers agree to supply services as needed for all patients on their roster, in return for a fixed monthly amount per patient. In the DRG model (which originally was developed for the U.S. Medicare plan, but now is used in many countries), the principle is that a hospital’s revenue from treating given patients will depend only on the classification of their health problems, not on their length of stay or what drugs and services were actually used in treating them.

Prospective funding methods have been used not only in government plans, but also by private insurers in the U.S., in conjunction with expanded use of ‘selective contracting and patient steering.’ In plans that use this approach, the insured are only fully covered if they get their care from providers who have signed a contract in which they agree to be compensated for their services according to terms set by the plan, and often also to abide by restrictions in the way they will treat the plan’s patients. For example, in some managed-care plans, the participating doctors have to agree to choose prescription drugs from a formulary provided by the plan, or to a second opinion before a patient can receive major elective surgery. Under selective contracting, fees and other terms according to which services are supplied are no longer determined through transactions between providers and individual patients at the point of service; instead, insurance plans negotiate the terms in advance on behalf of their insured clients. The trend toward more use of selective contracting has strengthened the market power on the buyers’ side in the markets for health services and drugs, and made them more competitive in comparison with the earlier model in which the buyers were the individual patients.

Private Health Insurance: Competition, Cream Skimming, and Adverse Selection

Even though government has taken over most of the responsibility for pooling the financial risk associated with health care costs in almost all advanced countries other than the U.S. and a few others, theoretical and empirical research on private health insurance markets continues to be a prominent part of the health economics literature. This research is motivated in part by the importance of private health insurance in the U.S. system, but also by the fact that private insurance continues to play a significant role in several other countries, as provider of supplementary coverage for items excluded from government plans (such as outpatient pharmaceuticals and dental care), or complementary coverage when the public plan contains deductibles or patient cost-sharing (as in France, or in the basic U.S. Medicare plan for retirees).

An active line of research, on risk adjustment, relates to attempts in some countries (especially the Netherlands) to allow private insurers a more prominent role in government-organized universal social insurance systems in a way that is both efficient and consistent with the equity objective. In the absence of regulation, competition among private insurance plans will cause them to charge higher premiums, or deny coverage, to individuals who can be predicted to have high expected health care costs, based on factors such as their own or their families’ illness history. In order to create more equitable access to insurance, regulators can simply prohibit premium discrimination and require plans to cover everyone who is willing to pay the quoted premium. However, the theoretical and empirical literature on risk selection shows that there are ways in which insurers can design their plans so as to make them more attractive to low-risk individuals (‘cream skimming’), undermining the equity objective to some extent. In response, regulators in the Netherlands and elsewhere have tried to reduce insurers’ incentive to engage in risk selection by paying a risk-adjusted premium subsidy for individuals with high expected expenditure, and by restricting insurers’ ability to cream-skim by limiting the extent to which they can vary the content of their coverage. Every plan must also accept any applicant willing to pay its net-of-subsidy premium (which must be the same for everyone).

Much of the early literature on private health insurance focused on the case where the information about factors leading to differences in expected costs was private (known to the buyers) and not readily observable by the insurers. As Rothschild and Stiglitz showed in their classic article on adverse selection (1976), competitive insurance markets could then break down or lead to inefficient outcomes. A somewhat surprising prediction of their analysis was that plans with generous benefits would tend to survive in a competitive market, though they would be very expensive and used only by individuals whose risk of loss was high. In the context of health insurance, the empirical evidence suggests that another consequence may be ‘death spirals’ under which plans with generous benefits will become so expensive that they will disappear, leading to outcomes in which surviving plans will offer only limited benefits (Cutler and Reber, 1998). The problem of adverse selection can be at least partially overcome when health insurance is in the form of a common plan that is purchased by a group of individuals who are related in some way that is independent of their expected health care costs, for example, all employees in a firm; the fact that most private health insurance in the U.S. is through employment is partly a reflection of this (Diamond, 1992).

The Industrial Organization of the Health Insurance and Health Services Industries

Selective contracting and patient steering is a means by which insurance plans can take a more active role on the buying side in the markets for health services, creating a better balance in market power between buyers and sellers. But closer integration between insurers and producers of health services can also be interpreted as a model for supplying these services that is more like the way they would be supplied in an idealized model of state-contingent contracts.

