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Health Economics
FIFTH EDITION
Health Economics
CHARLES E. PHELPS
University of rochester
First published 2013, 2010, 2003, 1997 by Pearson Education, Inc.

Published 2016 by Routledge

2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
711 Third Avenue, New York, NY, 10017, USA

Routledge is an imprint of the Taylor & Francis Group, an informa business

Copyright © 2013, 2010, 2003, 1997 Taylor & Francis

All rights reserved. No part of this book may be reprinted or reproduced or utilised in any
form or by any electronic, mechanical, or other means, now known or hereafter invented,
including photocopying and recording, or in any information storage or retrieval system,
without permission in writing from the publishers.

Notice:
Product or corporate names may be trademarks or registered trademarks, and are used only
for identification and explanation without intent to infringe.

Credits and acknowledgments borrowed from other sources and reproduced, with
permission, in this textbook appear on page 523.

Cover Designer: Suzanne Duda

ISBN-13: 978-0-13-294853-1 (hbk)

Library of Congress Cataloging-in-Publication Data

Phelps, Charles E.
Health economics / Charles E. Phelps. — 5th ed.
p. ; cm. — (Pearson series in economics)
Includes bibliographical references and index.

I. Title. II. Series: Pearson series in economics.

[DNLM: 1. Economics, Medical—United States. 2. Financial Management, Hospital—
economics—United States. 3. Health Policy—
economics—United States. 4. Insurance, Health—economics—United States. 5. Marketing of
Health Services—economics—
United States. W 74 AA1]
338.4’73621—dc23

2012000860
TO DALE—OUR TIME HAS JUST BEGUN… ONCE AGAIN.
Contents

Preface

CHAPTER 1 Why health Economics?

Important (If Not Unique) Aspects of Health Care Economics

How Markets Interrelate in Medical Care and Health Insurance
Afterthought
Summary
Related Chapters in Handbook of Health Economics
Problems

CHAPTER 2 Utility and health

How to Think About Health and Health Care (or… How Health Economics?)
The Production of Health
Health Through the Lifecycle
A Model of Consumption and Health
Summary
Related Chapter in Handbook of Health Economics
Problems
Appendix to Chapter 2: A Formal Model of Utility Maximization
CHAPTER 3 The Transformation of medical care to health

The Productivity of Medical Care

Confusion About the Production Function: A Policy Dilemma
Physician-Specific Variations (Medical Practice Styles)
Extensive and Intensive Margin Differences: Are They Similar?
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendix to Chapter 3: Marginal, Average, and Total Productivity

CHAPTER 4 The demand for medical care: conceptual Framework

Indifference Curves for Health and Other Goods

From Indifference Curves to Demand Curves
How Demand Curves Depend on Illness Events
Demand Curves for Many Medical Services
The Demand Curve for a Society: Adding Up Individual Demands
Use of the Demand Curve to Measure Value of Care
How Insurance Affects a Demand Curve for Medical Care
Time Costs and Travel Costs
The Role of Quality in the Demand for Care
Revisited: The Price Index for Health Care
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendix to Chapter 4: Demand Curves and Demand Elasticities

CHAPTER 5 Empirical studies of medical care demand and applications

Studies of Demand Curves

Effects of Age and Gender on Demand
The Effects of Illness on Demand
Lifestyle and Its Effects on Demand
The Demand for “Illness”
The Demand for Quality: Choice of Provider Specialization
Other Studies of Demand for Medical Care
Applications and Extensions of Demand Theory
Decision Theory: Deriving the “Right” Demand Curve for Medical Care
Cost-Effectiveness Ratios and Demand Curves
Why Variations in Medical Practice?
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendix to Chapter 5: An Example of Medical Decision Theory

