Health Economics Research Paper

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Health economics is widely understood to encompass the study of the demand and supply for medical services (physician services, services provided in hospitals and independent laboratories, pharmaceuticals, etc.) and for health insurance, as well as comparative studies of different health care systems. It also includes the study of the determinants of demand for health itself, global public health problems, and the nonmedical inputs into health, such as a decent living standard, education, physical and social environment, and personal lifestyle choices, to the extent that they are exogenous (e.g., independent of one’s health status). Although the nonmedical factors are increasingly realized to be important in achieving a healthy community at an affordable level of expenditure, most courses in health economics are primarily concerned with the provision of medical care and with health insurance that primarily covers medical care. This research paper will adhere to that tradition since expenditure on medical care, insurance, and research represents such a high proportion of gross domestic product (GDP), especially in the United States, and a proportion that is increasing in all high-income industrialized nations. We also focus on medical care as an input into health because it provides no benefits other than its contribution to health, unlike diet, recreation, and exercise.

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Medical care also differs from most other expenditures, even those that we think of as human capital investments, because much of it occurs as a result of negative shocks to health that are largely unanticipated. It is the combination of the degree of uncertainty about one’s future health state and the high cost of medical care (relative to household budgets) that makes the transferring of risk to a third-party payer through insurance such an important phenomenon in the market for health care. For this reason, the role of health insurance will be discussed before the analysis of markets for other health care services.

The last several sections of this research paper are devoted to policy concerns. Before considering possible reforms of the U.S. health care system, a brief overview of several other countries’ health care systems will be provided.

Methodology Used in Health Economics Research

The methodology of health economics research includes the following two categories.

Statistical Techniques

In health economics, experimental laboratory conditions rarely can be created. Therefore, once a hypothesis has been formulated and sample data have been gathered, statistical techniques must be used to isolate and estimate the effects of particular factors. Economists most commonly “remove” the other effects by using the techniques of multivariate correlation and regression analysis. Whenever possible, researchers use “difference-in-difference” estimators, where changes in a control group are compared with changes in a treatment group.

In isolating the effect of a change in policy or environment, one needs to have a control group to compare with a treatment group. In some cases, “natural experiments” are provided by the environment. For example, quasi-experimental conditions were provided when Tennessee raised its rate of Medicaid remuneration for physician visits while a neighboring state, Maryland, did not. This enabled researchers to estimate the effect of fees on willingness of physicians to treat Medicaid patients. Physicians in Maryland were the control group.

Researchers occasionally are able to undertake experiments in which large numbers of subjects are randomly assigned to different groups. An example is the RAND Health Insurance Experiment, conducted over 1974 to 1982. More than 2,000 households were randomly assigned to a variety of insurance plans that offered differing degrees of coverage. This freed the research from the problem of selection bias that results when people systematically choose different insurance plans based on their expected use of medical care. Today an opportunity for a new experiment has been provided by a decision of Medicaid in Oregon to establish a lottery to randomly choose people from the eligible pool who will receive coverage for medical care.

Cost-Benefit and Cost-Effectiveness Analysis

Cost-benefit analysis is a strategy for comparing benefits with costs. It compares marginal benefits and marginal costs and employs the rule that one should devote resources to a use until the extra or incremental cost of the last unit just equals the incremental benefit of that unit. This rule assumes that marginal benefits are declining and marginal costs are either constant or rising. The underlying assumption is that people are rational and thus want to maximize benefits relative to costs. This approach is used to answer whether an activity is worth undertaking or continuing. It can be used only if we can measure both costs and benefits in the same metric. We can only decide whether the cost of a medical treatment is worth it if we can establish a monetary value for the benefit. For example, when considering whether to undergo heart surgery, the probable effects of the heart surgery are usually stated in terms of an estimated improvement in length of life and/or quality of remaining life years. To use cost-benefit analysis, one must assign a monetary value to a year of life or to a given quality-of-life improvement.

When it is not possible to establish monetary values for benefits, cost-effectiveness analysis may be used to compare marginal costs, expressed in monetary terms, with incremental benefits, expressed in natural units, such as amount of improvement in life expectancy or degree of reduction in blood pressure. Cost-effectiveness analysis can never establish whether some course of action is worthwhile, but it can be used to compare different treatment methods in terms of their relative effectiveness. This analysis can only provide unambiguous results when one alternative provides at least as good an outcome using fewer resources or a better outcome using the same level of resources. It is a better indicator of a rational use of resources than just cost, whether we are considering decision making of individuals or of societies.

