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Chapter 7
Medical Care: Costs Out of Control?
What's in This Chapter and Why
There are two primary concerns about health care in the United States: (1) that we are spending
too much on health care, and (2) that although we spend too much, a significant number of
Americans still receive inadequate health care. The first of these concerns is the primary focus
because it seems to dominate the discussion of health care reform and because elementary
economics is especially helpful in clarifying this issue.
Expenditure on health care has increased from 4.4% of the national output in 1950 to 14% of
national output in 2001. Government analysts project expenditures equal to 17% of national output
by 2011. Growing alarm over this trend has spawned a host of proposals in Congress for health
care reform. The objective in this chapter is to examine the economic basis for this reform effort.
Instructional Objectives
After completing this chapter, your students should know:
1. Why heath care expenditures have increased relative to GDP, and various theoretical
explanations of this trend.
The cost-benefit analysis to determine if appropriate level of health care is being provided.
3. The impact of technological change on the medical care, and if it is worth it.
4. If the present system provides the right amount of health care.
5. Various approaches to reducing wasteful expenditures on medical care.
Key Terms
These terms are introduced in this chapter:
Cost Disease of the Services Sector
Income elasticity of demand
Inferior good
Superior good
The residual
Value of a life
Third-party payment
Physician-induced demand
Defensive medicine
Net cost of health insurance
Managed care
Utilization review
Voucher
Suggestions for Teaching
In learning the contents of this chapter, students may find it difficult to calculate the present value
of cost and benefits of health care to understand if the expenditure is worth it. Also, gaining an
understanding of the arithmetic of the federal tax exemption for health insurance may pose
problems. Thus, it is recommended that you plan to spend some extra class time on these concepts
as gaining understanding of these concepts will payoff in the future chapters.
The rest of the concepts are relatively straightforward, except, perhaps, managed care. If your
community has one of the managed care organizations mentioned in the text, why not invite a
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representative to address your class? Frequently, such individuals will be well versed in many of
the options being discussed in the health policy arena, and they can certainly speak to the pressures
the industry perceives to attenuate the rate of growth in costs.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Davis, Karen "Access to Health Care in a Cost-Conscious Society" In Access to Social Care:
Who Shall Decide What? edited by Helen Rehr, (Lexington, MA: Ginn Press, 1986).
2. Eberstadt, Nick "Economic and Material Poverty in the United States" The Public Interest
(Winter 1988).
3. Blendon, Robert J., Drew Altman and Saul Kilstein, "Health Insurance for the Unemployed
and Uninsured" National Journal (May 28, 1983).
Outline
I. THE RISING COST OF MEDICAL CARE
A. National health expenditures (NHE) grew at an annual average rate of 11 percent between
1980 and 1990, while Gross Domestic Product (GDP) grew at only 7.6 percent per year.
As a result, NHE increased from 8.8 percent of GDP to 12 percent. NHE and GDP are
projected to grow at annual rates of 7.3 percent and 4.8 percent, respectively. As a
consequence, NHE are expected to be 17.0 percent of GDP by 2011.
II. WHY HEALTH EXPENDITURES HAVE INCREASED RELATIVE TO GDP
A. National health expenditures equal the amount spent for all health care (HC) goods and
services. GDP equals the amount spent for all goods and services (AGS). The amount
spent, or expenditure, for a good or service is the product of the price per unit (P) and the
number of units, or quantity (Q), purchased. Thus, NHE = PHC X QHC, where PHC is the
average price of health care and QHC is the average quantity of health care, and GDP =
PAGS X QAGS, where PAGS and QAGS are the average price and quantity of all goods
and services, respectively.
Thus, NHE/GDP = (PHC X QHC) / (PAGS X QAGS), implying that NHE/GDP will
increase if PHC increases relative to PAGS; that is, if the average price of medical care
increases relative to the average price of all other goods and services. NHE/GDP will also
increase if QHC increases relative to QAGS; if the average quantity of medical care
increases relative to the average quantity of all goods and services.
1. The Cost Disease of the Services Sector: William Baumol divides the economy into
two sectors: (1) the technologically-progressive, capital-intensive sector that exhibits
rapid growth in output per labor hour or productivity, and (2) the labor-intensive sector
that exhibits slow growth in labor productivity. Wages will grow rapidly in the
capital-intensive sector as workers are rewarded for productivity increases. Wages will
follow suit in the labor-intensive sector as employers find that they have to match what
workers can earn in the capital-intensive sector in order to recruit new employees and
retain existing workers.
