Healthcare Economics and Organisation
Module 1 Decision-making in healthcare and insurance markets
Diseases may have global (economic) impact. (Some) treatments are getting more and more
expensive, while others (of high importance) are getting cheaper, and it takes a long time to generate
profits. Ethical considerations and emotions play a big role. People may not always behave rationally
when confronted with health economic problems. Almost everyone likes to be healthy (and live long),
but this is costly. Not everyone who wants to be healthy receives the treatment he or she deserves
(e.g. because of discrimination). Important decision makers (and laymen) lack understanding of
differences between correlation and causality (important for healthcare markets – and life in general).
Basic concepts in health economics – what do we need to consider:
Scarcity occurs when the resources available to us are less than the resources
required for everything we would like to do
Choices must be made about how to use available resources
Opportunity cost benefit that a person could have received but gave up in order to take
another course of action
Efficiency maximize the health outcome (population average)
Equity reduce social disparities in health and healthcare
> Target points in health economics (sometimes trade-off between the two)
Supply has decreasing marginal productivity, or a diminishing rate of return. In markets with perfect
competition, the supply equals demand. The price is determined by the equilibrium (intersect of
demand and supply) – market equilibrium.
Healthcare markets
Third parties (insurers, governments, and unwitting bystanders) 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 often paid not by the patients but by private or government health
insurance. The rules established by these insurers, more than market prices, determine the allocation
of resources. the invisible hand can’t work its magic, and so the allocation of resources in the
healthcare market can end up highly inefficient.
> Thus: assumptions from standard theory do not apply to healthcare markets (Arrow, 1963).
Externalities, uncertainties, information asymmetry -> market failure
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,Externalities
An economic actor engages in behaviour that affects the utility of another actor (bystander) who
neither receives payment from that actor nor compensates him or her. There are positive
externalities and negative externalities.
Uncertainty
Healthcare spending is unpredictable since people (most of them at least) do not know when and
whether they get sick and what kind of treatment they might need (and what the costs of such
treatment are). Therefore, people like to take insurance (especially if they are risk averse and dislike
uncertainty).
Insurance covers part (or all of the risk) for a premium.
Two problems may arise in healthcare markets (with insurance):
1. Adverse selection: before agreeing on some transaction, one of the 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, M. and Stiglitz, J. (1976). Equilibrium in competitive insurance markets: An essay on the
economics of imperfect information. Quarterly Journal of Economics 90(November): 629-649
Analyse insurance markets under adverse selection -> show that there may be a separating
equilibrium as well as pooling equilibrium.
> But that both may not be stable
Pooling equilibrium offering one contract which is
attractive for both sick and
healthy people.
Separating equilibrium offering different contracts to
different types of people.
y-axis: wealth in an accident state
x-axis: wealth in a no accident state
Every point on the 45-degree line is a point where a person is
equally well off whether there is an accident or not.
If you start in e.g. point G, then an insurance company might offer you point D. This means that you
give up some wealth in the no accident state, but if you do get into an accident insurance covers part
of it, so your wealth in the accident state goes up. This is essentially what an insurance does.
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, Any point to the right of the starting point is not possible, as this would mean that insurance pays you
to take it (wealth increases), even in a no accident state. This is not going to happen. A point too far
up is also not possible, as it makes you wealthier in the accident state than the no accident state. This
incentivizes irresponsible behaviour, so insurance won’t offer it. So, it shouldn’t be higher up than it is
out to the right. An insurance that is left and below the starting point you should never take, as it
decreases your wealth in both the accident and no accident state. A point too far left incentives
reckless behaviour, if it increases your wealth more in the accident state than it costs in the no
accident state, because it will make you richer to be in an accident. Everything above the 45 degree
line is not possible, as it means we would be better off in the accident state than in the no accident
state. Getting rid of these areas leaves us with a triangle of possible space for an insurance contract.
If there are two utility curves, the flatter one is from a sick person, the steeper from a healthy person.
This is because utility functions move outwards. This means that flat utility functions gain mostly in
the accident state, while steeper utility functions gain mostly in the no accident state.
The lines of the triangle of possible insurance contracts in the Rothschild-Stieglitz model are called
fair odds lines. Fair odds = zero profits. The top/right line is the line for healthy people, the lower one
is the fair odds line for sick people. The utility functions go through the triangle. There is also a
straight line between the fair odds lines, which is the population pooling line. It is the line where you
can offer an insurance to both sick and healthy people without making a loss. If this line is close to
the fair odds line of the sick people, it means that there are many sick people. If it’s close to the fair
odds line of healthy people it means that there are many healthy people.
Insurance companies prefer healthy people, they want to take the healthy people away from other
companies (= cream skimming). They can do this in the triangle between the fair odds line of healthy
people and the population pooling line. The result would be that healthy people get insurance on the
fair odds line of healthy people, and sick people on their fair odds line. This means that sick people
will be worse off compared to the pooling equilibrium, and healthy people will be better off. To make
sure that doesn’t happen there is mandatory health insurance, which basically forces healthy people
to take insurance. The line should be closer to the fair odds line of healthy people than to the fair
odds line of sick people.
Starting point X, are the following points possible?
S: no, it would put you on a lower utility function than
with X.
T: no, as it’s not on the population pooling line. But, it is
attractive for both the sick and healthy people.
V: only attractive for healthy people, not for the sick.
R: no, insurance won’t offer it as it incentives risk taking.
Y: not possible for insurance but possible for healthy type.
Sick people would also take it but it’s not on the
population pooling line so it’s not maintained.
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