Health Economics and The Demand for Health

It is important to clearly distinguish between health and health care. Health can be considered a form of human capital (like education), and medical care and other components of health care are inputs into the production of health. Spending on health is more appropriately treated as an investment in a stock of health (capital) rather than an item of current consumption. The formal model of investment in health, developed by Michael Grossman, employs a marginal efficiency of health capital function (MEC), which we can think of as a quasi-demand function for health (Grossman, 1972). The MEC is specific to an individual in that different people are endowed with different initial stocks of health and also suffer different shocks to their health status over time. It is downward sloping because it assumes diminishing returns to marginal inputs into the production function. Grossman distinguished between gross and net investment in health since there is depreciation in health capital that must be overcome as well as net investment in improvements in the health stock.

Things that augment the value of healthy days will increase the demand for health. Thus, an increase in the wage rate will shift the demand function. Education has also been found to be positively associated with the demand for health, although just why is still under investigation. Education may shift the demand for health because of a taste or preference change, and/or it may increase the productivity of the inputs into health.

This model can easily be accommodated to incorporate risk or uncertainty. The role of uncertainty in the demand for health and health care is very important. Uncertainty about one’s future state of health, uncertainty about what kind of treatment to pursue, and uncertainty about the cost of treatment all contribute to the importance of insurance, or “third-party payment” in the market for health care services. Uncertainty has implications not only for the role of insurance but also for the relationship between patients and their health care providers, particularly their physicians (Arrow, 1963). Patients consult physicians in large part because of the latter’s expertise. Asymmetry of information thus introduces the classic principal/agent set of problems that will be discussed later.

Health Economics and Health Insurance

Insurance is a mechanism for assigning risk to a third party. It is also a mechanism for pooling risk over large groups, which in the case of health insurance involves transferring benefits from healthy to ill individuals within a pool. Health insurance may be either private insurance, purchased by individuals or groups, or social insurance, provided by governments out of tax revenues.

The Demand for Private Health Insurance

Why is health insurance so widely purchased? The demand exists because people desire to protect themselves against potential financial losses associated with the treatment of illness. Why don’t they self-insure themselves by saving money when they are well to use in times of illness? There are a number of reasons, including the fact that many people could never save or borrow enough to pay for potential catastrophic levels of medical expenditure. However, even people who have extensive wealth usually buy insurance. The reason is that most people want to avoid risk—that is, they are “risk averse.” Economists define risk aversion as a characteristic of people’s utility functions. Attitudes toward risk depend on the marginal utility of an extra dollar (lost or gained). If the marginal utility of an extra dollar is decreasing as wealth increases, a small probability of a large reduction in wealth entails a larger loss of utility than the certain loss of a smaller amount of wealth (the cost of the insurance) when the probability weighted or “expected value” of the two alternatives is equal. This is what is meant by being “risk averse.” Risk-averse people will be willing to pay for insurance even though the cost of the insurance premium is more than the expected value of loss due to illness. (Insurance companies are willing to supply insurance when this excess over expected payouts allows them to cover administrative costs, build up a reserve fund, and, in the case of for-profit insurance firms, make a profit.)

Structure of Private Health Insurance Contracts

Insurance policies are commonly structured as indemnity contracts, where individuals are compensated by a certain amount in the event of an adverse event. Historically, most health insurance policies covering hospitalization and other health care services were modified indemnity contracts in which a certain portion of fee-for-service costs of covered services was reimbursed.

Deductibles and co-payments are used by insurance companies to try to limit the degree of moral hazard associated with insurance coverage. Moral hazard is the phenomenon of a person’s behavior being affected by insurance coverage. The main way in which moral hazard operates in the health insurance market is through the tendency for the insured to use a greater quantity of medical care since insurance lowers its cost to the individual. Breadth of coverage increases moral hazard since more “discretionary” services are included. Moral hazard is greater where the price elasticity of demand for the service is greater.

Most private health insurance in the United States is provided on a group basis at one’s place of employment. This type of health insurance has been favored by workers and firms since the 1950s in part because of the favorable tax treatment it receives in the United States. The cost of employment-based health insurance is not considered taxable income to employees but can be deducted by firms as labor expense. It is also favored because larger insurance pools usually involve lower premiums.

The problem of adverse selection is a feature of insurance markets in which there are multiple insurance pools. A pool suffers from adverse selection if it is composed of older, sicker, or other individuals more prone to use medical services. Insurance companies will, if legally allowed, charge higher premiums to higher risk individuals, families, or groups or avoid insuring them altogether. In some cases, regulation requires insurers to use community rating (e.g., charge the same premium to all subscribers for the same coverage), regardless of risk factors such as age or medical histories. Group health insurance is one means of dealing with adverse selection since risk factors are pooled for the group and community rates are charged to all members of the group.

In the past 20 years, health insurance policies have also evolved to incorporate aspects of “managed care,” a variety of features instituted by third-party payers to contain costs and provide greater efficiency in the provision of services.