2. the increase in the relative price of medical care can be expected to explain some of the
increase that has occurred in NHE.
Instructor's Manual  97
B.
C.
D.
E.
3. Increases in QHC must have also exceeded increases in QAGS. There are several
reasons to expect an increase in QHC over time. Chief among these are:
a. the aging of the population,
b. the relatively high income elasticity of demand for health care,
c. increases in insurance coverage, and
d. technological change.
Population Aging: Other things equal, the quantity of health care purchased can be
expected to increase as a result of population growth, but this is also true of purchases of
other goods and services. Thus, there is no assurance, a priori, that QHC will increase
relative to QAGS as a result of population growth. Population aging, on the other hand, is
expected to make QHC grow relative to QAGS. Health care spending increases with age
because older people tend to have more medical needs than younger people.
Income Elasticity of Demand for Health Care: U.S. households have experienced
significant increases in income at the same time that health care expenditures have been
rising so rapidly. The income elasticity of demand (IED) is a measure of the change in the
quantity demanded (or amount purchased) of a specific good or service as a result of a
change in income, expressed in percentages.
Increases in Insurance Coverage: There is substantial evidence that people with health
insurance receive more care, more frequently, than people without health insurance. The
number of people with health insurance has grown significantly over the last 50 years.
Thus, it is reasonable to expect some of the increase in QHC to be due to increases in
insurance coverage.
Technological Change: New technology normally increases costs because it increases the
"intensity" of care - i.e., it expands the opportunities for providing more services (more
QHC) to patients. Even when new technology could reduce unit costs, it often increases
health care expenditures by increasing the number of patients to which the technology is
applied. Using the "residual" method, it is estimated that 70 percent of real spending
increases during the 1940-1990 period can be attributed to technological change!
III. IS TECHNOLOGICAL CHANGE IN MEDICAL CARE WORTH IT?
A. There are two primary sources of benefits from medical advances: reduced mortality or
increased life expectancy, and reduced morbidity or enhanced quality of life. Up to now,
economists have been much more successful in valuing increases in life expectancy than in
valuing enhancements in the quality of life. Studies show that economic benefits exceed
costs.
IV. DOES THE MEDICAL SYSTEM PROVIDE THE RIGHT AMOUNT OF MEDICAL CARE?
A. A good medical care system uses medical services that are appropriate, but avoids using
them too much. Substantial research has examined whether the U.S. medical system does
well by this criterion. The universal conclusion is that it does not.
B. We get a lot from medical care because we pay a lot for providing very intensive - and
expensive - services. Paying more for intensive services gets a lot of these services
provided, both when they are valuable and, unfortunately, also when they are not. And the
corollary of paying more for intensive care is paying less for routine care.
C. Third-Party Payments:
1. A third-party payment is a payment made directly to the provider of a good or service
by a party other than the buyer.
98  Chapter 7/Medical Care: Costs Out of Control?
a. The principal third parties in the market for health care are insurance companies
and government agencies.
2. With third-party payments, consumers make partial-cost payments equal to the
difference between the full cost of health care and the third-party payment.
3. Because third-party payments lower the price of health care services to consumers,
they tend to purchase some care for which marginal social costs exceed marginal social
benefits.
a. Marginal social benefit is the sum of marginal private and marginal external
benefits.
1. Marginal private benefit is the value the consumer places on the marginal unit
purchased.
2. Marginal external benefit is the value individuals other than the consumer
place on the marginal unit purchased.
3. Marginal social cost depicts the cost producers and others incur when the
marginal unit is provided.
D. Physician-Induced Demand
1. Physician-induced demand refers to clearly ineffective health care prescribed by
physicians in order to increase their wealth.
2. There are at least three necessary conditions for the existence of physician-induced
demand.
a. There is asymmetric information regarding the efficacy of health care alternatives.
b. Physicians must have a desire to increase their wealth.
c. Physicians' income must directly depend on the amount of health care they
prescribe.
