CHAPTER 7 |The Economics of Health Care 157

CHAPTER 7 | The Economics of

Health Care
Brief Chapter Summary and Learning
Objectives
7.1 The Improving Health of People in the United States
(pages 220–222)
Use data to discuss trends in U.S. health care over time.

 The health of the average person in the United States improved significantly during the
nineteenth and twentieth centuries and continues to improve today.

7.2 Health Care around the World (pages 220–228)

Compare the health care systems and health care outcomes in the
United States and other countries.

 In many countries the government supplies health care directly or pays for most health
care expenses. This complicates cross-country comparisons of health care outcomes.
 Health care spending per person in the United States is higher than in other countries.

7.3 Information Problems and Externalities in the Market

for Health Care
(pages 228–234)
Define information problems and externalities and explain how they
affect the market for health care.

 The market for health care is affected by asymmetric information, adverse selection,
moral hazard, and the principal–agent problem.

7.4 The Debate over Health Care Policy in the United

States (pages 234–245)
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
Protection and Affordable Care Act (ACA) in 2010. Some critics of the ACA believe that
the government should provide health care directly, while other critics favor market-
based reforms of health care.

Key Terms

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158 CHAPTER 7 | The Economics of Health Care

Adverse selection, p. 229. The situation in
which one party to a transaction takes advantage
of knowing more than the other party to the
transaction.
Asymmetric information, p. 228. A situation in
which one party to an economic transaction has
less information than the other party.
Moral hazard, p. 230. Actions people take after
they have entered into a transaction that make
the other party to the transaction worse off.
Patient Protection and Affordable Care Act
(ACA), p. 240. Health care reform legislation
passed by Congress and signed by President
Barack Obama in 2010.

Fee-for-service, p. 223. A system under which Principal–agent problem, p. 230. A problem

doctors and hospitals receive a payment for each
service that they provide.
Health care, p. 220. Goods and services, such
as prescription drugs, consultations with a
doctor, and surgeries, that are intended to
maintain or improve a person’s health.
Health insurance, p. 222. 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.
caused by agents pursuing their own interests
rather than the interests of the principals who
hired them.
Single-payer health care system, p. 225. A
system, such as the one in Canada, in which the
government provides health insurance to all of
the country’s residents.
Socialized medicine, p. 225. A health care
system under which the government owns most
of the hospitals and employs most of the
doctors.

Market-based reforms, p. 243. Changes in the

market for health care that would make it more
like the markets for other goods and services.

Chapter Outline
Where Will You Find Health Insurance?
During 2017, two bills designed to revise the Patient Protection and Affordable Care Act (ACA) failed in
Congress, reflecting the lack of political consensus about the role of the federal government in the health
care system. One feature of the ACA was the fine imposed on individuals who did not have health
insurance. Many young, healthy individuals chose to pay the fine, which was typically lower than the
premiums they would have to pay to buy health insurance.

Under the ACA companies that sell insurance on the health insurance marketplace were not allowed to
charge higher premiums for older people or people with preexisting conditions. As more young and
healthy people did not buy individual health insurance policies, the remaining consumers on the health
insurance marketplaces became older and less healthy – and more likely to file insurance claims. This led
human and other insurance companies to leave the marketplace. In more than 1,000 counties nationwide,
only one insurance company continued offering policies. The increasing health care costs individuals and
businesses face are reflected in trends in health care spending in the overall economy, which increased
from about 5 percent of gross domestic product in 1960 to more than 18 percent in 2017.

7.1 The Improving Health of People in the United States

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 CHAPTER 7 |The Economics of Health Care 159

(pages 220–222)
Learning Objective: Use data to discuss trends in U.S. health over
time.

Health care refers to 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, but
the average life expectancy at birth was only 38 years, and 30 percent of the population died before
reaching the age of 30. Today, the average life expectancy at birth in the United Kingdom and other high-
income countries is around 80 years.

A. Changes over Time in U.S. Health

The health of the average person in the United States improved significantly during the nineteenth and
twentieth centuries. Individuals in the United States today are taller, they live much longer, and they are
much less likely to die in the first months of life than was true 165 years ago. Over time, people in high-
income countries have, on average, become taller, indicating that their nutritional status has improved.