An important innovation in managed care is the sharing of risk not only with consumers of health care (through deductibles, co-payments, lifetime payout limits, etc.) but also with providers of health care (by entering into contracts with them that set the amount of reimbursement per treatment or by paying a fixed amount per subscriber).

In some cases, individuals join health maintenance organizations (HMOs), which provide integrated health care services and require subscribers to use in-network providers. In HMOs, primary care physicians act as “gatekeepers”; subscribers must get referrals from them to be reimbursed for other specialized services. The most common form of managed care contract in the United States today is the preferred provider organization (PPO). In this arrangement, consumers face lower prices if they use “in-network” providers but also receive some reimbursement for other services, although these usually have higher co-payments and are subject to deductibles. The PPO is a hybrid between the traditional indemnity contract and an HMO. In PPOs, the gatekeeper function of a primary care physician is not imposed.

In managed care contracts, there are usually requirements that patients receive precertification (e.g., obtain permission from the insurance company) before surgery, diagnostic tests, and so on, and physicians and hospitals are often subject to utilization review of treatments prescribed.

As health care costs have risen over time, insurance premiums have also risen. Employers, particularly those with smaller groups of workers, have tended to cut back on coverage, require employees to pay higher proportions of premiums, and in some cases discontinue coverage. Workers, even in jobs that provide options for group insurance, have also tended, in increasing numbers, to fail to subscribe to group plans as their required contributions have risen. Thus today, the ranks of the uninsured include many workers as well as people who are unemployed, not in the labor force, or self-employed.

Social Insurance

Social insurance, in addition to pooling risk, usually has a redistributive function since it is financed out of taxes, so one pays an amount dependent on income but receives benefits in accordance with need. In the United States, social insurance covers only certain groups: those over 65 years of age, most of whom are covered by Medicare; a portion of low-income persons who are covered by Medicaid; children of low-income families, who may be covered by the State Child Health Insurance Program (SCHIP); Native Americans living on reservations; and veterans who can receive health care services through the Veterans Administration. Certain other people with approved disabilities may also be eligible for social insurance. Federal employees, including members of Congress, are also covered by public insurance.

The two largest programs, Medicare and Medicaid, came into being in 1965 as amendments to the Social Security Act. Medicare Part A, which covers all senior citizens who are Social Security eligible, covers part of hospital bills and is financed federally out of payroll taxes paid jointly by employees and employers. Medicaid Parts B and D are voluntary and require contributions out of Social Security retirement benefit checks but are heavily subsidized. Medicaid is jointly financed by federal and state tax revenues. States administer Medicaid and are required to finance their portion of their programs or the federal contribution is reduced.

The financial solvency of Medicare is vulnerable not only to rising health care costs but also to shifts in the age distribution of the population since it is financed on a pay-as-you-go basis, which means that contributions from current workers are used to pay benefits to current beneficiaries. The financial solvency of Medicaid, which is means tested, is vulnerable to cycles in economic activity since during recessions, tax receipts fall and eligibility roles swell. The problem is exacerbated by the fact that states are required to balance their budgets annually.

Both Medicare and Medicaid originally reimbursed physicians and hospitals on a fee-for-service basis. However, both programs have adopted some of the same managed care strategies used by private insurance companies, and in fact, Medicare pioneered a prospective payment system of hospital reimbursement based on fixed payments per diagnosis. This diagnostic-related group (DRG) method has been copied by many private insurers. Physicians’ payments are also set according to a scale (RBRVS) that determines reimbursement rates for different types of physician visits, factoring in the input resources (effort) used and the costs (based on capital intensity of an office practice, number of years of training required for a specialty, etc.).

Medicare and Medicaid both contract out to some private HMOs and other managed care insurers. Medicare Parts B and D contain options for subscribers to assign their premiums to private third-party payers. The intent is to provide competition in the social insurance market. Currently, the government is subsidizing the Medicare Advantage Programs (private options), paying more per beneficiary than for traditional Medicare Part B. Some states require Medicaid beneficiaries to receive services from an HMO.

The United States is nearly unique among high-income industrialized countries in not having universal health insurance coverage. About 15% of the U.S. population currently has no health insurance. It should be noted, however, that universal coverage does not mean universal social insurance coverage. Proposals for increasing insurance coverage of Americans involve various combinations of social and private insurance.