3. Economists have identified several potential limits to the pure exercise of physicians'
preferences.
a. Physicians do not have the ability to close the market to competitors.
b. The patient may seek alternative diagnoses if the procedures suggested by the
physician deviate significantly from the patient's a priori expectations.
c. Many third-party payers now require second opinions before agreeing to pay for
expensive medical care.
d. There are limits to the amount of work that physicians want to create for
themselves.
e. Some physicians consider it unethical to put a patient through procedures that have
questionable beneficial effects.
E. Defensive Medicine
1. Physicians may perform or prescribe medical procedures or drugs that provide little
benefit to their patients in order to reduce their risk of a malpractice suit.
F. Federal Tax Exemption for Health Insurance
1. The federal tax code exempts employee compensation received in the form of health
insurance from the federal individual income tax. This lowers the bottom line cost, the
difference between the net cost of insurance and the value of the insurance exemption,
of health insurance.
Instructor's Manual  99
2. Because the federal tax code lowers the price of health insurance, the quantity of health
insurance demanded will increase. As the quantity of health insurance demanded
increases, so does the quantity of medical care consumed.
V. APPROACHES TO REDUCING WASTEFUL EXPENDITURES
A. Basic Concepts
1. The key to cost reduction is to make patients and providers more responsible for the
costs of their choices.
2. Three ways for doing this are discussed.
B. Managed Care
1. Managed care is health care that is reviewed by someone other that the patient or
provider to determine whether the right services are being provided and whether the
cost of provision in minimized.
2. There are three principal types of managed care organizations.
a. A health maintenance organization (HMO) provides both insurance coverage and
the delivery of health care in the same organization.
1. The HMO hires or contracts with a group of doctors to provide care.
2. The HMO either owns hospitals or contracts for their services.
3. Doctors and hospitals agree to provide all of the medical care required by
enrollees for a fixed amount per enrollee.
b. An independent practice association is a network of physicians who maintain their
own practices, but who act like an HMO by agreeing to provide stipulated services
to enrollees.
c. A preferred-provider organization strikes a deal with doctors and hospitals. The
PPO agrees to send its members as patients to the providers in return for a reduced
price.
C. Eliminating the Tax Exemption for Health Insurance
1. Federal tax exemption for employer-provided health insurance increases the demand
for health insurance, and thus adds to the excess demand for health services.
2. The exemption tends to benefit workers in large firms, but these firms can usually
secure favorable premiums, anyway.
3. Because the exemption is more valuable at higher marginal tax rates, it benefits high
income workers more than low income workers.
4. Politically, elimination of the exemption will be very hard to achieve. Millions of
businesses, workers, doctors, and hospitals benefit from it.
D. Health Care Vouchers
1. Vouchers are coupons that the recipient can use to pay for health care at hospitals or
doctors’ offices chosen by the recipient.
2. The recipient could also be required to use the voucher to purchase a conventional
health insurance policy or to participate in a lower-cost managed care system.
3. Critics of vouchers say they may not work as intended because recipients may make
poor choices of health insurers or providers.
100  Chapter 7/Medical Care: Costs Out of Control?
Answers to Review Questions
1. Briefly describe the relationship between national health expenditures (NHE) and GDP
over the period 1980-2011.
National health expenditures (NHE) grew from 1980 to 2000, and the actuaries at the Centers
for Medicare and Medicaid Services (CMS) project that they will grow from 2001 to 2011.
NHE grew at an annual average rate of 11% between 1980 and 1990, while Gross Domestic
Product (GDP) grew at only 7.6% per year. As a result, NHE increased from 8.8% of GDP to
12%. The growth in NHE continued to outpace the growth in GDP until 1993 - in fact, by
enough that NHE as a percent of GDP was higher in 1995 than in 1990. GDP continued to
grow faster than NHE from 1993 to 1998, producing a decrease in the NHE/GDP ratio. The
system reverted to its earlier form in 1999 and 2000, however, causing analysts to predict a
continuation of the historical trend for the next decade. NHE and GDP are projected to grow at
annual rates of 7.3% and 4.8%, respectively. As a consequence, NHE are expected to be 17%
of GDP by 2011.
2. Explain how the "Cost Disease of the Services Sector" works in the case of health care,
using equation (7.4) or (7.5).
