, Module 1
Module 1 - Decision-making in healthcare and Insurance markets
Basic Concepts in Health Economics
– Scarcity: Occurs when the resources available to us are less than the
resources required for everything we would like to do.
– Opportunity cost: Benefit that a person could have received but gave up
in order to take another course of action.
Efficiency and Equity
– Efficiency = maximize the health outcome (population average) given the
available resources
– Equity = reduce social disparities in health and health care.
Principles of markets: Demand
– Assumptions;
• Consumers act rationally.
• Consumers have perfect information about the quality of services
and products.
• Scarcity: consumers have to choose between various goods (budget
restriction).
– When making decisions, consumers compare:
• Preference (relative valuation) for one good.
• Cost: The price of the good and the consumer's budget constraints.
• Utility: The satisfaction or benefit they expect to gain from consuming
a particular good.
, Principles of markets: Supply
– Assumptions;
• Firms act rationally.
• Firms have perfect information.
• Firms maximize profit.
– The profit function can be represented as: 𝜋 = 𝑝𝑞 - 𝑤𝑟.
→ Where:
• 𝜋 = profit • 𝑞 = quantity of output • 𝑟 = quantity of input
• 𝑝 = price of output • 𝑤 = price of input
Healthcare Markets
– Healthcare markets are unique and the standard assumptions about
market efficiency do not always apply to healthcare.
– This is because;
• Third parties (insurers, governments) often have an interest in healthcare
outcomes.
• Patients often don’t know what they need and cannot evaluate the
treatment they are getting.
• Healthcare providers are typically paid by private or government
insurance, rather than directly by patients. Insurance rules significantly
influence how resources are allocated in healthcare.
– Due to these factors, the "invisible hand" of the market may not work
efficiently in healthcare, leading to potential market failures such as
externalities, uncertainties, information asymmetry, and the need for
regulation to correct these issues.
,Externalities
– An externality refers to a situation where the actions of one economic
actor affect the well-being or utility of another actor, without any
compensation or payment between them.
– There are two types of externalities:
1. Positive externalities: These occur when the activity of one actor
benefits another actor without compensation.
2. Negative externalities: These occur when the activity of one actor
harms or imposes a cost on another actor without compensation.
Uncertainty
– Healthcare spending is unpredictable since most people do not know when
and whether they get sick and what kind of treatment they might need
(and what the cost of such treatment are).
– Therefore, people like to take insurance (especially if they are risk averse
and dislike uncertainty).
– Two problems may arise in healthcare markets (with insurance);
1. Adverse selection: Before agreeing on some transaction, one of the
two parties has some relevant information that is not known to the
other party.
2. Moral hazard: After agreeing on some transaction, one party can take
an action to its own benefit that is not observed by the other party.
→ Both may arise because of asymmetric information.
,Rothschild-Stiglitz Model
– Rothschild and Stiglitz's analysis shows that under adverse selection, both
separating and pooling equilibria can exist, but they might not be stable in
the long run.
– This instability can create challenges for insurers in designing optimal
insurance contracts and may require regulatory interventions to ensure
market efficiency.
– The terms used are;
• Equilibrium: In economics, equilibrium refers to a situation where market
forces are balanced, and there's no incentive for firms or individuals to
change their behavior.
• Separating equilibrium: This occurs when individuals with different levels
of risk are offered separate insurance contracts, allowing insurers to
distinguish between high-risk and low-risk individuals.
→ This separation can lead to different premiums and coverage levels
for different risk groups.
• Pooling equilibrium: Here, individuals with varying levels of risk are
grouped together and offered the same insurance contract.
→ This pooling can result in a single premium for everyone, with high-
risk and low-risk individuals sharing the costs.
Demand Side (patients) Cost Sharing
– Patients usually make decisions about using healthcare services by
comparing the costs and benefits.
– Patients consider the decreasing marginal benefit of treatment, meaning
that each additional unit of treatment provides less benefit than the
previous one.
,– Patients weigh the benefits (e.g., pain relief, improved appearance) against
the costs (e.g., lost work time, travel expenses, out-of-pocket payments).
– These cost considerations can impact:
• Access to medical services (whether or not to seek treatment-extensive
margin).
• The extent of treatment received (the intensity of treatment-intensive
margin).
Supply Side (providers) Cost Sharing
– Healthcare providers’ decisions can be influenced by different
reimbursement methods, also known as supply-side cost-sharing.
– Providers have discretion or control over aspects like the quantity of care
provided, the resources used, the quality of care, and the prices they charge.
– Physician agency: Different reimbursement methods create different
incentives for providers in terms of cost containment and quality of care:
• Purely prospective payment (e.g., capitation, salary): Providers receive
a fixed amount for each patient or a fixed salary, regardless of the
services provided.
→ This can encourage providers to minimize costs, avoid unnecessary services.
• Purely retrospective reimbursement (fee-for-service): Providers are
reimbursed for each service provided, which can create an incentive to
provide more services, even not all necessary, to increase earnings.
• Blended reimbursement (diagnosis-related group payments, pay-for-
performance,): These methods combine elements of the above payments,
aiming to strike a balance between cost containment & quality of care.
→ Providers may receive a fixed amount per patient or case, with additional
payments tied to performance or outcomes.
