CHAPTER 5 | The Economics of Health Care
Brief Chapter Summary and Learning Objectives
5.1 The Improving Health of People in the United States (pages 218–220)
5.2 Health Care around the World (pages 220–226)
Compare the health care systems and health care outcomes in the United States and other
5.3 Information Problems and Externalities in the Market for Health Care
(pages 226–232)
5.4 The Debate over Health Care Policy in the United States (pages 232–243)
Explain the major issues involved in the debate over health care policy in the United
States.
▪ The rising cost of health care led President Obama and Congress to pass the Patient
Key Terms
Adverse selection, p. 227. The situation in
which one party to a transaction takes advantage
Fee-for-service, p. 221. A system under which
doctors and hospitals receive a payment for each
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Health insurance, p. 220. A contract under
which a buyer agrees to make payments, or
premiums, in exchange for the provider’s
agreeing to pay some or all of the buyer’s
medical bills.
passed by Congress and signed by President
Barack Obama in 2010.
Principal-agent problem, p. 228. A problem
caused by agents pursuing their own interests
Chapter Outline
How Much Will You Pay for Health Insurance?
In 2010, major changes in the U.S. health care system resulted from the enactment of the Patient
Protection and Affordable Care Act (ACA). Under the ACA young people who seldom visit their doctors
still must purchase health insurance or pay a fine. Some of the state and federal taxes withheld from
5.1
The Improving Health of People in the United States (pages 218–220)
Learning Objective: Use date to discuss trends in U.S. health over time.
Health care refers to the goods and services, such as prescription drugs, consultations with a doctor, and
surgeries, that are intended to maintain or improve a person’s health.
In the late 1700s, England had the highest level of per level of income per person of any large country,
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A. Changes over Time in U.S. Health
The health of the average person in the United States improved significantly during the nineteenth and
B. Reasons for Long-Run Improvements in U.S. Health
Life expectancy at birth in the United States increased from 47.3 years in 1900 to 79.6 years in 2015. The
5.2
Health Care around the World (pages 220–226)
Learning Objective: Compare the health care systems and health care outcomes in the
United States and other countries.
In the United States, private firms, either through doctors’ practices or hospitals, provide most health care.
The main exception is the care the government provides through hospitals operated by the Veterans
Administration. Governments in most countries outside of the United States have a more substantial
direct role in paying for or providing health care.
A. The U.S. Health Care System
Most people in the United States have health insurance that helps them to pay their medical bills. Health
insurance is a contract under which a buyer agrees to make payments, or premiums, in exchange for the
B. The Health Care Systems of Canada, Japan, and the United Kingdom
Canada has a single-payer health care system, a system in which the government provides health
insurance to all of the country’s residents. As in the United States, most doctors and hospitals are private
businesses, but they are required to accept fees that are set by the government. As in the United States,
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C. Comparing Health Care Outcomes around the World
Typically, the higher the level of income per person in a country, the higher the level of spending per
Difficulties in making cross-country comparisons in health care outcomes include:
• Data problems
• Problems with measuring health care delivery
The large and rising cost of health care is a significant problem for most private businesses. Many
companies have addressed the problem by encouraging employees to join company-run wellness
programs and health clubs. Some companies even locate health clinics on their premises. Executives at
MasterBrand Cabinets, an Indiana-based company with 7,000 employees, decided to do more to control
its escalating health care costs. In 2010 MasterBrand began tying the company’s contributions to workers’
insurance premiums to health measures such as blood pressure, body-mass, and tobacco use. Employees
with the worst health indicators were charged as much as $10.50 extra per week for health insurance,
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5.3
Information Problems and Externalities in the Market for Health Care
(pages 226–232)
Learning Objective: Define information problems and externalities, and explain how
they affect the market for health care.
The health care market is affected by the problem of asymmetric information: A situation in which one
party to an economic transaction has less information than the other party.
A. Adverse Selection and the Market for “Lemons”
The seller of a used car has more information on the true condition of the car than potential buyers. Used
car buyers don’t know whether any particular car offered for sale is a good car or a lemon. The sellers do
B. Asymmetric Information in the Market for Health Insurance
Asymmetric information problems are severe in markets for all types of insurance. Insurance companies
provide risk pooling when they sell policies to households. An insurance company can pool the risk of
your house burning down by selling fire insurance to thousands of other homeowners. For the insurance
The insurance market is also subject to moral hazard: The actions people take after they have entered
into a transaction that make the other party to the transaction worse off. Moral hazard in the insurance
market occurs when people change their behavior after becoming insured.