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 78.8 years in 2016. The
overall mortality rate decreased by more than 25 percent between 1981 and 2015. The decline in death
rates after 1981 was due to changes in lifestyle and advances in new diagnostic equipment, new
prescription drugs, and new surgical techniques. Improving health shifts out a country’s production
possibilities frontier and higher incomes allow the country to devote more resources to research and
development, including medical research.

Health Care around the World (pages 222–228)

7.2 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
provider’s agreeing to pay some or all of the buyer’s medical bills. In 2016, about 49 percent of people
received health insurance through their employers, and about 7 percent purchased an individual or family
health insurance policy from an insurance company. About 35 percent of people receive health insurance
from government programs, including Medicare and Medicaid and the Department of Veterans Affairs.
In 2016, 98 percent of firms employing at least 200 workers and about 55 percent of firms employing 3 to
199 workers offered health insurance as a fringe benefit. Some health insurance plans reimburse doctors
and hospitals on a fee-for-service basis: A system under which doctors and hospitals receive a payment
for each service they provide. About 9 percent of people were not covered by health insurance in 2016.
Some young people opt out of employer-provided health insurance because they are healthy and do not
believe the cost of the premium their employer charges for the insurance is worth the benefit of having the

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insurance. The uninsured must pay for their medical bills out-of-pocket, or receive care from doctors or
hospitals either free or below the normal price.

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. Doctors and hospitals are
typically reimbursed on a fee-for-service basis. But unlike in the United States, doctors and hospitals are
required to accept the fees set by the government.
Japan has a system of universal health insurance under which every resident is required to enroll in one
of many health insurance societies organized by industries or professions, or enroll in the health insurance
program provided by the national government. The Japanese system requires substantial copayments
under which patients pay as much as 30 percent of their medical bills. As in the United States, most
doctors do not work for the government, and there are many privately owned hospitals.

In the United Kingdom, the health care system is referred to as socialized medicine, a health care system
under which the government owns most of the hospitals and employs most of the doctors. Apart from a
small copayment for prescriptions, the National Health Service (NHS) supplies health services without
charge to patients. Nonemergency care is a low priority. To avoid waiting lists, more than 10 percent of
the population has private health insurance to pay for elective procedures.

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
person on health care. Health care spending per person in the United States is higher than in other
countries. Comparing health care outcomes among members of the Organization for Economic
Cooperation and Development (OECD), the United States does relatively poorly in terms of infant
mortality and about average with respect to life expectancy. People in the United States are more likely to
be obese, which can lead to diabetes and other health problems. The U.S. rates well in the availability of
medical equipment that can be used to diagnose and treat illness. People in the United States have a lower
rate of cancer deaths and a relatively low mortality ratio from cancer.

D. How Useful Are Cross-Country Comparisons of Health

Outcomes?
Difficulties in making cross-country comparisons in health care outcomes include:
 Data problems
 Problems with measuring health care delivery
 Problems with distinguishing health care effectiveness from lifestyle choices
 Problems with determining consumer preferences

Extra
U.S. Companies Use Financial Incentives to Stem
Apply the
Rising Health Care Costs
Concept

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

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 CHAPTER 7 |The Economics of Health Care 161

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,
while employees with the best health indicators earned a $2 weekly discount. Workers are allowed to opt
out of the program without a medical excuse only by agreeing to pay an extra $37.50 weekly. Programs
such as the one begun at MasterBrand have been criticized by the American Heart Association and the
American Diabetes Foundation because they discriminate against people based on their health. But a
survey by the consulting firm Towers Watson and the National Business Group on Health found that
13 percent of U.S. companies have chosen to tie financial incentives to health outcomes. At MasterBrand,
the benefit of the program went beyond financial incentives for several employees who were warned that
their test results suggested a significant risk of heart attack. One female worker who found out she had
high blood pressure and diabetes lost fifty pounds after she started an exercise program.

Sources: Anna Wilde Mathews, “The Future of U.S. Health Care,” Wall Street Journal, December 12, 2011, and Reed Abelson,
“Health Insurance Costs Rising Sharply This Year, Study Shows,” New York Times, September 27, 2011.

