Unique Aspects of Health Economics in Modern Society

MODERN LABOR ECONOMICS THEORY AND PUBLIC POLICY Charles E. Phelps Health Economics 12THEDITION 6THEDITION 1 CHAPTER CHAPTER Why Health Economics? 1 22 March 2025

Learning Goals Assess why the special study of health economics makes sense Understand novel aspects of health care and ways to approach the issues. Identify how health care markets differ from others, particularly understanding the unique role of health insurance. Ascertain how medical spending has evolved over time (and why), dissecting the changes over the years in medical spending. 22 March 2025 2

In the U.S. in 2016, the services, products, institutions, regulations, and people involved in health care accounted for about 18% of gross domestic product (GDP). $3.3 trillion $10,500 per person (325 million people) Almost every person deals with the health care system at some point There are fundamental differences between health care markets and most other sectors of the economy. 22 March 2025 3

1.1 Important (If Not Unique) Aspects of Health Care Economics 1. Extent of government involvement 2. Dominant presence of uncertainty at all levels of health care (from randomness of illness to understanding of how well treatment options may work) 3. Large difference in knowledge between health care providers and their patients (consumers of health care) 4. Externalities behaviors that impose costs or benefits to those outside the market 22 March 2025 4

1.1 Important (If Not Unique) Aspects of Health Care Economics Government Intervention Licensing of health professionals, often also including private certification of competence Government intrusion into the market in uncommon ways 2010 Patient Protection and Affordable Care Act (PPACA or ACA) requires: Citizens must maintain a minimum level of health care coverage Insurers cannot use preexisting conditions to determine access to health care or premium cost The establishment of regional exchanges to provide insurance in small-group setting Government provides or subsidizes insurance for a variety of groups (elderly, poor, military, disabled, schoolchildren, those with birth defects or kidney disease) 22 March 2025 5

1.1 Important (If Not Unique) Aspects of Health Care Economics Government Intervention, continued. Price controls, particularly in terms of prices paid by the government to physicians Control of entry and exit into the market Hospitals often must comply with regulations to expand or contract number of beds and purchase of some diagnostic devices. Financial aid by states and federal government for students entering health care fields. Government research National Institute of Health (NIH), in Bethesda, MD 22 March 2025 6

1.1 Important (If Not Unique) Aspects of Health Care Economics Government Intervention, continued. Rigorous testing of new drugs and medical devices before they can come to market Favored tax treatments Employer-paid insurance exempt from taxation Most hospitals and insurance plans are granted corporate immunity from taxation State governments largely exempt such institutions from sales taxes Local governments largely exempt such institutions from property taxes Extent of government intervention in health care markets is actually less in the U.S. than in almost all other countries. 22 March 2025 7

1.1 Important (If Not Unique) Aspects of Health Care Economics Uncertainty The need for health care often arises from random events. Providers confront large amounts of uncertainty. Different treatment recommendations Therapies of choice change over time, often with little scientific basis. Approach to uncertainty differs widely by area Rigorous testing of new drugs versus discretion on the part of a licensed surgeon 22 March 2025 8

1.1 Important (If Not Unique) Aspects of Health Care Economics Asymmetric Knowledge Asymmetric information problems arise when one party to a transaction has more relevant knowledge than another. Doctors (and other providers) may have far greater levels of knowledge than patients. Patients and doctors may have different incentives to reveal or conceal information. Arrow (1963) stressed the desirability of professional codes of ethics and licensing Doctor-patient relationship May be difficult to obtain good information about quality of health care Mistakes may be difficult to correct 22 March 2025 9

1.1 Important (If Not Unique) Aspects of Health Care Economics Externalities Positive externalities create benefits for those not involved in the market. A flu shot creates benefits both for the person who gets it and for those that the person is in contact with. Private benefits are less than public benefits, so people will underinvest in flu shots. Negative externalities create costs for those not involved in the market. Within the system: use of antibiotics fractionally increase the probability of the development of an antibiotic-resistant strain of bacteria Outside the system: actions such as drinking and driving impose injuries on others 22 March 2025 10

1.2 How Markets Interrelate in Medical Care and Health Insurance Framework for analysis Assumes that markets are static Medical Care Markets with Fixed Technology Supply and demand interact to create the observed quantity demanded and observed price. Supply and demand are assumed to be independent of each other. In health care markets, one major difference is that the price that consumers pay is different from the price that sellers receive. 22 March 2025 11

