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Transcript of Health Economics- Lecture Ch08
8/3/2019 Health Economics- Lecture Ch08
http://slidepdf.com/reader/full/health-economics-lecture-ch08 1/64
Demand and Supply
Of Health Insurance
Dr. Katherine Sauer
Metropolitan State College of Denver
Health Economics
8/3/2019 Health Economics- Lecture Ch08
http://slidepdf.com/reader/full/health-economics-lecture-ch08 2/64
Chapter outline:
I. Risk and Insurance
II. The Demand for Insurance
III. The Supply of Insurance
IV. Moral HazardV. Deductibles, Coinsurance, and Secondary Insurance
VI. Income Transfer Effects of Insurance
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I. Risk and Insurance
A. Desirable Characteristics of an insurance arrangement
1. large number of insured who are independently
exposed to the potential loss
2. covered losses should be clearly defined in terms of
time, place, and amount
3. probability of loss should be measurable
4. loss should be accidental from viewpoint of the insured
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B. Insurance vs Social Insurance
Insurance is provided through markets in which buyers protect themselves against events with probabilities that
can be estimated statistically.
Social Insurance programs are insurance with thegovernment as insurer and are distinguished by two
features:
Premiums are heavily and often completely (as in the
case of Medicaid) subsidized.
Participation is constrained according to government-
set eligibility rules.
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C. Expected Value
Expected value incorporates the probability of an
occurrence of an event with its outcome.
E = p1R 1 + p2R 2 + « + pnR n
pi is the probability of an event
R i is the outcome associated with an event
The probabilities must always sum to 1.
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You are considering playing a game where the flip of a
coin determines whether you earn a reward or not.
heads: you win $1
tails: you win $0
How much would you pay to play this game?
If you are risk neutral, you should be willing to pay up to
the expected value of the game.
E = (pr. of heads)($1) + (pr. of tails)($0)
E = (0.5)($1) + (0.5)($0)
E = $0.50
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If the expected payouts from an insurance policy are
exactly equal to the premiums taken in, then the policy is
called actuarially fair .
- use as a benchmark
- in reality, other administrative costs
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What if the size of the bets are changed?heads: win $100
tails: win $0
Are you willing to pay $50 to play?- refuse an actuarially fair bet
The disutility from losing money is larger than the utility
of winning the same amount!- risk averse
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D. 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) Wealth
Total Utility of
Wealth
10,000 20,000
140
200 TU
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Suppose that John¶s income is $20,000.
He has a 10% chance of becoming sick.
If he becomes sick, he will spend $10,000 as he pays
medical expenses and misses work.
Let¶s calculate his expected utility and expected wealth.
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EU = (0.90)(200)
+ (0.10)(140)
= 194
EW = (0.90)(20,000)
+ (0.10)(10,000)
= 19,000
Wealth
Total Utility of
Wealth
10,000 20,000
140
200 TU
194
19,000
EU
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In a world with risk,$19,000 of wealth would
give John an expected
utility of 194.
In a world without risk,
the same $19,000 would
yield a higher utility.
Wealth
Total Utility of
Wealth
10,000 20,000
140
200 TU
194
19,000
EU
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The horizontal distance
between the expectedutility line and the total
utility line represents
John¶s risk aversion.
At point A, he would be
willing to pay up to
$4,000 for insurance that
protects against areduction in wealth from
illness.Wealth
Total Utility of
Wealth
10,000 20,000
140
200 TU
194
19,000
EU
A
16,000
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Insurance can be sold only in circumstances where the
consumer is risk averse.
Expected utility is an average measure.
If insurance companies charge more than the actuarially
fair premium, people will have less expected wealthfrom insuring than from not insuring.
increased well-being comes from the elimination
of risk
The willingness to buy insurance is related to the
distance between the total utility curve and the expected
utility line.
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II. The Demand for Insurance
Suppose John¶s wealth is $20,000. He has a 10% chance
of becoming sick. If he does, his wealth will be reduced
by $10,000. He is considering buying $500 worth of insurance at a premium of 20%.