Considerable attention has been paid in the literature to Health Maintenance Organizations (HMOs), a type of firm that was considered a promising model in the U.S. health care industry in the 1970s and 1980s (Luft, 1981). In their simplest form, HMOs were insurance plans whose enrolees paid a fixed monthly premium, in return for being entitled to health services and drugs as needed, but only in hospitals owned by the HMO, and from doctors who were its salaried employees. Because the doctors were paid by salary, and the hospitals’ revenues did not directly depend on the services they supplied, they had no direct incentive to supply large volumes of services. Moreover, because HMOs were responsible for the full range of health services (primary care, services of specialists and hospitals) and drugs, they could ask their providers to follow rules that would combine these inputs efficiently. Empirical evidence in the Rand study suggested that HMOs could supply care to given populations at lower cost than under the conventional model, with similar health outcomes on average (Newhouse and The Insurance Experiment Group, 1993). The fact that the U.K. health care system seems to be able to provide good care to its population at a low cost relative to others is consistent with this evidence, since the U.K. NHS can be loosely interpreted as a nationwide HMO.

HMOs and similar managed-care plans increased their share of the U.S. health insurance market to a considerable extent in the 1980s and early 1990s, and health economists like Enthoven envisaged reforms that would create an efficient system of universal insurance coverage through one of many competing plans (Enthoven, 1993). However, the 1993 reform proposals of the first Clinton administration which drew on these ideas met with vigorous opposition, and in the second half of the 1990s, there was what has been described as a ‘backlash’ against managed care (Havighurst, 2002). While the principle of selective contracting has survived, plans with fewer restrictions on providers and less integration between the different kinds of health services now dominate the market. In the Obamacare legislation, there are incentives encouraging different providers who treat patients under the Medicare plan to form Accountable Care Organizations for the purpose of saving resources by integrating care more closely. These provisions can be interpreted as a sign that integration of care remains an unresolved issue in much of the U.S. system (McClellan et al., 2010).

Enthoven’s ideas of ‘managed competition’ have also been an important influence on the process of health financing reform that has been underway in the Netherlands over several decades (van de Ven and Schut, 2008). Under the legislation governing the system, the competing insurance plans from which citizens can choose are allowed to engage in selective contracting and patient steering, although so far they have only done so to a limited extent.

Health as Capital; Communicable Disease

Part of the work in health economics has been concerned with quantifying the concept of health. In the model analyzed by Grossman (1972), health is interpreted as a form of capital. Each person is born with a certain quantity, and can build up his or her health capital by using health services produced by others, by eating well, exercising, and so on. But health capital is also subject to depreciation, as people fall ill and grow old. Health capital yields benefits in the form of a flow of healthy time which is both valuable in itself (the consumption motive for investing in health), and because it can be used to earn an income through working (the investment motive).

Empirical work on the production of health capital obviously is difficult, because health can only be imperfectly observed and measured. Nevertheless, research inspired by Grossman’s analysis has yielded important insights and evidence. In particular, it has shown that childhood health, and the health services used to improve it, including prenatal care, are important predictors of adult health and well-being (Currie, 2009). It has also focused on the long-term benefits of factors such as exercise and weight control, as well as on the relation between addiction to tobacco and alcohol and health. The theory of ‘rational addiction’ proposed by Becker and Murphy (1988) is similar to Grossman’s analysis in that both seek to reconcile the evidence on the long-term consequences of behaviors that influence health with the hypothesis of rationality in human decision making. However, the evidence from behavioral economics is casting more doubt on the helpfulness of this hypothesis in contexts that involve long time horizons and small risks of major adverse outcomes (Rabin and Thaler, 2001). Both these features are characteristic of many decisions that affect health in the long run.

In the analysis of population health, there is a critical distinction between communicable and noncommunicable diseases, with the former being much more prevalent in poor countries while the latter now dominate in rich countries. In the early health economics literature, the focus was implicitly on noncommunicable diseases and on decisions by individuals that only affect their own health. For communicable diseases, there are significant spillover effects as actions (or lack of actions) by individuals influence the health risks of others. In epidemiological models of communicable diseases, these actions have typically been taken as given. Since the 1990s, however, there is a branch of the literature that draws on both epidemiology and economics and looks at how economic incentives can influence individual decisions that affect the spread of contagious diseases (Kremer, 1996). This research has partly been motivated by the spread of HIV/AIDS, but also by the increasing attention being paid to health care and health policy in developing countries. Analysis that combines the modeling of individual incentives and spillover effects will also be relevant as more resources are devoted to the growing problem of infections that become resistant to existing drugs.