1.2 How Markets Interrelate in Medical Care and Health Insurance 22 March 2025 12

1.2 How Markets Interrelate in Medical Care and Health Insurance Medical Care Markets with Fixed Technology, continued Some important points from Figure 1.1 The markets for health care and health insurance are interrelated. Health insurance is different from other types of insurance because there is no objective valuation of the underlying asset. The PPACA has created new parts of the health care market. Medical care is a collection of goods and services rather than a single good or service. 22 March 2025 13

1.2 How Markets Interrelate in Medical Care and Health Insurance Dynamic Issues: Changes Through Time Table 1.1: Per Capita Gross Domestic Product (2015 $) Year Per Capita GDP 1960 $24,100 1970 $31,900 1980 $35,400 1990 $43,300 1995 $44,600 2000 $50,100 2005 $53,200 2010 $52,200 2015 $56,100 Source: Bureau of Labor Statistics for per capita GDP. National Center for Health Statistics for medical spending data to compute budget shares. Medical Care (% of GDP) 5.0 6.9 8.9 12.1 13.3 13.3 15.0 17.4 17.8 Economywide Income Growth Health care is a normal good, so demand is expected to increase with income. Real per capita purchasing power has increased by about 2% per year since World War II. 22 March 2025 14

1.2 How Markets Interrelate in Medical Care and Health Insurance Dynamic Issues: Changes Through Time Table 1.2: Age Distribution of the U.S. Population Year Percentage over 65 Years Old 1950 8.1 1960 9.2 1970 9.8 1980 11.3 1990 12.6 2000 12.4 2010 13.2 2015 14.9 Percentage under 5 Years Old 10.8 11.3 8.4 7.2 7.4 6.8 6.7 6.2 Demographics The population of the U.S. is aging. As people age, health stock deteriorates, and more medical care is used. Source: census.gov/quickfacts/table/PST04 22 March 2025 15

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.3: Federal Investments in New Knowledge: The NIH Budget Through the Years Year Total ($ Million) Dynamic Issues: Changes Through Time Total (Year 2000 $ Million) Annual Percentage Real Growth -- 1.8 29.3 1.9 3.1 6.7 3.0 -1.8 R&D and Technical Change Technical change has been extensive, fueled largely by biomedical research Much is private, and data is hard to obtain. Government research is extensive, although declining since the 1980s 1950 1960 1970 1980 1990 2000 2010 2015 59 81 360 431 5,630 6,823 9,299 17,800 24,000 22,000 1,444 3,573 7,581 17,800 31,000 30,362 Source: www.nih.gov/about/budget.htm 22 March 2025 16

1.2 How Markets Interrelate in Medical Care and Health Insurance The Growth in Medical Prices Difficult to measure because the nature of the service changes Medical Consumer Price Index (CPI) has two main areas Medical care services (MCS), largely professional services Medical care commodities (MCC), drugs and medical equipment Measurement units: Standardized list of professional services Hospital visits Prescription drugs based on random sampling of pharmacies Higher prices may mean better quality of service rather than inflation 22 March 2025 17

1.2 How Markets Interrelate in Medical Care and Health Insurance The Growth in Medical Prices, continued Figure 1.2 here Figure 1.2 shows the overall time trends for the total CPI and the medical component of the CPI since 1960. With 1982-84 as the base, total CPI is now about 240 while the medical CPI is about 450. Overall CPI has averaged 3.85% annual growth while the medical CPI has averaged 5.6% annual growth. 22 March 2025 18

1.2 How Markets Interrelate in Medical Care and Health Insurance The medical CPI gives an idea of the cost of an activity, but would be better to know the cost of treating an illness Shifting treatments may lower the cost of hospital stays and thus the cost of treatment, but CPI does not show this New drugs may be more expensive but require less physician monitoring Masks important differences in the parts that make up the health care sector Tables 1.4 shows medical expenditures broken down by category. 22 March 2025 19