If John stays healthy, his wealth is
20,000 - (0.20)(500) = $19,900
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If John gets sick his wealth is
$20,000 - $10,000 +$500 - $100 = $10,400
So, the insurance provides him with an additional $400 if
he is ill.
The additional cost is the $100 premium.
John¶s marginal benefits are greater than the marginal
costs.
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How about purchasing an additional $500 of coverage?
Healthy:
19,900 - (0.20)(500) = $19,800
Sick:10,400 + 500 - 100 = $10,800
Additional Benefit: $10,800 - $10,400 = $400
Additional Cost: $100
Additional benefits outweigh the additional costs.
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However, recall that we are now starting from differentincome levels:
$400 benefit to $10,000 is larger than a $400 benefit to
$10,400. (diminishing marginal utility of wealth)
$100 cost to $19,900 is smaller than $100 cost to
$19,800.
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MC
MB
Q of insurance purchased
MB,
MC
500 1000
Should John buy
another $500 worth
of insurance?
The optimal amount
of insurance is Q*.
Q*
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1. Change in Premiums
Suppose the premium rises to 25% instead of 20%.
Healthy:
20,000 - (0.25)(500) = $19,875
Sick:
20,000 - 10,000 + 500 - 125 = $10,375
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MC
MB
Q of insurance purchased
MB,
MC
500 1000
The $500 of
coverage now gives
John a lower
marginal benefit.
An increase in
premiums shifts the
marginal benefit
curve to the left.
Q*
MB2
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MC
MB
Q of insurance purchased
MB,
MC
500 1000
Similarly, the
marginal cost of
$500 of insurance
has increased.
An increase in
premiums shifts the
marginal cost curve
to the left.
Q*
MB2
MC2
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MC
MB
Q of insurance purchased
MB,
MC
500 1000
The new optimallevel of insurance is
Q2.
Higher premiumsresults in lower
amounts of insurance
being purchased.
Q*
MB2
MC2
Q2
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2. Change in Expected Loss
(Start from the original premium of 20%)
Suppose the expected loss from illness increases from
$10,000 to $15,000.
Healthy:
20,000 - (0.20)(500) = $19,900
Sick:
20,000 - 15,000 + 500 - 100 = $5,400
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Again, in the case of sickness, insurance provides $400
of benefit vs having no insurance.
But, this $400 must be compared to the $5000 he would
have if he didn¶t have insurance.
$400 extra on $5000 is more than $400 extra on
$10,000.
The marginal benefits are higher.
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MC
MB
Q of insurance purchased
MB,
MC
500 1000
An increase in the
expected loss will
increase the marginal benefits from having
insurance.
The optimal level of insurance is now
higher.
Q*
MB2
Q2
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3. Changes inWealth
(Start from the original premium of 20% and originalloss value)
Suppose John¶s wealth is $25,000 instead of $20,000.
Healthy:
25,000 - (0.20)(500) = $24,900
Sick:
25,000 - 10,000 + 500 - 100 = $15,400
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At a higher level of wealth, the insurance policy¶s
benefits of $400 are a lower marginal benefit than at a
lower level of wealth.
At a higher level of wealth, the insurance policy¶s cost
of $100 is a lower marginal cost than at a lower level of
wealth.
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MC
MB
Q of insurance purchased
MB,
MC
500 1000
The marginal benefits are lower.
The marginal costs
are lower.
The effect on the
quantity of insurance
is ambiguous.
Q*
MB2
MC2
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III. The Supply of Insurance
How are premiums determined?
Insurance firms will maximize profits.
profit = revenue - cost
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Let a be the premium rate.
Let q be the insurance payout.
Let t be the processing / administrative cost of writing a policy.
Let p be the probability of a payout.
Profit = aq - pq - t
For firms in a competitive market, profits equal zero.
0 = aq - pq ± t
a = p + (t/q)
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Suppose that premiums are 20% and policies are written
in $500 increments.
Suppose that the processing costs are $8 per policy.
For those who do not get sick (90% of the policies), the
only cost would be the cost of processing, $8.
For those who do get sick (10% of the policies), the cost
would be the $500 payment plus the $8 processing cost,or $508.