Markets for Physicians and Nurses, Hospitals, and Pharmaceuticals

Supply and Demand for Physicians and Registered Nurses


The supply of professionals, whether physicians, nurses, engineers, attorneys, or accountants, depends on the willingness of people to undertake training to enter these professions. This investment in human capital is determined, at least in part, by the expected financial return compared with the cost of training. Assuming that people make rational, utility-maximizing decisions, the decision to invest in training will involve estimating the returns over a lifetime and comparing these returns with the costs of the training This model of human capital investment helps explain such questions as why the United States has so many medical specialists compared to general practitioners. The simple answer is that the net financial returns to specialties such as orthopedic surgery are higher than the returns to primary care physician practices. Public policy has attempted to change this somewhat. For example, Medicare’s RBRVS method of determining reimbursements to physicians now provides relatively higher payments to primary care physicians than formerly. Nonetheless, a wide difference in incomes of physicians in different specialties, even when adjusted for years of training, still remains. However, over time, the net return to medical training as a whole, compared with many other professions, has declined. This is due in no small part to the growth of managed care in both private and public insurance.

In understanding the market for physician services, it is also necessary to look at the demand side. Demand for medical services has increased with improvements in medical technology, which make it possible to accomplish more improvements in health. This will be discussed further later in this research paper. Medicare (and Medicaid) also brought about a huge increase in the demand for physicians as elderly and low-income Americans could afford more medical care.

This led to a shortage of physicians. Medical schools received more government subsidies. The student loan program for medical training was expanded. Medicare began to heavily subsidize resident training in hospitals. Immigration and licensing laws were changed to make it easier for internationally trained physicians to immigrate to the United States and to become licensed practitioners once here.

Registered Nurses

Training to become a registered nurse (RN) also involves human capital investment, although one that requires fewer years of training. Because of chronic shortages of registered nurses, measured by persistent chronic vacancy rates in hospital nursing positions, there has been a great deal of subsidization of nurse training programs over the years. Although health policy planners still find a shortage of nurses, the nurse/physician ratio as well as the nurse/population ratio in the United States increased until the mid-1990s. Since then, the enrollment in nurse training programs has been declining. One reason for this is that there are now more professions open to women, including becoming an MD.

The market for nurses has been analyzed as a classic case of monopsony. Monopsony exists when there is monopoly power on the part of employers (hospitals) and an upward-sloping supply curve of nurses. It is manifested by a disequilibrium in the form of a gap between supply and demand at a given wage. There is considerable evidence of monopsony in the nurse market between 1940 and 1960. Whether it still exists today is a bit more problematic.

In the absence of monopsony, one expects a shortage to be resolved by a rise in wages until an equilibrium is reached. If shortages persist and wages do not rise, the logical explanation, in the absence of governmental intervention to control wages, is that there is monopsony. In that case, employers find that the marginal return to raising wages is not equal to the marginal cost of hiring more workers, even when there is a gap between demand and supply, such as persistent vacancy rates in positions for hospital nurses. Note that the supply curve is, to the employer, the average factor cost curve, whereas the real cost of hiring more workers is the marginal factor cost. The marginal factor cost rises faster than the average factor cost because when additional nurses are hired, wages of those already employed have to be raised to create parity. This is the reality of the workplace where productivity will decline if new hires are paid more than other employees doing comparable work.

The Physician-Patient Relationship

Although the proportion of total expenditure on medical care devoted to physician payments is less than 25%, physicians are of central importance in the provision of medical care in that they organize and direct the path of treatment. Because of asymmetry of knowledge between patients and physicians, patients delegate authority to physicians. This is a good example of a principal-agent relationship in which there is always the possibility of imperfect agency since physicians can substitute their own welfare for that of the patient. Since professional standards forbid this, we can assume that physicians experience some disutility in behaving as imperfect agents and will therefore only do so if there are offsetting benefits from this behavior, such as enhancement of income.

The way in which physicians are paid for their services will have no effect on their treatment of patients if they are perfect agents. But in the case of imperfect agency, physicians paid on a fee-for-service basis may be tempted to recommend greater treatment intensity than is in the patient’s best interest. Thus, there may be “physician-induced demand.” On the other hand, if payment is on a capitation basis, where physicians agree to treat patients in return for a fixed fee per year, they may be tempted to skimp on the amount of treatment offered in order to handle a larger patient load. A risk-averse physician, worried about the possibility of accusations of malpractice, might also order unnecessary tests. Note that all of these examples apply only to an established patient-physician relationship. If a physician locates an office practice in a wealthy neighborhood in order to attract patients who will pay higher fees, this is not considered imperfect agency, although it may be done to enhance income.

