Economics of Health

B.A. (Programme) Economics/B.A. (Hons.) Economics

Semester-VII
Discipline Specific Elective (DSE)

Course Credit-4
AS PER THE UGCF-2022 AND NATIONAL EDUCATION POLICY 2020

READING NOTES
 Table of Content

Sl. No. Title Page No.

Unit-I Lesson 1: Health Economics 1-10

Unit-II Lesson 2: Theories of Demand and Supply in Health Care 11-14

Lesson 3: Externalities and Regulations in Healthcare Sector 15-30

Lesson 4: Theories of Demand and Supply in Health Care 31-50

Lesson 5: Insurance and Market Incentive Problems in Health 51-65

Economics

Unit-III Lesson 6: Economic Evaluation of Health Sector 66-75

Unit-IV Lesson 7: Health Systems: An Overview of International Health 76-80

Systems and Indian Experiences
 Unit-I
Lesson 1

Health Economics
1.1 Introduction
Health Economics is the branch of economics that studies how societies allocate limited
resources to produce, distribute, and consume health and healthcare. Unlike most goods, health
is both a consumption good that provides direct satisfaction and an investment good that
enhances productivity, lifespan, and human capital. The subject examines not only healthcare
markets but also the economic behavior of patients, providers, insurers, and governments,
emphasizing efficiency, equity, and sustainability in health systems. Foundational ideas stem
from Kenneth Arrow, who highlighted market failures in healthcare—particularly uncertainty,
information asymmetry, and moral hazard. Later, the health-as-human-capital perspective was
shaped by Michael Grossman, whose model views health as a stock that yields healthy time,
influenced by medical care, lifestyle, and socioeconomic factors.
Health Economics explores the functioning of health financing institutions such as World
Health Organization and the economic rationale for insurance markets dominated by firms like
UnitedHealth Group. It evaluates public financing models, including programs such as
Medicare, and universal coverage initiatives like Ayushman Bharat. At the macro level, it
studies national health system performance, comparing countries such as India and high-
income benchmarks like United Kingdom, where the state-run National Health Service
exemplifies publicly delivered care.
The discipline also analyzes economic evaluation tools—cost-benefit, cost-effectiveness, and
cost-utility analysis—used by agencies like National Institute for Health and Care Excellence
to make decisions on new technologies such as vaccines developed by Serum Institute of India.
It measures health outcomes using indicators like DALY and QALY, guiding prioritization
across populations. Central concerns include health externalities observed during global shocks
like the COVID-19 pandemic, behavioral distortions in provider-patient decision-making,
rising costs of chronic conditions such as diabetes mellitus, and the policy economics of
infectious diseases like tuberculosis. Ultimately, Health Economics seeks to explain how health
systems can improve population well-being, protect households from financial risk, and
translate medical progress into economic and social development.
1.2 Significance and Linkages with the Economy: The Need for Health Economics as a
Discipline
Health Economics has emerged as an essential discipline because health is inseparable from
economic performance, social stability, and long-term human development. A healthy
population forms the foundation of national productivity, labor market participation, cognitive
capacity, and economic resilience. Poor health reduces workforce efficiency, increases
absenteeism, raises household medical expenditure, and diverts savings away from
investment—creating cycles of poverty and lower aggregate demand. Economists first

1
recognized the deep structural differences between healthcare and traditional markets through
the work of Kenneth Arrow (without repeating), who demonstrated how uncertainty and
asymmetric information generate persistent market failures in health systems. Building on this,
Michael Grossman (without repeating) formalized the idea that health is a form of human
capital, produced by individuals using medical care, nutrition, time, and behavioral choices,
with direct implications for earnings, education, and national output.
At the national level, rising healthcare costs affect government budgets, inflation dynamics,
and fiscal sustainability, linking health economics directly to macroeconomic policy. Public
institutions such as World Bank and global health authorities like the World Health
Organization (without repeating) emphasize that investment in health yields high economic
returns through improved life expectancy, demographic dividends, and reduced long-term
disease burdens. Governments operationalize these insights through public health financing
systems including programs like Ayushman Bharat Pradhan Mantri Jan Arogya Yojana, which
aim to protect households from catastrophic medical shocks, increase effective consumption
capacity, and stabilize domestic markets. Similarly, publicly funded delivery structures like the
National Health Service illustrate how large-scale health systems interact with employment
generation, procurement markets, wage structures, and national expenditure.
Health economics is also needed because disease burdens influence economic structure and
growth trajectories. Chronic conditions such as diabetes mellitus reduce labor productivity and
raise insurance costs, while infectious illnesses like tuberculosis and global disruptions such as
the COVID-19 create economy-wide externalities, supply-side contractions, and shifts in
consumption behavior. To manage priorities, health economists employ outcome metrics
including the QALY and the DALY, guiding cost-effectiveness decisions for medical
innovations, pharmaceuticals, and preventive strategies. These tools enable economic
evaluation agencies like National Institute for Health and Care Excellence to determine which
health interventions generate the highest welfare gains per unit of expenditure.
Thus, the discipline is vital because it explains how health systems shape economic incentives,
financial markets, consumption patterns, labor supply, public expenditure, and national growth.
It provides the theoretical and empirical basis for policymaking, cost evaluation, insurance
design, behavioral responses, and equitable access—ensuring that health improvements
translate into sustainable economic progress.
1.3 Health Capital
Health capital refers to the stock of physical and mental well-being that individuals inherit and
accumulate over time, which produces healthy time, generates utility, and enhances economic
productivity. The concept treats health not merely as a flow output (like healthcare services)
but as an evolving asset that depreciates, can be invested in, and yields lifetime returns in both
welfare and income.
1.3.1 Health as a Durable Good or Capital
Health is unique because it behaves simultaneously as a durable consumption good and an
investment asset. Like durable goods (e.g., vehicles or appliances), health provides benefits

2
over many periods—it yields healthy days and quality of life, not instant exhaustion upon
consumption. However, unlike a refrigerator or car, health directly determines a person’s
capacity to work, learn, and participate in economic activity, making it a productive asset
similar to capital in classical economics.
The theoretical foundation of health as capital is formalized in the seminal Michael Grossman
framework, often called the Health Capital Model, where:
• Health is modeled as a stock that produces healthy time (not medical care itself),
• Individuals invest in this stock using medical services, nutrition, time, and lifestyle
behaviors,
• The stock depreciates naturally with age, and
• Investment offsets depreciation to maximize lifetime utility and earnings.
This capital interpretation connects health to labor productivity studied by organizations like
the International Labour Organization, and to growth impacts analyzed by development
institutions such as the World Bank.
1.3.2 Initial Stock of Health Capital and Variability Among Individuals
Every individual begins life with an initial stock of health, which varies widely due to
genetics, prenatal conditions, nutrition, family income, environment, and early healthcare
access. This heterogeneity explains why two individuals of the same age may experience vastly
different health trajectories and economic outcomes.
Key sources of variability include:

Determinant Implication for Initial Health Stock

Genetic endowment Biological differences in resilience and disease susceptibility (e.g.,

predisposition to illness)

Prenatal & maternal Strong influence—maternal malnutrition, infections, or stress

health reduce initial stock

Early-life nutrition Protein and micronutrient intake determine foundational health

Environmental Pollution, sanitation, climate, and water quality shape early capital
conditions

Socioeconomic status Income and parental education strongly predict initial stock

For example:
• Metabolic disorders like diabetes mellitus may show intergenerational predisposition
that influences starting capital,
• Regions that successfully reduced early-life health risks draw on vaccination markets
supported by firms like the Serum Institute of India,

3
 • Sanitation-driven initial stock improvements are linked to government missions like
Swachh Bharat Mission,
• Countries tracking childhood health stock variability use demographic-health data
supported by the World Health Organization.
This variability also explains unequal ability to convert education into earnings, linking health
capital to human capital models studied in labor and growth economics.
1.3.3 Importance of Good Health: Utility Analysis
Good health generates utility directly and indirectly through income and capabilities. In
consumer choice theory, individuals derive satisfaction (utility) from goods and time—health
increases both:
1. Direct Utility Channel (Consumption Good Aspect)
o Good health yields enjoyment, mobility, longevity, and quality-adjusted life
satisfaction.
o People value health for the ability to consume life pleasure itself.
2. Indirect Utility Channel (Investment Good Aspect)
o Higher health → higher productivity → higher income → higher ability to
consume other goods.
o Health protects households from catastrophic expense, stabilizing consumption
behavior (insurance rationale).
Health economists measure these welfare outcomes using utility-based health metrics like the:
• QALY,
• DALY.
Utility maximization in health is constrained by income and time, since individuals must
decide:
• How much time to allocate to earning vs producing health (exercise, sleep, doctor
visits),
• How much income to spend on healthcare vs other goods.
Insurance markets influence perceived health utility via risk protection provided by firms like
the UnitedHealth Group, while public programs enhance consumption stability through
schemes such as the Ayushman Bharat Pradhan Mantri Jan Arogya Yojana.
Core insight from utility analysis:
Individuals do not demand healthcare itself, they demand health because it increases lifetime
satisfaction and the economic ability to participate in markets.
Why Health Economics Needs the Health Capital Approach
4
 • It explains long-term demand for preventive vs curative care,
• It models health investment decisions behaviorally and economically,
• It connects health with wages, schooling, savings, insurance, and growth, and
• It provides the basis for cost-effectiveness and policy prioritization in modern health
systems.
The basic four Questions of HealthCare sector
Health economics fundamentally deals with how limited healthcare resources are allocated,
organized, and utilized to maximize societal well-being. Healthcare resources differ from
conventional economic inputs because they are deeply tied to human survival, labor capacity,
ethical priorities, and public externalities. They can be broadly categorized into three
interdependent components of the healthcare production system.
Capital Inputs include the physical infrastructure and medical technology required to deliver
care—diagnostic equipment, imaging machines, medical tools, hospital beds, operating
theaters, and facilities for establishing diagnostic centers, nursing homes, and hospitals.
Technological markets supplying such critical capital inputs have been shaped by major
organizations like General Electric, which revolutionized diagnostic imaging and hospital
equipment supply chains, influencing national investment decisions in health systems.
Healthcare Personnel represent the skilled labor that produces and delivers healthcare
services—physicians, surgeons, nurses, lab assistants, pharmacists, lab technicians, and
medical consultants. The global supply and mobility of healthcare professionals are studied
extensively by bodies such as the World Health Organization and labor trends for medical
professionals are linked to workforce analytics produced by institutions like the International
Labour Organization. The economic behavior of physicians, their service incentives, and the
provider-patient decision market are rooted in theories of decision-making under uncertainty
first outlined by Kenneth Arrow.
Medical Supplies refer to consumable inputs necessary for diagnosis, treatment, and care
delivery—medicines, life-saving drugs, vaccines, syringes, injections, surgical gloves, gloves,
dressings, and hospital necessities such as bed linens and protective materials. The
pharmaceutical supply chain, pricing structures, and production costs of essential drugs are
heavily influenced by companies like Pfizer, while mass vaccine availability for developing
nations has been shaped by manufacturers such as Serum Institute of India.
Having established this foundation, we now shift from inputs to core economic decision
frameworks in healthcare. Similar to mainstream economics, which studies the distribution of
scarce resources across unlimited wants, healthcare economics evaluates decisions around
consumption, production, and distribution of health goods and services, always
constrained by income, time, budgets, information gaps, and policy choices. The approach
becomes clearer when analyzed through the three pillars of economic efficiency:
• Allocative Efficiency – choosing what mix of health and non-health goods should be
produced to optimize national welfare,

5
 • Production Efficiency – ensuring the health system produces maximum outcomes at
minimum possible cost, and
• Distribution Efficiency – determining who receives care, and how equitably and
sustainably access is distributed across society.
These efficiency concerns generate the four fundamental economic questions of the
healthcare sector, which every economy must answer regardless of its income structure,
institutional model, or demographic environment.
1.4 The Four Basic Questions of the Healthcare Sector
Allocative Efficiency
Question 1: What should be the optimal combination of medical and non-medical goods and
services produced in the macroeconomy?
This question situates health priorities within the broader economy where governments balance
investments between healthcare, nutrition, sanitation, housing, and education. Countries
designing these macro health allocation decisions often benchmark public health expenditure
against models like the state-delivered system of the National Health Service, where medical
services compete within the total government budget allocation.
Question 2: What mix of medical goods and healthcare services should a health economy
produce?
Here, decisions narrow to the healthcare sector itself—should the economy produce more
preventive care, curative facilities, diagnostic services, pharmaceuticals, or emergency life-
saving resources? This question is central in policy design of schemes such as the earlier
mentioned universal coverage model of the Ayushman Bharat, which determines demand
priorities in India’s health sector.
Production Efficiency
Question 3: Which healthcare resources should be used to produce the desired medical goods
and services?
This examines input selection—efficient combinations of capital, labor (personnel), and
medical supplies. It also includes decisions on technology adoption, hospital size, procurement
systems, wage incentives, and scale efficiencies. Decisions on these inputs are sensitive to
healthcare financing constraints analyzed in macroeconomic health policy discussions guided
by institutions like the World Bank.
Distribution Efficiency
Question 4: Who should receive the healthcare services and medical facilities produced?
This question introduces equity vs efficiency debates—should care go to those who can pay,
those who need it most, or those who contribute most to productivity? This forms the basis for
insurance design, subsidy policy, rationing mechanisms, and public health access rules. During
global shocks such as the COVID-19 outbreak, this question determined vaccine rationing,
public access, and economic stabilization decisions.

6
1.5 Health Capital
Health capital refers to the stock of physical and mental well-being that individuals possess
and can accumulate over their lifetime. It functions both as a durable good, providing direct
satisfaction and well-being, and as a productive asset, generating returns in the form of healthy
time, labor productivity, and lifetime utility. Understanding health as capital helps explain
individual and societal investment decisions in healthcare, lifestyle, and preventive measures,
as well as the economic implications of ill health.
1.5.1 Health as a Durable Good or Capital
Health differs from ordinary consumption goods because it provides sustained benefits over
time rather than immediate, one-time satisfaction. Like durable goods (cars, appliances), it
yields ongoing utility: good health allows individuals to work, learn, travel, and enjoy life over
many years. Unlike physical capital, however, health is self-producing and depreciating: it
naturally declines with age and must be actively maintained through investments in medical
care, nutrition, exercise, and preventive practices.
The Health Capital Model, developed by Michael Grossman, formalizes this concept.
According to the model:
• Health is a stock that produces healthy time, which can be spent on work, leisure, and
education.
• Individuals invest in health to maintain or increase this stock, using healthcare services,
nutritious food, and healthy lifestyles.
• Health depreciates naturally with age, illness, or poor lifestyle choices.
• Optimal health investment balances the cost of inputs (money, time, effort) against the
utility derived from improved health and productivity.
Viewing health as durable capital allows policymakers and economists to model healthcare
demand as an investment decision, not just a consumption choice. It also emphasizes the long-
term impact of early-life health interventions on labor productivity, educational outcomes, and
national economic growth.
1.5.2 Initial Stock of Health Capital and Variability Among Individuals
Every individual is born with an initial stock of health, which varies widely across
populations. This variability stems from multiple determinants:
• Genetics and biological endowments: inherited traits influence susceptibility to
chronic conditions or resilience to disease.
• Prenatal and maternal health: maternal nutrition, prenatal care, and exposure to
infections shape the newborn’s health.
• Early childhood nutrition and care: protein, micronutrients, vaccination, and early
medical interventions determine foundational health stock.