Information Problems and Externalities in the

7.3 Market for Health Care (pages 228–234)
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
know. As sellers of lemons take advantage of knowing more about the cars they are selling than buyers
do, the used car market will fall victim to adverse selection: The situation in which one party to a
transaction takes advantage of knowing more than the other party to the transaction. Adverse selection
reduces the total quantity of used cars bought and sold in the market because few good cars are offered
for sale.

B. Asymmetric Information in the Market for Health Insurance

Asymmetric information problems are severe in markets for all types of insurances. 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
company to cover its costs, the total amount it receives in premiums must be greater than the amount it
pays out in claims to policyholders. A company that charges premiums that are too high will lose
customers to other companies and may be driven out of business. One obstacle to health insurance
companies accurately predicting the number of claims policyholders will make is that buyers always
know more about the state of their health than do the companies. Therefore, insurance companies face an
adverse selection problem. If companies have trouble determining who is healthy and who is sick, they
may end up setting premiums that are too low and will fail to cover their costs. If companies raise their
premiums, healthier people may drop their insurance. This would lead to an adverse selection problem
because policyholders will be less healthy on average than they were before the premium increase. One
way to deal with adverse selection is to require individuals to buy health insurance. The Patient

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162 CHAPTER 7 | The Economics of Health Care

Protection and Affordable Care Act (ACA) requires residents of the United States to carry insurance or
pay a fine. This provision is known as the individual mandate.

The insurance market is also subject to moral hazard: 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
of health care do not pay a price that reflects the full cost of providing the service. Third-party payer
health insurance can lead to a principal–agent problem, a problem caused by agents pursuing their own
interests rather than the interests of the principals who hired them. Doctors can pursue their own interests
rather than the interests of their patients. Because health insurance pays most of the bills for medical
procedures, patients are more willing to accept them. The fee-for-service aspect of health insurance can
make the principal–agent problem worse because doctors and hospitals are paid for each service
performed, whether or not the service was effective.

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 preexisting
conditions. Critics argue that by excluding or limiting coverage of preexisting conditions, insurance
companies force people with serious illnesses to pay the entire amount of large medical bills or to go
without medical care. The companies argue that if they do not exclude coverage of preexisting conditions,
then adverse selection problems might make it difficult to offer any health insurance policies or force
companies to charge premiums so high as to cause healthy people to not renew their policies.

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
health care that economists believe involve externalities. For example, anyone vaccinated against a
communicable disease protects not just himself or herself but also reduces the chances that people who
have not been vaccinated will contract the disease.

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
whether health care is a public good. More than one person cannot consume the same operation and
someone who will not pay for an operation can be excluded from consuming it. But there are aspects of
health care that have convinced some economists that government intervention is justified. Certain types
of health care, such as vaccinations, generate positive externalities. Information problems can also be
important in the market for private health insurance which may raise the costs to insurance companies
when the pool of insured people is small. This can make insurance companies less willing to offer health
insurance to consumers that the companies suspect may file too many claims.

Many economists believe that market-based solutions are the best approach to improving the health care
system. It is an open question whether the U.S. health care system will continue to move toward more
government intervention or whether market-based reforms will be implemented.

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Extra Solved Problem 7.3

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
who are older or who are ill?
c. What do you think Brooks meant by an adverse selection cascade? How might the actions of
young and healthy people contribute to adverse selection problems in the health insurance
system?

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 229, and “How Insurance
Companies Deal with Adverse Selection and Moral Hazard,” which is on page 231.

Step 2: Answer (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
prescription medicines, you are likely to pay more in premiums—possibly much more—than
you receive back in benefits. Therefore, a young and healthy person might rationally decide
that he or she would be better off not buying health insurance. People who don’t buy health
insurance, though, are taking the risk of having to pay big medical bills if they are in an
accident or encounter an unexpected medical problem. Under the ACA, people who don’t buy
health insurance are also subject to a fine, although the value of the fine—which started at
$95 per year in 2014 and rose to $695 per year in 2016—is typically less than the amount
paid for insurance.

Step 3: Answer (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,
across many people. The people who benefit most from insurance are those who have the
greatest likelihood of making an insurance claim for payment of large medical bills. These
people are likely to receive more in benefits than they pay in insurance premiums. Young and
healthy people are in the opposite situation of being likely to pay more in premiums than they
receive in benefits. The only way an insurance plan can make payments to people who are ill
and make many claims is to have healthy people enrolled in the insurance plan who do not
make many claims. In that sense, young and healthy people provide a subsidy to other people
in the plan.