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.4 Price Levels Through Time (Base 1982-1984=100) Year CPI Medical Care 22.3 25.2 34.0 47.5 74.9 113.5 162.8 223.8 260.8 323.2 400.0 454.1 Hospital Services 9.3 12.3 23.6 38.3 68.0 115.4 175.4 253.0 317.3 439.2 600.0 772.6 Physician Fees 21.9 25.1 34.5 48.1 76.5 113.3 160.8 208.2 244.7 287.5 340.0 370.3 Dentist Fees 27.0 30.3 39.2 53.2 78.9 114.2 155.8 205.3 258.5 324.0 400.0 455.5 Prescription Drugs 54.0 47.8 47.4 51.2 72.5 120.1 181.7 238.1 285.4 349.0 425.0 481.1 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 29.6 31.5 38.8 53.8 82.4 107.6 130.7 153.5 172.2 196.8 225.0 236.0 Source: Bureau of Labor Statistics, Consumer Price Index 22 March 2025 20

1.2 How Markets Interrelate in Medical Care and Health Insurance Examining Table 1.4 shows that looking only at the aggregate figures is misleading. Between 1960 and 2015, overall prices had increased by a factor of 8, and medical prices by a factor of 20. Hospital services increased by a factor of 83, physician and dentists services both by a factor of about 17-18 (a bit more than twice the CPI rate), and prescription drugs by about the same as the CPI. In recent years, prescription drugs have been the fastest growing part of the medical market basket. 22 March 2025 21

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.5 Annual Nominal Expenditures for Medical Services ($ billions) Year Total Hospital Physician Drug Other Nursing Home 0.8 4.0 19.0 52.6 74.1 95.3 122.0 140.0 157.0 196.0 1960 1970 1980 1990 1995 2000 2005 2010 2015 Relative Amount 2015/1960 23.3 62.9 215.0 608.0 864.0 1,140.0 1,661.0 2,596.0 3,206.0 138.0 9.2 27.6 101.0 252.0 341.0 417.0 612.0 822.0 1,036.0 113.0 5.4 14.0 47.1 157.5 220.5 288.6 421.2 513.0 634.0 117.4 2.7 5.5 12.0 40.3 60.9 121.0 201.0 253.0 325.0 120.0 5.3 11.8 36.2 106.0 168.0 218.0 306.0 450.0 602.0 114.0 Source: 22 March 2025 22

1.2 How Markets Interrelate in Medical Care and Health Insurance Medical Spending Patterns Although technical change makes simple measures misleading, examining spending on health care provides some insight. Table 1.5 shows nominal spending on various health care categories. Over the 1960-2015 period, most spending increased by a factor of about 100. Nursing home care increased by a factor of 200, due to the aging of the population. 22 March 2025 23

Dynamic IssuesChanges Through Time Table 1.6 Annual Expenses for Medical Services (2015 dollars, billions) Year Total Hospital Physician Drug Other Nursing Home 6.4 24.4 54.6 95.4 115.0 131.0 148.0 152.0 157.0 24.5 1960 1970 1980 1990 1995 2000 2005 2010 2015 Relative Amount 2015/1960 153.0 316.0 510.0 908.0 1,107.0 1,293.0 1,661.0 2,147 3,206.0 20.9 73.7 169.0 290.0 456.0 530.0 574.0 742.0 893.0 1,036.0 14.1 43.2 85.5 135.5 285.6 342.9 397.2 511.1 557.3 634.0 14.7 21.5 33.6 34.5 73.1 94.7 166.0 244.0 275.0 325.0 15.0 42.4 72.1 104.0 191.0 260.0 300.0 371.0 489.0 602.0 14.2 Source: 22 March 2025 24

1.2 How Markets Interrelate in Medical Care and Health Insurance Medical Spending Patterns Dividing nominal spending by the CPI gives a measure of real spending in these categories (Table 1.6). Table 1.6 shows that most of the spending increases over the period were actually due to inflation. Table 1.7 adjusts spending on the assumption that population had been the same in every year as it was in 2015. Table 1.8 adjusts spending on the assumptions that population was the same as in 2015 and that prices were constant (and that medical prices stayed the same relative to the overall price level). 22 March 2025 25

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.7 Annual Expenses (constant 2015 dollars, 2005 population, $ billions) Year Total Hospital Physician Drug Other Nursing Home 11.4 38.3 77.1 122.0 140.0 149.0 160.0 158.0 157.0 13.8 1960 1970 1980 1990 1995 2000 2005 2010 2015 Relative Amount 2015/1960 273.1 496.0 720.0 1,166.0 1,342.0 1,471.0 1,801.0 2,227.0 3,206.0 11.8 131.0 264.0 410.0 586.0 642.0 653.0 805.0 926.0 1,036.0 7.9 77.0 134.1 191.2 366.7 415.5 451.8 554.1 578.2 634.0 8.2 38.5 52.7 48.7 93.8 115.0 189.0 264.0 285.0 325.0 8.4 75.5 113.0 147.0 246.0 316.0 341.0 403.0 507.0 602.0 7.8 Source: 22 March 2025 26