7
 • Environmental factors: sanitation, clean water, pollution levels, and housing
conditions directly impact health.
• Socioeconomic status: family income, parental education, and access to healthcare
create disparities in early health capital.
These differences in initial health stock explain why two individuals of the same age and
background may have very different life trajectories in terms of productivity, earnings, and
lifetime health outcomes. For example, childhood malnutrition can reduce adult labor
efficiency, while access to preventive care and vaccination can extend healthy life years and
reduce future disease burden.
1.5.3 Importance of Good Health: Utility Analysis
Good health generates both direct and indirect utility:
1. Direct utility: Health itself provides satisfaction and quality of life. Individuals value
mobility, independence, and the ability to enjoy leisure and social interactions. A
healthy life allows people to experience well-being directly, without relying solely on
other goods or services.
2. Indirect utility: Health enhances productivity, income, and the ability to consume other
goods. Healthy individuals work more efficiently, incur fewer medical costs, and can
invest in education or business opportunities, thereby improving overall economic
outcomes.
Economic models measure the utility of health using metrics such as Quality-Adjusted Life
Years (QALYs) and Disability-Adjusted Life Years (DALYs). These measures allow
policymakers to compare the benefits of preventive care, medical treatments, and public health
interventions relative to their costs. For example, a vaccination program may be evaluated by
how many QALYs it adds to the population, guiding investment decisions.
From a microeconomic perspective, individuals allocate time and money between health
investment (exercise, medical care, diet) and consumption of other goods to maximize lifetime
utility. The trade-off illustrates that health is not just a consumption good but a form of human
capital that supports economic and personal well-being throughout life.
Summary
Health economics examines how societies allocate scarce healthcare resources to maximize
well-being, efficiency, and equity. The healthcare system relies on three essential inputs:
capital inputs (hospital infrastructure, diagnostic equipment, medical technology), healthcare
personnel (physicians, nurses, lab technicians), and medical supplies (medicines, vaccines,
consumables). Efficient allocation of these resources involves addressing the four fundamental
economic questions: what to produce, how to produce, and who should receive healthcare
services, with a focus on allocative, production, and distribution efficiency.
Beyond inputs, health itself functions as a form of durable capital—the stock of physical
and mental well-being that generates healthy time, utility, and productivity. Health capital is

8
dynamic: it depreciates with age and illness but can be maintained or increased through
investments in medical care, nutrition, exercise, and preventive measures. Individuals begin
life with different initial stocks of health, influenced by genetics, prenatal and early-life
conditions, environment, and socioeconomic status. Good health produces direct utility
through enhanced quality of life and indirect utility by increasing productivity, income, and
consumption potential.
Understanding health as both a consumption good and an investment asset links individual
health decisions to broader economic outcomes. By integrating resource allocation, health
capital formation, and utility analysis, health economics provides a framework for designing
policies, prioritizing interventions, and improving population health while promoting
economic growth and social welfare.
Glossary of Key Terms
1. Health Economics – The branch of economics that studies how scarce resources are
allocated to produce, distribute, and consume health and healthcare, aiming to maximize
well-being, efficiency, and equity.
2. Healthcare Resources – Inputs used to produce healthcare services, including capital,
personnel, and medical supplies.
3. Capital Inputs – Physical infrastructure and equipment used in healthcare, such as
hospitals, diagnostic machines, surgical tools, and treatment facilities.
4. Healthcare Personnel – Skilled labor that delivers healthcare services, including
physicians, nurses, lab technicians, pharmacists, and medical consultants.
5. Medical Supplies – Consumable items used in healthcare delivery, such as medicines,
vaccines, injections, surgical gloves, and bed linens.
6. Allocative Efficiency – The economic principle of producing the optimal combination
of goods and services that maximizes societal welfare.
7. Production Efficiency – The efficient use of resources to produce healthcare services at
the minimum possible cost while achieving desired outcomes.
8. Distribution Efficiency – The equitable allocation of healthcare services among
individuals or groups in society.
9. Health Capital – The stock of physical and mental well-being that individuals possess,
which can be maintained or increased through investments and generates utility and
productivity.
10. Durable Good – A good that provides utility over multiple periods; in health economics,
health is treated as a durable good that yields long-term benefits.
11. Initial Stock of Health – The level of health an individual is born with, influenced by
genetics, prenatal care, early nutrition, environment, and family socioeconomic status.

9
12. Depreciation of Health Capital – The natural decline of health over time due to aging,
disease, or unhealthy behavior, which can be offset by investment in healthcare and
lifestyle.
13. Health Investment – Actions taken to maintain or improve health capital, including
medical care, nutrition, exercise, and preventive measures.
14. Utility (Health Context) – The satisfaction, well-being, or quality of life derived from
good health, both directly (enjoyment of life) and indirectly (through increased
productivity and income).
15. QALY (Quality-Adjusted Life Year) – A measure used to evaluate health interventions
by combining quality and quantity of life, indicating the value of health improvements.
16. DALY (Disability-Adjusted Life Year) – A measure of population health that quantifies
the burden of disease by combining years lost due to disability and premature death.
17. Human Capital – The stock of knowledge, skills, and health that enhances an
individual’s productivity and economic potential.
18. Health Production Function – An economic concept describing how inputs (capital,
personnel, supplies) and individual investment translate into health outcomes.
19. Externalities in Health – Spillover effects of health actions that affect others, such as
vaccination reducing disease transmission or pollution affecting community health.
20. Preventive Care – Healthcare actions aimed at avoiding disease or complications, such
as immunizations, screenings, and lifestyle interventions.

10
 Unit-II
Lesson 2

Theories of Demand and Supply in Health Care

The healthcare market is unique compared to conventional markets because healthcare goods
and services are not ordinary commodities. People consume healthcare not for pleasure but
to achieve health outcomes such as survival, recovery, and improved quality of life. This
introduces complexities in analyzing demand and supply, including:
• Uncertainty: Patients cannot predict the timing, severity, or cost of illness.
• Asymmetric information: Providers often know more than patients, which can
influence the quantity and type of care consumed.
• Third-party payment: Insurance or government coverage reduces the direct financial
burden, altering demand behavior.
• Externalities: Preventive measures like vaccination benefit not only the individual but
society by reducing disease transmission.
Understanding demand and supply in healthcare allows policymakers and providers to allocate
resources efficiently, set prices, and ensure equitable access.
2.1 Demand in Health Care
The demand for healthcare is a derived demand: people do not demand medical care itself;
they demand health, which improves life expectancy, productivity, and well-being.
Factors affecting healthcare demand include:
1. Price of Healthcare Services:
o Higher consultation fees, treatment costs, or medicine prices can reduce
consumption, especially for elective or non-urgent care.
o For critical care or emergencies, demand tends to be inelastic, meaning patients
will seek treatment regardless of price.
2. Income and Wealth:
o Healthcare is generally a normal good—as income rises, individuals demand
more healthcare services.
o High-income groups may access advanced diagnostic procedures, elective
surgeries, or private hospital services.
3. Health Status and Perceived Need:
o Sicker individuals naturally consume more healthcare.

11
 o Perception of risk (e.g., susceptibility to chronic disease) influences preventive
care consumption.
4. Availability of Substitutes and Complements:
o Preventive care (vaccinations, check-ups) can substitute for more expensive
treatments later.
o Complementary services, like physiotherapy after surgery, increase overall
demand.
5. Insurance Coverage:
o Reduces out-of-pocket expenses, increasing effective demand for medical
services.
o May also lead to moral hazard, where insured patients overuse healthcare
services.
Behavioral Factors: Cultural attitudes, trust in providers, health literacy, and risk aversion
significantly influence demand patterns.
Example: A patient may choose preventive cardiac screening (elastic demand) when fees are
low or covered by insurance but may still undergo urgent heart surgery (inelastic demand)
regardless of cost.
2.2 Supply in Health Care
Supply of healthcare services refers to the amount of care providers are willing and able to
deliver at different prices, considering resources, technology, and incentives.
Determinants of healthcare supply:
1. Resource Availability:
o Human resources (physicians, nurses, technicians), medical capital (hospitals,
machines), and consumables (medicines, gloves) constrain supply.
2. Production Technology:
o Improvements in medical technology, telemedicine, and hospital management
increase productivity, allowing more services at lower cost.
3. Provider Behavior and Incentives:
o Fee-for-service systems may encourage higher service provision (supplier-
induced demand).
o Salary-based or capitation payment systems may influence the number of
patients served and types of treatments provided.
4. Regulatory and Institutional Factors:
o Licensing, accreditation, price ceilings, and government interventions affect
supply quantity and quality.

12
Example: During the COVID-19 pandemic, hospitals faced supply constraints due to limited
ICU beds, ventilators, and trained personnel, which influenced the availability and pricing of
services.
2.3 Elasticities of Health Care Services
Elasticity measures how responsive demand or supply is to changes in price, income, or related
goods. Elasticity analysis is vital for predicting healthcare consumption, designing policies,
and managing resources efficiently.
2.4 Price Elasticity of Demand (PED)
Price elasticity of demand measures the responsiveness of the quantity demanded of
healthcare to price changes:
% change in quantity demanded
𝑃𝐸𝐷 =
% change in price

• Inelastic Demand: Essential care such as emergency surgery, dialysis, or intensive

care—patients will consume nearly the same quantity regardless of price.
• Elastic Demand: Elective procedures like cosmetic surgery or preventive screenings—
higher prices may reduce consumption.
Policy Implication: Understanding PED helps design copayments, subsidies, or price
regulations without restricting access to essential care.
2.5 Income Elasticity of Demand (YED)
Income elasticity of demand shows how healthcare demand changes with income:
% change in quantity demanded
𝑌𝐸𝐷 =
% change in income
Healthcare is usually a normal good (YED > 0); demand rises with income.
• Some high-end services are luxury goods (YED > 1), such as private hospital rooms
or advanced diagnostic scans.
Policy Implication: As income rises, developing countries face increased demand for
advanced healthcare, requiring supply expansion and investment in infrastructure.
2.6 Cross-Price Elasticity (XED)
Cross-price elasticity of demand measures how the demand for one healthcare service
responds to the price change of another:
% change in quantity demanded of service A
𝑋𝐸𝐷 =
% change in price of service B

13
 • Substitutes: Higher price for private hospital surgery may increase demand for
outpatient clinics.
• Complements: Vaccination and preventive screening often complement each other;
higher cost of one may reduce consumption of both.
Policy Implication: Helps design pricing and service bundling strategies to maintain or
optimize service utilization.
2.7 Implications for Policy and Providers
1. For Policymakers:
o Design subsidies, co-payments, and insurance coverage to maintain access
while controlling costs.
o Predict changes in demand due to price, income growth, or policy interventions.
o Identify essential services that require regulation to prevent inequities or
overuse.
2. For Providers:
o Optimize pricing for elective and emergency services.
o Allocate resources efficiently based on expected patient responsiveness.
o Plan service expansion, staffing, and equipment procurement based on
elasticity-informed demand estimates.
Conclusion
Understanding demand, supply, and elasticity in healthcare is critical because the market for
medical services behaves differently from traditional goods markets. The presence of
uncertainty, information asymmetry, insurance, and externalities makes economic analysis of
healthcare complex. Elasticity measures provide practical insights for pricing, policy design,
and resource allocation, ensuring that healthcare delivery is efficient, equitable, and
sustainable.

14
 Lesson 3

Externalities and Regulations in Healthcare Sector

(THIS LESSON IS A PART OF THE HEALTH ECONOMICS BOOK WRITTEN FOR
MBA HEALTHCARE SOL COURSE)
Dr. Ruhee Mittal
Assistant Professor
Department of Economics, School of Open Learning
University of Delhi

Structure
3.1 Learning Objectives
3.2 Introduction
3.3 Taking the Pulse of the Macroeconomy of Health of India
3.3.1 Cost of Medical Care facilities
3.3.2 Access of Healthcare in India
3.3.3 Quality of Healthcare
3.4 The Prevalence of Externalities in Healthcare sector
3.5 Regulatory environment of Healthcare Sector
3.5.1 Regulatory, Economic and Social Environment of the Healthcare Sector
3.5.2 Social Regulation of the Healthcare
3.5.3 Economic Regulations of Healthcare
3.6 Cross-country Comparison
3.7 Summary
3.8 Glossary
3.9 Answers to In-text questions
3.10 Self-Assessment Questions
3.11 References
3.12 Suggested Readings

3.1 Learning Objectives

After studying this lesson, students will be able to:

• Analyse the three-legged stool of the healthcare sector macroeconomy.

• Describe about the regulatory environment related to the health care sector in the
country.

15
 • Compare about the contribution of healthcare to the GDP, life expenancy rate of the
people in the various countries and study about the various macroeconomic factors
to have an overview of the cross country comparison.
3.2 Introduction
In the last lesson you have understood about the importance of health. Healthcare is not just an
individual’s concern. It is an important component of the nation’s economic structure. As the
health of the population influences the labor productivity, income levels and overall economic
growth of the country. Thus, making healthcare sector an integral part of the macroeconomic
planning and policy-making.
To understand in the macroeconomic environment of the healthcare sector, the concept of three
legged stool – cost, access and quality is used to gauge the performance of a health economy.
The various dimensions are studies to understand the contribution of the healthcare sector to
the economy. The indicators studies are related to cost of medical care facilities, access and
quality of the services. This will broaden your horizons on how health outcomes are deeply
tied to the nation’s economic stability and development.
Than we delve into externalities associated with the healthcare sector. The externalities are the
unintentional outcomes of the individuals health-related choices on the society. These can
positive or negative effects. Such as if an individual get vaccinated on timely basis than they
contribute to the herd immunity, which will benefit the enitre community. On the other hand,
lack of proper sanitation can spread communicable diseases which will have a huge social
impact. So, understanding these externalities is vital for designing effective health policies.
Finally, we explore the regulatory social and economic environment that governs the healthcare
sector. This includes the various laws, regulatory bodies and institutions that ensure the quality,
accessibility and affordability of the healthcare services. Finally, cross country comparison of
selected developed and developing countries is done to analyse the status of healthcare
segment.
3.3 Taking the Pulse of the Macroeconomy of Health of India
When we are referring to macroeconomy our key focus is on production, consumption and
distribution of goods and services to the consumers. But when we are referring to the health
economy than we have to distinctly consider the production, consumption and distribution of
the good and services related to health of the population. The countries across the globe are
spending a significant amount on healthcare as a percentage of GDP (Figure 3.1).This has
increased from 8.62% to 10.36% in the period spanning from 2000 to 2023.

16
Source: World Health Organization Global Health expenditure database, accessed on Jan 13,
2025
Figure 3.1: Current Health Expenditure (% of GDP)
The key health indicators which can provide a better understanding of the macroeconomic
environment of the health sector form a three-legged stool of the healthcare sector. The so-
called three legs of the health sector are: cost, access and quality.
3.3.1 Cost of Medical Care facilities
Lets understand the cost of the healthcare services in India with respect to the expenditure made
by the households on the healthcare. According to the data from Centre for Monitoring Indian
Economy’s Consumer Pyramids Household Survey (CMIE-CPHS), Indian households spent
over Rs. 120 billion on healthcare-related expenditure in Nov 2023. The CMIE-CPHS
conducted a survey on 178,677 households with 875,000 members as of on [Link] found
that urban and rural India spends 42.3% and 57.7% of the total health. The data of the estimated
household expenditure on the healthcare on sector is presented in Figure 3.2:

Estimated Total Household Expenditure on

Healthcare
80
69.3
66.4
70 62.9
Expenditure (in billion)

57.8 58.5
60 55.2
49 50.1 50.8
50 40.1 40.9
38.4
40
30
20
10
0
Jan- 18 Jan-19 Jan-20 Jan-21 Jan-22 Nov-22
Urban (billion) Rural (billion)

Data Source: CEDA, CMIE-CPHS

Figure 3.2: Estimated total household expenditure on Healthcare

17
They collected data on household expenditure on medicines, doctor / physiotherapists fees,
medical tests, health insurance premium, hospitalisation, health enhancement services
(hygiene, fitness, parlors/spa), spectacles, contact lenses and other medical aids for the month
of Nov, 2022 (Table 3.1 & Figure 3.3):
Table 3.1: Breakdown of Total estimated total household expenditure on healthcare by
different components

Particulars % of total Expenditure made in the month of

Nov, 2022
Health enhancement 45.50%
Medicines 42.30%
Doctors/Physiotherapists fees 5.60%

Health insurance premium 2.00%

Medical tests 1.60%
Medical aids 1.60%
Hospitalisation 1.40%
Data Source: CEDA, CMIE-CPHS

Health enhancement

Medicines

Doctors/Physiotherapists fees

Health insurance premium

Medical tests

Medical aids

Hospitalisation

Data Source: CEDA, CMIE-CPHS

Figure 3.3: Breakdown of Total estimated total household expenditure on healthcare by
different components
3.3.2 Access of Healthcare in India
To measure the access of healthcare facilities in India, the data on various types of hospitals in
India is taken. According to the data released by Press Information Bureau on 31 March 2023,

18
the current position of public healthcare infrastructure and Human Resources in India is
presented in Table 3.2:
Table 3.2: Public Healthcare Infrastructure and Human Resources in India

Facility Type Number of Doctors/Medical Nursing Paramedical

Facilities Officers Staff Staff
Sub-Centres (SCs) 1,69,615 – – 2,39,911 Health
Workers
Primary Health 31,882 40,583 47,932 –
Centres (PHCs)
Community Health 6,359 26,280 Specialists 51,059 –
Centres (CHCs) & Medical Officers
Sub-Divisional 1,340 --
Hospitals (SDHs) 45,027 Doctors & 1,35,793
District Hospitals 714 Specialists --
(DHs)
Medical Colleges 362 – – –
(MCs)
Source: PIB, as on 31 March, 2023
3.3.3 Quality of Healthcare
To gauge the quality of Healthcare services in India, we can take the infant mortality rate and
life expectancy rate. The data for infant mortality rate i.e. the number of deaths of children
under one year of age per 1,000 live births from 2012 to 2022 (Figure 3.4)

Infant Mortality Rate in India

45.00
40.00
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Source: Data extracted from [Link]

Figure 3.4: Infant Mortality Rate in India

19
3.4 The Prevalence of Externalities in Healthcare sector
Let’s begin this section by recalling what are externalities: An externality arises when the
production, consumption or investment activities carried out by an individual have an adverse
impact on the well-being of the third party/society who has neither paid or not received any
compensation for the effect. If the effect is beneficial for the society, it is called positive
externality. If it is adverse for the society, it is called negative externality. in the presence of
such kind of phenomenon, the market outcomes extend beyond the buyers and sellers who are
the participant of the market forces, extend to include third parties too. As the buyers and sellers
often tend to ignore the external effects of their action, this leads to unregulated markets with
inefficient outcomes.
Similarly, healthcare segment is not different from these kinds of externalities. Lets begin by
understanding the externalities of the health care segment (Figure 3.5):

• Positive Externalities
• Ex: Vaccination programs, Health Education, Medical Research and
Development
Externalities • Negative Externalities
of Helathcare • Ex: Antibiotic Resistance, pollution from healthcare facilities, health
sector inequalities.
• For Positive Externalities
• Subsidies or incentives
• Encourage more of the activity
• For Negative Externalities:
Possible • Taxes or regulations
Solutions • Discourage harmful activities
• Regulating the mdeical sector through government intervnetion

• Government intervention (taxes/subsidies) suggested by Cecil Pigou

Implementa- such as providing 'free vaccines'
tion • Setting up environmental standards for Medical Waste Disposal

Figure 3.5: Externalities of Healthcare sector

3.4.1 Positive Externality
The positive externality arises from the healthcare sector when the actions of the physicians,
patients, hospitals or government are beneficial for the others. Let’s take the example of
vaccines. If one individual gets vaccination against some disease then she is less likely to get
infected from it. But because she has reduced her chances of catching the infection, it is possible
that she will not act as a carrier for the same and infect other people. Thus, getting vaccination
is a positive externality. if getting vaccination has will charge something from the individual,
even than they will opt for it and will ignore the indirect benefits arising out of it to the society.