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164 CHAPTER 7 | The Economics of Health Care

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,
then companies have to raise premiums on the people remaining in the plan. But higher
premiums make the insurance an even worse deal for healthy people, causing even more of them
to drop out of the plan. Over time, the ratio of ill people to healthy people in the insurance plan
continues to increase, undermining the risk pooling services the plan can provide.

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 preexisting 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 provide enough incentive for young
and healthy people to buy health insurance.
Source: David Brooks, “Health Chaos Ahead,” New York Times, April 25, 2013.

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.

Source: “Romney on Health Care: To Boldly Go Where He Had Already Been Before,” Economist, May 13, 2011.

Answers
a. Healthy people may not want to purchase health insurance because they expect the costs to be
greater than the benefits.
b. The statement is true in the same sense that fire insurance is meant for people whose houses burn
down. No one can predict with absolute certainty whether he will become sick or not, so having
health insurance will reduce out-of-pocket expenses if he becomes sick.
c. This situation is a problem for a system of health insurance because of adverse selection. If
people only buy health insurance when they are already ill, insurance companies are unable to
supply the service of risk pooling, and the system cannot operate efficiently. Solutions to this
problem might include limiting coverage of preexisting conditions or requiring individuals to buy
health insurance. In passing the ACA, Congress and the president decided to use the second of
these solutions.

7.4 The Debate over Health Care Policy in the United

States
(pages 234–245)
Learning Objective: Explain the major issues involved in the debate

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 CHAPTER 7 |The Economics of Health Care 165

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
declined from 48 percent of all health care spending in 1960 to about 10 percent today. As average
incomes rise, consumers might be expected to spend a rising share on health care. But because consumers
do not pay the full cost of increases in health care spending, they may be buying more health care than
they would if they had to pay the full price.

By 2017, spending on Medicare and Medicaid had grown to 7 percent of GDP. That percentage is
expected to more than double over the next 40 years unless health care costs grow at a slower rate.

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
that it generates more paperwork and waste than systems in other countries. But this cannot account for
health care’s increasing share of GDP unless paperwork and waste are increasing each year.

Although it is relatively easy for patients in the United States to sue doctors and hospitals for damages,
payments to settle malpractice lawsuits plus the premiums doctors pay for malpractice insurance amount
to less than 1 percent of health care costs. Between 1 percent and 4 percent of health care costs are due to
uninsured patients receiving treatments at hospital emergency rooms, not enough to account for much of
the increase in health care as a percentage of GDP.

Medicine requires face-to-face meetings between doctors and patients. As wages rise in industries in
which productivity increases rapidly, service industries in which productivity rises less rapidly must
match these wage increases or lose workers. Growth in labor productivity in health care has been less
than half as fast as labor productivity growth in the economy as a whole.

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
58 million in 2017 to 74 million by 2025.

Some of the increase in health care spending results from consumers choosing to spend more on health care
as their incomes rise. Consumers also demand a greater quantity of health care services than they would if
they paid a price that represented the cost of providing the services. Health care providers have a reduced
incentive to control costs because they know that an insurance company will pick up most of the bill. By
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.

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166 CHAPTER 7 | The Economics of Health Care

 State health insurance marketplaces. Each state must establish an Affordable Insurance Exchange
for individuals and businesses with fewer than 50 employees.
 Employer mandate. Every firm with more than 200 employees must offer health insurance to its
employees.
 Regulation of health insurance. Insurance companies are required to participate in a high-risk
pool that will insure individuals with preexisting medical conditions who have been unable to buy
health insurance for at least six months.
 Changes to Medicare and Medicaid. To control Medicare costs, an Independent Payment
Advisory Board (IPAB) was established.
 Taxes. Workers earning more than $200,000 pay higher Medicare payroll taxes, and investors
who earn more than $200,000 pay a new 3.8 percent tax on their investment income. Beginning
in 2018, a new tax is scheduled to be imposed on employer-provided health insurance plans.

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
government-owned hospitals and government-employed doctors or pay for health care through national
health insurance.