Conventional models treat independent physician practices as monopolistically competitive firms with downward-sloping demand curves since physicians, even those practicing in the same subspecialty, are not perfect substitutes for each other and may have considerable market power based on reputation. A newer model, developed by Thomas McGuire (2000), applies particularly well to a post-managed-care world. In this model, physicians may not be able to set the price, but they can vary the quantity of service provided. McGuire substitutes the notion of a net benefit function for a demand curve. In this framework of analysis, there are substitutes (though imperfect ones) for physicians, and patients will only remain under the care of a given physician if he or she provides a service (net benefit) equal to or greater than some minimum level. Since patients have imperfect knowledge, they may want less treatment than a caring and conscientious physician thinks optimal. So, a patient might leave a physician, even if he or she were behaving as a perfect agent. However, this model can also explain the limits of either physician-induced demand or skimping on service that a patient will permit, in the case of a physician who is an imperfect agent.


Hospitals are complex organizations. The modern acute-care hospital is a multiproduct firm providing a variety of different in- and outpatient services. The most common form of hospital in the United States is the private nonprofit community hospital, although there are also public (government) hospitals and for-profit private hospitals. Public hospitals tend to have a higher proportion of patients of lower socioeconomic status, and most elite teaching hospitals, associated with medical schools, are private, not-for-profit institutions.

Theories of hospital management are derived from theories of the modern corporation, in which the function of manager and owners is usually separated. They focus on the behavior of the decision makers and differentiate between hospitals in which the CEOs are nonmedical professional managers (Newhouse, 1970), hospitals that are run by physicians (Pauly & Redisch, 1973), and those in which there is shared management by business managers and physicians who may have differing objectives (Harris, 1977). In all cases, the models assume that managers behave so as to maximize their utility.

In theory, managers of nonprofit organizations would be expected to emphasize quality over quantity or cost minimization compared with managers of for-profit hospitals since they do not distribute profits to owners. However, empirical research finds little difference between for- and not-for-profit hospitals. Studies that compare different ownership types of acute-care hospitals find that there is not much difference, on average, in prices charged, intensity of care, or patient outcomes. With respect to nursing homes and psychiatric hospitals, for-profit institutions are more prevalent but also may provide lower quality care.

Many communities have only one or two hospitals serving the area. Hospitals may be viewed as monopoly firms, particularly when we consider their relationships with employees. Hospitals may in some situations be natural monopolies. A natural monopoly is a firm characterized by long-run economies of scale (a downward-sloping cost curve) over the whole range of its demand. In this case, adding additional firms within the same market will result in higher costs (and prices). However, more commonly we use oligopoly models to analyze the behavior of hospitals as sellers of services since there is usually some degree of competition within a region, and natural monopoly characteristics do not seem to pertain beyond certain capacity levels.

Oligopolies often compete on some basis other than price. This was certainly true of hospitals, at least until the 1990s. This led to the notion of the “medical arms race,” where hospital managers compete to have the best facilities and equipment. When one hospital acquires some new technology or opens a new department, other hospitals in the region are forced to follow suit. In this case, competition in a region leads to higher prices and duplication of facilities. The belief that hospital competition is not in the public interest led to the passage of certificate of need (CON) laws. CON laws require government approval to add facilities. The study of effects of CON laws has found some evidence that CON laws provide barriers to entry and lead to higher prices (Salkever, 2000). Moreover, in the post-managed-care era, there is evidence that hospitals do engage in price competition, faced with cost-conscious insurers who themselves have a good deal of market power.

Hospitals are well known to engage in price discrimination. They charge different prices to different third-party payers, public and private, and they may charge lower prices or provide free charity care to the uninsured. The latter is probably based on altruism, although it may be good public relations as well, and nonprofit hospitals are usually required by law to provide a certain amount of charity care. But price discrimination is consistent with a profit-maximizing model of the firm in which higher prices charged to customers whose price elasticity of demand is lower leads to greater profits.

Price discrimination does not necessarily involve cost shifting. The issue of the degree of cost shifting (e.g., charging more to certain consumers in response to lowered prices to others) is still not resolved, but there is less evidence of cost shifting than the general public assumes. There is, however, a good deal of cost shifting from individual patients to taxpayers who ultimately pay for much of the subsidized care that hospitals provide.


The market for pharmaceuticals is extremely complex. The pharmaceutical industry is heavily regulated, with many countries having some body similar to the U.S. Food and Drug Administration that rules on safety and efficacy of new products. Large drug companies are often thought to be oligopolies, but as the pharmaceutical industry has become global and smaller biotech companies have entered the market, it may be more accurate to think of the pharmaceutical industry as monopolistically competitive. However, drug companies do have some degree of temporary monopoly power in individual product markets when they obtain patents on new drugs. Patent protection is important in providing incentives to innovate. In the drug industry, patents are limited to 20 years, including time when the drug is being developed but is not yet on the market. The pharmaceutical industry, unlike many other industries characterized by rapid technological change (such as computers), is characterized by very high development costs compared with production costs (i.e., the marginal cost of an additional bottle of pills). An implication of this is that consumers in countries that have pharmaceutical industries that innovate are likely to experience higher prices for new drugs since the high cost of discovering the new drug, clinically testing it, and bringing it to market must be recouped, and only a small fraction of new innovations turn out to be marketable at a profit.