20
The government often tend to provide subsidies for the development, manufacuting and
distribution of vaccines. One such programme carried out by India against Polio. India battle
against polio serves as a remarkable example of vaccination program which have positive
externalities.
In 1995, the government of India launched Pulse Polio Immunization Program. Under this
programe oral polio vaccines (OPV) were given free of cost to all children under five years of
age. Finally, in 2014 the country was declared polio-free. Other such programmes were:
Mission Indradhanush launched in 2014 to prevent such as measles, diphtheria, and tetanus. In
2019, India initiated one of the world's largest vaccination drives to fight the COVID-19
pandemic.
These vaccination program had a positive economic impact too. India saved million dollars in
healthcare segment and prevented long-term productivity loses or preventing lockdown and
closures.
Another positive externality in the healthcare system is related to medical research. These days
companies, doctors are spending lots of time and money for developing new methods of
treating an ailment. The benefit provided to other physicians and patients is a kind of positive
social cost/externality. Government also responds to these externality in different ways. They
provided patents, trademarks and copyrights on the new products. The government also provide
subsidies to for carrying out research in the field of medical sciences.
3.4.2 Negative Externality
The negative externality arises from the healthcare sector when the actions of the physicians,
patients, hospitals or government has an adverse effect on others. These externalities often
arise due to inefficient resource allocation. One such example of negative externality is
pollution occurred due from various healthcare facilities such as hospitals, nursing homes etc.
These facilities might engage in improper disposal of medical waste which can in turn
contaminate the water air, soil leading to an increased risk on living beings.
Another example of negative externality in healthcare segment is the overuse of the antibiotics
by the patients or over-prescription of drug may contribute to antibiotic resistance amongst the
people. This may become a global threat that will escalate the cost of treatment and will reduce
effectiveness of drugs for everyone.

In-text Question
Q1 Which of the following is an example of a positive externality in the healthcare sector?
A. A hospital generating waste that pollutes nearby rivers
B. Vaccination programs reducing the spread of infectious diseases in a community
C. A pharmaceutical company charging high prices for essential medicines
D. Overuse of antibiotics leading to antibiotic resistance
Q2 Why are externalities considered a form of market failure in healthcare?
A. Because they always lead to profits for private hospitals
B. Because their effects are limited only to the individual receiving treatment

21
 C. Because costs or benefits spill over to others who are not directly involved
D. Because they only occur in government-funded health programs
Q3 Which policy tool is commonly used by governments to correct negative
externalities in public health?
A. Increasing subsidies for luxury hospitals
B. Providing free spa and wellness treatments
C. Imposing fines for improper waste disposal by hospitals
D. Offering cash incentives for private clinics
Q4. An unvaccinated individual spreads a contagious disease in a community. This is
an example of:
A. A public good
B. A moral hazard
C. A negative externality
D. A healthcare monopoly

3.5 Regulatory environment of Healthcare Sector

The healthcare sector serves as both service and industry. It needs to be regulated properly so
that the government’s requirements can be enforced properly. The patients safety regulation is
defined as, “the processes engaged in by institutional actors that seek to shape, monitor, control
or modify activities within healthcare organizations in order to reduce the risk of patients being
harmed during their care.”
Regulation is very important entity in the healthcare sector. The regulatory bodies play a key
role in protecting the interest of not only healthcare consumers from health risk but also
safeguards the interest of the healthcare professionals. These regulations ensure that the public
health and welfare schemes are implemented properly and their benefits reaches the masses.
The regulatory standards are developed and enforced by the government as well as private
organisations. These regulations are mandatory to standardize and supervise the healthcare
segment. With help of these regulations it is ensured that healthcare bodies and facilities
comply with the public health policies so that they can provide safe treatment to all the patients
visiting our healthcare institutions.
The regulatory agencies also monitor the corporate hospitals and professionals who have their
own nursing homes and small-scale hospital. These bodies also set guidelines for the insurances
sector providers too. They even keep on updating the government about the latest treatment
protocols and latest developments in the field on healthcare industry. They ensure that higher
safety standards are maintained and make regular attempts to improve the healthcare quality.
3.5.1 Regulatory, Economic and Social Environment of the Healthcare Sector
The key aspects related to regulatory environment are:
• Role of Government: The government creates policies and laws which governs the
various stakeholder of the healthcare sector i.e. the physicians, industry engaged in the

22
 production of pharmaceuticals/ drugs and medical devices. For example, Food and
Drug Administration (FDA) in the U.S. and Central Drugs Standard Control
Organsiation (CDSCO) in India regulate drugs and devices.
• Setting up of Standards and Accreditation: The various institutions (hospitals,
nursing homes, clinics etc) of the healthcare sector must adhere to national and
international quality standards, like those of the Joint Commission or ISO certifications.
• Data Privacy Laws: It is mandatory for the insurance agencies and hospital to ensure
the protection of the data of the patients and their personal information. One such
agency is Health Insurance Portability and Accountability Act (HIPAA) in the U.S. that
protects patient health information. This agency also encourages the use of electronic
health records to improvise the quality and efficiency of the healthcare sector.
• Universal Health Coverage (UHC): Many countries mandate UHC to provide
equitable healthcare access.
• Ethical and Legal Compliance: Laws addressing medical malpractice, organ
donation, euthanasia, and informed consent.
3.5.2 Social Regulation of the Healthcare
The social dimension focuses on the needs, delivery and outcomes. It ensures that equitable
access of the healthcare services for all segments of the society. It addresses the social
disparities based on the income, geography, demographic, cultural beliefs, etc.t these polices
aims to enhance the health awareness, improve inclusivity and support the vulnerable group.
The other key aspects of this dimension are:
• Demographics: The countries like Japan where the aging populations is higher have
higher demand for chronic disease management and long-term care.
• Cultural Beliefs: The healthcare sector is also influenced by the cultural beliefs of the
residents depending on the history of the country such as alternative medicine in India
or preventative care in Scandinavia. In India, cultural beliefs have deeply rooted ties to
traditional and alternative medicine systems, such as Ayurveda, Yoga, Unani, Siddha,
and Homeopathy (commonly referred to as AYUSH). These practices have been passed
down through generations and are widely trusted as effective means of prevention and
treatment.
• Addressing health inequalities: There are disparities in any country based on
socioeconomic status, gender, or ethnicity.
• Public Awareness: The government on timely basis runs awareness campaigns for
diseases like HIV/AIDS or vaccination drive social changes and improve the public
health.
3.5.3 Economic Regulations of Healthcare
The economic regulation of the healthcare sector involves the government or institutional
policies to ensure fair competition, affordability and efficient resource allocation. This was
originally set up to regulate natural monopolies in the interest of the consumer and to promote

23
competition wherever [Link] aims to balance the interest of the patients, providers and other
stakeholders while promoting equity and quality in healthcare. The key aspects of this are:

• Regulating the prices: The government needs to ensure that the medical services,
drugs and devices are provided to the patients and physicians at affordable prices. For
instance, India’s National Pharmaceutical Pricing Authority (NPPA) is working on
fixing prices of the essential drugs. Some countries even use international benchmarks
to regulate the prices of the drugs. Government also regulates the insurance companies
to prevent the practice of charging excessive premiums.

• Market entry and competition: In each country the policy of obtaining license and
getting accreditation is must for the professional, physicians and corporates working in
the healthcare segment to set up hospitals, clinics, and nursing homes. These regulations
ensure prevent the creation of monopoly practices and promote fair competition
amongst the healthcare providers, insurers and pharmaceutical companies. In India,
Competition Commission of India regulates the anti-competitve practices in the
healthcare segment. The policy of patent expiration promote the production of generic
drugs and lowers the cost of the same.

• Insurance Regulation and Healthcare financing: Government regulate the

insurance system to ensure that risk pooling, provides subsidies and launch schemes to
provide healthcare to the lower income group. The Government of India (GOI) aims to
provide free access and health insurance coverage for low income earners. For this
purpose, GOI has launched Ayushman Bharat Pradhan Mantri Jan Arogya Yojana. In
this scheme almost 50% of the population qualifies. In Germany, everyone must have
health insurance to ensure universal coverage of the s ame.
The table 3.3 provides you a brief overview of the regulatory, social and economic aspect of
the healthcare sector.
Table 3.3: Regulatory, Social and Economic Aspect of Healthcare Sector

Aspect Description Examples

Regulation Policies and laws • India: The National Pharmaceutical Pricing
governing the operation Authority (NPPA) regulates the prices of
of healthcare systems, essential medicines, ensuring affordability for
providers, and insurers. all sections of society.
• USA: The Food and Drug Administration
(FDA) strictly monitors drug and vaccine
approvals to ensure safety and efficacy.
Ensures quality, safety, • EU: GDPR protects patient data privacy.
and equitable access to • Canada: Licensing requirements for
healthcare services. healthcare facilities.
Social Focuses on societal • United Kingdom: In UK, National Health
factors like equity, Service (NHS) provides free healthcare at the

24
 inclusion, and access to point of use, ensuring universal access for
care, addressing citizens.
disparities in health. • South Africa: Government programs combat
the high prevalence of HIV/AIDS, focusing on
both treatment and prevention, especially in
rural areas.
Promotes health • Brazil: The Unified Health System (SUS)
awareness and ensures offers free healthcare services to low-income
vulnerable populations populations, emphasizing primary and
are covered. preventive care.
• Japan: Elderly and unemployed citizens are
comprehensively covered under the national
healthcare system, ensuring no one is left
behind.
Economic Economic policies • Germany: Mandatory health insurance for all
affecting pricing, citizens.
financing, and resource • Australia: Bulk billing under Medicare.
allocation in healthcare.
Balances cost control, • China: Drug price negotiations to lower costs.
efficiency, and • India: Ayushman Bharat for financial
investment in the protection.
healthcare sector.

3.6 Cross-country Comparison

The cross-country comparison of the selected countries was done on the basis of the life
expectancy, nurses and midwives (per 1,000 people), hospital beds (per 1,000 people) and
physicians (per 1,000 people).
Table 3.4 shows a comparison of life expectancy among males and females of various countries
across the globe and rank of the countries is also given. According to the ranking people living
in Hongkong have highest life expectancy amongst various countries of the world. India stands
at 123th rank with average expectancy rate of 72.24 out of which average age of males is 73.86
and females is 70.73.
Table 3.4: Life Expectancy of Male and Females for various countries of the world and
their Rankings

Rank Country Life Expectancy Females Males

(both sexes) Life Expectancy Life Expectancy
1 Hong Kong 85.63 88.26 82.97
2 Japan 84.85 87.88 81.83

25
 3 South Korea 84.43 87.28 81.32
5 Switzerland 84.09 85.95 82.17
6 Australia 84.07 85.85 82.28
7 Italy 83.87 85.87 81.75
8 Singapore 83.86 86.36 81.38
58 China 78.02 80.97 75.25
65 Sri Lanka 77.67 80.75 74.45
123 India 72.24 73.86 70.73
139 Nepal 70.64 72.14 69.09
198 Central African 57.67 59.56 55.51
Republic
199 Chad 55.24 57.19 53.36
200 Nigeria 54.64 54.94 54.33
Source: Worldometers, 2025s
The Figure 2.6, 3.7 and 3.8 shows the infrastructure availability of healthcare facilities in terms
of three key parameters i.e. hospital beds (per1,000 people), physicians ( per1,000 people) and
Nurses and midwives (per 1,000 people). The graphs shows that in India there are average 1.6
hospital beds are available per 1000 person in India. The Figure 3.7 and 3.8 shows that the
merely 0.727 physicians and 1.728 nurses are available per 1000 people residing in India. This
shows that there is huge burden on the healthcare sector and government need to develop proper
infrastructure in terms of providing training and running courses to maintain a supply and
demand equilibrium.

Hospital beds (per 1,000 people)

14 12.72
12

10
7.8
8

6 5
3.84
4 2.74 2.56
2.35 2.46
1.6
2
0
0
India United United Germany Japan Canada China Australia Brazil South
States Kingdom Africa

Source: Author’s own, data retrieved from WHOGHWS

Figure 3.6: Cross-country comparison of Hospital beds (per 1,000 people)

26
 Physicians (per 1,000 people)
5 4.52
4.5 4.102
4 3.555
3.5 3.17
3 2.46 2.387
2.5 2.164 2.14
2
1.5
0.727 0.81
1
0.5
0
India United United Germany Japan Canada China Australia Brazil South
States Kingdom Africa

Source: Author’s own, data retrieved from WHOGHWS

Figure 3.7: Cross-country comparison of Physicians (per 1,000 people)

Nurses and midwives (per 1,000 people)

16 14.8
14 12.47 12.35 12.45
12 10.3
10 9.17

8
5.51 5.01
6
4 3.31
1.728
2
0
India United United Germany Japan Canada China Australia Brazil South
States Kingdom Africa

Source: Author’s own, data retrieved from WHOGHWS

Figure 3.8: Cross-country comparison of Physicians (per 1,000 people)
In-text questions
Q5: What is the primary objective of economic regulation in the healthcare sector?
A. To promote private sector dominance in healthcare services
B. To ensure affordability, control prices, and prevent anti-competitive practices
C. To reduce government involvement in the provision of medical services
D. To impose taxes on healthcare providers to fund public health campaigns
Q6: What is the primary objective of regulatory bodies in the healthcare sector?
A. To ensure maximum profitability for healthcare providers
B. To standardize medical education globally
C. To protect patient rights and ensure quality and safety in care delivery

27
D. To eliminate public sector healthcare facilities
Q7. Which of the following is responsible for regulating medical education and the ethics of
medical professionals in India?
A. Indian Council of Medical Research (ICMR)
B. Ministry of Health and Family Welfare
C. National Medical Commission (NMC)
D. Central Drugs Standard Control Organization (CDSCO)
Q8 Price caps on essential medicines in India are governed under which regulatory
framework?
A. Foreign Exchange Management Act (FEMA)
B. Competition Act
C. Drugs and Cosmetics Act
D. Drugs (Prices Control) Order (DPCO)
Q9: One major regulatory challenge in the Indian private healthcare sector is:
A. Excessive government subsidies
B. Lack of skilled human resources in rural areas
C. Inconsistent enforcement of quality and pricing standards
D. Oversupply of public hospitals in metro cities
3.7 Summary
In this lesson, we have tried to lay the foundation for the upcoming lesson in the book. This
lesson, starts with
Further we discuss about the macroeconomic environment and contribution of the healthcare
to the GDP of the world. Than we discuss the positive and negative externalities in the
healthcare sector. The positive externalities of healthcare are: Vaccination programs, Health
Education, Medical Research and Development. The negative externalities of healthcare are:
Antibiotic Resistance, pollution from healthcare facilities, health inequalities.
Towards the end the regulatory, economic and social regulations related to the healthcare sector
are discussed. This regulations are important to provide equitable access, affordable and safe
healthcare facilities to the patients. These regulations not only protect the interest of the
patients/ consumers but also the physicians/doctors. Lastly, cross-country comparison is done
to related to various macroeconomic parameters oof the healthcare sector.

28
3.8 Glossary

• Positive Externality: The positive externality arises from the healthcare sector when
the actions of the physicians, patients, hospitals or government are beneficial for the
others.

• Negative Externality: The negative externality arises from the healthcare sector when
the actions of the physicians, patients, hospitals or government has an adverse effect on
others.

• Infant Mortality Rate: The number of deaths of children under one year of age per
1,000 live births
3.9 Answers to In-text questions
1. B
2. C
3. C
4. C
5. B
6. C
7. C
8. D
9. C
3.10 Self-Assessment Questions
Q 1. Explain the regulatory, economic and social regulations related to the healthcare
sector.
Q 2. What are the so-called three legs which make the medical stool. what trade-off
between these legs you will determine while allocating the resources among these three
legs. State reasons with proper explanation.
Q 3. What are the externalities of the healthcare sector. Identify them as positive and
negative externalities. Give appropriate examples.
3.11 References:

• [Link]
life-expectancy accessed on 10 Jan, 2025

• Santerre, R. E., & Neun, S. P. (2012). Health economics (p. 266). South-Western.

• [Link]
every-month/ accessed on 3 April,2025

29
 • [Link] World Health
Organization's Global Health Workforce Statistics, OECD, supplemented by country
data of year 2020/2021 accessed on 10 Jan, 2025
3.22 Suggested Readings:

• Morris, S., Devlin, N., Parkin, D., & Spencer, A. (2012). Economic analysis in
healthcare. John Wiley & Sons.

• Folland, S., Goodman, A. C., Stano, M., & Danagoulian, S. (2024). The economics of
health and health care. Routledge.