Normally, there are two parties to a transaction: the buyer and the seller. The insurance company becomes
a third party to the purchase of medical services because the company pays for some or all of the services.
Economists refer to traditional health insurance as a third-party payer system. This means that consumers
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Insurance companies can reduce adverse selection and moral hazard problems by using deductibles and
coinsurance. Someone applying for an individual health insurance policy is usually required to submit his
or her medical records. Insurance companies have frequently offered limited coverage of pre-existing
C. Externalities in the Market for Health Care
Some goods or services involve an externality, which is a benefit or cost that affects someone who is not
directly involved in the production or consumption of a good or service. There are several aspects of
D. Should the Government Run the Health Care System?
Economists categorize goods on the basis of whether they are rival and excludable. A public good is both
nonrival and nonexcludable. Public goods are often supplied by the government. Economists differ on
Extra Solved Problem 5.3
If You Are Young and Healthy, Should You Buy Health Insurance?
New York Times columnist David Brooks wrote about the implementation of the Patient Protection and
Affordable Care Act (ACA) and described a possible adverse selection cascade: “the young may decide
en masse that it is completely irrational for them to get health insurance that subsidizes others.”
a. Why might it be irrational for young and healthy people to buy health insurance?
b. In what sense do young and healthy people who buy health insurance provide a subsidy to people
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Solving the Problem
Step 1: Review the chapter material.
This problem is about adverse selection, so you may want to review the section “Adverse
Selection in the Market for Health Insurance,” which is on page 227, and “How Insurance
Companies Deal with Adverse Selection and Moral Hazard,” which is on page 229.
Step 2: Answer part (a) by explaining why a young and healthy person might decide not
to buy health insurance.
When you buy health insurance, you (or your employer on your behalf) make premium
payments to an insurance company. If you are healthy and rarely visit the doctor or buy
Step 3: Answer part (b) by explaining why young people who buy health insurance may
be providing a subsidy for people who are older or who are ill.
The basis of insurance is risk pooling, with insurance companies pooling the risks of a
catastrophic event, such as injuries from a car accident or expensive treatment for disease,
Step 4: Answer part (c) by explaining how the actions of young people might lead to an
adverse selection cascade in the health insurance system.
Brooks is referring to a process sometimes called an adverse selection “death spiral.” If young
and healthy people who pay premiums but make few claims drop out of an insurance system,
Extra Credit: The authors of the ACA law were well aware of the potential for adverse selection
problems in the health insurance system, particularly because the law sharply limits the ability of
insurance companies to deny coverage to people with pre-existing conditions. The law attempted to
reduce adverse selection problems by requiring that everyone have health insurance. Those who refuse
are subject to a fine. There is some question, however, whether the fines will provide enough incentive for
young and healthy people to buy health insurance.
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Questions
An article in the Economist magazine argues that the real problem with health insurance is: The healthy
people who decide not to buy insurance out of rational self-interest, and who turn out to be right. By not
buying insurance, those (largely young) healthy people will fail to subsidize the people insurance is meant
for: The ones who end up getting sick.
a. Why is it rational for healthy people not to buy health insurance?
b. Do you agree that health insurance is meant for people who end up getting sick?
c. Why is the situation described here a problem for a system of health insurance? If it is a problem,
suggest possible solutions.
Answers
a. Healthy people may not want to purchase health insurance because they expect the costs to be
greater than the benefits.
5.4
The Debate over Health Care Policy in the United States
(pages 232–243)
Learning Objective: Explain the major issues involved in the debate over health care
policy in the United States.
The Patient Protection and Affordable Care Act (ACA) that Congress passed in 2010 proposed
far-reaching changes in the U.S. health care system.
A. The Rising Cost of Health Care
Most people pay for health care by relying on third-party payers, such as employer-provided health
insurance or government-provided Medicare or Medicaid. Out-of-pocket spending on health care has
B. Explaining Increases in Health Care Spending
Health care spending has grown faster than the economy as a whole for several decades. Because the U.S.
health care system relies on many independent hospitals and insurance companies, some observers argue
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The aging of the U.S. population and the introduction of higher cost drugs and medical equipment interact
to drive up spending on health care. Health care spending on people over age 65 is six times greater than
spending on people aged 18 to 24. The number of people receiving Medicare is expected to grow from
54 million in 2015 to 74 million by 2025.
disguising the true cost of routine expenses, health insurance encourages overuse of health care services.