CHAPTER 6 The Physician and the Physician-Firm

The “Firm”—Inputs, Output, and Cost

The Physician as Entrepreneur
The Physician-Firm and Its Production Function
The Physician as Diagnostician
Nonphysician Primary-Care Providers
The Size of the Firm—Group Practice of Medicine
Practice Ownership Patterns
The Physician as Labor
The Aggregate Supply Curve: Entry and Exit
The Open Economy: U.S.- and Internationally Trained Physicians
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendix to Chapter 6: Cost Passthrough

CHAPTER 7 Physicians in the marketplace

Physician Location Decisions

Consumer Search and Market Equilibrium
The Consequences of Incomplete Search
Actual Search by Patients
Advertising and the Costs of Information
The Role of Licensure
Estimates of the Demand Curve Facing Physician-Firms
Induced Demand
The Role of Payment Schemes
Summary
Related Chapters in Handbook of Health Economics
Problems

CHAPTER 8 The hospital as a supplier of medical care

The Hospital Organization
Who Is the Residual Claimant?
Where Does the Utility Function Come From? A Political Theory Model
Hospital Costs
Long-Run Versus Short-Run Costs
The Hospital’s “Cost Curve”
Another Complication: Outpatient Surgery
The Demand Curve Facing a Single Hospital
The Utility-Maximizing Hospital Manager Revisited
Summary
Related Chapters in Handbook of Health Economics
Problems

CHAPTER 9 hospitals in the marketplace

Hospitals and the Market for Medical Staff

Hospitals and Patients
A Model of Equilibrium Quality and Price
Insurance and Competition in the Hospital’s Decision
Interaction of Doctors and Hospitals: “Goodies” for the Doctor
Interaction of Doctors and Hospitals: Patients for the Hospital
Competition—“Old Style” Versus “New Style”
Entry and Exit: The Pivotal Role of For-Profit Hospitals
The Hospital in Labor Markets
Nursing “Shortages”
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendix to Chapter 9: The Hospital’s Quality and Quantity Decision

CHAPTER 10 The demand for health insurance

The Demand for Health Insurance

Reasons People Want Insurance
Choice of the Insurance Policy
The Patient Protection and Affordable Care Act: Prelude
Insurance Market Stability: The Question of Self-Selection
Income Tax Subsidization of Health Insurance
Empirical Estimates of Demand for Insurance
The Overall Effect of the Tax Subsidy on the Health Sector
“Optimal” Insurance
Other Models of Demand for Insurance
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendixes to Chapter 10:
Appendix A: A Detailed Calculation of Welfare Loss
Appendix B: The Calculus of the Risk/Moral Hazard Trade-off
Appendix C: The Statistics of an Insurance Pool

CHAPTER 11 health insurance supply and managed care

The Supply of Insurance
Insurance Exchanges in the PPACA
Managed Care: A Response to the Incentives of Traditional Insurance
Why Managed Care?
Market Share Trends
Types of Interventions
Which Interventions Work Best for Managed Care?
Long-Run Issues
Summary
Related Chapters in Handbook of Health Economics
Problems

CHAPTER 12 government Provision of health insurance

The Medicare Program

Medicare Advantage
Operational Changes in Medicare
The Medicaid Program
Summary
Related Chapters in Handbook of Health Economics
Problems

CHAPTER 13 medical malpractice

Background of the Legal System in the United States

The Economic Logic of Negligence Law
Judicial Error, Defensive Medicine, and “Tough Guys”
Medical Malpractice Insurance
Evidence on Actual Deterrence
Malpractice Awards: “Lightning” or a “Broom Sweeping Clean”?
Tort Reform
Tort Reform Writ Large
HMO Liability: A New Domain for Malpractice Law
Summary
Related Chapter in Handbook of Health Economics
Problems

CHAPTER 14 Externalities in health and medical care

Externalities, Property Rights, and the Control of Externalities

Externalities of Contagion
Solutions to the Externality Problems
International Issues—Expanding the Scope of the Externality
Externalities from Tobacco
Information as an Externality
Research as an Externality
Reasons for Such Little Research on Medical Effectiveness
Transfusion-Induced AIDS and Hepatitis
Summary
Related Chapters in Handbook of Health Economics
Problems
Appendix to Chapter 14: Value of Life
CHAPTER 15 managing the market: regulation, Quality certification, and
Technical change