30
 Lesson 4

Theories of Demand and Supply in Health Care

(THIS LESSON IS A PART OF THE HEALTH ECONOMICS BOOK WRITTEN FOR
MBA HEALTHCARE SOL COURSE)
Pranav Pilaniya
Assistant Professor
Department of Economics, School of Open Learning
University of Delhi
Structure
4.1 Learning Objective
4.2 Introduction
4.3 Supply and Demand Analysis
4.3.1 Demand in Health Care
4.3.2 Definition of Supply
4.3.3 Equilibrium in Health Care Markets
4.4 Elasticity
4.4.1 Price Elasticity of Demand
4.4.2 Income Elasticity of Demand
4.4.3 Cross-Price Elasticity and Healthcare Substitutes
4.4.4 Implications for Policy and Providers:
4.5 Access to Health Care
4.6 Market Structures in Health Care sector and Theory of the Firm
4.7 Value-Based Competition Theory
4.8 Summary
4.9 Answer to in-text Questions
4.10 Self-Assessment Questions
4.11 Suggested Readings

4.1 Learning Objectives

● To explore the fundamental principles of demand and supply as they apply to health
care markets.
● To analyse how elasticities (price, income, and cross-price) influence decision-making
and policy in health care.

31
 ● To identify the barriers to access and evaluate strategies to improve equitable health
care delivery.
● To recognize the distinct market structures within the health care sector and their
implications for competition and efficiency.
● To examine the behaviour of health care firms, including their production, costs, and
decision-making processes.
● To explore the principles of value-based competition and their application in health
care systems.
4.2 Introduction
Defining Health care economics is extremely tricky because it combines basic economic ideas
with the difficult workings of human health and well-being. Unlike many other goods and
services, the health care market is driven by uncertainty, information asymmetry, and
significant moral considerations. This lesson goes into details about the basic economic ideas
that are at work in health care systems. These ideas would be useful in understanding the
structure, behaviour, and outcomes of health systems closely.
The interaction between demand and supply lies in the centre of health care economics.
However, unlike markets for conventional goods, demand for health care is not just driven by
consumer preferences or price considerations. Instead, it is heavily influenced by the urgency
of medical needs, availability of insurance, and in-general goal of achieving good health.
Similarly, the supply side of health care is shaped by a limited workforce, technological
advancements, and regulatory constraints, making it distinct from standard economic models.
The understanding of the distinctive characteristics is handy for the policymakers, service
providers, and other stakeholders of health care systems.
In this lesson we would also be discussing about the concept of elasticities in health care. It
will help the learners to understand how sensitive the demand is with the change in price,
consumer’s income, or price of related goods. The idea and thinking about elasticities play an
important role in designing effective health care policies. For example, the demand for
essential, life-saving treatments often remains inelastic, meaning that consumers are less price-
sensitive. On the other hand, elective procedures may exhibit greater elasticity. Policymakers
use this knowledge to structure pricing, subsidies and insurance coverage, ensuring a balance
between affordability and sustainability.
Further, access to health care is still a major challenge around the world. Economic and
geographical hurdles making it hard for everyone to get the care they require. Various
disparities in access cause health issues that can be avoided. These include unequal wealth, bad
infrastructure, and unfair treatment of some groups. This lesson also throws lights on different
issues of access and their probable solutions, focusing on how important it is for health care to
be delivered fairly.
Additionally, we will discuss about the market structures in the health care sector. Generally,
market structures in health care deviate from the ideal model of perfect competition and show

32
characteristics of monopolistic competition, oligopolies, and monopoly. The reasons for this
characteristic of health care are the high entry costs, the essential nature of services, and the
dominance of large providers or insurers. Understanding these market structures will provide
insight into inefficiencies and areas where policy interventions are necessary to enhance
competition and fairness.
We will also discuss the theory of the firm because it offers another valuable perspective in
health economics, examining how health care organizations operate, allocate resources, and
make decisions. Unlike traditional firms driven solely by profit maximization, many health
care entities balance financial objectives with social missions, navigating a complex landscape
of costs, regulations, and stakeholder expectations. Thus even when they come across as
Monopolies or monopolistic competitive structures, unlike such firms in economic theory, their
objective functions may be different.
Finally, in this lesson we shall explore the concept of value-based competition in health care,
which is a paradigm shift aimed at improving outcomes while controlling costs. By focusing
on patient-centred care and measurable value, value-based competition model seeks to realign
incentives across the health care system, fostering collaboration and innovation.
Through these topics, this lesson equips readers with the analytical tools to understand the
economic forces shaping health care. It bridges theoretical concepts with real-world
applications, offering a comprehensive framework for evaluating and improving health systems
globally.
4.3 Supply and Demand Analysis
Understanding the dynamics of demand and supply in health care is essential to understand
how health care services are allocated, priced, and consumed. This section talks about the
unique characteristics of health care demand and supply, the impact of insurance, and the
challenges in achieving equilibrium in health care markets.
4.3.1 Demand in Health Care
Demand refers to the need for a commodity combined with the ability and willingness to pay
for it. It reflects the quantity of a product or service that consumers are willing and able to
purchase at various prices levels. While desire represents the willingness to own a good,
demand quantifies the actual amount consumers are prepared to buy at a given price. For
instance, in the health care sector, individuals may desire access to premium health services,
but their demand is determined by whether they can afford and are willing to pay for these
services. Consider a situation where vaccination for a specific disease is offered at varying
price levels. The demand schedule will show the number of individuals willing to get
vaccinated at each price point.
But it is not that simple because demand in healthcare is often driven by necessity rather than
choice, making it less price-sensitive for critical services. Factors influencing demand include
the prevalence of diseases, demographic shifts, and changes in healthcare policies. For
example, an aging population typically leads to higher demand for chronic care and specialized
medical services. Additionally, health crises like pandemics create sudden surges in demand

33
for specific services, such as ICU beds and ventilators. Consumer behaviour in healthcare is
also influenced by insurance coverage and perceived quality. Insurance lowers the out-of-
pocket cost for patients, increasing the consumption of healthcare services, a phenomenon
known as moral hazard. Similarly, perceptions of high-quality care can lead to greater demand
for specific providers or hospitals, even if alternatives exist at lower costs.
Now let’s discuss the major factors that influence Health care demand. Factors can be
categorized as price and non-price factors. Apart from price level demand also depends on
factors related to patient such as their health status, demographic characteristics, and economic
status. Physicians affect demand through their standard as a provider of medical services.
Health care demand may be represented in a functional relationship as follows:
Quantity of Health Care Demand (Qd) = F(P, HS, DC, IL, HI, PF)
Here demand for health care is a function of price level and also a function of other factors
related to patient, including health status (HS), demographic characteristics (DC), and Income
level (IL) and access to health Insurance (HI). Physician factors are denoted by PF. F(...) stands
for function, shows how these factors interact to generate a demand for medical care.
Figure 3.1 shows the graphical relation between the Demand for healthcare products/services
and their prices. We can observe the blue-coloured downward-sloped demand cure,
representing a negative or inverse relation between the Demand and price. The steepness of the
curve varies depending on the price elasticity of the product/service. Essential services, like
emergency care, exhibit inelastic price demand, while elective procedures show more elastic
demand. Factors such as rising income or improved health awareness can shift the demand
curve outward, increasing demand at all price levels as shown in the figure 3.2. For instance,
the implementation of health campaigns can boost awareness and lead to higher demand for
preventive care like vaccinations. Elective surgeries, such as cosmetic procedures like
rhinoplasty, are highly price-elastic because individuals can postpone or forego them based on
their cost. Chronic condition treatments, on the other hand, like diabetes medicines, don't
change quantity demanded much and demonstrate price inelasticity because patients always
need them, even when prices change.

34
 Figure 3.1: Demand and Supply curve for the health care market.
Factors Influencing Demand
Some of the factors that affect the demand for health care services are listed below:
1. Price Sensitivity (P): Most economic theories say that when prices go up, demand goes
down. However, health care has different levels of price flexibility. Essential services,
like medical care, tend to be price inelastic, which means that demand stays pretty
steady even when prices change. Elective treatments, on the other hand, may have
higher price elasticity, meaning that demand changes depending on how much it costs.
2. Income Levels (IL): Higher income levels generally increase the ability to afford
health care services, potentially increasing demand. However, the relationship between
income and health care demand is complex and influenced by factors such as insurance
coverage and availability of services.
3. Health Status (HS): Individuals with chronic conditions or acute health issues are more
likely to demand health care services.
4. Demographics (DC): Age, gender, and population demographics significantly
influence health care demand. For instance, aging populations typically require more
medical attention, increasing overall demand.
The Role of Economic Factors in Health Care Demand
It is a common misconception that economic theory has little relevance to the demand for health
care, particularly in situations where urgent medical attention is required. For example, an
individual experiencing a heart attack is unlikely to consider the cost of health care when
deciding to seek immediate treatment. However, the majority of health care interactions, such
as visits to a physician’s office or hospital emergency room, are not life-threatening. These

35
scenarios often allow individuals sufficient time to make informed choices, with price playing
a significant role in decision-making.
Research supports the significant impact of price in determining the demand for health care.
According to (Winslow, 1994), price was identified as a more significant factor than patient
satisfaction or access to doctors in influencing the economic success of health care providers.
This shows how important it is to understand the way in which economic factors like prices
affect both the supply and demand of health care services.
Impact of Health Insurance on Demand
Health insurance has an important impact over health care demand. By reducing the out-of-
pocket costs for health services, insurance lowers the effective price paid by consumers, leading
to an increase in the quantity of services demanded. When people use more health care services
than they would if they had to pay the full cost, this is called "moral hazard," and it can lead to
overutilization. Because of this, if a patient only has to pay Rs700 for a service that usually
costs Rs1000, they might do it even if they don't need to. This higher level of consumption can
put a strain on health care resources and cause costs to rise generally.

Figure 3.2: (i) Shift in Demand curve, (ii) Shift in Supply curve for the health care
market.
4.3.2 Definition of Supply
Supply is the amount of a good or service that sellers are ready and willing to offer at a certain
price. It reflects the ability of suppliers to provide goods or services in response to market price
level. In health care, supply could involve the number of doctors available for consultations,
the availability of hospital beds, or the stock of medicines at pharmacies. For instance, during
a flu season, pharmacies may increase the supply of flu vaccines in response to higher demand
from patients. Health care supply may be represented in a functional relationship as follows:
Quantity of Health Care Supply (Qs) = f (P, Z)

36
Here supply for health care is a function of price level P and Z. Here Z represents all other
factors that can influence the supply apart from the Price such as national emergencies like
COVID 19 etc. Figure 3.2 (ii) shows the graphical relation between the supply for healthcare
products/services and their prices. We can observe the orange-coloured upward-sloped supply
cure, representing a positive or direct relation between the supply and price, indicating that as
the price increases, providers are more willing to offer services. An increase in the number of
providers, such as training more nurses or physicians, can shift the supply curve outward,
reducing prices at every quantity level as shown in the figure 3.2 (ii). For example,
technological innovations like telemedicine platforms have expanded the supply of
consultations, especially in remote areas. However, regulatory barriers, such as strict licensing
rules in some regions, can constrain the supply of specialized care, creating shortages.
4.3.3 Equilibrium in Health Care Markets
Equilibrium in health care markets occurs at the intersection of the demand and supply curves,
where the quantity demanded equals the quantity supplied at the equilibrium price (P*). This
point makes sure that the market distributes resources well, with neither too much demand nor
an excessive supply. Understanding how these two things work together helps policymakers
and providers in fixing imbalances, which makes health care more accessible and affordable.
But in health care markets, it is harder to reach equilibrium because of things like the fact that
services are essential there isn't equal access to information, and Third-Party Payers like
insurance companies and government programs make the process more difficult. Both the
supply and demand sides of the market are impacted by these third-party payers' frequent
interactions with service providers over prices. For example, if insurance companies pay for
substantially of a person's medical bills, those people may ask for more services, which could
cause the total cost of medical care to go up.
Unique Challenges in Health Care Markets
Due to some differences between the health care market and the normal market, there are some
factorsthat can keep health care markets from finding equilibrium:
● Information Asymmetry: Patients often lack the medical knowledge to make fully
informed decisions, they rely on providers who may have conflicting interests.
● Barriers to Entry: High Fixed costs and regulatory requirements can prevent new
providers from entering the market, this limits competition.
● Price Rigidity: Prices for health care services may not adjust quickly due to insurance
contracts, government regulations, and ethical considerations;
this makes it harder for the market to reach equilibrium.
Implications for Policy and Practice
It is very important for policymakers and practitioners to understand how demand and supply
work in health care. Policies that try to lower the cost of health care must think about how they
will affect both demand and supply. If they don't, they could lead to unexpected results like a
smaller population being able to get care or care that isn't as satisfactory.

37
For instance, making copayments may lower demand for services that aren't necessary but they
could also stop people from getting care they need, especially those with low incomes. In the
same way, efforts to increase the supply of health care services, like hiring more people or
spending money on technology, need to think about problems that might come up, like the cost
and time needed for training.
Self-Check Questions
Q1: What is market equilibrium in the healthcare system?
A) When supply exceeds demand at a fixed price
B) When the quantity of healthcare services demanded equals, the quantity supplied at a
given price
C) When government interventions completely regulate the market
D) When only private providers operate in the healthcare sector
Q2: Which factor often disrupts market equilibrium in healthcare systems?
A) Perfect competition among providers
B) Efficient information flow between consumers and providers
C) Supply constraints due to resource-intensive production
D) Decrease in population growth rates
Q3: Which factor is most likely to cause a surge in demand for healthcare services?
A) A decrease in healthcare worker wages
B) An aging population
C) Reduced government regulations
D) Technological advancements in manufacturing
Q4: What is the term for increased healthcare consumption due to insurance lowering out-of-
pocket costs for patients?
A) Cross-price elasticity
B) Moral hazard
C) Supply elasticity
D) Demand saturation
Q5: What is a key factor influencing the demand for healthcare services in a population?
A) Length of hospital stays
B) Level of disease prevalence

38
C) Number of healthcare providers
D) Cost of medical education
4.4 Elasticity
The idea of "elasticity" comes from the physical sciences. It defines the way an item or material
reacts to external forces. Similarly, in economics, elasticity describes how responsive demand
or supply is to changes in price, income, or other factors. This analogy will not only help us
conceptualize the term but also highlights the adaptability of dynamic health care system,
where resources and services are often stretched to their limits. If a variable y depends on a
variable x, then the percentage change in y divided by a percentage change in x is defined to be
the elasticity of y with respect to x.
Elasticity is an essential concept to understand how various economic factors influence the
consumption and demand of goods and services. In the healthcare sector, elasticity indicates
the responsiveness of health care demand with the change in factors such as price of health care
products/services, individual’s income, and the availability of substitutes. We are going to talk
about three types of elasticity today: cross price elasticity of demand, price elasticity of
demand, and income elasticity of demand. We will understand these concepts by using
examples and situations from the healthcare sector.
4.4.1 Price Elasticity of Demand
Price elasticity of demand (PED) measures how sensitive the quantity demanded of a product
or service is, with the change in its price. In other words, it is the ratio of percentage change in
the quantity demanded with the percentage change in its prices.

The formula indicates that when we change the price of a good by 1% how much the quantity
demanded will decrease or increase. In the healthcare sector, this concept is important to
understand consumer behaviour, especially because health services often show different
characteristics compared to other goods.
Example:
If the price of multivitamins went up by 10% and the quantity bought went down by 5%, then
the price elasticity of demand (PED) would be –5%/10% = – 0.5. This shows that demand for
multivitamins is not particularly sensitive to changes in price. It is what economists call price
inelastic.
Take another example, if the price of gym memberships went down by 20% and the quantity
of memberships increased by 30%, then the value of PED would be +30%/–20% = –1.5. In this
case, the demand for gym memberships is price elastic, i.e., sensitive to changes in price.

39
The value of PED is always negative, reflecting the inverse relationship between price and
quantity demanded. How do we know whether demand is elastic or inelastic? The rule is:
● Demand is price inelastic whenever the % change in price leads to a smaller % change
in quantity demanded. This gives PED values between 0 and –1.
● Demand is price elastic whenever the % change in price leads to a larger % change in
quantity demanded. This gives PED values between –1 and –infinity.
For example, healthcare services, such as emergency surgeries or life-saving medications, are
price inelastic (Ep < 1). Even if prices go up, patients who need these services probably will not
reduce their use substantially. On the other hand, elective procedures like cosmetic surgeries
may have higher price elasticity (Ep > 1), because these are optional, they can postpone or skip
depending on their cost.
A real-life example of this can be observed in the case of prescription drug pricing. A rise in
the cost of essential medications, such as insulin for diabetes, often results in minimal reduction
in demand, showing its price inelastic nature. However, if the price of over-the-counter
painkillers increases or the gym membership prices increase it will result in significant decrease
of demand, consumers might switch to generic or alternative options, showing higher elasticity
in this segment.
4.4.2 Income Elasticity of Demand
Income elasticity of demand examines how the demand for a product or service changes with
the change in consumer’s income levels. It shows how sensitive is the quantity demanded of a
product or service is with the change in consumer’s Income. Similar to the PED it is also the
ratio of the percentage change in quantity demanded with the percentage change in the
consumers income.

income elasticity of demand (Ey) is usually positive. This reflects the tendency for demand to
rise as consumer incomes increase. However, an exception arises in the case of inferior goods.
For these goods, Ey is negative because higher incomes lead consumers to purchase fewer of
them, as they switch to higher-quality alternatives. In the healthcare sector, for instance, as
income grows, people might opt for private health clinics over free or subsidized government
hospitals, viewing private services as superior options. Similarly, an increase in income might
lead individuals to replace generic medications with branded drugs or advanced treatments. In
these examples, government hospitals and generic medications can be considered inferior
goods, while private clinics and branded drugs represent superior alternatives.
So, we can say that economic behaviour of healthcare products and services vary depending
on the nature of the product or services. It may act as normal good as well as inferior good.
Often considered as a normal good, tends to see an increase in demand as income increases.