There is also a great deal of price discrimination, with cross-country differences in price, within-country price differences between brand-name and generic versions of drugs, and different prices charged depending on the negotiating power of third-party payers. Although on-patent brand-name drug prices tend to be higher in the United States than in many other countries, generic versions of drugs are often cheaper.

Comparative Health Care Systems: Brief Overviews


At approximately the same time that Medicare and Medicaid were enacted in the United States, Canada adopted a universal social health insurance system that covers most medical care for all citizens and permanent residents. Also called Medicare, it is a “single-payer” system in which the government acts as insurer. It is financed out of tax revenues. There is a separate Medicare budget for each province, jointly funded by the federal and provincial governments, but health insurance is portable throughout Canada. The medical care system is similar to that in the United States in that physicians are reimbursed on a fee-for service basis and patients are free to choose their own doctors and are not subject to a gatekeeper system.

However, in Canada, global budgets determine how much health care is available, and physicians and hospital associations have to negotiate with the government, which sets rates of remuneration for providers. Technology is less widely diffused. For instance, there are many fewer magnetic resonance imaging (MRI) machines per 10,000 population.

In Canada, there is no option to the public system. Services that are covered by Medicare cannot be purchased privately. Supplementary private insurance can be used only to pay for services not covered by Medicare or to pay co-payments charged by Medicare.

United Kingdom

After World War II, the National Health Service (NHS) was enacted in the United Kingdom. It differs from the Canadian system in that it is a national health system, not a nationwide universal insurance system. Doctors who participate in the NHS are employees of the government and are paid by a mix of salary and capitation. Originally, hospitals contracted directly with the district health authorities who paid them for their services. In the early 1990s, the system was altered to give hospitals and physician practices some degree of autonomy. Hospitals are now often organized as trusts. Large regional groups of physicians are given their own budgets to manage. However, the source of funding is still the government, and therefore global budget caps apply. The United Kingdom is well known for high-quality care but long waits for all but emergency services, known as “rationing by queuing.” In the United Kingdom, unlike Canada, there is the option to “go private” and purchase services outside the NHS system. These services are paid for out of pocket or by private insurance. Physicians in private practice are paid on a fee-for-service basis.


Germany has a system of many competing “sickness funds” that are nonprofit insurers. Most workers join sickness funds through their place of employment, though unions and other community organizations also provide access to the funds. The sickness fund system is social insurance in that premiums are financed through a payroll tax, which, like the Medicare Social Security tax in the United States, is jointly paid by workers and employers. It is, however, much higher than in the United States. Retired persons and the self-employed are also enrolled in sickness funds and contribute in proportion to their pensions or self-employment earnings. Only the very wealthy may opt out of this social insurance system. About 95% of all German citizens are members of the sickness funds.

Since the sickness fund system is a not a single-payer system, there is the problem of adverse selection. To offset this, government regulation requires sickness funds to cross-subsidize each other so that those that have a more expensive pool of members receive payments from other funds whose expenses are lower.

Physicians associations negotiate fees with the sickness funds served by their members. The German government has imposed global caps on different components of the medical budget. If a group of physicians serving a particular sickness fund exceeds their budget cap, every member of the physician group is subject to a reduction in the rate of remuneration (fee schedule).

Reforms in the German system have increased co-payments and have introduced a degree of competition in that individuals or worker groups may choose which sickness fund to join and may shift their membership if they are dissatisfied. The German system has, historically, been very generous in its coverage of services. Physician visits are still free, although some fees are now charged for prescription drugs, eyeglasses, and so on.

In each of these countries, demand for medical services is rising, and the public systems, all of which have global budgets, are finding their finances strained. Services have to be rationed, by queuing up for nonemergency care, by charging fees for formerly free services, or by denying certain kinds of treatment. In Germany and the United Kingdom, it is possible to purchase services through the private market. In Canada, this can be done only by crossing the border and purchasing medical care in the United States.

Public Health Care in the Developing World

Although it is difficult to generalize about low-income nations in different parts of the world, there are certain common characteristics. Communicable diseases represent a higher proportion of the populations’ sickness. A smaller proportion of the GDP is generally devoted to health care. Rural areas are often disproportionately lacking in health care facilities. And even countries that have recently experienced dramatic rates of economic growth, such as India and China, do not provide adequate free public health care, even to the poor. International agencies such as UNICEF and nongovernmental organizations (NGOs) play an important role in providing health care and medicine to the developing nations. This is particularly important in Africa, given the high incidence of HIV/AIDS.

