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Final Exam HCA 451 – Economics of Health Spring 2021 The Final Exam consists of the five short-answer/essays below

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Final Exam HCA 451 – Economics of Health Spring 2021 The Final Exam consists of the five short-answer/essays below. Provide your responses on this document and submit under the Drop Box on Beachboard for the Final Exam. Provide your word count for those with a minimum word count. Cite references as needed. Each question is worth 20 points. 1. Are public choices better or worse than private choices? Address the pros and cons of each with respect to health care. (150 word minimum) {Chapter 1 – normative and positive judgments} 2. Give three good reasons why someone might choose to pay $1,150 for health insurance when the actuarially fair premium was only $900. (no word minimum but you should have three clear and distinct reasons) {Chapter 4 – Load, gains from trade) 3. Which government insurance program is more affected by adverse selection, Medicare or Medicaid? Justify your response. (150 word minimum) {Chapter 5 – adverse selection} 4. Which factor has accounted for more of the increase in the cost of hospital care per patient: increases in the number of physicians, the number of days of care, physician incomes, wages of non-physician employees, or number of non-physician employees? (Address each factor in your response: 150 word minimum) {Chapter 13 – flow of funds} 5. Why redistribute health insurance costs and not automobile insurance costs? (150 word minimum) {Chapter 18 – distribution} Final Exam HCA 451 – Economics of Health Spring 2021 FIFTH EDITION Health Economics and Financing Thomas E. Getzen This page is intentionally left blank HEALTH ECONOMICS AND FINANCING This page is intentionally left blank HEALTH ECONOMICS AND FINANCING Fifth Edition Thomas E. Getzen Temple University and iHEA VP & Executive Publisher Executive Editor Content Editor Assistant Editor Senior Editorial Assistant Associate Director of Marketing Senior Marketing Manager Marketing Assistant Product Designer Media Specialist Senior Production Manager Associate Production Manager Production Editor Designer Cover Photo George Hoffman Joel Hollenbeck Jennifer Manias Courtney Luzzi Erica Horowitz Amy Scholz Jesse Cruz Justine Kay Greg Chaput Daniela DiMaggio Janis Soo Joel Balbin Yee Lyn Song Kenji Ngieng c Pawel Gaul/istockphoto This book was set in Minion by Aptara, Inc. and printed and bound by Courier Kendallville. The cover was printed by Courier Kendallville. This book is printed on acid-free paper. ∞ Founded in 1807, John Wiley & Sons, Inc. has been a valued source of knowledge and understanding for more than 200 years, helping people around the world meet their needs and fulfill their aspirations. Our company is built on a foundation of principles that include responsibility to the communities we serve and where we live and work. In 2008, we launched a Corporate Citizenship Initiative, a global effort to address the environmental, social, economic, and ethical challenges we face in our business. Among the issues we are addressing are carbon impact, paper specifications and procurement, ethical conduct within our business and among our vendors, and community and charitable support. For more information, please visit our website: www.wiley.com/go/citizenship. c 2013, 2010, 2007, 2004 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be Copyright reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, website http://www.wiley.com/go/permissions. Evaluation copies are provided to qualified academics and professionals for review purposes only, for use in their courses during the next academic year. These copies are licensed and may not be sold or transferred to a third party. Upon completion of the review period, please return the evaluation copy to Wiley. Return instructions and a free of charge return mailing label are available at www.wiley.com/go/returnlabel. If you have chosen to adopt this textbook for use in your course, please accept this book as your complimentary desk copy. Outside of the United States, please contact your local sales representative. Library of Congress Cataloging-in-Publication Data Getzen, Thomas E. Health economics and financing / Thomas E. Getzen.