Market-based reforms are changes to 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.

Extra Economics in Your Life & Career:

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
skills. Agents earn more revenue by negotiating more contracts; therefore, there is an incentive to spend
less time than might be needed to negotiate the best deal for each of his clients. Parnell argues that the
large salaries that athletes earn and the complexity of legal and business issues suggest that a player
would be best represented by a business law firm, rather than a sports agency or agent, which “… has
hundreds of highly qualified partners” with expertise in financial planning, celebrity endorsements and
other areas that can help their client avoid the problems many athletes have faced after their retirement
from profession football.

Source: David J. Parnell, “NFL Bankruptcies, Moral Hazard and The Evolution of Sports Agents,” Forbes, December 6, 2013.

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 CHAPTER 7 |The Economics of Health Care 167

Solutions to End-of-Chapter Exercises

The Improving Health of People in the United States

7.1 Learning Objective: Use data to 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 (doctors and
hospitals) but also by government, both directly (through the U.S. Department of Veterans Affairs)
and indirectly (through the Medicare and Medicaid programs). Furthermore, the market for health
care is different from the markets for other goods and services in that, because of insurance, the
typical consumer does not pay the full price of the health care he or she purchases.

1.2 Over the last 165 years, the average person in the United States has become taller, lives much
longer, is less likely to suffer from a variety of diseases, and is less likely to die in the first months
of life.

1.3 Better health allows people to be more productive, which in turn raises a country’s total income.
Increases in a country’s income lead to better sanitation, more food, a better system for distributing
food, and more resources devoted to medical research, which in turn lead to better health.

Problems and Applications

1.4 Improvements in health have led to a more productive labor force, which shifts the U.S.
production possibilities frontier outward (to the right). Generally speaking, when there is a
decline in resources, such as labor, there is a decrease in the productive capabilities of an
economy. The 1918 influenza epidemic increased mortality rates in the United States, reducing
what would otherwise have been the size of the labor force, and shifted the production
possibilities frontier inward compared with where it would otherwise have been.

1.5 Improvements in technology shift a country’s production possibilities frontier outward. Similarly,
improving health also shifts out a country’s production possibilities frontier. Better health makes it
possible for people to work harder as they become taller, stronger, and more resistant to disease.

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
measure, the standard of living rose in the United States during the 1830–1890 period but
declined using the height measure. The decline in height provides the insight into the poor
nutritional status and poor state of sanitation in U.S. cities during the 1830–1890 period, before
the public health movement in the late nineteenth century.

Health Care around the World

7.2 Learning Objective: Compare the health care systems and health
care outcomes in the United States and other countries.

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168 CHAPTER 7 | The Economics of Health Care

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.
b. Fee-for-service is a system under which doctors and hospitals receive a separate payment for
each service they provide.
c. A single-payer health care system is a system, such as the one in Canada, in which the
government provides health insurance to all of the country’s residents.
d. Socialized medicine is a health care system, such as the one in the United Kingdom, under
which the government owns most hospitals and employs most doctors.

2.2 Private insurance, mainly through employers, is the largest source of health insurance in the
United States. The government, through Medicare, Medicaid, and programs administered by the
Department of Veterans Affairs, is another significant source of health insurance.

2.3 Canada has a single-payer system, in which the government provides health insurance to all
residents; in the United States, private insurance is the largest source of health insurance.
Both Canada and the United States have a fee-for-service system. Japan has a universal health
insurance system in which preventive care, such as annual physical exams, is not covered; in the
United States, preventive care is generally covered by health insurance. Both Japan and the United
States have many privately owned hospitals and doctors who are not employed by the government.
Unlike the United States, the United Kingdom has a system of socialized medicine in which the
government owns most of the hospitals and employs most of the doctors.

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
expectancy at birth, infant mortality, and obesity, it does relatively well in the availability of
medical equipment and cancer treatment. Cross-country comparisons in health outcomes are
difficult to make because of problems with data, measuring health care delivery, distinguishing
health care effectiveness from lifestyle choices, and determining consumer preferences.