To explain the Cost Disease of the Service Sector William Baumol divides the economy into
two sectors: (1) the technologically-progressive, capital-intensive sector that exhibits rapid
growth in output per labor hour or productivity, and (2) the labor-intensive sector that exhibits
slow growth in labor productivity. Wages will grow rapidly in the capital-intensive sector as
workers are rewarded for productivity increases. Wages will follow suit in the labor-intensive
sector as employers find that they have to match what workers can earn in the capital-intensive
sector in order to recruit new employees and retain existing workers.
Wage competition between the two sectors leads to costs that grow faster in the labor-intensive
sector. To see why, consider this equation:
LABOR COST PER UNIT OF OUTPUT = LABOR PRODUCTIVITY X WAGE PER HOUR.
There is a direct relationship in this equation between the wage per hour and labor cost per unit
of output; that is, increases in the hourly wage increase labor costs per unit of output. There is
an inverse relationship in this equation, however, between labor productivity and labor cost per
unit of output; that is, an increase in labor productivity reduces labor cost per unit of output.
This happens because an increase in labor productivity is the same thing as a reduction in labor
hours per unit of output.
It follows that, if wages are rising at roughly the same rate in both sectors of the economy, but
labor productivity is increasing faster in the capital-intensive sector, labor costs will rise more
slowly (faster) in the capital-intensive (labor-intensive) sector. Given that labor costs are by far
the most important component of costs in both sectors, total costs per unit will rise faster in the
labor-intensive sector. In a demand-supply context, cost increases shift the supply curve up (or
to the left) relative to the demand curve, resulting in increases in prices. Thus, the slower
growth in productivity in the labor-intensive sector eventually shows up in the form of faster
increases in prices in this sector.
Instructor's Manual  101
3. Explain how the income elasticity of demand for health care (IEDHC) increases the
quantity of health care and NHE/GDP, using equation (7.6).
U.S. households have experienced significant increases in income at the same time that health
care expenditures have been rising so rapidly. It is reasonable to assume that at least some of
the increase in expenditures that has occurred is a result of deliberate choices by households to
spend a portion of their growing incomes on health care. The effect of increases in income on
household purchases of health care is captured by the income elasticity of demand for health
care. The income elasticity of demand (IED) is a measure of the change in the quantity
demanded (or amount purchased) of a specific good or service as a result of a change in
income, expressed in percentages. Applied to health care:
IEDHC = Percent Change in QHC / Percent Change in Income
If the value of IEDHC were negative, health care would be an inferior good - one for which
quantities purchased actually fall as income increases. A number of estimates indicate,
however, that IEDHC is greater than zero. In fact, there is good evidence that IEDHC exceeds
1.0. If so, health care is a superior good - one for which quantities purchased not only increase
as income increases, but at a faster rate than the increase in income.
4. Suppose that the risk of dying in an automobile accident is reduced by 1 in 10,000
through the use of front seat air bags and that 10,000 auto buyers choose to purchase
these air bags as an option at a price of $250. What is the implicit value of a life to these
buyers? Explain how you got your answer.
If the risk of dying in an automobile accident is reduced by 1 in 10,000 through use of air bags
and 10,000 auto buyers choose to purchase air bags, we expect one person to be saved from
death from using air bags. The group pays $2.5 million ($250 X 10,000) for the front air bag
option, thus, the implicit value of life to these buyers is $2.5 million.
5. Suppose that a year of life is worth $150,000 and that a new treatment for diabetes
increases life expectancy for a 40-year old woman by 2 years. Suppose, further, that the
treatment will cost $50,000 in present value per woman. If the discount rate is 3 percent (i
= 0.03) determine if this treatment is worth the cost.
The treatment would be worth the cost if the present value of benefits exceed or equal the
present value of costs. The present value of treatment cost is given at $50,000 per woman. The
present value of benefits at age 40 is calculated by the following equation:
PVLY40 = FVLYt / (1+i)t-40
where PVLY is the present value of a life year at age 40, FVLY is the future value of a life year
in year t, (1+i)t-40 is the discount factor, and i is the discount rate. Let us assume that life
expectancy without treatment is 75 years, thus, treatment would lead a life expectancy of 77.