40
But this phenomenon is limited to the healthcare products and services that are of preventive
in nature, for example, subscription of gym and yoga classes.
In particular, the demand for high-quality healthcare services and advanced medical
technologies increases with higher income levels. For instance, an individual’s decision to seek
comprehensive health check-ups or access to premium hospital facilities may depend on
consumer’s disposable income. During economic growth period, healthcare systems observe a
rise in demand for preventive and elective services, demonstrating positive income elasticity.
On the other hand, during recessions, even essential services may see reduced utilization among
lower-income groups, highlighting the income-sensitive nature of healthcare consumption.
Moreover, disparities in income elasticity can be observed across different healthcare services.
Public health interventions, such as vaccinations, may remain consistent due to government
subsidies, while luxury health services, such as personalized wellness programs, show
significant elasticity as they cater to higher-income groups.
4.4.3 Cross-Price Elasticity and Healthcare Substitutes
Cross-price elasticity of demand examines how the demand for one good changes in response
to the price change of another related good. In healthcare, this concept is essential when
analysing substitutes and complements. So basically, here we are interested in knowing the
impact of increase in price of one good over quantity demanded of another good.

In this case, how do we interpret the cross-price elasticity of demand? The rule is:
● If the cross-price elasticity of demand is positive, it means that the goods are substitutes
(can be used as an alternative to each other)
● If it is negative, then the goods are complements.
Calculating cross-price elasticity of demand is important in the healthcare sector for
understanding the relationships between related goods and services. It helps to identify
substitutes, such as generic drugs and their branded counterparts, where a price increase in one
lead to higher demand for the other, indicated by a positive XED. It also shows complements,
like diagnostic tests and treatments, where an increase in the price of one reduces the demand
for the other, as shown by a negative XED. This information is very important for making
decisions about pricing and reimbursement, like making generic drugs cheaper to keep
consumer spending in check. XED also helps with bundling choices by finding services which
complement well together, such as pairing preventive diagnostic procedures with follow-up
appointments to get more people to use them. Policymakers can use XED to guess what will
happen when prices or subsidies are changed for a service and how those changes will affect
goods that are linked, which will improve healthcare. For instance, if the price of insulin goes
up, XED can help doctors figure out if patients switch to different medicines or use other
devices like glucose monitors lesser. Pharmaceutical companies and healthcare providers can

41
use XED to look at how their competitors are doing and change their price or service delivery
methods accordingly.
4.4.4 Implications for Policy and Healthcare Management
Understanding elasticity in healthcare has profound implications for policymakers, insurers,
and health care providers. Policies aimed at controlling drug prices, for instance, must consider
the inelastic nature of demand for essential medications to avoid adverse health outcomes.
Similarly, efforts to subsidize preventive care can reduce long-term costs by shifting demand
from more expensive curative services to affordable preventive measures.
Providers can utilize elasticity insights to optimize service delivery and pricing strategies. For
example, understanding the income elasticity of demand for elective procedures can help
hospitals design packages targeting different income groups. Insurance companies can also
tailor premiums and coverage options based on the elasticity profiles of various healthcare
services, ensuring accessibility while managing risks.
Self-Check Questions
Question 6: If the price of a branded medication increases by 20% and the quantity demanded
decreases by 10%, what is the price elasticity of demand (PED)?
A. -2
B. -0.5
C. -1.5
D. -1
Question 7: If the price of insulin increases and the demand for glucose monitors decreases,
what type of relationship exists between these two products?
A. Substitutes
B. Complements
C. Unrelated goods
D. Independent goods
Question 8: Which of the following is an example of a healthcare product with negative
income elasticity of demand?
A. Generic medicines
B. Private hospital services
C. Health insurance for critical illnesses
D. Preventive health checkups
Question 9: The demand for a diagnostic test decrease by 15% when its price increases by
5%. What can be inferred about the price elasticity of demand for this test?
42
A. It is perfectly inelastic.
B. It is elastic.
C. It is unitary elastic.
D. It is inelastic.
Question 10: A hospital observes that reducing the price of vaccinations by 10% increases
demand for preventive consultations by 8%. This indicates that:
A. Vaccinations and consultations are substitutes.
B. Vaccinations and consultations are complements.
C. The demand for vaccinations is price inelastic.
D. The demand for consultations is price inelastic.
4.5 Access to health care:
Access to healthcare is the ability of individuals to have the necessary means to prevent and
treat illnesses and maintain health. There are various factors that influence and determine the
access of healthcare such as geographic location, economic status, and availability of medical
resources etc. Some of these factors are detailed below (in the Indian context):
1. Out of pocket expenditure:
Out of pocket expenditure on health care remains one of the biggest challenges of ensuring
universal access to healthcare. It is the expense on healthcare which is paid by the people out
of his own pocket and is not covered by insurance or is not reimbursed later on. This out-of-
pocket expenditure with a low per capita income makes the healthcare services unaffordable
for a large section of population.
Various steps are being taken in India to reduce this out-of-pocket expenditure such as
providing universal health care cum health insurance schemes such as PM Ayushman Bharat
Mission. Recently released National Health Account Estimates 2021-22 suggest that the current
out of pocket expenditure on health out of the total health expenditure stands at around 39%
which has reduced from 48.8% in the year 2017-18. This is a welcome change but we still have
a long way to go as it is still very high in comparison to the developed world where the out of
pocket expenditure is below 10%.
2. Proximity of healthcare facility:
Our nation has a very diverse landscape which is dotted by mountains, hills, rivers, valleys,
forests, etc. This diverse geographic landscape of our nation makes it difficult for the people
who live in remote areas to access to healthcare. The proximity of healthcare facilities is a very
important determinant in ensuring the universal health coverage. The particularly vulnerable
tribal groups that reside in the dense forest areas are at the greatest risk of preventable diseases
due to non-availability of healthcare facilities in nearby areas. The cluster development model
of development of village clusters as self-sufficient units by our former President Dr. A.P.J.

43
Kalam is a possible way forward to ensure availability of healthcare facilities in the vicinity.
Further, the government is actively trying to bring the healthcare facilities closer to people by
providing free ambulance services to the people in need.
3. Awareness:
Awareness among people plays a crucial role in access to healthcare. The lack of awareness
regarding the nature and symptoms of the major diseases prevents most people from seeking
timely intervention of doctors and get treatment. Early detection and treatment can increase the
chances of cure or management of illness significantly. Further, the lack of awareness regarding
the government schemes, health rights and available medical services also prevent people
especially in the rural areas and marginalised communities from getting treatment.
4. Healthcare infrastructure
A large section of nation’s population depends on the public health infrastructure which
includes the tertiary care centres, public hospitals and the PHCs at the grassroots level. The
equipment and human resources are also important components of this health infrastructure.
But it is often found insufficient to bear the patient load and patients are often found to be
accommodated in the corridors and other common areas of the public hospitals due to
unavailability of hospital beds. The medical equipment in the public hospitals is also not
sufficient to meet the demand. The equipment in public hospitals is most of the times
inoperative due to lack of maintenance or skilled operators. Therefore, the public health
infrastructure often fails to meet the demand.
5. Medical staff
The backbone of India’s healthcare system constitutes of doctors, nurses, paramedics and
support workers. Even with a large number of skilled professionals in the country, the doctor
patient ratio according to the WHO standards falls very short in many regions. Most of the
health care facilities and healthcare providers are concentrated in the urban areas whereas more
than 60% of the population resides in the rural areas, which further aggravates the disparities
and causes significant shortages and uneven distribution of medical staff, in rural and remote
areas.
This gap in the demand and supply of healthcare services in the rural areas is often fulfilled by
unqualified doctors, medicine men and quacks. These untrained and unqualified doctors often
cause more harm than good and the dependence of people on them pose a serious challenge.
Many healthcare workers lack access to continuous medical education and training which
impacts the quality of care they provide, which leads to misdiagnosis, improper treatments and
unsafe medications which may even lead to life threatening complications.
6. Lack of confidence of people in public health facilities
A substantial challenge in India’s healthcare system is the lack of people’s confidence in public
health facilities. A lot of things, like overcrowding, not enough medical staff, old equipment,
and long wait times, make people not believe the system. This trust is also hurt by inconsistent
standard of care and reports of negligence from time to time.

44
Many people, even those from lower-income groups, choose private healthcare over public
healthcare because they think it is more reliable and effective. Private healthcare centres, on
the other hand, charge more, which makes people less likely to go there unless they really need
to. This hurts the purpose of public healthcare centres, which are meant to offer services that
are affordable and easy to get to.
The government is actively trying to address these issues by improving the healthcare facilities
and their access through various schemes such as PM Ayushman Bharat, Janani Suraksha
Yojana, opening new medical colleges etc.
4.6 Healthcare Market Structure and Theory of Firm
The structure of the healthcare market and the behaviour of firms operating within it are shaped
by unique economic and institutional characteristics. Unlike traditional markets, the healthcare
market is distinguished by its complex interplay of providers, payers, and patients, which
creates distinct market structures and challenges.
Types of Market Structures in Healthcare
1. Perfect Competition:
Properties of Perfect Competition:
● Many buyers and sellers
● Homogeneous products
● Free entry and exit
● Perfect information
● Price takers
This is rarely observed in healthcare due to the significant barriers to entry, specialized
knowledge requirements, and the heterogeneity of services in the health care sector. However,
some segments, such as generic drug manufacturing and pharmaceuticals stores etc. are
examples which show the features of perfect competition because these stores are perfect
substitutes of each other and the consumer is going to buy from the store which is giving the
medicines at a lower price.
2. Monopolistic Competition
In monopolistic competition, many providers offer differentiated products or services, allowing
them some degree of price-setting power. Differentiation can be based on quality, location, or
brand reputation. Can you think about such a market structure around you? For example,
hospitals and clinics differentiate themselves through specialized services (e.g., cardiac care
centres) or patient-focused amenities (e.g., private rooms, cutting-edge technology). What
about gym facilities in your area? They also differentiate themselves on the basis of amenities
like personalised coaching, locker facilities, lounge area and sauna facilities etc.

45
Properties of Monopolistic Competition:
● Many sellers
● Product differentiation
● Some barriers to entry
● Non-price competition (e.g., advertising)
3. Oligopoly
An oligopoly exists when a few large firms dominate the market. Certain sectors, such as
pharmaceutical manufacturing or insurance, are dominated by a few large firms. These firms
can influence pricing and market outcomes and influence market dynamics through research,
advertising, and lobbying.
Properties of Oligopoly:
● Few dominant players
● Interdependence among firms
● High barriers to entry
● Potential for collusion
4. Monopoly
A monopoly may arise in regions where only one provider operates due to geographic isolation
or regulatory constraints (high barriers to entry and patents). For instance, a single hospital
serving a rural area often functions as a monopoly. Monopolies can lead to higher prices and
reduced access unless regulated. Private firms, when inventing a new groundbreaking medicine
or technology, usually act like monopolists because patents give them rights to restrict other
firms from using that method or technology and remain the sole producer.
Properties:
● Single seller
● High barriers to entry
● Price maker
● Lack of substitutes
Knowing about the different market structures in the healthcare system is helpful for
understanding how the field works. Policymakers and other interested parties can work together
to make a healthcare system that balances speed, innovation, and fair access for everyone by
looking at how different structures work and how to solve their problems.

46
4.7 Value-Based Competition in Health Care
A lot of the strategies used in the current state of health care competition fail to ensure patients
get quality care. There is a lot of competition where both sides try to get the upper hand in
negotiations, shift costs, take patients by narrowing their options, or cut back on services to
save money. The main goal of these methods is to make providers or insurers more money, but
they don't improve patient results or the system as a whole. We need a change toward value-
based competition because this kind of unfair competition makes it clear that we need one.
Value-based competition in health care focuses on improving patients' health outcomes
compared to costs, which raises the total value for patients. In contrast to standard volume-
based care models, this framework focuses on getting the best results for patients while making
the best use of resources. The main idea behind this method is to switch from incentives that
focus on quantity to ones that focus on quality care. This will help the health care system work
better and more efficiently.

Figure 3.3: Key principles of value-based competition

Value-based competition is based on four main ideas: focused on high-value outcomes for
patients, encouraging competition based on measurable results, and integrating care delivery
across the full spectrum of medical conditions. For example, making sure that people with
diabetes get all the care they need includes more than just regular checkups. It also includes
taking preventative steps and managing their care over the course of their lives. This approach
strongly supports and rewards innovations that lead to better outcomes for patients, like more
advanced diagnostic tools or easier-to-use platforms for coordinating care. In addition,
providers compete by trying to get better results, which creates an evolving environment where
quality improvements are always being sought.
A lot of important writings on value-based competition, like "Redefining Health Care" by
Michael E. Porter and Elizabeth Olmsted Teisberg and other similar works, explain how this
method works in theory and in practice. This model tries to change incentives so that care is
more focused on the patient, but it has been criticized for problems like not being able to
accurately measure value across a wide range of patient groups and worries about possible

47
moral problems that might arise when cost-efficiency is put first. The adoption of value-based
principles does hold a lot of hope for making health care delivery more efficient and fairer.
4.8 Summary
The lesson covers the main ideas of health economics in great depth. It mainly talks about
supply and demand, elasticity, access to healthcare, market structures, and the theory of the
firm. It helps you understand how economic ideas are specifically useful for healthcare
systems.
Demand for healthcare is based on need rather than choice, and is affected by things like how
demand is sensitive to price, their income, their health, and their demographics. For example,
the demand for necessary services like emergency care is price inelastic in nature, but the
demand for optional procedures is elastic. Insurance also changes demand because it lowers
out-of-pocket costs, which can lead to moral hazard and overutilization.
On the supply side, healthcare providers face problems like a shortage of staff, limited
infrastructure, and rules and regulations that make it hard to do their jobs. Price and supply are
linked in a way that makes more providers want to enter the market when prices are higher.
Innovations like telemedicine have increased supply, but problems like licensing and unequal
spread across the country still exist. When demand and supply are similar in the healthcare
market, it's called equilibrium. However, information gaps, third-party payers, and rigid prices
make equilibrium more difficult to achieve.
Elasticities in healthcare describe how demand or supply responds to changes in price, income,
or the cost of related goods. Essential treatments often have price-inelastic demand, while
preventive and luxury services are more elastic. Income elasticity shows how rising incomes
increase demand for premium healthcare. Cross-price elasticity analyzes relationships between
substitutes (e.g., generic and branded drugs) and complements (e.g., diagnostic tests and
treatments).
Access to health care is still a big problem because of systemic, geographical, and economic
hurdles. Disparities are made worse by high out-of-pocket costs, a lack of close facilities, bad
infrastructure, and an uneven distribution of medical staff. These gaps are meant to be
addressed by government programs like health insurance plans and building up infrastructure.
The healthcare market often varies from perfect competition due to high entry costs,
differentiated services, and dominant players. It exhibits characteristics of monopolistic
competition (e.g., differentiated hospitals), oligopoly (e.g., pharmaceutical giants’ firms), and
monopoly (e.g., sole providers in rural areas). The theory of the firm explains how healthcare
organizations balance financial goals with social missions, navigating costs, regulations, and
innovation.
Value-based competition is also talked about in the lesson, with a focus on better patient health
outcomes compared to prices. This approach shifts the focus from volume to value,
encouraging high-quality, coordinated care. It fosters innovation and efficiency but faces
challenges in measuring value across diverse populations.

48
4.9Answer to In-text Questions
Answer 1: B) When the quantity of healthcare services demanded equals the quantity
supplied at a given price
Answer 2: C) Supply constraints due to resource-intensive production
Answer 3: B) An aging population
Answer 4: B) Moral hazard
Answer 5: B) Level of disease prevalence
Answer 6: B) -0.5
Answer 7: B) Complements
Answer 8: A) Generic medicines
Answer 9: B) It is elastic.
Answer 10: B) Vaccinations and consultations are complements.
4.10 Self-Assessment Questions
1. What factors primarily influence the demand for healthcare services?
2. How does health insurance impact healthcare demand and utilization?
3. What is price elasticity of demand, and how does it differ for essential and elective
healthcare services?
4. Explain the concept of cross-price elasticity using examples from the healthcare
sector.
5. What are the major barriers to accessing healthcare services globally?
6. Describe the key properties of monopolistic competition in the healthcare market.
7. What distinguishes value-based competition from traditional volume-based healthcare
models?
4.11 Suggested Readings
1. Culyer, A.J. & Newhause, J.P. (2000). Handbook of Health Economics (Vol.I and II).
North Holland.
2. Folland, S., Goodman, A. C. & Stano, M. (2013). Economics of Health and Health
Care (7th ed.). Pearson International
3. Govindarajan, V. and R. Ramamurti (2018). Reverse Innovation in Health Care: How
to make Value-Based Delivery Work (1st ed.). Harvard Business Review.
4. Henderson, J. W. (2011). Health Economics and Policy(5th ed). South-Western College
Publishing.