Valuing Health

Government decision makers are often called upon to evaluate projects or regulations that affect safety, for example, in the transportation sector, leading to the question whether there is a meaningful way to estimate the value of saving human lives. Following the work of Schelling (1968) and others, it is widely accepted that it is reasonable to use estimates of the value of saving a ‘statistical life’ (that is, the life of a person whose identity is not known in advance) on the basis of evidence regarding how much people are willing to pay for reducing the risk that they will die. Such evidence can be derived from contingent valuation (answers to hypothetical questions), or from revealed preference, for example, based on observed wage differentials between risky and safe jobs (Viscusi, 1993). Estimated values of reducing mortality are obviously relevant to health economics, since much of what is spent on health care goes toward drugs and interventions that increase the chances of survival among patients with different kinds of illness. Murphy and Topel (2006) argue that conventional GDP statistics have seriously underestimated secular growth in human welfare because they fail to account for the value of increased life expectancy, which has occurred at least partly in response to the development of new drugs and medical technology.

Death, however, is only the most extreme form of ill health; the main purpose of many types of health care is to improve patients’ quality of life, not just to reduce the risk of death. An active branch of health economics research has concerned itself with the development of a generalized health index, quality-adjusted life expectancy, that accounts both for improvements in the quality of patients’ lives and longer life expectancy. In calculating the expected number of quality-adjusted life years (QALYs) among members in a given population, a year lived with a disabling or painful health problem is counted as the equivalent of a fraction of a year lived in normal health. Much of the research in this area has been about simple methods to estimate what quality-of-life weights should be assigned to years lived with different kinds of health problems, based on patients’ answers to hypothetical questions.

Cost-effectiveness evaluations of different treatment approaches or drugs that compare their costs with their ability to produce additional QALYs in given patient populations are increasingly common in the literature; the term ‘cost-utility analysis’ is often used to refer to this methodology. In countries where most health care is directly paid for by government, such as the U.K., certain procedures or drugs may not be approved for coverage under the public plan if their cost-effectiveness is unfavorable (the cost per incremental QALY is too high), but even in the U.S. where coverage restrictions are opposed by many who object to ‘rationing’ of patients’ access to care, economic evaluations can play a role in establishing clinical guidelines or drug formularies that are used by many insurance plans.

Although cost-utility analysis is widely used, certain conceptual issues remain controversial, for example, whether future QALYs should be discounted, and when it is appropriate for an evaluation to include only costs to the government as opposed to costs borne by all members of society, including private individuals. Or, in calculating the costs to society of using a new technology that reduces mortality, should one include an allowance for the fact that additional survivors will mean higher health care costs in the future, as well as more resources required for their consumption of other goods and services?

The importance of providing information and incentives to make cost-effective choices in medical care has been indirectly illustrated by studies showing large variation in practice patterns across different locations; this line of research has been particularly active in the U.S. Data on the per capita cost of medical care in similar populations (for example, U.S. retirees covered by the Medicare plan) show differences of a hundred percent or more in comparisons across major urban areas, and while they can be attributed in part to different unit prices for various services, they remain large even after correcting for this. Studies of particular procedures also show wide variation in the rates at which they are applied in comparable populations. These findings lend credence to the widely held view that large gains could be realized (either in the form of lower cost or better health outcomes on average) if practice patterns everywhere could be made to align more closely with the findings of cost-effectiveness studies.

Pharmaceuticals and Medical Technology

While other factors, such as the high labor intensity of health care production, have contributed to the increase in health care spending as a share of GDP in almost all countries, the main driver appears to have been the continuing development of new and often costly types of medical and pharmaceutical technology. The costs of developing and using the new technologies have been high, but their benefits, in the form of longer life expectancy and better quality of life have been large and, on average, have more than justified the costs (Murphy and Topel, 2006). New technology will continue to come on stream, partly driven by advances in molecular biology and research on the human genome, but several issues regarding the cost of developing and using new technology remain controversial.