A Taxonomy of Regulation
Licensure
Measuring Quality
Paying for Outcomes: Accountable Care Organizations in PPACA
“Certificate of Need” (CON) Laws
Price Controls
Drugs and Devices: The New Wave of Medical Care
Summary
Related Chapters in Handbook of Health Economics
Problems

CHAPTER 16 Universal insurance issues and international comparisons of

health care systems

Aggregate International Comparisons

Increase in Costs and Health Outcomes
The Patient Protection and Affordable Care Act of 2010
General Considerations for a National Health Policy
A Final Conundrum
Summary
Related Chapters in Handbook of Health Economics
Problems
Author’s Postscript
Bibliography
Credits
Index
Preface
What’s New in this Edition?
As with previous editions, this edition revises and updates all data tables
where new data are available. The advent of the Patient Protection and
Affordable Care Act (PPACA) in 2010 has led to changes in many chapters of
Health Economics, most notably in the organization and focus of Chapter 16.
However, rather than just appending a discussion of the PPACA at the end
of the book, the fifth edition integrates PPACA issues (as appropriate)
throughout the book.

Chapter 1 integrates the PPACA into the overall market equilibrium

analysis.
Chapter 10 discusses key requirements in the PPACA, including the
requirement that all people in the U.S. must have health insurance
coverage, the requirement that employers provide health insurance for
their employees, and the importance of the PPACA rule eliminating the
use of pre-existing conditions in health insurance underwriting.
Chapter 11 discusses the PPACA requirement that states form
“insurance exchanges” to help individual buyers find low-cost health
insurance if they are not insured through employer groups. Chapters 11
and 12 also discuss a new health care delivery model envisioned in the
PPACA—the Accountable Care Organization.
Chapter 15 expands the discussion of regulated prices for hospital care
to include Medicare’s new linkage of outcomes of care to
reimbursement and the encouragement of Accountable Care
Organizations, both facets of the PPACA legislation.
Chapter 16 summarizes the entire PPACA and expands the previous
economic analysis of universal insurance in the U.S. to include what
options are available to address each issue, and how the PPACA
 actually dealt with the key issues surrounding implementation of
universal insurance coverage.

Other significant changes to this edition are:

Chapter 3 expands the discussion of cost-effectiveness analysis,

including (in addition to a discussion of Quality-Adjusted Life Years) a
new analysis of the Disability Adjusted Life Years (DALY) measure that
is used by the World Bank, the World Health Organization, and many
European nations.
Chapter 6 explores physician practice ownership patterns, taking note
of recent changes such that over half of all physician practices are now
owned by hospitals.
Chapter 6 expands the discussion of International Medical Graduates
including new data and discussion that links together IMG certification
and quality and medical resident “fill rates.”
Chapter 9 extends the discussion of nursing practice, including a new
analysis of internationally trained nurses and their role in the U.S.
nursing market.
Chapter 10 explores the analysis of the tax subsidy to health insurance
by introducing explicitly the share of health insurance premiums paid
by employers into the analysis and new data and forecasts of the extent
of the tax expenditure attributed to the exclusion of employer paid
health insurance from the tax base.
Chapter 11 introduces new estimates of the insurance “loading fee” by
employer group size, using the first firm estimates of this relationship
in the literature.
Chapter 11 expands and adds new data on the discussion of the market
shares held by different types of health insurance plans.
Chapter 12 examines the changes in the Medicare Part B deductible
over time.
Chapter 12 adds a new discussion about the extent of enrollment in
Medicare Advantage (Part C) programs as an alternative to traditional
Medicare coverage.
Chapter 12 explores ambulatory surgery and its effect on hospital
occupancy, as well as an expanded discussion of hospice use as an end-
of-life alternative to hospitalization.
Chapter 13 adds a new discussion about the relationship between
quality of care and negligence lawsuits.
Chapter 14 approaches the topic of transfusion-related illnesses to
discuss the extent of this externality in a wide set of nations, rather
than focusing wholly on the United States.
Putting the Fifth Edition in Context
The study of health economics is becoming more important and more useful.
The health care sector continues to grow in size, both in absolute dollars and
as a portion of the overall economic activity of the United States. In terms of
employment, now about one person of six in the country is employed in the
health care sector.
The government’s role in health care has become increasingly important
through the years, beginning with the founding of the U.S. Public Health
Service in 1798. Many people point to the 1965 creation of Medicare and
Medicaid as a landmark step in the government’s role in health care. In 2010,
however, sweeping new legislation heightened the government’s role in
health care even more—the Patient Protection and Affordable Care Act
(PPACA), sometimes referred to in shorthand as the “Affordable Care Act.”
This edition of Health Economics contains numerous new analyses of issues
created or highlighted by passage of the PPACA. Readers will find these
analyses throughout the book.
The PPACA does not bring legislative change to a halt. Indeed, as this fifth
edition goes to press, numerous issues remain unsettled regarding the most
basic structures built into the PPACA. Perhaps most important are legal
challenges to the very core of the Act—the requirement (“mandate”) that
individuals obtain health insurance coverage of at least a minimum level as
defined in the Act. Numerous lawsuits arose shortly after President Obama
signed the PPACA into law, most of them challenging the constitutional
validity of the individual mandate. Numerous lawsuits challenged the
constitutionality of the PPACA, with conflicting rulings from several Circuit
Courts of Appeals. As one would expect in such a situation, the Supreme
Court “accepted certiori” on these cases in the autumn of 2011, as this edition
went to press. A ruling is expected before the 2012 summer recess of the
Supreme Court—after the publication of this edition.
Readers of this text will find analyses of many of the facets of the PPACA
as it was crafted. As the legal landscape changes, this background should
allow the reader to understand how the environment may shift in the future,
and readers should be able to use the tools and approaches contained in this
book to understand the conse quences of various changes. Indeed, readers
will find that even the core legal challenge to the PPACA’s individual
mandate can be analyzed using key economic issues examined throughout
this textbook, including understanding how insurance markets work and
game-theoretic approaches to understanding how they would work in
various alternative legal settings.
To analyze health care economics in general and the PPACA specifically,
one must use a wide array of analytic tools and approaches. Useful tools
include cost-effectiveness analysis, game theory, and a careful analysis of the
linkages between lifestyle choices (tobacco, diet and exercise, alcohol abuse,
etc.) and health outcomes. A parallel development comes from the world of
genetics and molecular medicine, leading to a whole new array of diagnostic
and therapeutic alternatives not previously available as well as a better
understanding of how our genetic heritage may control our lifestyle choices.
(For example, some of us are genetically disposed to become addicted to
nicotine.) These new findings from genetic medicine require rethinking not
only diagnostic and therapeutic choices for physicians and their patients but
also the structure of health insurance programs and (most importantly) how
new technologies are introduced into the list of covered services. These same
genetic findings alter the legal and ethical landscape in thinking about
health care.
Additional Resources
Each chapter points readers to key chapters in the two-volume compendium
Handbook of Health Economics edited by Anthony Culyer and Joseph P.
Newhouse (2000). This two-volume series (part of an extended series of
Handbooks in Economics edited by top scholars in their fields) contains
summary articles from state-of-the-art researchers in topics spanning a wide
array of the field of health economics. These articles, while “dated” to the
2000 publication year, still stand as a useful resource for scholars in this field
and will do so for years to come.
The Companion Web site for Health Economics
(www.routledgetextbooks.com/textbooks/9780132948531) offers additional
resources for students such as useful Web links, additional material on the
role of genetics in obesity and the use of alcohol and tobacco, and self-study
quizzes. The Companion Web site also features three appendixes culled from
the text. These online appendixes consist of material covering Marginal Tax
Rates in the United States, a Review of Health Policy and Systems in
Selected Countries, and an Introduction to Basic Economics Concepts.
Acknowledgments
I wish to express my appreciation to the entire Pearson publication team for
their excellent help and collaboration in preparing this fifth edition,
beginning with the manuscript management, copyediting, production (many
thanks to Karen Berry at Laserwords and Alison Eusden at Pearson), and all
other steps leading to publication. I particularly wish to thank David
Alexander and Lindsey Sloan at Pearson for all of their help in this process
and valued guidance in thinking about additions, modifications, and
inevitable deletions in the book.
Acknowledgments