49
5. Philips, J. & Rapoport, J. (2000). Economics of Health and Medical Care (5th ed.).
Jones and Bartlett Publishers.
6. Porter, M. E. and E. O. Teisberg (2006). Redefining Health Care: Creating Value-
Based Competition on Results (1st ed.). Harvard Business Review Press.
7. Rao, K. S. (2017). Do We Care: India's Health System (1st ed.). OUP India.

50
 Lesson 5

Insurance and Market Incentive Problems in Health Economics

(THIS LESSON IS A PART OF THE HEALTH ECONOMICS BOOK WRITTEN FOR
MBA HEALTHCARE SOL COURSE)
Dr. Sant Kumar
Assistant Professor
Vivekananda Institute of Professional Studies, GGSIP University, Delhi
Email-Id: santk571@[Link]

Structure
5.1 Learning Objectives
5.2 Introduction
5.3 Insurance and its Associated Incentive Problems
5.3.1 Insurance and Incentive Problems
5.3.2 Adverse Selection
5.3.3 Moral Hazard
5.4 Summary
5.5 Glossary
5.6 Answers to In-Text Questions
5.7 Self-Assessment Questions
5.8 References
5.9 Suggested Readings

5.1 Learning Objectives

• Understand the concept of insurance and its associated incentive problems.

• Understand various measures of dealing with the problems of adverse selection and
moral hazard.
5.2 Introduction

This unit is an attempt to give you a basic idea of the economics of insurance contracts. Section
4.3 introduces the concept of insurance and explores its two main incentive problems 1)
Adverse selection and 2) Moral hazard. These incentive problems are highly prevalent in the
insurance market, they cannot be ignored at all. Their impact and solutions have been discussed
here. Section 4.4 focuses on the funding of private and public health care services. Sections 4.5
and 4.6 highlight the role of Government and NGOs in health care services. Section 4.7 focuses
on the learnings for India from the rest of the world. In this section, a few best practices of
health care services have been discussed, and finally, Section 4.8 summarises the discussion.
The unit has been written in such a way that it will be understood by the readers in an intuitive
way with minimal mathematics.

51
5.3 Insurance and Its Associated Incentive Problems

5.3.1 Insurance and Incentive Problems

Insurance is an agreement between two parties where one party (known as the insurer) agrees
to compensate the other party (known as the insured or policyholder) for a loss suffered. This
loss may be theft, death of an individual, accidents, fire, etc. For this agreement, the insured
has to pay an amount (known as an insurance premium) to the insurer.
The concept of insurance is based on the idea that not everyone will experience a loss at the
same time, so the premiums from many policyholders can cover the losses of a few who have
suffered the losses. For example, if 100 individuals insure their homes against fire by
purchasing an insurance policy of ₹ 5,000 each, at a single premium of ₹ 1000 per person, the
total premium received by the insurer would be ₹ 1,00,000. If only 5 houses catch fire, then ₹
25,000 can be paid as compensation to these 5 policyholders. The probability of all 100 houses
catching fire at the same time is very low, which makes the system feasible.
Insurance is an attractive concept, but its fair pricing or premium is not so easy because of
various incentive problems associated with it. Incentive problems primarily include the
following:
▪ Adverse selection: Policyholders have an incentive to mispresent their actual risk due
to asymmetry of information. The problem has been discussed in detail below.
▪ Moral hazard: It is a behavioural problem. Policyholders have an incentive to behave
in a riskier manner after buying insurance. The problem has been discussed in detail
below.
▪ Free-riding problem: It means people benefit from insurance without paying for it as
it generally happens in government-funded insurance.
▪ Principal-Agent problem: In this problem, the agent (e.g., an insurance agent) keeps
his or her interests above those of the principal (e.g., insurer).
5.3.2 Adverse Selection
I. Meaning of Adverse Selection
Adverse selection means the market failure or inefficiency or non-optimal outcome arising
from asymmetric information where one party in an agreement, contract, or transaction has
more information than the other party. This information gap may lead to losses for the less-
informed party. Thus, in adverse selection, one person exploits the information asymmetry (or
gap) between him and the other person to gain an advantage in the transaction. Let us consider
these two scenarios to understand adverse selection.
Scenario 1: Suppose R has a serious medical history but decides to hide this information when
applying for a health insurance policy from AIC Insurance Co. Despite conducting a medical
diagnosis, the company is unable to fully uncover his medical condition. This creates an
asymmetry of information. Consequently, there is a high chance or probability that R will file

52
a claim soon after the policy is issued. Had the company been aware of his medical history, it
might have declined to offer the policy or charged a significantly higher premium.
This scenario exemplifies adverse selection because one party (R) exploits the information gap
to gain an advantage, potentially causing losses to the other party (insurance company).
Scenario 2: Suppose there are two individuals, A (a chain-smoker) and B (a non-smoker).
Studies show that A has 90% probability of developing lung cancer, while B has only a 20%
probability. Both purchased a medical policy worth ₹ 50,000 from an insurance company X, at
a uniform premium of ₹ 20,000. However, the insurance company is unaware of A’s smoking
habits and the significantly higher risk of lung cancer and similarly, it is not aware of the non-
smoking habit of B and low risk of lung cancer. As a result, the company charges both A and
B the same premium, assuming an average premium. Had the company been aware of A’s habit,
then the actuarially fair premium1 would have been ₹ 45,000 ( = ₹ 50,000 × 90%), not ₹ 20,000.
Therefore, A has a great incentive to get him insured because he might have to pay ₹ 45,000
but pay ₹ 20,000 only. Conversely, the actuarially fair premium for B would have been ₹ 10,000
( = ₹ 50,000 × 20%), meaning B is being overcharged.
This scenario exemplifies adverse selection because A, the high-risk individual, has a strong
incentive to purchase insurance at a lower premium, while B, the low-risk individual, may feel
disincentivised or unfairly treated. This all happened because there was an asymmetry of
information about smoking and non-smoking habits between the insured (A and B) and the
insurance company.
II. Impact of Adverse Selection: Deadweight Loss
The impact of adverse selection is market failure, as it is a hindrance in achieving the best
outcome or the most efficient outcome in the market. If we are concerned about insurance and
healthcare, then this problem of adverse selection arises because people have private
information about their health risks, while the insurance companies are not able to fully uncover
those risks (may be due to limitations of medical science, corruption, etc.). We have learned
from scenario 2 that people, who are high-risk individuals, are more likely to buy insurance
and those who are low-risk individuals are less likely to buy insurance. Consequently, in the
long run, high-risk individuals will dominate the market causing insurance companies to incur
higher costs than expected. To cover these higher costs, they may raise the premium amounts,
which further discourages low-risk individuals from buying insurance products.
To elaborate on the impact of this problem of adverse selection, consider two truck drivers X
(running his truck on a tight highway and more likely to be involved in a road accident) and Y
(running his truck on a very open highway and less likely to involve in a road accident). Thus,
X is a high-risk individual causing a high cost to the insurance company, if insured, and Y is a
low-risk individual causing a low cost to the insurance company if insured. Further, suppose
that the expected marginal cost of insurance for X is MC1 and that of Y is MC2. Since X is a
higher-risk individual than Y, therefore, we can assume that MC1 > MC2. Also, their respect

1
In actuarial science, actuarially fair premium = Insurance claim or loss amount × probability of the loss.

53
demand2 for insurance is shown by D1 and D2. Now, if the truck insurance market is full of
people like X only, then the insurance premium P1 should be such that P1 = MC1 (as fixed by
the profit-maximising rule in perfect competition). This is shown in Part (a) of Figure 1.
Similarly, if the market is full the people like Y only, then the premium P2 should be such that
P2 = MC2 as shown in Part (b) of Figure 2. Thus, if the insurance market is clear about the type
of truck drivers it is going to make insured i.e., there is no asymmetry of information (= no
adverse selection), then the premium amounts are P1 and P2. Now, we bring asymmetry of
information into the picture. Since, now, the insurance market is not sure about what type of
truck driver it is going to make insured, therefore, it assumes that there will be 50% drivers
who are high-risky and 50% low-risky. Consequently, it calculates an average premium using
the given formula. This average premium is shown by the horizontal line Pr in Part (c).
P1 + P2
Pr =
2

Price Price Price

a
P1 MC1 P1 MC1
b c
Pr
d e f
P2 MC2 P2 MC2
D1 D2 DT

0 x1 x2 Insurance 0 y2 y 1 Insurance 0 x1 qr y1 Insurance

Part (a) Part (b) Part
(c)
High-risk truck drivers Low-risk truck drivers
High-Low risk truck drivers
(No asymmetry of information) (No asymmetry of information)
(Asymmetry of information)
Figure 1 – Deadweight Loss Caused by Adverse Selection
Now, to capture the effect of adverse selection, we will use the concept of consumer surplus.3.
In the absence of asymmetry of information, the consumer surpluses are as follows:
X: a
Y: a+b+c+d+e+f
In the presence of asymmetry of information, their consumer surpluses are:

2
In economics, demand is also known as average revenue curve (or price).
3
In economics, consumer surplus means the difference between the price which a consumer is ready to pay and
the price he or she actually pays. Geometrically, this is measured by the area under the demand curve upto the
price being actually charged.

54
 X: a +b+c
Y: a+b+c
The changes in their surpluses are as follows:
ΔX : a + b + c – a = b + c
ΔY : a + b + c – a – b – c – d – e – f = – d – e – f = – (d + e + f )
Since b = d and c = f because Pr falls exactly half of the total of P1 and P2 and therefore,
ΔY : a + b + c – a – b – c – d – e – f = – (d + e + f) = – (b + e + c)
Total change in consumer surplus = ΔX + ΔY
= (b + c) – (b + e + c) = – e
Thus, asymmetry of information has caused the loss of area e. This loss is known as deadweight
loss and this is nothing but due to adverse selection.
III. Solution to the Problem of Adverse Selection in Insurance Market
Some of the possible solutions to the problem of adverse selection in the insurance market are
given below:
1. Classification of insured: Insurers can make a detailed risk analysis of their potential
customers. They should conduct their thorough health diagnosis, go through their
driving records, get an idea of their lifestyle, etc. so that they can classify them into
various categories like high-risk individuals or low-risk individuals. Separate premiums
may be asked for these classes created.
2. Multi-level diagnosis: Suppose that a medical professional appointed by the insurer
may detect a serious illness in an individual during his diagnosis, but the individual
may bribe him to prepare a favourable report. To mitigate this risk, the insurer should
implement a multi-level diagnosis process involving multiple independent evaluators.
This approach may reduce the probability of manipulation by ensuring that no single
individual has complete control over the diagnostic outcome. While this approach is
particularly relevant for health insurance, it can also be adapted for other types of
insurance policies.
3. Exclusion clause: Exclusion clause means some condition under which an insurance
claim can be rejected. Insurance companies may restrict coverage for certain types of
losses. This may reduce the incentive for individuals to purchase insurance when they
know their claims would be rejected for such risks.
4. Incentives for information disclosure: Insurance companies can offer some type of
incentives for individuals to disclose their health conditions or risk information
honestly. Such incentives may reduce the asymmetry of information.

55
 5. Group insurance: Group insurance pools risk across a broad range of individuals. In
group insurance, the probability that only high-risk individuals will dominate gets
reduced.
___________________________________________________________________________
Real Life Case-1
Obamacare and Adverse Selection in the Health Insurance Market
Besanko & Braeutigam (2014) present the following real-world case in their book. “In March
2010, the U.S. Congress passed one of the most significant pieces of domestic legislation in
decades, the Patient Protection and Affordable Care Act (PPACA), typically referred to as the
health care reform bill, or even more casually, as Obamacare (because the reform was strongly
supported by President Barack Obama). Even though the bill is described as health care reform,
the heart of the legislation is really about reform of the health insurance market, and more
specifically the health insurance market for individuals. The case for reform, and the approach
that the PPACA takes to reform, is directly related to the issue of adverse selection in health
insurance markets. In the United States, most people who have health insurance coverage
receive it from their employer. In 2008, 58.5 percent of the U.S. population was covered by an
insurance plan obtained through the workplace; 8.9 percent of the public was covered by a plan
purchased in the individual health insurance market; 29 percent was covered by a government
health insurance plan (either Medicare, Medicaid, or a military health care plan), and 15.4
percent of the population (or about 46.3 million people) did not have health insurance coverage.
(Note: These percentages add up to more than 100 percent because an individual may have
both individual coverage and some form of government insurance as well.) As has been noted
in the text, employer-based health insurance coverage solves the adverse selection problem by
pooling risk across a large group of people, so that the insurance rates paid by the company (or
the workers) reflect the average health risk of the employees in the company, not the risk of
the high-risk workers. However, the individual health insurance market is different. This
market provides insurance for those who cannot obtain health insurance from an employer or
government health insurance plan. Unlike group health plans in a company or government-
provided insurance, healthier individuals who might otherwise purchase health insurance in the
individual market may instead decide to go without insurance. The result of this behaviour can
lead to an adverse selection “death spiral” that operates something like this: Insurance
companies set prices based on the average health risk of the anticipated purchasers of insurance,
but at these prices, relatively healthy individuals choose to go without coverage, and the
riskiness of the pool of insured is worse than anticipated. This, in turn, induces insurance
companies to increase premiums to cover their now higher-than-expected insurance expenses.
But if insurance premiums are increased, even more individuals will opt out of the market,
leaving an even higher risk pool. If insurance companies are still unable to cover their expenses,
they may raise rates even more, leading to more individuals opting out of the insurance market,
and an even higher risk pool still. The end result might be a very thin market with very high
premiums that only the highest-risk individuals are willing to pay. Broadly, this describes the
individual health insurance market in the United States. The significant number of individuals
who go without health insurance is, in part, a reflection of adverse selection in the health

56
insurance market. In practice, insurance companies do take steps to sell insurance policies
based on differences in individuals’ health risks. And setting prices based on different risk
profiles is a possible antidote to adverse selection death spirals and may help health insurance
markets operate more efficiently. This is why, for example, individuals may not be able to
obtain health insurance coverage in the individual insurance market if they have a preexisting
condition. The preexisting condition is a signal of the individual’s intrinsic health risk. But
denial of coverage based on preexisting conditions is unpopular and seen by some as
fundamentally unfair, since preexisting conditions may arise through no fault of the individual.
Further, denial of coverage based on preexisting conditions adds to the population of the
uninsured. And from an economic efficiency perspective, a large uninsured population may be
problematic. Uninsured parties may lack access to the health care system that would otherwise
induce them to engage in preventive care (e.g., annual checkups) or seek care when a medical
condition is treatable. Without health insurance, individuals may wait until the problem is so
severe that high-cost emergency care is the only option. Distortions in medical decisions
stemming from lack of health insurance may raise the overall cost of medical care in the United
States. A key goal of Obamacare is to reduce the number of uninsured, while at the same time
eliminating denial of coverage based on preexisting conditions (or in the parlance of insurance,
providing “guaranteed issue” of insurance). By itself, adopting guaranteed issue could actually
worsen the adverse selection problem. Knowing that you cannot be turned away for health
insurance, you might wait until you need health care to purchase insurance. Thus, to prevent
the system from being “gamed” in this way (which is really an extreme form of adverse
selection) and to deal with adverse selection and the thinness of the individual health insurance
market more generally, the PPACA mandates that all individuals must have health insurance
(the so-called individual mandate).”
Source: Besanko, D., & Braeutigam, R. R. (2014). Microeconomics (5th ed.). 629-631. Wiley.

___________________________________________________________________________
Real Life Case-2
Choosing among Health Plans
Bernheim and Whinston (2008) write that “ Many jobs, particularly at larger firms, include
some form of health insurance. Often, an employer offers each employee a choice from among
several health plans. The employer covers a significant fraction of the costs of these plans, with
the employee absorbing the rest. Typically, an employee pays more for plans that offer more
extensive coverage and/or give the employee more freedom in choosing her doctor or hospital.
When designing these menus of plans, employers and health insurance companies must pay
careful attention to the possibility of adverse selection. Economists Daniel Altman, David
Cutler, and Richard Zeckhauser have studied the health plan choices of state and local
government employees in Massachusetts.5 These employees could select from a traditional
indemnity plan that allowed them to freely choose their doctor and hospital, a preferred-
provider (PPO) plan that partially restricted their choice, and a number of health maintenance
organization (HMO) plans that required them to use particular doctors and hospitals. Altman,
Cutler, and Zeckhauser observed these employees’ choices as well as their actual medical

57
expenses in fiscal years 1994 and 1995. Employees’ choices reflected the presence of adverse
selection. For example, between 1994 and 1995, employees who switched from an HMO to
the more generous indemnity plan, on average, had incurred $1,651 of medical expenses in
1994 compared to an average of only $1,125 for those who stayed in an HMO plan.6 In
contrast, employees who switched from the indemnity plan to an HMO plan had incurred an
average of $1,444 in medical expenses in 1994 compared with expenses of $2,252 for those
who stayed in the indemnity plan. Thus, there is strong evidence that employees who chose the
indemnity plan had a higher likelihood of filing claims than those workers who chose HMO
plans. Economists who have studied individuals’ choices among insurance plans have not
always found evidence of adverse selection, however. Why not? First, in some contexts, people
may not know much about their true risk levels. (For example, bad drivers may not know they
are bad drivers.) Second, people may differ in ways that cause those with lower risk exposure
to demand relatively more insurance, rather than less. For example, people who are more risk
averse buy more insurance (see Section 11.3). But, they may also engage in less risky activities
and therefore have fewer accidents. Because differences in risk aversion can create a negative
relationship between the demand for insurance and the risk of an accident, insurers may not
experience adverse selection.”
Source: Bernheim, B. D., & Whinston, M. D. (2008). Microeconomics. 2I-9. McGraw-Hill
Irwin.