C. The Continuing Debate over Health Care Policy
The Patient Protection and Affordable Care Act (ACA) is health care reform legislation passed by
Congress and signed by President Barack Obama in 2010. Provisions of the act include:
• Individual mandate. With few exceptions, every resident of the United States must have health
insurance; those who don’t have insurance are subject to a fine.
• State health exchanges. Each state must establish an Affordable Insurance Exchange for
The ACA is scheduled to be fully implemented by 2019.
Some economists and policymakers believe that information problems and externalities in the market for
health care are sufficiently large that the government should either provide health care directly through
Market-based reforms are changes in the market for health care that would make it more like the markets
for other goods and services. Economists who support market-based reforms to improve the health care
system were disappointed that the ACA did not adopt this approach. One goal of market-based reforms
would be to ensure that U.S. firms continue their innovations in equipment, procedures, and drugs.
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Extra Economics in Your Life:
Asymmetric Information and NFL Player Contracts
Question: Although Peyton Manning, Tom Brady and other star players have had long and lucrative
careers in professional football, the career of the average NFL player ends in less than four years. In an
article in Forbes magazine David Parnell explains that about 80 percent of NFL players go bankrupt or
“… are under financial stress within two years of retirement due to joblessness and/or divorce.” Few
professional athletes negotiate the contracts they sign with their teams; agents are hired to negotiate on
their behalf. The NFL requires agents (or “contract advisors”) to represent the interests of their clients in
negotiating contracts. Parnell argues that “As a result, most agents ONLY negotiate the player’s contracts
and nothing more.” As a consequence, Parnell argues that these circumstances result in “… massively
asymmetric information.” How does the relationship between professional football players and their
agents result in asymmetric information?
Answer: Experienced agents negotiate many contracts but each player is only familiar with the terms of
his own contract. Therefore, it is difficult for the player to judge the quality of his agent’s negotiating
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Solutions to End-of-Chapter Exercises
5.1
The Improving Health of People in the United States
Learning Objective: Discuss trends in U.S. health over time.
Review Questions
1.1 Health care is provided through markets, so there is a demand for health care and a supply of
health care. However, health care in the United States is supplied not just by private firms
1.2 Over the last 150 years, the average person in the United States has become taller, lives much
longer, and is less likely to suffer from a variety of diseases.
Problems and Applications
1.4 Improvements in health have led to a more productive labor force, which shifts the U.S.
production possibilities frontier out. Generally speaking, when there is a decline in resources,
1.5 Improvements in technology shift out a country’s production possibilities frontier. Similarly,
1.6 The standard of living can be measured in different ways. Income per person is often used, but
height, as an indicator of health and well-being, can also be used. By the income per person
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5.2
Health Care around the World
Learning Objective: Compare the health care systems and health care outcomes in the
United States and other countries.
Review Questions
2.1 a. Health insurance is a contract under which a buyer agrees to make payments, called premiums,
in exchange for the provider agreeing to pay some or all of the buyer’s medical bills.
2.2 Private insurance, mainly through employers, is the largest source of health insurance in the
2.3 Canada has a single payer system, in which the government provides health insurance to all its
residents; in the United States, private insurance is the main source of health insurance.
2.4 Health care outcomes generally address how healthy a country’s citizens are, as measured by
factors such as life expectancy. Although the United States does relatively poorly in terms of life
Problems and Applications
2.5 “Free at the point of delivery” means that patients pay nothing when they receive health care
2.6 There is no one readily available statistic that measures “quality of life” or “improvement in
function” as there is to measure, for example, the number of automobiles sold in a month or year.
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2.7 Collecting data on how soon after surgery patients get back to work would be expensive because
patients would have to be tracked after they leave the hospital and surveyed about how quickly
2.8 a. Many people who have seriously ill family members would likely support medical decisions
to extend the lives of their loved ones, even if that extension is for a short period of time.
Because resources are scarce, however, resources devoted to marginally extending the lives
2.9 a. The efficiency of a nation’s health care system can be measured by the cost at which the
system delivers a given level of heath outcomes. The cost of providing health care is much
easier to measure than are health outcomes. As Table 5.2 shows, in comparison with other
countries, the U.S. health care system does well in providing good health outcomes in some
respects, but not as well in other respects. In addition, there are health outcomes that are
5.3
Information Problems and Externalities in the Market for Health Care
Learning Objective: Discuss how information problems and externalities affect the
market for health care.
Review Questions
3.1 a. Asymmetric information is the situation in which one party to an economic transaction has
less information than the other party.
3.2 The asymmetric information problems in the market for health insurance include adverse
selection (where buyers know more about their health status than insurance companies do) and
moral hazard (where buyers run up bigger medical bills after being insured).