—5th ed. p. ; cm. Includes bibliographical references and index. ISBN 978-1-118-18490-5 (cloth : alk. paper) I. Title. [DNLM: 1. Economics, Medical—United States. 2. Delivery of Health Care—economics—United States. 3. Health Care Reform—economics—United States. W 74 AA1] 2013 338.4 33621–dc23 2012028595 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 —to Karen, Matt, Zoa, and Kayla This page is intentionally left blank BRIEF CONTENTS Preface xxiii Acknowledgments About the Author Foreword 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 xxv xxvi xxvii Choices: Money, Medicine, and Health 1 Demand and Supply 23 Cost–Benefit and Cost-Effectiveness Analysis 44 Health Insurance: Financing Medical Care 69 Insurance Contracts and Managed Care 96 Physicians 124 Medical Education, Organization, and Business Practices 146 Hospitals 172 Management and Regulation of Hospital Costs 191 Long-Term Care 212 Pharmaceuticals 236 Financing and Ownership of Health Care Providers 259 Macroeconomics of Medical Care 292 The Role of Government and Public Goods 319 History, Demography, and the Growth of Modern Medicine 347 International Comparisons of Health and Health Expenditures 372 17 Economic Evaluation of Health Policy: The Patient Protection and Affordable Care Act of 2010 408 18 Value for Money in the Future of Health Care 427 Glossary 443 Index 453 vii This page is intentionally left blank CONTENTS Preface xxiii Acknowledgments About the Author Foreword 1 xxv xxvi xxvii Choices: Money, Medicine, and Health 1 Questions 1.1 1 WHAT IS ECONOMICS? 2 Terms of Trade 2 Value 3 Can We Pay Somebody to Care? 3 Financing Health Care 4 Full Cost: Paying for Medical Care 5 1.2 THE FLOW OF FUNDS 6 Health Care Spending in the United States 7 Sources of Financing 7 Health Care Providers: The Uses of Funds 10 1.3 ECONOMIC PRINCIPLES AS CONCEPTUAL TOOLS 11 Scarcity (Budget Constraints) 12 Opportunity Cost 12 Willingness to Pay 12 Trade 12 Money Flows in a Circle 12 The Margin: What Matters? 13 Maximization: Marginal Costs and Marginal Benefits 13 Choice: Are Benefits Greater than Costs? 13 Investment 13 Contracts: Complex Exchanges to Deal with Timing and Risk Organizations Adapt and Evolve 14 Distribution: Who Gets What 14 1.4 HEALTH DISPARITIES 1.5 WHOSE CHOICES: PERSONAL, GROUP, OR PUBLIC? 14 15 16 ix x CONTENTS 1.6 SOCIAL SCIENCE AND RATIONAL CHOICE THEORY Suggestions for Further Reading 19 Summary 19 Problems 20 Endnotes 21 2 18 Demand and Supply 23 Questions 2.1 23 THE DEMAND CURVE 23 The Diamonds–Water Paradox: An Example of Marginal Analysis 24 Consumer Surplus: Marginal versus Average Value of Medicine 25 Ceteris Paribus 27 Individual, Firm, and Market Demand Curves 27 2.2 THE SUPPLY CURVE Marginal Revenue 2.3 27 28 PRICE SENSITIVITY 28 Price Elasticity and Marginal Revenue Price Discrimination 31 30 2.4 IS MONEY THE ONLY PRICE? 2.5 INPUTS AND PRODUCTION FUNCTIONS Production Functions Marginal Productivity 32 33 33 33 2.6 MARKETS: THE INTERSECTION OF DEMAND AND SUPPLY 2.7 NEED VERSUS DEMAND 35 How Much is a Doctor Visit Worth? 36 The Demand for Medical Care is Derived Demand 37 The Demand for Health: What Makes Medical Care Different 2.8 DETERMINANTS OF HEALTH 2.9 EFFICIENCY 38 Suggestions for Further Reading Summary 40 Problems 42 Endnotes 43 3 38 40 Cost–Benefit and Cost-Effectiveness Analysis 44 Questions 3.1 34 44 COST–BENEFIT ANALYSIS IS ABOUT MAKING CHOICES An Everyday Example: Knee Injury 45 Stepwise Choices: Yes or No? How Much? 48 45 37 CONTENTS Calculating Marginal and Average Costs 49 Defining Marginal: What Is the Decision? 