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.8 Annual Expenses in Constant 2015 Population and Constant Relative Prices (constant 2015 dollars, 2015 population, $ billions) Year Total Hospital Physician Drug Other Nursing Home 28.7 82.7 160.0 185.0 182.0 186.0 183.0 167.0 157.0 3.5 1960 1970 1980 1990 1995 2000 2005 2010 2015 Relative Amount 2015/1960 686.0 1,070 1,498.0 1,498.0 1,748.0 1,835.0 2,055.0 2,360.0 3,206.0 4.7 330.0 571.0 853.0 884.0 837.0 815.0 918.0 982.0 1,036.0 3.1 193.5 289.4 397.8 553.2 541.4 563.7 632.3 612.6 634.0 3.3 96.8 84.1 70.2 98.4 101.0 160.0 201.0 255.0 325.0 2.6 190 244.0 306.0 371.0 411.0 426.0 460.0 537.0 602.0 3.2 Source: 22 March 2025 27

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.9 Selected Medical Care Use by Age, Per Person, 2005 Age Ambulatory Visits 2.53 Hospital Days Ambulatory Prescriptions 3.30 Total Personal Spending $2,650 Under 18 0.20 18-44 45-54 55-64 65-74 75+ 75-84 85+ 2.24 3.44 4.58 6.47 7.68 0.33 0.47 0.71 1.40 2.59 4.70 8.40 12.40 18.40 23.60 $3,370 $5,210 $7,787 $10,778 -- $16,389 $25,691 Sources: CDC, Health 2008, Table 92 (ambulatory), Table 99 (hospital days), and Table 128 (prescription use). Total personal medical spending from personal communication, Sean Keehan, Center for Medicare Services, Office of the Actuary, National Health Statistics Group. Note: Total personal spending accounts for only 83 percent of total health care spending (by excluding, e.g., research and administrative costs) so these totals are lower than total per capita medical spending for the U.S. 22 March 2025 28

1.2 How Markets Interrelate in Medical Care and Health Insurance Table 1.10 Age Distribution of the U.S. Population 22 March 2025 29

1.2 How Markets Interrelate in Medical Care and Health Insurance Medical Spending Patterns From Table 1.7, real per capita spending on health care has increased by a factor of 11.8. Real per capita income doubled, increasing the demand for health care. Demand in income-elastic, increasing budget share over time. The relative price of medical care increased by a factor of 2.5 over the period. The bottom rows of Tables 1.7 and 1.8 differ due to the increase in the relative price of health care a growth factor of 11.8 counting the increase in relative prices becomes only 4.67 if relative prices had not changed. From this, we can also estimate that the income elasticity of demand for medical care is about 2.5. Decomposing the changes over time into annual growth rates shows that the relative price of medical care has increased at 1.7 percent faster over time than the overall CPI. 22 March 2025 30

1.2 How Markets Interrelate in Medical Care and Health Insurance How Much Spending Growth Arises from Population Aging? Table 1.9 shows selected medical care use by age, per capita. Table 1.10 shows the age distribution of the population. Using these two tables allows calculation of estimated spending if the age distribution had not changed. Using the 1960 population distribution, the average is only 82 percent of what we get using the 2015 population distribution. Thus 18 percent of the growth in medical spending is due to the aging of the population. Had the age mix of the population remained constant at the 1960 levels, we would be spending 82 percent of that, or 14.75 percent of our GDP. The remaining 3.25 percent of GDP is a result of the aging population. 22 March 2025 31

1.2 How Markets Interrelate in Medical Care and Health Insurance How Much Spending Growth Arises from Population Aging? Extrapolating to 2050, using the Census Bureau projections, estimated spending is 30 percent higher than in 2015 simply because of the changing age mix. If nothing else changes in our health economy between now and 2050 except for the age mix of the population, we will spend 23 percent of our GDP on health care. If medical care prices continue to rise at 1.7 percent per year above inflation, we would that forecast 42 percent of GDP will be devoted to health care spending in 2050. 22 March 2025 32