Problems and Applications

2.5 a. “Free at the point of use” means that patients pay nothing when they receive health care
services. The National Health Service supplies health care services without charging patients
directly for its services because it receives its funding from taxes. Health care is not actually
free to residents of the United Kingdom because they pay for it through their taxes.
b. When they are not charged for an appointment, patients have less incentive to take care of
themselves and to avoid making appointments for conditions, such as colds, where medical
treatment is ineffective. With patients having more appointments than they would have if they
were charged for the appointments, the National Health Service requires more doctors and
staff, and, therefore, more funding.

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.
Also, one’s “quality of life” is affected by things that are outside of a doctor’s ability to control;
for example, diet and lifestyle choices. The economist’s observation does have relevance to
comparisons in health care outcomes across countries, which are affected by many different
factors and so can be difficult to measure.

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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
they returned to work. The expense may be the key reason governments don’t currently collect
the data. The data could be useful in evaluating how successful surgeries are, given that the goal
of surgery is usually to allow the patient to return to a normal life. Better measures of health care
outcomes are needed to properly evaluate the effectiveness of a country’s health care system.

2.8 a. Many people who have seriously ill family members would likely support medical decisions
to provide palliative care to their loved ones, even if that care is for a short period of time.
Because resources are scarce; however, resources devoted to palliative care to very ill patients
are not available for improving other health care outcomes, such as funding preventive care
that, in the long run, may result in people living healthier and longer lives. Nor would these
resources be available for use in medical research.
b. It could be possible to measure how successful health care systems are in providing palliative
care to very ill patients. For example, data could be collected on the number of patients who
receive palliative care and for how long they receive the care. The ratio of patients who
receive palliative care relative to the total number of very ill patients could be compared
across countries, as could the average length of time patients received palliative care.

2.9 a. Health care spending per person in the United States is higher than in other countries. Some
economists and policymakers have argued that the U.S. health care system has lower
productivity because spending is very high while outcomes are mixed. Other economists and
policymakers argue that comparing the productivity of different health care systems may be
difficult because of problems in fully measuring health outcomes. For example, the U.S.
system may do a better job of providing consumers with speedy access to elective surgeries—
such as joint replacements—than the systems in other countries where health care spending
per person is lower.
b. Widely adopting information technology in the U.S. health care sector will more likely result
in employment of fewer workers as some tasks could be automated that are currently carried
out by health care workers. The result would be an increase in labor productivity in health care
as the same level of output would be produced with fewer workers.

Information Problems and Externalities in the

7.3 Market for Health Care
Learning Objective: Define information problems and externalities
and explain how they 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.
b. Adverse selection occurs when one party to a transaction takes advantage of having more
information than the other party to the transaction.
c. Moral hazard occurs when the actions people take after they have entered into a transaction
make the other party to the transaction worse off.
d. The principal–agent problem is caused by agents pursuing their own interests rather than the
interests of the principals who hire them.

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3.2 The asymmetric information problems in the market for health insurance include adverse
selection (buyers know more about their health status than insurance companies do) and moral
hazard (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-existing
conditions). They also offer group policies, such as the group health insurance policies offered to
the employees of large firms or colleges. This “risk pooling” helps insurance companies better
estimate the number of claims they are likely to receive when they are setting insurance
premiums. Insurers reduce moral hazard by using deductibles and coinsurance (or copayments),
which result in people with insurance paying part of the cost of their health care. Deductibles and
copayments give people with insurance an incentive not to overuse health care by, for example,
visiting a doctor for treatment of a cold.

3.4 An externality is a benefit or cost that affects someone who is not directly involved in the
production or consumption of a good or service. Positive externalities in the market for health
care include vaccinations against diseases, which benefit other people in addition to those who
receive the vaccine, and negative externalities include obesity, because people who are not obese
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
car dealer with a good reputation (or by an individual you know well enough to trust), if you can
cheaply determine that it isn’t a lemon (for example, by an inspection), or if you’ll receive a
warranty against defects.

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
asymmetric information. The lemons problem also exists in the market for health insurance
because the buyers of health insurance policies know more about the condition of their health
than do insurance companies. As a result, people who are likely to need medical care are more
likely to buy health insurance than are people who are in better health and who are unlikely to
need much medical care.

3.7 When, for example, you buy fire insurance you are pooling or 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 will use to pay someone whose house burns down. Adverse selection undermines the
ability of insurance companies to provide risk pooling services. Risk pooling can only occur if all
the people who buy insurance policies face about the same risk of having their house burn down.
It does not occur when the only people who buy insurance policies are people whose houses are
likely to burn down.