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Profit = $100 ± (0.10 )( $508) ± (0.90 )($8)
Profit = $100 - $50.80 - $7.20
Profit = $42
These are positive profits, and they imply that another
similar firm might enter the market.
Such entry into the market would continue until allexcess profit was competed away.
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IV. Moral Hazard
- any change in behavior in response to a
contractual arrangement
ex: failure to protect yourself from disease
because you have health insurance
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!)
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Q of health
care
price
Q1 Q2
p1
Suppose you pay all of your
expenses out of pocket. If the
price is p1, then you wouldconsumeQ1 units of health care.
Your total expense
would be (p1)(Q1).
Demand
(assume p1 is
cost of
production)
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Suppose the probability you will need to see adermatologist 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.
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Q of health
care
price
Q1 Q2
p1
At a price of zero, you would consumeQ2
units of health care.
Your care would cost (p1)(Q2) in terms
of resources.
Demand
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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)(Q2) > (0.5)(p1)(Q1)
If the company charged (0.5)(p1)(Q2), then you may not
buy the insurance.
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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
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V. Deductibles, Coinsurance, and Secondary Insurance
A. Deductibles
Price of care
Quantity
P1
Q1 Q3
With no insurance, if the
price is p1, you consume
Q1 units of care.
With insurance, the price of
care falls to zero so you
consumeQ3 units.
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Price of care
Quantity
P1
Q1 Q2 Q3
If you must pay a
deductible before care isfree to you:
then if the deductible is
small you will consume anamount in between Q1 and
Q3.
then if the deductible islarge, you may decide to
³self-insure´ and will
consumeQ1.
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A deductible has two potential impacts:
1. Small deductible: some effect on consumption
2. Large deductible: makes it more likely for people to
self-insure and consume the amount of care they would
have consumed with no insurance
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B. Coinsurance
Coinsurance is the consumer¶s out-of-pocket payment
rate. (higher coinsurance means consumer pays more)
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.
MC
Demand with 100%
coinsurance (MB)
price
quantity
p1
Q1
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With 20% coinsurance, the price the consumer pays out
of pocket falls to P2.
Q2 units will be
demanded
A new demand curve is
generated to reflect the 20%
coinsurance.
MC
Demand with 100%
coinsurance (MB)
price
quantity
p1
Q1
p2
Q2
Demand with 20%
coinsurance (MB)
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The additional resource
cost is:
The additional benefits tothe consumer are:
The additional costs exceedthe additional benefits.
MC
Demand with 100%
coinsurance (MB)
price
quantity
p1
Q1
p2
Q2
Demand with 20%
coinsurance (MB)
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Consumers are led by insurance to act as though theyare not aware of the true resource cost of their
consumption.
Insurance subsidizes insured types of care at theexpense of other types of care.
Insurance subsidizes insured types of care relative to
non-health goods.
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C. Secondary Insurance
Suppose your employer provides health insurance
which pays 60% of all medical expenditure.
You have secondary coverage through your spouse,
which pays 60% of the medical expenditures not
covered by your primary insurance.
The market price of a doctor¶s visit is $50.
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Price per visit
Number of visits
50
With no insurance coverage,
you decide to purchase 12doctor¶s visits per year.
Your out-of-pocket expense
will be: (50)(12) = $600
The total cost of providing
this care to you is:
(50)(24) = $600
12
MC
of visit
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Price per visit
Number of visits
50
With your employer
sponsored insurance, the
cost of a doctor¶s visit is
now: (0.40)(50) = $20
At this price you consume
24 visits.
Your out-of-pocket expense
is: (20)(24) = $480
The total cost of providing
this care to you is:
(50)(24) = $1,20012
20
24
MC
of visit
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Price per visit
Number of visits
50
Of that $1,200, your
employer pays:
(0.60)(50)(24)=$720
Of that $1,200 you pay the
rest:
1200 ± 720 = $480
12
20
24
MC
of visit
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Price per visit
Number of visits
50
Suppose you have
supplemental insurance that pays 60% of what your
primary insurance doesn¶t
pay.
The price of a doctor¶s visit
is now (0.40)(20) = $8.
