Health Insurance

Public Finance Dr. Katie Sauer

Figure 15-1: Health Spending in OECD Nations

Figure 15-2: US Health Expenditures (2007)

Table 15-1:

Why Employers Provide Health Insurance To make money, insurance firms need to be able to predict the distribution of risk of the insured. - looking for large ³risk pools´ of people to insure - reduce adverse selection - law of large numbers

Employees of large firms make up a favorable risk pool. - particularly sick people don¶t all choose to work at the same firm

1. Insurance firms want to sell large, group policies to employers. - large risk pool - administrative costs are fixed

2. employer-provided health insurance gets a tax subsidy Workers are taxed on any wage compensation but are not taxed on compensation in the form of health insurance. - good for workers who want insurance - doesn¶t hurt the firm¶s bottom line

- Suppose a competitive labor market (w = MRP) - a worker earns $30,000 - tax rate is 33% (flat tax) - no employer-provided health insurance - private insurance costs $4,000 taxes = 30,000 x 0.33 = 10,000 after-tax wage = 30,000 ± 10,000 = $20,000 net income = 20,000 - 4,000 = $16,000

Marginal Revenue Product no insurance $30,000

employer health insurance spending $0

pre-tax wage $30,000

personal health after-tax insurance wage spending $20,000 $4,000

net income $16,000

Now suppose that the employer offers health insurance for $5,000. - reduce wages by $5,000 - total compensation remains $30,000 taxes = 25,000 x 0.33 = $8333.33 after-tax wage = 25,000 ± 8333.33 = $16,666.67 net income = $16,666.67

Marginal Revenue Product no insurance employer insurance $30,000 $30,000

employer health insurance spending $0 $5,000

pre-tax wage

after-tax wage

personal health insurance net income spending $4,000 $0 $16,000 $16,666.67

$30,000 $20,000 $25,000 $16,666.67

How Generous Should Health Insurance Be? The most generous insurance plans offer first-dollar coverage. - little or no patient payment Most plans cover some services fully, some not at all, and some with cost-sharing.

The Utility of Wealth This utility of wealth function exhibits diminishing marginal utility. - 2x the wealth doesn¶t make you 2x as happy - describes an individual who is risk averse (will not accept an actuarially fair bet)
Total Utility of Wealth

200

TU

140

10,000 Wealth

20,000

Suppose that your income is $20,000. You have a 10% chance of becoming sick. If you become sick, you will spend $10,000 as you pay medical expenses and miss work. Calculate your expected utility and expected wealth.

E[U] = (0.90)(200) + (0.10)(140) = 194 E[W] = (0.90)(20,000) + (0.10)(10,000) = 19,000

Total Utility of Wealth 200 194 EU 140

TU

10,000

19,000 20,000 Wealth

In a world with risk, $19,000 of wealth would give you an expected utility of 194. In a world without risk, the same $19,000 would yield a higher utility.

Total Utility of Wealth 200 194 EU 140

TU

10,000

19,000 20,000 Wealth

The horizontal distance between the expected utility line and the total utility line represents your risk aversion. At point A, you would be willing to pay up to $4,000 for insurance that protects against a reduction in wealth from illness.

Total Utility of Wealth 200 194 A

TU

EU 140

10,000

16,000 19,000 20,000 Wealth

How much are people willing to pay for insurance? When the probability of being well is 100%, then there are no gains from insurance. When the probability of being sick is 100%, then there are no gains from insurance. - might as well set money aside

Total Utility of Wealth 200

no gain from purchasing insurance
TU

EU 140

max gain from purchasing insurance

The horizontal distance between the certainty utility curve and the expected utility curve is the marginal gain from insurance. The marginal gains increase, then decrease.

no gain from purchasing insurance

10,000 Wealth

20,000

Total Utility of Wealth 200 EU EU 140

TU

Some events can substantially reduce wealth. - heart attack Some events won¶t substantially reduce wealth. - hang nail The expected utility line will reflect that.

10,000 Wealth

20,000

When comparing types of losses at any given probability, the larger the expected loss, the larger the gain from having insurance coverage.

Consumers¶ Expected Marginal Gain $, Insurer¶s Marginal Cost $

Marginal Gain for Heart Attack Insurance Marginal Gain for Hangnail Insurance
insurer¶s marginal cost

Wealth

When the marginal gains to the consumer exceed the insurer¶s marginal cost, insurance coverage will exist.

Moral Hazard So far we have assumed that the amount of a loss is fixed. But, buying insurance often lowers the out-of-pocket price of services. (buy more services!)

price

Suppose you pay all of your expenses out of pocket. If the price is p1, then you would consume Q1 units of health care. Your total expense would be (p1)(Q1).

p1

Demand Q1 Q3 Q of health care

(assume p1 is marginal cost of production)

Suppose the probability you will need to see a dermatologist is 0.50. You should be willing to pay the actuarially fair price of (0.50)(p1)(Q1) for insurance that would cover all of your losses. However, now additional medical care costs you nothing.

At a price of zero, you would consume Q3 units of health care.
Price of care

Your care would cost (p1)(Q3) in terms of resources.
P1

Q1 Quantity

Q3

If your insurance charged (0.5)(p1)(Q1) they would be losing money. The expected payout is larger than the expected premium. (0.5)(p1)(Q3) > (0.5)(p1)(Q1) If the company charged (0.5)(p1)(Q3), then you may not buy the insurance.

Any insurance premium has two components: - premium for protection from risk - resource cost due to moral hazard Moral hazard analysis helps us predict the types of insurance that are likely to be provided. 1.developed first for inelastic services 2. more coverage for inelastic services

Deductibles
Price of care

If you must pay a deductible before care is free to you: if the deductible is small you will consume an amount in between Q1 and Q3. (perhaps Q2)
Q1 Q2 Quantity Q3

P1

if the deductible is large, you may decide to ³selfinsure´ and will consume Q1.

Coinsurance Coinsurance is the consumer¶s out-of-pocket payment rate. (higher coinsurance means consumer pays more)
price

With marginal cost P1 and no insurance, the consumer will demand Q1 units of care. The consumer¶s marginal benefit will be equal to the marginal cost.

Demand with 100% coinsurance (MB)

p1

MC

Q1

quantity

With 20% coinsurance, the price the consumer pays out price of pocket falls to P2. Q2 units will be p1 demanded A new demand curve is generated to reflect the 20% coinsurance.

Demand with 100% coinsurance (MB) Demand with 20% coinsurance (MB) MC

p2

Q1

Q2

quantity

The additional resource cost is: The additional benefits to the consumer are:

price

p1

Demand with 100% coinsurance (MB) Demand with 20% coinsurance (MB) MC

The additional costs exceed the additional benefits.

p2

Q1

Q2

quantity

The role of health care in society is ultimately a production question. How does health care contribute to the health status of the population? health status = f (health care, lifestyle, environment,«) - many ways to measure health status ex: # disability days mortality rates / morbidity rates # healthy days in the population per capita life expectancy

The production function for health
HS HS 0.96 0.95 0.92 0.85 0.07 MP 0.10

0.75

0.03 0.02

MP

0

1

2

3

4

0

1

2

3

4

Health Care Inputs

Health Care Inputs

Takeaway: The total contribution of health care is substantial while the marginal contributions may be small. - on the ³flat of the curve´ The margin is often of interest to policy makers. - Many government programs encourage health care use (especially certain populations). - What effect would an increase (or decrease) of $1 billion in health spending have?

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