3.8 Perhaps. Some argue that Social Security does not involve offering insurance against difficult-to-
predict events like a fire or an illness, but that it is more like a program of forced saving for
retirement. Others argue that Social Security is a system that insures against outliving your
savings due to the difficulty of predicting how long you are likely to live after retiring.

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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
hazard in marriage. The person who bought flowers before marriage stops buying flowers for his
or her spouse after marriage. Moral hazard refers to actions that occur after a transaction
(marriage in this example) has occurred.

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 patients
have insurance that covers most or all of the cost of unnecessary procedures, they are more likely
to agree to the treatments than if they had to pay the full cost from their own funds. The fee-for-
service aspect of health insurance worsens the principal–agent problem because health care
providers are typically paid for each service they provide whether the service improves health
care outcomes or not. So, physicians have an incentive to prescribe unnecessary tests because
they receive a payment for the test, whether it was necessary or not. Distinguishing necessary
from unnecessary tests can be difficult, however, so economists have not been able to fully
measure the extent of the principal–agent problem in the U.S. health care system.

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
the services. Doctors and other health care providers also have a reduced incentive to control
costs because they know that an insurance company will pick up most of the bill and they
generally work under a system (fee-for-service) under which they receive a separate payment for
each service they provide, whether the service was actually medically necessary or not. While
insurance companies try to avoid reimbursing physicians for medically unnecessary tests and
other procedures, distinguishing necessary from unnecessary medical procedures can be difficult.

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
burn down. No one can predict with certainty whether he will become sick or injured, so
having health insurance will reduce a person’s out-of-pocket expenses if the person does
become sick or injured.
c. This situation is a problem for a health insurance system because of adverse selection. If
people only buy health insurance when they are ill, insurance companies will be unable to
supply the service of risk pooling, and the system cannot operate efficiently. Solutions to this
problem include limiting coverage of preexisting conditions and requiring individuals to buy
health insurance. In passing the ACA, Congress and the president decided to use the second
of these solutions.

3.14 a. The “young invincibles” 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 subsidy by the young invincibles is particularly important for the Patient Protection and
Afford Care Act because the law sharply limited the ability of insurance companies to deny
coverage to people with preexisting conditions.
b. Expected health care claims would rise with an increase in the ratio of people with
preexisting conditions to young invincibles. To cover the higher expected claims, insurance

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companies would raise premiums. An increase in the ratio of people with preexisting
conditions to young invincibles illustrates the economic problem of adverse selection where
sick people are more likely to want health insurance than are healthy people.
c. More and more young invincibles will opt out of the health care plan as insurance companies
increase premiums rise to cover the increase in the expected claims from more people with
preexisting conditions. The cycle of more sick people relative to young invincibles, followed
by higher premiums, and then more young invincibles opting out, followed by even higher
premiums, and so on is called an insurance “death spiral.”

3.15 Disagree. 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 less likely to contract the disease. The existence of positive externalities does not
mean that health care is a public good because (as we discussed in Chapter 5) public goods are
both nonrivalrous and nonexcludable; health care has neither characteristic.

The Debate over Health Care Policy in the United

7.4 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
Congress and signed into law by President Barack Obama in 2010. Its major provisions include
individual mandates, state health exchanges, an employer mandate, regulation of health insurance,
Medicaid expansion, and new taxes.

4.2 Health care spending in the United States has increased from less than 6 percent of GDP in 1965
to nearly 18 percent of GDP in 2017. Spending on health care has grown faster in the United
States than in many other high-income countries. Because the federal and state governments in
the United States pay for a significant fraction of health care spending, increases in health care
spending place strain on government budgets.

4.3 The rapid increase in health care spending in the United States is due to slow rates of growth of
labor productivity in health care, the population becoming older, improvements in medical
technology, new prescription drugs, the tax treatment of private health insurance, and the reliance
on third-party payers.

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.

4.5 Proponents of market-based reforms believe market prices would better convey information on
consumer demand and supplier costs. They also believe increased competition would reduce the
costs of providing health care and increase economic efficiency.