I wish to express my appreciation to the entire Pearson publication team for

their excellent help and collaboration in preparing this fifth edition,
beginning with the manuscript management, copyediting, production (many
thanks to Karen Berry at Laserwords and Alison Eusden at Pearson), and all
other steps leading to publication. I particularly wish to thank David
Alexander and Lindsey Sloan at Pearson for all of their help in this process
and valued guidance in thinking about additions, modifications, and
inevitable deletions in the book.
Chapter 1
Why Health Economics?

Learning Goals

Assess why the special study of health economics makes sense.

Understand novel aspects of health care and ways to approach the
issues.
Identify how health care markets differ from others, particularly
understanding the unique role of health insurance.
Ascertain how medical spending has evolved over time (and why),
dissecting changes over the years in medical spending.

Health care represents a collection of services, products, institutions,

regulations, and people that, in 2012, accounted for about 18 percent of our
gross domestic product (GDP), growing at about 2–4 percent of GDP per
decade in recent years. Projections for 2013 show that aggregate spending on
medical care will reach $3 trillion, of which $2.5 trillion represents “personal”
health care (the remainder goes to administrative expenses, research, and
construction). Thus, personal health care expenses are forecast to average
over $7,500 for each of the projected 320 million people living in the United
States in 2013. About half of this comes from private spending, the other half
from government spending (financed by taxation). This alone makes the
study of health care a topic of potential importance.1
Almost every person has confronted the health care system at some point,
often in situations of considerable importance or concern to the individual.
Even the most casual contact with this part of the economy confirms that
something is quite different about health care. Indeed, the differences are
often so large that one wonders whether anything we have learned about
economic systems and markets from other areas of the economy will apply,
even partly, in the study of health care. Put most simply, does anybody
behave as a “rational economic actor” in the health care market?
Important (If not Unique) Aspects of Health
Care Economics
Although the health care sector shares many individual characteristics with
other areas of the economy, the collection of unusual economic features that
appears in health care markets seems particularly large. The unusual
features include (1) the extent of government involvement; (2) the dominant
presence of uncertainty at all levels of health care, ranging from the
randomness of individuals’ illnesses to the understanding of how well
medical treatments work, and for whom; (3) the large difference in
knowledge between doctors (and other providers) and their patients, the
consumers of health care; and (4) externalities—behavior by individuals that
imposes costs or creates benefits for others. Each of these is present in other
areas of the economy as well, but seldom so much as in health care, and
never in such broad combination. A brief discussion of each issue follows.
As background to each of these ideas, and indeed for the entire book, the
student of health economics will be served by the following notion:
Uncertainty looms everywhere. Uncertain events guide individual behavior
in health care. This major uncertainty leads to the development of health
insurance, which in turn controls and guides the use of resources throughout
the economy. The presence of various forms of uncertainty also accounts for
much of the role of government in health care. Thus, if all else fails, search
for the role of uncertainty in understanding health care. Such a search will
often prove fruitful, and will lead to a better understanding of why the
health economy works the way it does and why the institutions in these
markets exist.