Leading Proposals for Reform in the United States

The proportion of national income spent on health care in the United States is greater than in any other industrialized country. It is now in excess of 15%. Our medical technology, measured in terms of such indices as number of MRI units per 10,000 population, also exceeds that of other comparable countries. Yet, aggregate statistics (averages) of health outcomes place the United States far from the top of a list of comparable (Organisation for Economic Co-operation and Development) nations in life expectancy, both at birth and at 60 years of age, and U.S. infant mortality rates are discouragingly high. The United States is also the only high-income industrialized nation that does not have universal health insurance coverage for its citizens and permanent residents. More than 15% of families were without health insurance coverage in 2009. The fact that health insurance and medical care costs are increasing much more rapidly than the consumer price index, although not unique to the United States, also leads to the conclusion that the system needs reforms both with respect to its efficiency and its equity.

Incremental Reforms

Improvements in efficiency could be defined as those that result in the same quality of care provided at lower cost and/or better patient outcomes provided at no higher cost.

Use of Information Technology to Provide Better Records

Using information technology (IT) to provide comprehensive patient records would both reduce medical errors, such as prescribing drugs that are counterproductive, given patient allergies or when combined with other medications, and provide cost-savings by eliminating unnecessary duplication of diagnostic tests.

Another use of IT is the expansion of health care provider report cards. Although critics fear that providers will attempt to avoid treating the most difficult cases that might spoil their records, risk/adjustment applied to reporting can largely overcome this difficulty, and public support for making such information available is now widespread.

The use of IT to simplify and standardize insurance claim forms is also broadly advocated. A related proposal requiring that all health insurance contracts cover certain basic services is more controversial. Critics argue that this would curtail freedom of choice if “consumer-driven” insurance options were ruled out. However, proponents of regulation believe that most consumers would benefit from requirements that all plans cover a broad range of medically necessary treatments and not exclude any on the basis of preexisting health conditions.

Better Management of Care for Chronic Diseases

Another widely accepted reform is better ongoing care for patients with chronic illnesses. This would be facilitated by more continuity in health care provision as well as better recordkeeping over the lifetime of patients. Critics of employment-based health insurance see it as a stumbling block to long-term management of chronic conditions in a world in which there is so much mobility between jobs and in which employees are subject to employers’ decisions to change insurance carriers based on cost considerations. Proposals for reforms that involve greater portability of health insurance address this problem. Advocates of a “single-payer” universal insurance system believe that this and other inefficiencies associated with the fragmented insurance system in the United States would be best overcome by having the government act as third-party payer for all citizens and residents.

Promoting Wellness

A third widely accepted reform is a health care system that provides incentives for a healthier lifestyle. Advocates favor promoting, through subsidies, types of preventive care that have been shown to be effective. This includes both screening for disease and programs that promote a healthier lifestyle.

Reforming the Tax Treatment of Employment-Based Health Insurance

This has been advocated for a number of decades by many economists who regard treating all employment-based health insurance premiums as tax-free income to be both inefficient and inequitable in that it encourages workers to demand excessive insurance coverage, which in turn promotes cost insensitivity and the use of health care services with low marginal value. It also benefits high-income workers disproportionately since they benefit more from the tax subsidy. Proposed reforms include capping the level of health insurance premiums that will receive favorable tax treatment and completely removing the taxfree status of insurance premiums.

Broadening Insurance Coverage

Although most people who advocate universal health insurance coverage in the United States are primarily concerned with equity or fairness, there are also inefficiencies associated with having approximately 47 million people currently uninsured. These include the inappropriate use of hospital emergency rooms by the uninsured who have no access to physician office visits and the postponing of treatment until advanced stages of disease. However, covering the uninsured would not be, at least in the short run, cost free (Institute of Medicine, 2003).

The Access Problem

There is a widespread belief in the United States that all residents should have access to affordable health insurance, but there is no general agreement on the best way to achieve this goal. Several main proposals are espoused by health economists, although the details differ. Some involve incremental change, building on our combination of existing employment-based private insurance and social insurance programs. Other plans would provide more dramatic changes by replacing employment-based health insurance altogether. Victor Fuchs and Ezekiel Emanuel (2005) have grouped reforms of the health care system into three main categories: (1) incremental reforms, such as expanding SCHIP or expanding Medicare to cover 55- to 65-year-olds, or individual or employer mandates, which create new insurance exchanges and provide subsidies to low-income families but do not radically alter the structure of the current health care system; (2) single-payer plans that would eliminate the private insurance market and have the government act as third-party payer; and (3) voucher-based reforms, which they advocate (Furman, 2008, chap. 4). Although they do not explicitly consider health savings accounts (HSAs), this is a fourth option that we need to include in a complete menu of proposed reforms.