50 3.2 MAXIMIZATION: FINDING THE OPTIMUM Declining Marginal Benefits 55 Optimization: Maximum Net Benefits Expected Value 56 54 55 3.3 THE VALUE OF LIFE 57 3.4 QUALITY-ADJUSTED LIFE YEARS (QALYs) 59 Discounting Over Time 60 QALY League Tables 60 3.5 PERSPECTIVES: PATIENT, PROVIDER, PAYER, GOVERNMENT, SOCIETY 62 Distribution: Whose Costs and Whose Benefits? CBA and Public Policy Decision Making 63 CBA Is a Limited Perspective 63 Suggestions for Further Reading Summary 64 Problems 65 Endnotes 67 4 64 Health Insurance: Financing Medical Care 69 Questions 4.1 69 METHODS FOR COVERING RISKS 69 Savings 70 Family and Friends 70 Charity 70 Private Market Insurance Contracts 71 Social Insurance 71 Strengths and Weaknesses of Different Forms of Risk Spreading 72 4.2 INSURANCE: THIRD-PARTY PAYMENT 73 Why Third-Party Payment? 73 Variability 75 Third-Party Transactions 75 Who Pays? How Much? 76 How Are Benefits Determined? 77 4.3 RISK AVERSION 78 4.4 ADVERSE SELECTION 4.5 MORAL HAZARD 79 81 Welfare Losses Due to Moral Hazard Ex Ante Moral Hazard 85 83 62 xi xii CONTENTS 4.6 TAX BENEFITS 85 4.7 EFFECTS OF HEALTH INSURANCE ON LABOR MARKETS 4.8 HISTORY OF HEALTH INSURANCE Suggestions for Further Reading 89 Summary 90 Problems 91 Endnotes 93 5 86 87 Insurance Contracts and Managed Care 96 Questions 5.1 96 SOURCES OF INSURANCE 96 Employer-Based Group Health Insurance 97 Medicare 98 Medicaid 100 State Children’s Health Insurance Program 100 Other Government Programs and Charity 100 The Uninsured 100 5.2 CONTRACTING AND PAYMENTS 101 Insurance Companies are Financial Intermediaries 101 Risk Bearing: From Fixed Premiums to Self-Insurance 101 Purchasing Medical Care For Groups 102 Medical Loss Ratios 103 Claim Processing 104 The Underwriting Cycle 104 ERISA, Taxes, and Mandated Benefits 105 Other People’s Money: Rising Costs and Mediocre Results 106 5.3 CONSUMER-DRIVEN HEALTH PLANS: HIGH DEDUCTIBLES AND HEALTH SAVINGS ACCOUNTS 108 Defined Contribution Health Plans 5.4 MANAGED CARE 109 109 Closed-Panel Group Practice HMOs 109 IPA-HMOs and Open Contracts 110 Managed Care Contract Provisions 111 The Range of Managed Care Contracts: POS, PPO, HMO 113 Management: The Distinctive Feature of Managed Care 114 Provider Networks and Legal Structure 114 Contractual Reforms to Control Costs 116 5.5 UNRESOLVED ISSUES: SPLIT INCENTIVES, DIVIDED LOYALTIES 117 Suggestions for Further Reading 118 Summary 119 CONTENTS Problems Endnotes 6 xiii 120 122 Physicians 124 Questions 6.1 124 FINANCING PHYSICIAN SERVICES: REVENUES 124 Copayments, Assignment, and Balance Billing 128 Physician Payment in Managed Care Plans 129 Incentives: Why Differences in the Type of Payment Matter A Progression: From Prices to Reimbursement Mechanisms 130 6.2 PHYSICIAN INCOMES 6.3 PHYSICIAN FINANCING: EXPENSES 131 132 Physician Practice Expenses 132 The Labor versus Leisure Choice 133 The Doctor’s Workshop and Unpaid Hospital Inputs Malpractice 135 6.4 130 THE MEDICAL TRANSACTION 134 135 Asymmetric Information 136 Agency: Whose Choices? 136 6.5 UNCERTAINTY 136 6.6 LICENSURE: QUALITY OR PROFITS? 137 How Does Licensure Increase Physician Profits? 138 Supply and Demand Response in Licensed versus Unlicensed Professions 139 How Does Licensure Improve Quality? 