Module 1 - Decision-making in healthcare and Insurance markets
Basic Concepts in Health Economics
– Scarcity: Occurs when the resources available to us are less than the
resources required for everything we would like to do.
– Opportunity cost: Benefit that a person could have received but gave up
in order to take another course of action.
Efficiency and Equity
– Efficiency = maximize the health outcome (population average) given the
available resources
– Equity = reduce social disparities in health and health care.
Principles of markets: Demand
– Assumptions;
• Consumers act rationally.
• Consumers have perfect information about the quality of services
and products.
• Scarcity: consumers have to choose between various goods (budget
restriction).
– When making decisions, consumers compare:
• Preference (relative valuation) for one good.
• Cost: The price of the good and the consumer's budget constraints.
• Utility: The satisfaction or benefit they expect to gain from consuming
a particular good.
, Principles of markets: Supply
– Assumptions;
• Firms act rationally.
• Firms have perfect information.
• Firms maximize profit.
– The profit function can be represented as: 𝜋 = 𝑝𝑞 - 𝑤𝑟.
→ Where:
• 𝜋 = profit • 𝑞 = quantity of output • 𝑟 = quantity of input
• 𝑝 = price of output • 𝑤 = price of input
Healthcare Markets
– Healthcare markets are unique and the standard assumptions about
market efficiency do not always apply to healthcare.
– This is because;
• Third parties (insurers, governments) often have an interest in healthcare
outcomes.
• Patients often don’t know what they need and cannot evaluate the
treatment they are getting.
• Healthcare providers are typically paid by private or government
insurance, rather than directly by patients. Insurance rules significantly
influence how resources are allocated in healthcare.
– Due to these factors, the "invisible hand" of the market may not work
efficiently in healthcare, leading to potential market failures such as
externalities, uncertainties, information asymmetry, and the need for
regulation to correct these issues.
,Externalities
– An externality refers to a situation where the actions of one economic
actor affect the well-being or utility of another actor, without any
compensation or payment between them.
– There are two types of externalities:
1. Positive externalities: These occur when the activity of one actor
benefits another actor without compensation.
2. Negative externalities: These occur when the activity of one actor
harms or imposes a cost on another actor without compensation.
Uncertainty
– Healthcare spending is unpredictable since most people do not know when
and whether they get sick and what kind of treatment they might need
(and what the cost of such treatment are).
– Therefore, people like to take insurance (especially if they are risk averse
and dislike uncertainty).
– Two problems may arise in healthcare markets (with insurance);
1. Adverse selection: Before agreeing on some transaction, one of the
two parties has some relevant information that is not known to the
other party.
2. Moral hazard: After agreeing on some transaction, one party can take
an action to its own benefit that is not observed by the other party.
→ Both may arise because of asymmetric information.
,Rothschild-Stiglitz Model
– Rothschild and Stiglitz's analysis shows that under adverse selection, both
separating and pooling equilibria can exist, but they might not be stable in
the long run.
– This instability can create challenges for insurers in designing optimal
insurance contracts and may require regulatory interventions to ensure
market efficiency.
– The terms used are;
• Equilibrium: In economics, equilibrium refers to a situation where market
forces are balanced, and there's no incentive for firms or individuals to
change their behavior.
• Separating equilibrium: This occurs when individuals with different levels
of risk are offered separate insurance contracts, allowing insurers to
distinguish between high-risk and low-risk individuals.
→ This separation can lead to different premiums and coverage levels
for different risk groups.
• Pooling equilibrium: Here, individuals with varying levels of risk are
grouped together and offered the same insurance contract.
→ This pooling can result in a single premium for everyone, with high-
risk and low-risk individuals sharing the costs.
Demand Side (patients) Cost Sharing
– Patients usually make decisions about using healthcare services by
comparing the costs and benefits.
– Patients consider the decreasing marginal benefit of treatment, meaning
that each additional unit of treatment provides less benefit than the
previous one.
,– Patients weigh the benefits (e.g., pain relief, improved appearance) against
the costs (e.g., lost work time, travel expenses, out-of-pocket payments).
– These cost considerations can impact:
• Access to medical services (whether or not to seek treatment-extensive
margin).
• The extent of treatment received (the intensity of treatment-intensive
margin).
Supply Side (providers) Cost Sharing
– Healthcare providers’ decisions can be influenced by different
reimbursement methods, also known as supply-side cost-sharing.
– Providers have discretion or control over aspects like the quantity of care
provided, the resources used, the quality of care, and the prices they charge.
– Physician agency: Different reimbursement methods create different
incentives for providers in terms of cost containment and quality of care:
• Purely prospective payment (e.g., capitation, salary): Providers receive
a fixed amount for each patient or a fixed salary, regardless of the
services provided.
→ This can encourage providers to minimize costs, avoid unnecessary services.
• Purely retrospective reimbursement (fee-for-service): Providers are
reimbursed for each service provided, which can create an incentive to
provide more services, even not all necessary, to increase earnings.
• Blended reimbursement (diagnosis-related group payments, pay-for-
performance,): These methods combine elements of the above payments,
aiming to strike a balance between cost containment & quality of care.
→ Providers may receive a fixed amount per patient or case, with additional
payments tied to performance or outcomes.