The present value of benefits at age 40 is calculated as follows:
PVLY40 = FVLY76 / (1+0.03)76-40 + FVLY77 / (1+0.03)77-40
and
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PVLY40 = $150,000 / (1+0.03)36 + $150,000 / (1+0.03)37 = $51,755 + $50,247
= $102,002
Thus, the total present value of benefits is $102,002, which is greater than the present value of
costs for two years, $100,000, by $2,002. The treatment is worth the cost.
6. According to the analysis of economic efficiency in Chapter 3, there is a two-part test for
determining if the allocation of resources is efficient: Are total benefits greater than total
costs? And are marginal benefits equal to marginal costs? Explain how this two-part test
helps to explain the apparent paradox of the high payoff from medical advances and the
substantial overuse of medical procedures documented by the Dartmouth and Rand
research teams.
In their research, Kevin Murphy and Robert Topel of the University of Chicago have shown
that total benefits of medical advances and medical care exceed their total cost in U.S.
However, Americans overuse medical care at the same time that they are reaping huge benefits
from medical advances. Although, the total benefits from medical care exceed its total costs,
there are many instances where the marginal benefits are less than the marginal costs. A good
medical care system uses medical services that are appropriate, but avoids using them too
much. Research has shown that the U.S. medical system does well by this criterion. A lot of
medical care is provided in situations where it is of little or no value. This is particularly true of
intensive surgical procedures.
The Dartmouth Atlas Project has shown that medical spending in different areas of the country
varies enormously, without substantial differences in health benefits. They have estimated that
medical spending could fall by 20% if care, especially surgical procedures with low value,
were eliminated.
Another way to look at overuse of care is to determine if patients meet medical criteria for the
care they receive. A large number of RAND studies over the past decade have examined the
appropriateness of the use of various medical and surgical procedures. These studies rated all
of the indications for performing a given procedure, then used those ratings to determine
whether the procedures were performed for "necessary," "appropriate," "inappropriate," or
"equivocal" reasons. Generally, a procedure was considered to be "appropriate" if the patient's
expected health benefits exceeded the expected health risks by a substantial margin.
7. What do we mean by "too much" health care? Illustrate and explain briefly how partial
cost-prices for hospital care cause too much hospital care to be produced.
Too much health care is produced when the cost of providing the marginal unit of health care
exceeds the benefit received from this marginal unit. Partial-cost payments reduce the price
consumers pay for health care. This can cause "too much" health care to be consumed. In
order to understand this, observe the following diagram.
Instructor's Manual  103
Prices, Payments,
and Costs
MSC
300
225
100
D=MB
0
60
110
Hospital Days
(thousands)
Suppose consumers pay the partial-cost price of $100 per hospital day. At that price, they
would like to consume 110 hospital days. While the benefit they receive is $100 per hospital
day, the cost (represented by the MSC curve) is $300 per hospital day. There is overconsumption of hospital facilities. If individuals paid the full cost of their stay, they would pay
$225 per hospital day and only 60 hospital days would be consumed.
8. Carefully define physician-induced demand. Can it explain the large amount of
ineffective and inappropriate care? Why or why not?
Physician-induced demand means that a portion of health care purchases may reflect physician
preferences. This can occur because of consumers' lack of information about the effectiveness
of various health care alternatives. Thus, they delegate the choice of alternatives to their
physician. The physician, motivated by the self-interest of increasing his or her income, may
prescribe care that provides benefits to the consumer that are less than the costs of providing
that care.
While there is some evidence of ineffective health care, there is little of it that can be attributed
to physician-induced demand. Research shows that as much as 1/3 of certain common
procedures are inappropriate or of equivocal value. Other research shows that there is
enormous variation in the use of care in different areas of the country or across countries. Most
of this is due to variations in physician practices. Differences in practices could be caused by
the uncertainty of diagnostic medicine and variations in the training and skills of physicians.
Economists have also identified several potential limits to the exercise of physicians'
preferences. First is the inability of physicians to close the market to competitors. This threat
of potential competitors works to mitigate the market power of physicians. Second is the
possibility that patients form a priori expectations about the conditions for which they seek
medical assistance. If the procedures suggested by physicians deviate significantly from these
expectations, patients are likely to seek second opinions. The growing practice of third-party
104  Chapter 7/Medical Care: Costs Out of Control?
payers to require second opinions also reduces the likelihood of physician-induced demand.
Finally, there may be a limit to the amount of work that physicians want to create for
themselves.