1a. Expand Medicare. This can be accomplished by allowing people to buy into the Medicare program. One way to do this would be to allow anyone to pay a standard premium and buy Medicare as an alternative to private insurance. More ambitious proposals would gradually phase out Medicaid and other forms of social insurance, subsidizing low-income families’ Medicare premiums and reducing the co-payments for them. There might, however, have to be some kind of subsidy from the federal government if Medicare suffered from adverse selection, compared with employment-based private insurance.

1b. Mandate Individual Health Insurance Coverage: The Massachusetts Plan as Blueprint. Massachusetts has instituted a plan for statewide universal health insurance coverage, achieved through a mandate that individuals must have health insurance or pay a fine. This plan involves a combination of private and public health insurance coverage, with Medicare, Medicaid, and SCHIP remaining in place. Low-income families that are not currently covered by social programs receive subsidies to cover all or part of their health insurance premiums. Most workers who currently have employment-based insurance are expected in the short run to remain with these plans. However, they have the option to acquire health insurance through the Commonwealth Connector, a market clearinghouse through which insurance providers can offer portable health plans that function like employment-based plans of large employers. To make the system work, the portable plans must be subject to the same tax treatment as employer-based plans. Other states are considering similar plans. Jonathan Gruber (2000) is the architect of a national health insurance system based on Massachusetts’s plan.

  1. Single-Payer System. Universal health insurance in the form of a single-payer system, modeled on Canadian Medicare, has been proposed (e.g., Rice, 1998) but has generally not been considered politically feasible, although it has had the support of some presidential candidates and members of Congress. Even though the U.S. Medicare program is more cost-efficient than most private health insurance, and the simplicity of a Canadian-type single-payer system is appealing and removes the problem of adverse selection, there is widespread belief in the United States that government- run programs have no built-in mechanisms that ensure efficiency and are likely to be subject to corruption. Moreover, Medicare itself in its present form is no longer a single-payer system since Parts B and D allow beneficiaries to assign their benefits to private insurers.
  2. A Voucher System (Fuchs & Emanuel, 2005). All U.S. residents would receive a health care voucher that would cover the cost of an insurance plan with standard benefits. In the short run, those who are currently insured through Medicare, Medicaid, SCHIP, and so on would have the option of remaining in those plans or switching to the voucher plan. However, the existing forms of social insurance would gradually be phased out, and employment-based insurance would be discontinued. The latter would lose its attractiveness since part of the reform plan is to discontinue the favorable tax treatment of employment-based group insurance.

The voucher has no cash value but gives the recipient the right to enroll in a health plan with standard benefits. National and regional health boards, modeled on the Federal Reserve System, would regulate insurance plans with respect to both their finances and their provision of adequate networks of providers. Although the system would be universal, third-party payers would be private. People could choose insurance programs or, if they failed to do so, be assigned to one. The system assumes that private insurance companies would have an incentive to remain in the market and compete for subscribers. In that sense, it is not unlike the managed competition model of health insurance markets (Enthoven, 1993). The Fuchs and Emanuel (2005) plan would be financed by a value-added tax on consumption, but a voucher plan could also be financed out of an income tax.

  1. Health Savings Accounts (HSAs). HSAs, whose advocates often structure the plans as forms of tax-free income, are not insurance per se. They are personal savings accounts, similar to 401K or 403B retirement accounts, and employers could contribute to them instead of supporting group health insurance. One of the earliest advocates of HSAs was Martin Feldstein (1971). An advantage of HSAs is that they encourage judicious use of health care since individuals are paying the bills themselves out of their own savings. A disadvantage is the loss of pooling of risk across individuals. What is retained is the individual’s or family’s ability to smooth expenditure on medical care over periods of health and illness. For such plans to constitute anything close to a universal system, low-income families would need to have their HSAs heavily subsidized. HSAs could be limited to medical care after retirement, in which case they would be an alternative to Medicare, or they could replace employment-based health insurance as they have in Singapore. Singapore’s HSAs are supplemented by social health insurance for catastrophic health expenses.


The United States is widely acknowledged to need health care reform. More than 47 million people without insurance is considered unacceptable by most people. Changes in the nature of the labor market have made employment-based health insurance less appropriate than it was when long-term employment with the same firm was usual. It provides job lock and reduces the competitiveness of U.S. firms. The proportion of the GDP devoted to health care is much higher than in other countries without better patient outcomes. A well-conceived reform plan could significantly lower health care costs and provide much greater equity (access). However, technological advances in medical care and demographic trends will almost inevitably lead to a continued upward trend in the proportion of the budget devoted to medical care (Newhouse, 1992). This is, however, not unique to the United States but is a problem facing all industrialized nations.


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