Financing of global R&D is to a large extent through the patent system under which an incentive to develop new technology is provided through legal rules that give the patent owner a time-limited monopoly in the market for any products that use the patented technology. The most important health-related industry in which R&D is financed in this way is the pharmaceutical industry. Although most countries are bound by international agreements that place certain restrictions on their patent laws, national governments still retain considerable discretion with respect to the detailed rules regarding matters such as the definition of what constitutes a patentable invention, the length of the patent period, and what rules apply to competing producers (such as manufacturers of generic drugs) when the patent expires for a brand-name drug.

The application of the patent system in the pharmaceutical industry involves the same trade-off as in other sectors, between the need to create an incentive for future R&D spending, on the one hand, and the desire to quickly make new technology available to consumers at a reasonable price, on the other. However, in the market for drugs, the trade-off is complicated by the fact that they typically are paid for by third parties (public or private insurance plans), not by the consumers themselves. Prices of patented drugs in many countries therefore tend to be regulated by government, or established in bilateral negotiations between central agencies and the patent owner, with evidence from health economic evaluations playing a role. Rules with respect to drug patents have been important elements in international trade negotiations. In these negotiations, countries or jurisdictions where the large and research-intensive pharmaceutical firms are located and generate jobs and tax revenue (the U.S., the E.U., Japan) tend to push for policies that lead to high drug prices and revenue for these firms. Smaller and poorer countries that mostly use drugs that have been developed elsewhere prefer rules that shorten the period of patent protection, lower the prices of patented drugs, and allow quick entry of lower-cost generic drugs after the patents have expired.

The nature of R&D in the pharmaceutical and medical devices industries in the future may also be affected by the changing roles of insurers and of physicians as agents of both patients and third parties in many health care systems. In important early contributions, Goddeeris (1984a,b) introduced the idea that firms engaged in R&D face a choice between efforts to develop cost-saving technology (that would reduce the cost of existing treatment methods), or technology that leads to increased spending because it enables providers to effectively treat new patients with problems for which current methods do not work. His insight was that when doctors act exclusively in their role as agents for their patients, they would look relatively more favorably on the latter type of innovations, since most of the additional costs will be paid by third parties, not by the patients. As more doctors work under contracts that also give them an incentive to pay attention to the costs of the third party, the implicit bias against cost-reducing innovations will be reduced, at least to some extent.

Health Economics, Health Policy, and Equity

Mandatory social insurance programs or direct government funding of health services are crucial elements of the welfare state in many countries that strive to attain a more equal distribution of income. The correlation between health and income or social status has been known for a long time, and continues to be explored in the literature. The question to what extent low income causes ill health or the other way around (or whether both are correlated with some third factor) remains open, but the correlation persists even in systems where universal government programs has largely eliminated income as a determinant of access to health care.

Most of the literature on economic inequality concerns itself with the distribution of measures of real income, whether in a given year or over individuals’ lifetime; less attention is paid to the question how inequality is reflected in different rates of consumption of specific goods and services. In health economics, however, there is a substantial literature on inequality in the utilization of health care, and whether it is correlated with income, partly reflecting the view that society should be less tolerant of inequality in health care than for other kinds of consumption (Tobin, 1970). In some countries, for example Canada, there is widespread support for the idea that utilization of health services should be independent of income, and various policies are used to discourage purchases of health services outside of the government plans even by people with high income who are willing to pay for them. An important question for the future, especially in countries with universal coverage through government plans, will be to what extent their health financing systems will allow choice for individuals among insurance plans with different treatment strategies and hence expected costs (Havighurst, 2002). This question will become more urgent as medical and pharmaceutical technology continues to progress and introduce a wide range of new drugs and methods that can be used to improve expected health outcomes, but often at very high cost. The aging of the population in many countries is relevant to this issue, since a large proportion of health care costs typically are incurred by older patients who are nearing the end of their lives. Rising government expenditure to pay for the health care costs of the elderly therefore contribute in a major way to the increasing burden that the relatively small younger generations of working-age taxpayers face in countries where the proportion of retirees will rise over the next several decades.

Health care and health insurance are not internationally traded to any significant extent, so there is little competition among providers and insurance systems across countries. While much of the research in health economics remains country-specific, the literature comparing health care systems and policies in different countries has become increasingly important over time, especially in the twenty-first century. A country whose health policy is attracting great interest is China, where it is a critical element in the regime’s efforts to reduce inequality, and health care reform is accorded a high priority because the current market-oriented model compares unfavorably, from the viewpoint of equity, with the one that existed before the 1980s when the experiment with less centralized economic management began (Qian and Blomqvist, 2014).


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