Government Intervention
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1039

Temperature of head in,

1036

1037

Trophic disturbances and disturbances of respiration,

1044

Vertigo in,

1034

Vomiting in,

1030

1034

Will, impairment of, and defects of speech,

1038

Treatment,

1066

Ergot, cannabis indica, and hyoscyamus, use,

1068

Leeches, use,

1068

Morphia and potassium bromide, use,

1068

Surgical,

1066

UMORS OF THE
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PINAL

ORD AND ITS

NVELOPES

1090

Definition,

1090

Diagnosis,

1098

from caries of spinal vertebræ,

1099

from hysteria,

1100
 from metallic and infectious diseases,

1100

from spinal congestion, hemorrhage, and meningitis,

1098

from traumatism, sclerosis, aneurism, and neuritis,

1100

localization of spinal tumors,

1100-1106

Duration and termination,

1106

Etiology,

1090

Age and sex, influence of,

1090

Traumatism, influence of,

1090

Pathology,

1096

characters, seat, and varieties of tumors,

1096-1098

vascular changes,

1098

Symptoms,

1091

Ataxia and atrophy in,

1094
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1096

Eye disorders,

1096

Headache in,

1096

Mental disturbances in,

1096

Pain, seat and characters,

1091

1092

Paralysis and paresis,

1091-1093
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1094

Sensation, alterations of,

1091-1093

Sense of constriction about waist,

1091-1093

Spasms and twitchings in,

1091

1092

1094

Temperature of body in,

1095

Vomiting in,
1096

Treatment,

1106

Tumors, phantom, in hysteria,

255

Turpentine, use of, in neuralgia,

1229

Tympanites, hysterical,

240

Typhoid fever as a cause of abscess of the brain,

799
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781

Typhus fever as a cause of hyperæmia of the brain,

768

U.

Ulcer of foot in tabes dorsalis,

839

Ulcerations in nervous diseases,

58
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1273

Unconsciousness, in cerebral meningeal hemorrhage,

712

Unilateral catalepsy, symptoms,

324

epilepsy,

482

facial atrophy, progressive,

693

preponderance of symptoms in cerebral anæmia,

784
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1165

Urine, state of, in brain tumors,

1045

in cerebral hemorrhage and hemiplegia,

961

in chronic lead-poisoning,

682

in epilepsy,

480

in general paralysis of the insane,

195

in hysteria,
253

in myxœdema,

1272

in neuralgia,

1212

1213

in symmetrical gangrene,

1260

in tabes dorsalis,

835

in the chloral habit,

662

in the opium habit,

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658

659

Uterine and ovarian irritation as a cause of reflex paralysis,

807

Uterus and ovaries, neuralgia of,

1240

V.

Vaginismus, hysterical,

246
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408

Varieties of hystero-epilepsy,

290

Vaso-constrictors, action of,

1243

Vaso-dilators, action of,

1244

Vaso-motor cerebral disturbances in general paralysis of the insane,

179
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520

nerves, origin of,

1246

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1242

Course,

1254

Diagnosis,

1252
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1242

Physiology,

1242

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1242

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1250

Origin of the vaso-motor nerves,

1246

Vaso-constrictors,

1243

Vaso-dilators,
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Vaso-motor reflexes,

1248

Vaso-motor tracts,

1249

Prognosis,

1255

Symptoms,

1252

Acrodynia,

1254

Angio-spasm and angio-paralysis,

1252
 Cutaneous angio-neuroses,

1252-1254

Digiti mortui and gangrene,

1252-1254

Erythromelalgia,

1253

Functional, derangements of internal viscera,

1254

Ruptured capillaries in,

1253

Sensation, disturbances of,

1252

1253
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1253

Treatment,

1255

Amyl nitrite and nitro-glycerin,

1256

Chloral hydrate and chloride of potassium in,

1256

Rest, massage, and electricity in,

1255

Vaso-motor and trophic neuroses,

1241

Definition,
1241

Reflexes,

1248

Symptoms of general paralysis of the insane,

189

Theory of pathology of hysteria,

211

Tracts of the spinal cord,

1249

Venous congestion in cerebral hyperæmia,

768

Ventricles of brain in cerebral anæmia,