9. "Defensive medicine is one of the primary causes of excessive health care spending." Is
this statement true or false? Justify your answer.
The U.S. legal system provides compensation to patients who can prove that they have been
victims of medical malpractice, deviations from accepted medical standards of care that cause
injury to the patient. In some instances, physicians may perform medical procedures in order
to decrease the risk of a malpractice suit rather than because of the benefit that such a
procedure provides a patient. Thus we may find the marginal cost of health services exceeding
the marginal benefits. However, the existence of defensive medicine does not necessarily
imply excessive health care spending. It may result in higher quality care, fewer injuries, or a
reduction in the number of high-risk procedures. In fact, the most widely cited estimate does
not support the idea of defensive medicine being a primary cause of excessive health care
spending. According to this statistic, defensive medicine accounted for only about 1 percent of
all medical expenditure in 1984.
10. How can the federal tax exemption for health insurance make the net cost of an insurance
policy negative?
Employee compensation in the form of health insurance coverage is not subject to the
individual federal income tax. To understand how this affects the net cost of health insurance,
we must first understand what this net cost is. The net cost of health insurance is the part of the
premium that the individual does not expect to get back in the form of benefits. It is the part of
the insurance premium that covers the cost of insurance administration and contributes to the
insurance companies' profits. The bottom line cost to the individual is the difference between
the net cost of insurance and the value of the insurance exemption. Given the net costs and the
marginal federal income tax rates, the bottom line cost to workers may be negative. In order to
see this, consider the following example.
Suppose an employer is paying $1000 per year for an insurance policy for James. Suppose
James's marginal tax rate is 28 percent. He would have to earn $1388.89 ($1000 = $1388.89 ($1388.89 x .28)) in order to have $1000 after taxes to pay for the premium himself. Thus the
value of the exemption to James is $388.89. Suppose James expects to get back $800 in
benefits. The net cost of insurance (the difference between the premium and benefits) is $1000
 $800, or $200. James's bottom line cost is the difference between the net cost of the
insurance, $200, and the value of the insurance premium, $388.89. Thus, the net cost is a
negative $188.89.
11. What are the key elements of managed care? Evaluate managed care in terms of its effect
on the rate of increase in health care expenditures.
Managed care is health care that is reviewed by someone other than the patient or the provider
to determine whether the right services are being provided and whether the cost of provision is
minimized. In some instances, the reviewer may decide that the charge for a certain service is
excessive and refuse to make a full third payment. In such a case, the patient must take
responsibility for the charges. Furthermore, the reviewer can determine a procedure to be
Instructor's Manual  105
unnecessary and refuse to make any payment. In this case, the patient is forced to recognize
the cost of the procedure.
Managed care insurers pay less to medical providers than did the traditional insurers, through
negotiations with the providers. It also saves money though restrictions on what services are
provided through a utilization review. Financial incentives are also used to reinforce the
restrictions. In addition to lowering fees, managed care creates financial incentives for
providers to provide fewer services.
In exchange for tighter restrictions on utilization, managed care offers lower out-of-pocket
payments. Most managed care plans charge very low fees - $5 or $10 - per physician visit,
substantially below what people paid in traditional policies. This is done in the hope that it will
increase preventive care, thereby reducing the incidence of higher cost health episodes. The
goal of managed care is to limit use of the system when patients access it, not to keep them
away from it.
12. In theory, vouchers should reduce excess health care spending. Explain why.
One possible way to reduce overspending for health care without denying benefits to program
recipients would be to replace the current system of reimbursement with a system of vouchers.
Their use has been suggested most often for Medicare and Medicaid patients. Vouchers are
coupons that the recipient can use to pay for something, in this case health care at hospitals or
doctors' offices chosen by the recipient. Alternatively, the individual could be required to use
the voucher to purchase a conventional health insurance policy or to participate in a lower-cost
managed care system. In fact, the voucher program could be tailored to encourage recipients to
choose managed care by providing a slightly larger voucher for those who do.
The government could save costs by issuing vouchers for a smaller amount than it currently
spends. Economists argue that this could be done without materially reducing beneficial health
care to the recipients because they would be faced with a greater share of the costs of their own
care and make better health care choices. Proponents of vouchers also stress that their use
would enhance price (and cost) competition by health care providers for Medicare and
Medicaid patients.