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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Costs increases are expected to result from low productivity in the health care sector and higher
prices for new prescription drugs and medical equipment.

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
health. If life expectancy improves because of a cure for a disease–breast cancer, for example–
then the cost of treating the disease will decline. But because the new technology will allow
people to live longer they are likely to require treatment for other medical conditions over the
additional years they live.

4.8 a. Instead of demand and supply determining who receives the benefits from new medical
technologies, as happens with most goods and services in a market economy, 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 think these new medical technologies
are not worth their costs, Medicare would not pay for them. This approach would be rationing
in that not everyone who wanted to use these new technologies would have access to them.
b. Higher-income individuals would receive fewer Medicare benefits, and some individuals
would pay higher premiums and copayments. Because beneficiaries would have to pay more
of the cost of health care, the quantity of health care they demand would decline, thereby
restraining the growth of Medicare spending. Premium supports would involve subsidies to
some (presumably lower-income) beneficiaries.
c. Congress and the president should be concerned about 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
may be only marginally effective. On the other hand, some people are reluctant to have
medical decisions made by a board of experts rather than by doctors and patients. Many
economists and policymakers favor market-oriented reforms of the Medicare system that
would result in beneficiaries paying more of the cost of their health care. Other economists
and policymakers are skeptical that Medicare costs would respond much to market-oriented
reforms because they doubt that beneficiaries’ demand for health care will be very sensitive
to increases in premiums or out-of-pocket costs. Some combination of the two approaches
might end up being adopted as a way to restrain the growth of spending on Medicare.
4.9 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.
b. As discussed in the chapter, other factors, such as the favorable tax treatment of private health
insurance may also be driving the increase in health care spending. Because of favorable tax
treatment and because government and private health insurance act as third-party payers for
many consumers, the choices consumers make about health care may be distorted to a greater
extent than Fogel’s position suggests.
4.10 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
equilibrium level of total compensation, which includes wages and fringe benefits. The value of
health insurance provided by employers would most likely decrease because these benefits would
no longer be tax-free and the wages paid to employees would increase.
4.11 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.

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b. Q1 is the efficient quantity of medical services where the demand for medical services if
consumers paid the full price of medical services, D1, intersects the supply of medical
services, S.
c. P3, which equals the equilibrium market price, P2, minus the amount covered by health
insurance, is the price consumers pay for medical services.
d. Area B represents the deadweight loss that results from consumers not paying the full cost of
medical services. The marginal cost of producing the quantity Q2 – Q1 as indicated by the
supply curve S, exceeds the marginal benefit consumers receive from these medical services,
as indicated by the demand curve D1.

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4.12 Advances in information technology will reduce the cost of providing medical services and will
shift the supply curve for medical services to the right. In the graph below, the supply of medical
services shifts to the right, decreasing the price and increasing the quantity of medical services.

4.13 Because health insurance covers much of the cost of many medical services, most patients are
unconcerned about the prices of these medical services. Therefore, patients have little incentive to
shop around for lower prices.

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
demand. If the federal government were to require employer health plans to have deductibles no
greater than $200 per year, employees would seek more medical care for minor injuries and
illnesses than they would with high deductible plans. This outcome would likely make employees
better off if they were made healthier as a result, but the cost of their health care plans would be
higher. Whether this change would result in all employees being made “better off” is complicated.
Less healthy employees who use more medical care would benefit more than employees who
required little medical care. And it is possible that some employees would be less careful about
maintaining their health through diet, exercise and other good habits because more of their
medical expenses would be covered by their plans. A key point is that labor markets determine
the equilibrium level of total compensation, which includes wages and fringe benefits. The value
of health insurance provided by employers (a fringe benefit) would increase because of the
requirement to have low deductibles, so the wages paid to employees would have to decrease to
keep the value of total compensation the same. Therefore, employers would not be greatly
affected by the change, apart from the cost of having to adjust their compensation plans.

Suggestions for Critical Thinking Exercises

CT7.1 First, one must be concerned with adverse selection and moral hazard. Second, in a competitive
market total employee compensation should be roughly comparable across firms.

CT7.2 Clearly, the responses depend upon the articles that students select. In addition, the chances for
passage of legislation will vary depending upon the political environment that exists when the
legislation is proposed.

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