5.3.3 Moral Hazard

I. Meaning of Moral Hazard
In the context of insurance, moral hazard means the tendency of human beings or organisations
to take more risk or behave less cautiously after they are insured against the consequences of
their actions provided their actions cannot be monitored by the insurer and charge premium
accordingly. Alternatively, moral hazard is a situation where an insured person does not take
care of his actions as he used to do before taking the insurance of something because the person,
now, knows that his risk will be compensated by the insurance company. For example, an
individual, after purchasing car insurance, may start driving recklessly, thinking that if an
accident occurs, then the insurance company will compensate for the same. This contrasts with
his behaviour before the insurance, when he may have driven more cautiously to avoid
accidents. Similarly, one may carry his laptop very carefully while travelling or using it, but as
he gets its accidental damage insurance, then his efforts to carry it carefully may come down
because he knows if it gets damaged, then the financial loss will be covered by the insurer.
McEachern (2006) defines moral hazard in the following words:
“…A situation in which one party, as a result of a contract, has the incentive to alter
their behavior in a way that harms the other party to the contract…. More generally,
moral hazard is a principal-agent problem because it occurs when those on one side
of a transaction have an incentive to shirk their responsibilities because the other
side is unable to observe them.”

58
Pindyck and Rubinfeld (2018) write:
“…In general, moral hazard occurs when a party whose actions are unobserved
affects the probability or magnitude of a payment. For example, if I have complete
medical insurance coverage, I may visit the doctor more often than I would if my
coverage were limited. If the insurance provider can monitor its insurees’ behavior,
it can charge higher fees for those who make more claims. But if the company cannot
monitor behavior, it may find its payments to be larger than expected. Under
conditions of moral hazard, insurance companies may be forced to increase
premiums for everyone or even to refuse to sell insurance at all.”
Frank (2015) writes:
“…Moral hazard incentives that lead people to file fraudulent claims or to be
negligent in their care of goods insured against theft or damage.”
II. Impact of Moral Hazard in Insurance Market
The problem of moral hazard is very prevailing in the insurance market. It also causes the
market inefficiency. Let us understand how! Suppose that there are n number of car drivers in
an insurance market. In Figure 2, D is the demand curve for car driving measured by the
marginal benefit of driving one extra kilometre. Now consider two scenarios.4.
Scenario 1: Suppose that the insurance company can monitor the kilometres driven and charge
₹ 0.5 per kilometre as a premium. The other costs (e.g., petrol, etc.) are ₹ 1 per kilometre. The
following table shows the costs calculated for different kilometres driven along with demand
(or marginal benefit). The marginal cost is equal to the marginal benefit (MB) when 5
kilometres are driven, therefore, the equilibrium distance driven is 100 kilometres. This is an
efficient level of kilometres driven.

Kilometres driven Premium Other costs Total cost MC5 MB

0 0 0 0

20 10 20 30 4.5 2.3

40 20 40 60 1.5 2.1

60 30 60 90 1.5 1.9

80 40 80 120 1.5 1.7

100 50 100 150 1.5 1.5

120 60 120 180 1.5 1.3

140 70 140 210 1.5 1.1

4
The two scenarios have been adapted from Pindyck and Rubinfeld (2018) and modified accordingly.
5
Marginal cost (MC) = Change in total cost / Change in kilometres driven = Δ total cost / Δ Change in
kilometres driven.

59
 160 80 160 240 1.5 0.9

180 90 180 270 1.5 0.7

Scenario 2: Suppose that the insurance company cannot monitor the kilometres driven,
therefore, charges ₹ 0.5 as a fixed premium. This fixed premium incentivizes the drivers to
overuse the insured activity (driving in this scenario), leading to inefficiency. Let us see how!
Keeping the other costs (e.g., petrol, etc.) the same as in scenario 1. Now, for 140 kilometres,
the marginal cost is almost equal to the marginal benefit.

Kilometres driven Constant Prem Other costs Total cost MC MB

0 0.5 0 0.5

20 0.5 20 20.5 1 2.3

40 0.5 40 40.5 1 2.1

60 0.5 60 60.5 1 1.9

80 0.5 80 80.5 1 1.7

100 0.5 100 100.5 1 1.5

120 0.5 120 120.5 1 1.3

140 0.5 140 140.5 1 1.1

160 0.5 160 160.5 1 0.9

180 0.5 180 180.5 1 0.7

MC,
MB Inefficient point.

Efficient
point.
Scenario 1: ₹ MC1
4.5
Scenario 1: ₹ MC2 (Perceived)
1.0
D
0 100 140 Kms. Per month
Figure 2 – Inefficiency Caused by Moral Hazard
In scenario 2, the problem of moral hazard arises because the drivers consider the premium as
a fixed cost and assume that the marginal cost is ₹ 1 not ₹ 1.5 causing higher kilometres driven
more than the efficient level of kilometres.

60
 III. Solution to Moral Hazard in the Insurance Market
The following measures can be adopted to tackle the problem of moral hazard.
1. Education and Awareness
Educating policyholders about the negative impacts of moral hazard, such as increased
risks and higher cost of insurance for everyone, can help reduce moral hazard issues.
By developing a sense of responsibility among the policyholders and highlighting the
collective cost of reckless actions, insurers can encourage them to act honestly and
ethically so that they can be insured at a low cost.
2. Sharing of Data by The Traffic Police with The Insurance Companies Engaged in
Auto Insurance
Laws can be passed in which the traffic police department can be empowered to share
the data of traffic rule breakers with the insurance companies. If the insurers find
frequent traffic rule violations or reckless driving by the policyholders, then their
premiums may be increased or their policies may be made void. Similarly, if the records
show that a policyholder follows the rule, then he or she may be incentivized by
reducing his or her premium or otherwise.
3. Contractual Clauses
Contracts include various terms and conditions that penalise fraudulent or negligent
behaviour, such as voiding the policy if the negligence is observed. Such clauses should
be more accurate, and clear and not carry any ambiguity.
4. Regular Checks and Audit
Insurers must conduct regular visits and audits to assess the adequacy of fire, theft, or
property safety measures implemented by the policyholders. Such audits and visits can
be made with the help of experts or professionals. The results of such visits and audits
must be compared over time to figure out any negligence or lapse.
5. Not 100% Coverage: The insurers may design policies in such a way that they cover
only a certain portion of the loss, but not 100%. For example, a policy may cover only
70% of the claim, and the remaining 30% claim shall be borne by the policyholder only.
Such an approach ensures that policy holders have a financial stake in preventing losses.
If they show moral hazard, then they know it will negatively affect their stake.
___________________________________________________________________________
Real Life Case - 3
Moral Hazard in the Insurance Market
Goolsbee, Levitt, & Syverson (2013) present the following real-world case in their book.
“Destroyed markets aside, moral hazard is still an issue in existing insurance markets. Many
have argued that the National Flood Insurance Program encourages homeowners to build —
and sometimes rebuild — too close to water. This program is administered by the U.S.
61
government. It covers damages to homes caused by flooding (private insurance rarely covers
such losses). The program’s provisions do not do a good job of matching premiums to risk,
however. Even policyholders with large prior claims can re-obtain coverage relatively cheaply.
As you might expect, knowing one’s beach house will be fully insured in case of a storm surge
doesn’t do much to discourage the construction of beach houses in vulnerable locations. There
are several cases where benefits were paid out on properties that had been destroyed by storms
multiple times, and then rebuilt each time in the same location. A Government Accountability
Office report in 2010 calculated that 1% of the properties covered by the program had
experienced repetitive losses, accounting for 25 to 30% of total claim costs. Auto insurers are
always concerned about their policyholders’ unobserved driving habits. Insurance is usually
priced by the period (per six-month term) rather than the intensity of driving. Sometimes rough
premium adjustments for mileage are made, but they are based on the policyholders’ reported
“typical” mileage numbers, not actual use. Additionally, there is no adjustment for aggressive
driving, like jackrabbit starts and stops or tailgating, which are associated with the increased
probability of being in an accident. Once covered, then, the driver doesn’t bear the full marginal
cost he imposes on the insurance company when driving more miles or more aggressively.
Drivers therefore have too little incentive to avoid actions that raise the likelihood of their being
in an accident. (The standard structure of auto insurance policies may be changing, however;
see the Application “Usage-Based Auto Insurance” later in this chapter.) Unemployment
insurance, while offering some financial relief to workers who have lost their jobs by partially
replacing their lost wages, can also reduce unemployed individuals’ incentives to look for work.
While unemployment benefits are tied to the recipient actively looking for work, the agencies
that administer the program cannot fully observe recipients’ true efforts to find employment.
The intensity of the job search and the individual’s effort in interviews are clearly difficult to
monitor.”
Source: Goolsbee, A., Levitt, S., & Syverson, C. (2013). Microeconomics. 620-621. Worth
Publishers.

62
 IN-TEXT QUESTIONS
1. What is the primary purpose of insurance?
A) To prevent losses entirely
B) To spread the risk of loss among many policyholders
C) To generate profits for insurers
D) To ensure every individual experience a loss
2. Which of the following is not an example of an insurable loss?
A) Theft
B) Death
C) Investment gain
D) Fire
3. Which of the following is an incentive problem associated with insurance?
A) Risk pooling
B) Free market
C) Risk aversion
D) Adverse selection
4. What concept of ensures that premiums collected from many
policyholders can cover the losses of a few?
A) Risk elimination
B) Pooling of risks
C) Moral hazard
D) Free-riding problem
5. Adverse selection occurs when
A) Policyholders misrepresent their actual risk
B) Insurers fail to offer coverage
C) All policyholders are treated equally
D) Losses are not covered
6. What is term for policyholder behaving in a riskier manner after buying
insurance?
A) Moral hazard
B) Adverse selection
C) Free-riding problem
D) Principal-Agent problem

63
 IN-TEXT QUESTIONS
7. What is deadweight loss in the context of adverse selection?
A) A loss incurred by insurer due to fraudulent claims
B) A loss in economic welfare caused by market inefficiency
C) A surplus generated from excessive insurance claims
D) A reduction in premiums
8. How can insurers mitigate moral hazard?
A) By conducting regular visits
B) By conducting regular audits
C) By increasing premiums
D) A) and B) both

5.4 Summary

This unit discusses the two main incentive problems associated with insurance i.e., problems
of adverse selection and moral hazard. Adverse selection occurs when two parties are at
different levels of information about the same product and it causes deadweight loss, whereas
moral hazard occurs when people start to take more risks once they purchase an insurance
policy and it makes insurance costly if it is detectable by the insurance companies. Both
problems cause market failure (inefficiency). Solutions to these problems may be risk
classification, multiple diagnosis, behaviour monitoring, group insurance, database sharing by
government departments with insurance companies, and so on. the aggrieved, and so on.
5.5 Glossary
1. Asymmetric information: Two parties in an agreement have different information
with respect to their action or product or service, etc.
2. Adverse selection: Market inefficiency caused by asymmetric information.
3. Moral hazard: Change in attitude towards the precautions after a person is insured.
4. Deadweight loss: This is the loss in consumer surplus (or economic welfare) caused
by adverse selection.
5.6 Answers to Intext Questions

1. B) 5. A)
2. C) 6. A)
3. D) 7. B)
4. B) 8. D)

64
5.7 Self-Assessment Questions

1. A health insurance company offers full coverage to its policyholders. After buying the
insurance, some policyholders start engaging in riskier behaviour (e.g., neglecting
routine check-ups, and increase in smoking). What kind of problem is this? How can
the company tackle this problem?
2. Is adverse selection a problem? Discuss its implication.
3. How can the problem of adverse selection be tackled?
4. What measures can be taken to deal with the problem of moral hazard?
5.8 References

• Besanko, D., & Braeutigam, R. R. (2014). Microeconomics (5th ed.). Wiley.

• Frank, R. H. (2015). Microeconomics and Behaviour (9th ed.). McGraw-Hill
Education.
• Goolsbee, A., Levitt, S., & Syverson, C. (2013). Microeconomics. Worth Publishers.
• McEachern, W. A. (2006). Economics - A Contemporary Introduction (7th ed.).
Thomson South-Western.
• Nechyba, T. J. (2011). Microeconomics: An Intuitive Approach with Calculus. South-
Western Cengage Learning.
• Pindyck, R. S., & Rubinfeld, D. L. (2018). Microeconomics (9th ed.). Pearson.
• Rao, K. S. (2017). Do We Care: India’s Health System (1st ed.). OUP India.
5.9 Suggested Readings

• Frank, R. H. (2015). Microeconomics and Behaviour (9th ed.). McGraw-Hill

Education.
• McEachern, W. A. (2006). Economics - A Contemporary Introduction (7th ed.).
Thomson South-Western.
• Nechyba, T. J. (2011). Microeconomics: An Intuitive Approach with Calculus. South-
Western Cengage Learning.
• Philips, J. & Rapoport, J. (200). Economics of Health and Medical Care (5th ed.). Jones
and Bartlett Publishers.
• Pindyck, R. S., & Rubinfeld, D. L. (2018). Microeconomics (9th ed.). Pearson.
• Porter, M. E. and E. O. Teisberg (2006). Redefining Health Care: Creating Value-Based
Competition on Results (1st ed.). Harvard Business Review Press.

65
 Unit-III
Lesson 6

Economic Evaluation of Health Sector

Introduction
Healthcare systems face the persistent challenge of scarce resources and unlimited health
needs. Governments, insurance providers, and hospitals must make critical decisions about
which interventions to fund, which services to expand, and how to allocate limited budgets
efficiently. Economic evaluation provides a systematic framework to assess the costs and
outcomes of healthcare interventions, enabling policymakers and practitioners to make
informed decisions that maximize health benefits per unit of expenditure.
Unlike ordinary markets, healthcare presents unique complexities, including uncertainty in
outcomes, asymmetric information, third-party payment systems, and the presence of
externalities. Economic evaluation addresses these challenges by comparing alternative
interventions in terms of both resources used and health outcomes achieved.
Three primary methods of economic evaluation are widely used:
1. Cost-Effectiveness Analysis (CEA): CEA compares interventions based on their cost
per natural health unit, such as life-years gained, disease cases prevented, or
hospitalizations avoided. It is particularly useful for comparing alternatives within the
same disease or health condition. For example, comparing two malaria prevention
programs by evaluating cost per case averted helps identify the more efficient strategy.
2. Cost-Benefit Analysis (CBA): CBA converts both costs and benefits into monetary
terms, allowing comparisons across different types of interventions—even beyond
health. By calculating net benefits or benefit-cost ratios, policymakers can determine
whether a program is economically worthwhile. For instance, assessing a vaccination
campaign by comparing treatment cost savings and productivity gains to program
expenses provides a clear economic rationale for investment.
3. Cost-Utility Analysis (CUA): CUA extends CEA by incorporating quality of life into
the analysis, measuring outcomes in units like Quality-Adjusted Life Years (QALYs)
or Disability-Adjusted Life Years (DALYs). This approach enables comparison across
diverse interventions affecting both longevity and life quality, such as chemotherapy
versus palliative care.
Economic evaluation helps maximize societal health benefits, guide budget allocation, and
support evidence-based policy decisions. It also ensures that healthcare investments are
efficient, equitable, and sustainable, balancing cost constraints with the goal of improving
population health.

66
1. Cost-Effectiveness Analysis (CEA)
Cost-Effectiveness Analysis (CEA) is a fundamental tool in health economics used to
evaluate healthcare interventions by comparing the cost incurred to achieve a given health
outcome. Unlike ordinary cost analyses, which consider only expenditure, or cost-benefit
analyses, which attempt to monetize all outcomes, CEA focuses on measuring outcomes in
natural health units, such as lives saved, cases prevented, hospitalizations avoided, or years
of life gained.
CEA is particularly important because healthcare resources are limited, and policymakers
must decide how to allocate budgets efficiently. By assessing the efficiency of interventions,
CEA informs decisions about which programs provide the maximum health benefit per unit
of expenditure.
2. Key Principles of CEA
CEA relies on several foundational concepts:
1. Derived Demand: People do not consume healthcare for its own sake; they demand it
to improve health outcomes. Therefore, CEA evaluates interventions in terms of health
gains rather than healthcare units alone.
2. Efficiency: CEA emphasizes allocative efficiency—achieving the greatest health
benefit with the available resources.
3. Incremental Comparison: Rather than evaluating interventions independently, CEA
compares the additional cost and additional benefit of one intervention relative to
another. This approach ensures resources are directed toward the most effective
alternative.
4. Perspective Matters: Costs and benefits can be analyzed from different perspectives:
o Societal perspective: Includes all costs and benefits, direct and indirect.
o Healthcare system perspective: Focuses on government or insurer
expenditures.
o Patient perspective: Considers out-of-pocket expenses and personal time
costs.
5. Time Horizon and Discounting: Some interventions, like immunization programs or
chronic disease management, have benefits accruing over many years. Future costs and
benefits are discounted to present value to allow fair comparison.
3. Methodology of CEA
CEA involves a structured approach:
Step 1: Define the Objective and Interventions
• Identify the interventions to compare, e.g., two different malaria prevention programs.