3.3 Insurers reduce adverse selection by screening applicants to avoid providing insurance to people
who are likely to file many claims (although under the Patient Protection and Affordable Care
Act (ACA), insurance companies cannot refuse to sell health insurance to people with pre–
3.4 An externality is a benefit or cost that affects someone who is not directly involved in the
pay for some of the health care of those who are obese.
Problems and Applications
3.5 You are facing the lemons problem that the seller of the car is likely to know more about its
reliability than you are. Therefore, you should buy the car only if the advertisement is placed by a
3.6 The “lemons problem” in the used car market occurs when the seller of a used car, who has more
information about the condition of the car than the buyer, is able to take advantage of this
3.7 When, for example, you buy fire insurance you are sharing the risk of a house fire with the other
people who buy fire insurance. Each of you has contributed to the funds the insurance company
118 CHAPTER 5 | The Economics of Health Care
3.8 Perhaps. Some argue that Social Security does not involve offering insurance against difficult–to–
3.9 You should disagree with the statement because it confuses moral hazard and adverse selection.
Adverse selection refers to what happens when two parties enter into a transaction. Moral hazard
refers to actions taken after a transaction is made.
3.10 The student’s reply of “Your spouse doesn’t bring you flowers anymore” is an example of moral
3.11 Most people in the United States have health insurance. This fact results in a principal-agent
problem. The agents are health care providers who have an incentive to prescribe unnecessary
tests or treatments for patients (the principals) in order to increase their incomes. Because their
3.12 Yes. With health insurance covering most of the cost, consumers demand a larger quantity of
health care services than they would if they paid a price that better reflected the cost of providing
3.13 a. Healthy people may not want to purchase health insurance because they expect the costs (the
insurance premiums they pay) to be greater than the benefits (the medical services they
receive).
b. The statement is true in the same sense that fire insurance is meant for people whose houses
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3.14 Young and healthy people provide a subsidy to less healthy people in the same health plan in the
sense that they typically pay more in premiums than they receive in health care benefits. The
3.15 Health care programs like vaccinations have positive externalities not only because those who
receive vaccinations are protected against disease, but because those who are not vaccinated are
5.4
The Debate over Health Care Policy in the United States
Learning Objective: Explain the major issues involved in the debate over health care
policy in the United States.
Review Questions
4.1 The Patient Protection and Affordable Care Act (ACA) is health care reform legislation passed by
4.2 Health care spending in the United States has increased from less than 6 percent of GDP in 1965
to about 18 percent of GDP in 2015. Spending on health care has grown faster in the United
4.3 The rapid increase in health care spending in the United States is due to slow rates of growth of
4.4 Proponents of more government involvement in the health care system criticize the ACA because
they believe even greater government involvement would reduce paperwork and waste and would
reduce health care spending per person while providing better health outcomes.
Problems and Applications
4.6 The Congressional Budget Office estimates that most of the increase in federal spending on the
Medicare and Medicaid programs will be due to increases in the cost of providing health care.
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4.7 It is difficult to predict the effect any improvement in medical technology will have on health care
expenditures without knowing the nature of the new technology and how it will affect people’s
4.8 a. Instead of demand and supply determining who receives the benefits from new medical
technologies, the “rationing decisions” would be left to a board of experts who would
determine whether the new medical technologies are worth their higher costs. If the experts
c. Congress and the president should be concerned with the growth of Medicare spending. If
Medicare spending continues to grow at its current rate, the result will be either significant
cutbacks in other types of government spending or significantly higher taxes. Both
approaches to restraining Medicare costs have benefits and drawbacks. A board of experts
would be one way to avoid the expenditure of substantial funds on medical procedures that
4.9 Health care is a normal good because as consumer incomes have risen in the United States
4.10 a. If Fogel is correct, then policymakers should be less concerned with increases in health
care spending because such increases reflect the choices of consumers rather than other
factors.
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4.11 If employees were taxed on the value of the employer-provided health insurance, the total
compensation employers pay employees would not change. Labor markets determine the
4.12 a. P2 is the equilibrium price where the demand for medical services when consumers pay
only a fraction of the true cost of medical services, D2, intersects the supply of medical
services, S.
4.13 Because health insurance covers much of the cost of many medical services, most patients are
4.14 Health care plans with high deductibles discourage employees from using their plans to cover the
costs of relatively minor injuries and illnesses because their costs must be paid “out of pocket” up
to the limit of their annual deductibles. High deductibles should result in fewer visits by
employees to their doctors and a reduction in the quantity of other health care services employees