At that lower price youconsume 29 doctor¶s visits.
12
20
24
MC
of visit
8
29
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Price per visit
Number of visits
50
Your out of pocket cost:
(8)(29) = $232
The total cost of providingthese health care services to
you: (50)(29) = $1450
12
20
24
MC
of visit
8
29
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Price per visit
Number of visits
50
Of that $1450, your employer pays
(0.60)(50)(29) = $870
Your secondary insurance pays
(0.60)(20)(29) = $348
You pay $232.
12
20
24
MC
of visit
8
29
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Price per visit
Number of visits
50
Claims paid by primary
insurance with no secondary
insurance:
Claims paid by secondary
insurance:
Increase in claims paid by
primary insurance due to the
secondary plan:
12
20
24
MC
of visit
8
29
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D. The demand for insurance and the price of care
Martin Feldstein (1973) was among the first to show that
the demand for insurance and the moral hazard brought
on by insurance may interact to increase health care
prices even more than either one alone.
More generous insurance and the induced demand in the
market due to moral hazard lead consumers to purchase
more health care.
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E.Welfare Loss of Excess Health Insurance
Insurance policies lead to increased health services
expenditures in several ways:- increased quantity of services purchased due to
decreases in out-of-pocket costs for services that
are already being purchased
- increased prices for services that are already
being purchased
- increased quantities and prices for services thatwould not be purchased unless they were covered
by insurance
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- increased quality in the services purchased
including expensive, technology-intensive
services that might not be purchased unless
covered by insurance
E i i l E i
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Empirical Estimates:
Feldstein found that the welfare gains from raising
coinsurance rates from .33 to .50 would be $27.8 billion per year in 1984 dollars.
Feldman and Dowd (1991) estimate a lower bound for
losses of approximately $33 billion per year (in 1984dollars) and an upper bound as high as $109 billion.
Manning and Marquis (1996) sought to calculate the
coinsurance rate that balances the marginal gain from
increased protection against risk against the marginal loss
from increased moral hazard, and find a coinsurance rate
of about 45 percent to be optimal.
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VI. The Income Transfer Effects of Insurance
John Nyman (1999) argues that in contrast to the
conventional insurance theory, we should view insurance
payoffs as income transfers from those who remain
healthy to those who become ill.
These income transfers generate additional consumption
of medical care and potential increases in economic
well-being.
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Conventional logic:
Suppose that Elizabeth is diagnosed with breast cancer ather annual screening.
Without insurance, she would purchase a mastectomy for
$20,000 to rid her body of the cancer.
With insurance, Elizabeth purchases (and insurance pays
for) the $20,000 mastectomy, a $20,000 breast
reconstruction procedure to correct the disfigurement
caused by the mastectomy, and an extra two days in the
hospital to recover, which costs $4,000.
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Total spending with insurance is $44,000 and totalspending without insurance is $20,000.
It appears that the price distortion has caused $24,000 in
moral hazard spending.
Nyman would ask: Is this spending truly inefficient?
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To answer we must determine what Elizabeth would
have done if her insurer had instead paid off the contract
with a check to Elizabeth for $44,000 upon diagnosis.
With her original resources plus the additional $40,000,
we can safely assume that Elizabeth would purchase the
mastectomy and the breast reconstruction. She may or may not purchase the extra recovery days in the hospital.
The $20,000 spent on the breast reconstruction is
efficient and welfare increasing.
The $4,000 spent on the two extra hospital days may be
inefficient and welfare-decreasing.
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Summary:
We have characterized risk and have shown whyindividuals will pay to insure against it.
The result, under most insurance arrangements, is the
purchase of more or different services than might
otherwise have been desired by consumers and/or their
health care providers.
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Discussion Questions:
1. The deductible feature of an insurance policy can affectthe impact of moral hazard. Explain this in the context
either of probability of treatment and/or amount of
treatment demanded.
2. Because health insurance tends inevitably to cause
moral hazard, will the population necessarily be
overinsured (in the sense that a reduction in insurance
would improve well-being)? Are there beneficial factors
that balance against the costs of welfare loss?