67
 • Determine the target population, timeframe, and outcomes of interest.
Step 2: Identify and Measure Costs
• Direct Costs: Medical expenses, hospital stays, doctor fees, drugs, equipment.
• Indirect Costs: Lost productivity due to illness or treatment.
• Intangible Costs: Pain, suffering, or decreased quality of life (sometimes included
qualitatively).
Step 3: Identify and Measure Outcomes
• Outcomes are measured in natural units relevant to the disease or condition:
o Life-years gained
o Cases prevented
o Hospital admissions avoided
o Disease complications avoided
Step 4: Calculate Cost-Effectiveness Ratio (CER)
• The CER indicates the cost per unit of health outcome
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝐶𝐸𝑅 =
𝐻𝑒𝑎𝑙𝑡ℎ 𝑂𝑢𝑡𝑐𝑜𝑚𝑒

• Example: A vaccination program costs $1,000,000 and prevents 10,000 cases of a

disease.
1,000,000
𝐶𝐸𝑅 = = 100 per case prevented
10,000
Step 5: Calculate Incremental Cost-Effectiveness Ratio (ICER)
ICER compares two interventions and measures the additional cost required to achieve
one additional unit of outcome:
𝐶1 − 𝐶0
𝐼𝐶𝐸𝑅 =
𝐸1 − 𝐸0
Where:

• 𝐶1 , 𝐶0 = Costs of interventions 1 and 0

• 𝐸1 , 𝐸0 = Health outcomes of interventions 1 and 0

Example:
Program A: $1,000,000, prevents 10,000 cases
Program B: $1,500,000, prevents 15,000 cases

68
 1,500,000−1,000,000 500,000
• 𝐼𝐶𝐸𝑅 = = = 100
15,000−10,000 5,000
Interpretation: Each additional case prevented by Program B costs $100.
Advantages of CEA
1. Practical for Healthcare Decisions: Provides policymakers with actionable insights
on which interventions provide maximum health per unit cost.
2. Outcome-Focused: Evaluates interventions in terms of actual health results, rather
than only expenditures.
3. Supports Resource Allocation: Helps governments, insurers, and hospitals prioritize
programs under budget constraints.
4. Transparency: Provides a clear numerical basis for comparing interventions within the
same health domain.
Limitations of CEA

• Cannot Compare Across Different Health Domains: Example: Comparing malaria

prevention with mental health programs is difficult because outcomes are measured in
different units (cases prevented vs. improvement in depression scores).

• Does Not Monetize Benefits: Unlike cost-benefit analysis, CEA does not provide a
measure of economic value, limiting cross-sector comparisons.

• Sensitive to Measurement Accuracy:

o Accurate costing and outcome data are crucial.
o Differences in patient populations, study design, or assumptions can affect
results.

• Ethical and Equity Considerations: CEA focuses on efficiency, but may not consider
equity, e.g., access for vulnerable populations.
6. Applications of CEA

• Vaccination Programs: Evaluating cost per case of disease prevented. Helps decide
which vaccines to prioritize in public health budgets.

• Screening and Preventive Care: Cost per life-year gained from cancer screening,
diabetes screening, or cardiovascular risk reduction.

• Treatment Interventions: Comparing surgical versus medical management for

chronic conditions based on cost per recovery or complication avoided.

• Public Health Programs: Allocating funds to water sanitation, mosquito control, or

nutrition programs by evaluating cost per DALY or case prevented.

69
7. Example: Real-World CEA
Scenario: Comparing two malaria control strategies in a rural region:

Cases CER ($ per case

Program Cost ($)
Prevented prevented)

Bed Nets Distribution (Program A) 1,000,000 10,000 100

Indoor Residual Spraying (Program

1,500,000 15,000 100
B)

Analysis:
• Both interventions are equally cost-effective per case prevented.
• Decision-makers may consider additional factors: ease of implementation,
sustainability, community acceptance, or environmental impact.
Policy Implications
• CEA helps maximize population health given budget constraints.
• Provides evidence to support policy choices such as funding vaccination programs over
less cost-effective interventions.
• Encourages efficient use of public funds, improving access and outcomes for the
greatest number of people.
• Can guide international health agencies in resource allocation for global health
programs (e.g., WHO, UNICEF).
Cost-Benefit Analysis (CBA) in Health Care
8. Key Concepts in CBA
• Monetizing Benefits:
o Benefits include direct health improvements, such as lives saved or cases
prevented, and indirect benefits, such as productivity gains from reduced
morbidity.
o Methods for valuing health benefits include:
▪ Human Capital Approach: Values life or health in terms of potential
earnings.
▪ Willingness-to-Pay (WTP): Measures how much individuals are
willing to pay to reduce health risks or improve quality of life.
• Identifying Costs:
o Includes direct costs (medical services, drugs, hospital care), indirect costs (lost
workdays, caregiver time), and sometimes intangible costs (pain, suffering).

70
 • Net Benefit (NB) and Benefit-Cost Ratio (BCR):

o Net Benefit: 𝑁𝐵 = 𝑇𝑜𝑡𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠

𝑇𝑜𝑡𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠
o Benefit-Cost Ratio: 𝐵𝐶𝑅 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠

o Programs with NB > 0 or BCR > 1 are considered economically worthwhile.

• Cost-Benefit Analysis (CBA) is an economic evaluation technique that compares the
costs and benefits of healthcare interventions in monetary terms. Unlike Cost-
Effectiveness Analysis (CEA), which measures health outcomes in natural units (e.g.,
cases prevented or life-years gained), CBA assigns a monetary value to both costs
and outcomes. This allows decision-makers to evaluate whether a program yields net
benefits to society and to compare interventions across different sectors or health
conditions.
• CBA is particularly useful for large-scale health policy decisions, where it is necessary
to assess the economic justification for public investments in healthcare programs.
Steps in Conducting CBA
1. Define the intervention and comparator: Decide which programs or strategies to
compare.
2. Identify and measure costs: Include all resources consumed.
3. Identify and measure benefits: Convert health and social outcomes into monetary
terms.
4. Discount future costs and benefits: Apply a discount rate to account for time
preferences.
5. Calculate NB or BCR: Determine if the intervention is economically justified.
Example of CBA
Scenario: Evaluating a vaccination program:

Item Value ($)

Program cost 2,000,000

Direct treatment savings 1,200,000

Productivity gains 1,000,000

Total Benefits 2,200,000

Net Benefit 200,000

Benefit-Cost Ratio 2,200,000 ÷ 2,000,000 = 1.1

71
Interpretation: The program generates positive net benefits and a BCR > 1, justifying
investment.
9. Advantages of CBA
• Allows comparison across interventions and sectors.
• Provides a monetary measure of value, facilitating budget decisions.
• Supports policy-making at national and international levels.
10. Limitations of CBA
• Ethical challenges: Placing monetary value on human life and health can be
controversial.
• Measurement difficulties: Intangible benefits like reduced suffering or improved
quality of life are hard to quantify.
• Sensitive to assumptions regarding discount rates, WTP, and productivity measures.
Cost-Utility Analysis (CUA) in Health Care
1. Introduction
Cost-Utility Analysis (CUA) is a method that evaluates healthcare interventions by comparing
costs to outcomes expressed in utility-adjusted measures, such as Quality-Adjusted Life
Years (QALYs) or Disability-Adjusted Life Years (DALYs).
CUA is particularly useful when interventions affect both length of life and quality of life,
allowing comparison across different diseases or health programs, unlike CEA, which only
uses natural units.
2. Key Concepts in CUA
1. Quality-Adjusted Life Years (QALYs):
o Combines quantity and quality of life into a single measure.
o Calculated as:

𝑄𝐴𝐿𝑌 = 𝐿𝑖𝑓𝑒 𝑌𝑒𝑎𝑟𝑠 × 𝑈𝑡𝑖𝑙𝑖𝑡𝑦 𝑊𝑒𝑖𝑔ℎ𝑡

• Utility weight ranges from 0 (death) to 1 (perfect health).

2. Disability-Adjusted Life Years (DALYs):
o Measures the burden of disease, combining years lost due to premature death
and years lived with disability.
o Useful for prioritizing public health interventions.

72
 3. Cost per QALY/DALY:
o CUA evaluates cost per unit of utility-adjusted health outcome, facilitating
comparisons across programs with different health effects.
3. Steps in Conducting CUA
1. Identify interventions to compare.
2. Measure costs (direct, indirect, intangible).
3. Estimate health outcomes in QALYs or DALYs.
4. Calculate cost per QALY or DALY:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑡𝑒𝑟𝑣𝑒𝑛𝑡𝑖𝑜𝑛
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑄𝐴𝐿𝑌 =
𝑄𝐴𝐿𝑌𝑠𝐺𝑎𝑖𝑛𝑒𝑑

5. Use thresholds (e.g., willingness-to-pay per QALY) to determine if the intervention is

cost-effective.
6. Example of CUA
7. Scenario: Comparing chemotherapy and palliative care for terminal cancer:

Intervention Cost ($) QALYs Gained Cost per QALY ($)

Chemotherapy 50,000 2 25,000

Palliative Care 30,000 1.2 25,000

8. Interpretation: Both interventions have similar cost per QALY, but chemotherapy
provides more total QALYs. Policymakers may consider patient preferences, side
effects, and budget constraints before decision-making.
Advantages of CUA
• Combines quantity and quality of life, providing a more comprehensive outcome
measure.
• Allows comparison across diverse interventions, including different diseases.
• Facilitates evidence-based resource allocation, especially when budgets are limited.
Limitations of CUA
• Assigning utility weights can be subjective.
• Difficult to incorporate societal preferences or equity considerations.
• Complex calculations require high-quality data and methodological expertise.

73
Applications of CUA
• Comparing cancer treatments with different survival and quality-of-life outcomes.
• Evaluating mental health interventions, where improvements affect quality rather
than length of life.
• Public health programs that improve both longevity and well-being, such as chronic
disease management or lifestyle interventions.
Policy Implications
• CEA, CBA, and CUA complement each other in guiding healthcare decisions:
o CEA: Efficient allocation within a single disease area.
o CBA: Economic justification for programs across sectors.
o CUA: Comparison of interventions with different health outcomes affecting life
quality and quantity.
• Policymakers can use these tools to maximize health benefits, ensure equity, and
optimize healthcare budgets.
Summary
This lesson elaborates the economic evaluation of healthcare interventions, focusing on
Cost-Effectiveness Analysis (CEA), Cost-Benefit Analysis (CBA), and Cost-Utility
Analysis (CUA). These methods are essential tools in health economics for efficient
resource allocation, helping policymakers, providers, and insurers decide how to
maximize health outcomes with limited resources.
Cost-Effectiveness Analysis (CEA) compares healthcare interventions based on cost per
unit of health outcome, such as cases prevented, life-years gained, or hospitalizations
avoided. CEA is particularly useful for evaluating interventions addressing the same health
problem. The Incremental Cost-Effectiveness Ratio (ICER) allows comparison of the
additional cost required to achieve one additional health unit, guiding decisions on the most
efficient intervention.
Cost-Benefit Analysis (CBA) measures both costs and benefits in monetary terms,
enabling comparison across different programs or sectors. Net Benefit (NB) and Benefit-
Cost Ratio (BCR) are key indicators used to determine whether a program is economically
justified. CBA is widely applied in large-scale public health programs and policy planning,
though monetizing human life and health can pose ethical and methodological challenges.
Cost-Utility Analysis (CUA) extends CEA by incorporating quality of life alongside
longevity, using metrics such as Quality-Adjusted Life Years (QALYs) or Disability-
Adjusted Life Years (DALYs). CUA allows comparison of interventions affecting both
quantity and quality of life, such as chemotherapy versus palliative care, providing a more
comprehensive evaluation when outcomes differ in nature or impact.

74
Together, these three methods offer complementary approaches:
• CEA focuses on efficiency within a single health condition.
• CBA provides a monetary perspective for cross-sector comparison.
• CUA evaluates interventions considering both quality and quantity of life.
By applying these methods, health economists and policymakers can ensure that
healthcare resources are used efficiently, equitably, and sustainably, maximizing
population health benefits under budget constraints.

75
 Unit-IV
Lesson 7

Health Systems
AN OVERVIEW OF INTERNATIONAL HEALTH SYSTEMS AND INDIAN
EXPERIENCES

Introduction
Healthcare systems across the world are designed to deliver medical care, preventive services,
and public health interventions to populations in an efficient, equitable, and sustainable
manner. Despite a shared goal of improving health outcomes, countries vary widely in how
they organize, finance, and deliver healthcare, reflecting differences in economic
development, political structures, social priorities, and cultural values.
1. Beveridge Model
Overview:
• Named after Sir William Beveridge, who designed the post-war British welfare system.
• Healthcare is financed and provided by the government, primarily through taxation.
• Medical services are free or very low-cost at the point of use for residents.
Key Features:
1. Public Funding: Government collects taxes to finance healthcare.
2. Public Provision: Most hospitals and clinics are government-owned and staffed by
salaried professionals.
3. Universal Access: All citizens are entitled to healthcare regardless of income or
employment.
4. Government Regulation: Prices for drugs, services, and physician salaries are
controlled.
Examples:
• United Kingdom (NHS), Spain, New Zealand, Sweden.
Strengths:
• Universal access ensures equity and reduces health disparities.
• Administrative costs are low due to centralized financing.
• Strong emphasis on preventive care and public health.

76
Weaknesses:
• Risk of long waiting times for elective procedures.
• Potential for underfunding and limited choice of providers.
• Government bureaucracy can affect efficiency and innovation.
2. Bismarck Model
Overview:
• Named after Otto von Bismarck, who introduced the social insurance system in
Germany in the 19th century.
• Healthcare is financed through mandatory insurance contributions from employers
and employees.
• Providers are often private, but insurance is tightly regulated by the government.
Key Features:
1. Insurance-Based Financing: Citizens and employers contribute to sickness funds or
health insurance schemes.
2. Private Providers: Hospitals and clinics are usually privately owned.
3. Mandatory Coverage: Everyone must have health insurance.
4. Government Regulation: Ensures standardized benefits, controls costs, and prevents
discrimination.
Examples:
• Germany, France, Belgium, Japan, Switzerland.
Strengths:
• Provides universal coverage while maintaining private sector competition.
• Offers a wide choice of providers and services.
• Encourages efficiency through regulated competition between insurers.
Weaknesses:
• Complex administration due to multiple insurance funds.
• High costs may occur if regulation is insufficient.
• Equity can be challenged if contributions are not proportional to income.
3. National Health Insurance Model (NHI)
Overview:
• Combines features of the Beveridge and Bismarck models.
77
 • Healthcare is financed by a single government-run insurance system, but most
providers are private.
• Patients pay into the system via taxes or insurance premiums, but care is provided by
private physicians and hospitals.
Key Features:
1. Single-Payer System: One government fund collects money to pay for all healthcare
services.
2. Private Delivery: Doctors and hospitals are usually private, retaining autonomy over
care delivery.
3. Universal Coverage: All citizens are insured under the single-payer scheme.
4. Cost Control: Government sets fees, approves procedures, and negotiates drug prices.
Examples:
• Canada, South Korea, Taiwan.
Strengths:
• Simplifies administration compared to multiple insurers (lower administrative costs).
• Universal coverage ensures equity.
• Strong government bargaining power controls costs.
Weaknesses:
• Risk of rationing or longer waiting times for elective procedures.
• Limited provider competition may reduce innovation.
• Heavily reliant on government efficiency and funding.
4. Out-of-Pocket Model
Overview:
• Common in low-income countries with underdeveloped health systems.
• Individuals pay directly for healthcare services at the point of care.
• There is little to no insurance or government coverage.
Key Features:
1. Direct Payment: Patients bear the full cost of care.
2. Limited Public Health Services: Government involvement is minimal or absent.
3. Access Based on Ability to Pay: Wealthy individuals receive care, while poor
populations may go untreated.

78
 4. Fragmented System: Providers operate independently without central coordination.
Examples:
• Parts of rural India, many African countries, some low-income Asian countries.
Strengths:
• Simple system with minimal bureaucracy.
• Providers are incentivized to deliver services efficiently to paying customers.
Weaknesses:
• Leads to inequity—the poor cannot afford care.
• High risk of catastrophic health expenditure and poverty.
• Preventive care and public health interventions are often neglected.
• Limited access reduces overall population health outcomes.
5. Comparative Analysis of Models

Model Financing Providers Coverage Strengths Weaknesses

Method

Beveridge Tax-funded Public Universal Equity, low Waiting times,

admin cost, underfunding
preventive
care

Bismarck Employer- Private Universal Choice of Complex admin,

employee providers, risk of high
contributions competition costs

National Single Private Universal Simpler Risk of

Health government admin, cost rationing,
Insurance insurance control limited
innovation

Out-of- Direct payment Private Limited Simple, Inequity,

Pocket provider catastrophic
incentives costs, poor
access

Conclusions
International health system models provide valuable lessons for designing national
healthcare policies. Countries often adopt hybrid approaches, combining elements of these
models to suit their economic resources, population needs, and social priorities.

79
 • Beveridge and NHI models emphasize equity and universal coverage.
• Bismarck model balances choice and competition with regulation.
• Out-of-pocket systems highlight the consequences of limited public investment and
the importance of financial protection.
Understanding these models is crucial for policymakers and health economists to design
sustainable, equitable, and efficient health systems, including lessons applicable to countries
like India, which has a mixed public-private system with ongoing reforms to improve
coverage and reduce out-of-pocket spending.

80