CHAPTER 1

WHY HEALTH ECONOMICS?

Why is health economics interesting?
 The health care economy is massive and
expensive.

 Health is a major source of uncertainty and risk.

 Governments around the world are deeply

involved in financing health systems.

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Health is uncertain and contagious

 The health economy may be huge, but how is it

different from other, smaller markets like the market
for bananas and the market for televisions?
 Two interesting economic properties
 Uncertainty: most people can predict how many
bananas or TVs they will buy in the next week, but
not how many emergency heart surgeries they will
need in the next week.
 Contagiousness: it doesn’t matter to you if your
neighbor buys a banana or a TV, but it does matter if
he skips his flu shot.
Bhattacharya, Hyde and Tu – Health Economics
Uncertainty and insurance

 An unforeseen broken leg or heart attack can

suddenly create demand for expensive health
care services.
 Because most people are risk averse, health-
related uncertainty motivates individuals to
demand health insurance.
 This in turn creates problems that arise in
insurance markets: adverse selection and moral
hazard.
 These two phenomena are what make health
policy really difficult (and really interesting).
Bhattacharya, Hyde and Tu – Health Economics
Adverse Selection
 Adverse selection generally refers to any
situation in which one party to a contract or
negotiation, such as a seller, possesses
information relevant to the contract or
negotiation that the corresponding party, such
as a buyer, does not have; this asymmetrical
information leads the party lacking relevant
knowledge to make decisions that cause it to
suffer adverse effects.

Bhattacharya, Hyde and Tu – Health Economics

 In the insurance industry, adverse selection
refers to situations in which an insurance
company extends insurance coverage to an
applicant whose actual risk is substantially higher
than the risk known by the insurance company.
The insurance company suffers adverse effects
by offering coverage at a cost that does not
accurately reflect its actual risk exposure.

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Moral Hazard
 Moral hazard is a term describing how behavior
changes when people are insured against losses.
If, for example, your car is fully insured against
any and all damage and there is no deductible,
then you would have no incentive to avoid minor
accidents, like scratches or backing into poles,
beyond the inconvenience of getting the car
fixed. You would be much more likely to take
risks that could lead to minor car damage
knowing that any damage is fully covered.

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 In health care, just as people are less likely to
take good care of a car when they have full
insurance, and just as they would get the car
fixed more often, people who have health
insurance are less likely to avoid health risks. As a
result, they will go the doctor and use other
medical services more frequently. That has the
potential to increase health care costs.

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Contagiousness and externalities
 Health Care Externalities. In health care, the
critical externality in most systems is the care
provided to others. You benefit from others
being healthy because it reduces the likelihood
of you catching their illness (assuming it's
contagious). You benefit from a positive
externality of others receiving health care.

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 The fact that other people’s health decisions
affect you creates externalities
 Examples:
 Vaccinations and other preventative measures create
positive externalities
 Going out in public with Ebola virus creates negative
externalities
 Externalities undermine the efficient function of
markets and often require government
intervention.

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Health economics = public finance

 Governments play a huge role in health markets

because of the features just discussed.
 In countries like the United Kingdom, Sweden,
and Canada, the government is responsible for
the vast majority of health care expenditures.
 Even in the US, with its private health care
system, the government is responsible for half of
all health care spending.

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Health care is only getting bigger and more
expensive for governments and taxpayers
• Increasing life expectancies and graying
populations throughout the developed world will
place stress on public health insurance systems.
• Governments will have to cope with ongoing
questions about whether to pay for expensive
new medical technologies.

Given these trends we can confidently expect health

care to be an ever-growing line item on government
balance sheets.

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 Positive vs normative questions
 Normative questions
 Does everyone deserve access to health care, even if they cannot pay?
 Should people be compelled to purchase insurance?
 When is it ethical to deny care to a dying patient?
 Should the government ban certain unhealthy foods?
 Positive questions
 How much would it cost to provide free checkups and drugs for
everyone in a population?
 Do strict patent protections for new drugs spur innovation?
 How much would consumers save if doctors were not required to
have medical degrees or medical licenses?
 Would a tax on saturated fat make a nation healthier?
 Economic reasoning cannot answer normative questions, but it can
answer positive questions, and that can help us form opinions
about normative questions.
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 The unique health care market
 In Turkey, patients sometimes pay out of pocket for
routine health care, like flu shots and health check ups.
 In many other countries, including Canada and the United
Kingdom, patients almost never pay out of pocket when they
receive basic health care.
 In Turkey, some people are not eligible for government
insurance and cannot afford (or do not want) to buy
private insurance.
 In almost all developed countries, uninsurance is extremely
rare or even nonexistent. Insurance is either provided for free
by the government, or provided by a mix of public and private
insurers.

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 The unique health care market
 This allows us to understand important cases that can
occur in private markets for health care: adverse
selection, moral hazard, and monopolistic firms.
 Understanding these problems is critical to
understanding why other countries approach health
policy in radically different ways.

Bhattacharya, Hyde and Tu – Health Economics