140 A Test of the Quality Hypothesis: Strong versus Weak Licensure 140 Suggestions for Further Reading Summary 142 Problems 143 Endnotes 144 7 141 Medical Education, Organization, and Business Practices 146 Questions 146 7.1 MEDICAL EDUCATION 146 7.2 THE ORIGINS OF LICENSURE AND LINKAGE TO MEDICAL EDUCATION 147 AMA Controls over Physician Supply, 1930–1965 148 Breaking the Contract: The Great Medical Student Expansion of 1970–1980 149 xiv CONTENTS Building Pressure: Fixed Domestic Graduation Rates, 1980–2010 151 7.3 ADJUSTING PHYSICIAN SUPPLY 151 The Flow of New Entrants and the Stock of Physicians 151 Immigration of International Medical Graduates 152 Growth in Non-MD Physicians 152 Balancing Supply and Incomes: Tracing the Past and Projecting the Future 152 7.4 GROUP PRACTICE: HOW ORGANIZATION AND TECHNOLOGY AFFECT TRANSACTIONS 153 7.5 KICKBACKS, SELF-DEALING, AND SIDE PAYMENTS 7.6 PRICE DISCRIMINATION 7.7 PRACTICE VARIATIONS 7.8 INSURANCE, PRICE COMPETITION, AND THE STRUCTURE OF MEDICAL MARKETS 161 157 159 7.9 CHOICES BY AND FOR PHYSICIANS Suggestions for Further Reading 165 Summary 165 Problems 166 Endnotes 169 8 156 164 Hospitals 172 Questions 172 8.1 FROM CHARITABLE INSTITUTIONS TO CORPORATE CHAINS: DEVELOPMENT OF THE MODERN HOSPITAL 172 8.2 HOSPITAL FINANCING: REVENUES Sources of Revenues 173 175 8.3 HOSPITAL FINANCING: EXPENSES 180 8.4 FINANCIAL MANAGEMENT AND COST SHIFTING 8.5 HOW DO HOSPITALS COMPETE? 181 Competing for Patients 182 Competing for Physicians 182 Competing for Contracts 183 Measuring Competitive Success 184 Measuring the Competitiveness of Markets 8.6 184 ORGANIZATION: WHO CONTROLS THE HOSPITAL AND FOR WHAT ENDS? 185 Suggestions for Further Reading 186 Summary 186 Problems 188 Endnotes 189 180 CONTENTS 9 Management and Regulation of Hospital Costs 191 Questions 191 9.1 WHY DO SOME HOSPITALS COST MORE THAN OTHERS? 9.2 HOW MANAGEMENT CONTROLS COSTS 192 Short-Run versus Long-Run Cost Functions Uncertainty and Budgeting 194 9.3 198 ECONOMIES OF SCALE 199 The Hospital Is a Multiproduct Firm Contracting Out 200 9.5 192 CONFLICT BETWEEN ECONOMIC THEORY AND ACCOUNTING MEASURES OF PER UNIT COST 196 Timing 196 Whose Costs? 9.4 191 QUALITY AND COST 200 200 Technology: Cutting Costs or Enhancing Quality? 200 Improved Efficiency May Raise Total Spending 201 9.6 HOSPITAL CHARGES, COSTS, AND PRICES: CONFUSION AND CHAOS 202 Chargemaster and Negotiated Fees 202 Cost Finding: Gross Revenues and the RCCAC Medicare as a Standard for Pricing 203 203 9.7 CONTROLLING HOSPITAL COSTS THROUGH REGULATION 204 Suggestions for Further Reading 208 Summary 208 Problems 209 Endnotes 210 10 Long-Term Care 212 Questions 212 10.1 DEVELOPMENT OF THE LONG-TERM CARE MARKET 213 10.2 AGE AND HEALTH CARE SPENDING 10.3 DEFINING LTC: TYPES OF CARE 10.4 MEDICAID: NURSING HOMES AS A TWO-PART MARKET 10.5 CERTIFICATE OF NEED: WHOSE NEEDS? 214 216 221 Money and Quality 221 Competing for Certificates of Need, Not for Patients Evidence on the Effects of Certificates of Need 222 10.6 COST CONTROL BY SUBSTITUTION 10.7 CASE-MIX REIMBURSEMENT 224 223 222 218 xv xvi CONTENTS 10.8 LONG-TERM CARE INSURANCE Is Long-Term Care “Medical”? 10.9 226 226 RETIREMENT, ASSISTED LIVING, AND THE WEALTHY ELDERLY 227 10.10 FINANCIAL REIMBURSEMENT CYCLES Suggestions for Further Reading 231 Summary 232 Problems 233 Endnotes 234 11 229 Pharmaceuticals 236 Questions 11.1 236 PHARMACEUTICAL REVENUES: SOURCES OF FINANCING 237 Inpatient Pharmaceuticals 11.2 USES OF FUNDS 238 239 Retail Pharmacies 239 Wholesalers 240 Insurance Companies and PBMs Pharmaceutical Firms 241 Cost Structure 242 240 11.3 HISTORY AND REGULATION OF PHARMACEUTICALS 11.4 RESEARCH AND DEVELOPMENT 11.5 PHARMACOECONOMICS AND TECHNOLOGY ASSESSMENT 11.6 INDUSTRY STRUCTURE AND COMPETITION 246 249 Value, Cost, and Marketing 250 The Role of Middlemen: Distribution versus Marketing Research Productivity 253 Suggestions for Further Reading Summary 255 Problems 256 Endnotes 257 12 242 251 255 Financing and Ownership of Health Care Providers 259 Questions 259 12.1 WHAT IS FINANCING? 260 12.2 VALUE AND RATE OF RETURN 260 The Time Value of Money 260 Interest Rates and Present Value 261 IRR: The Internal Rate of Return 262 Human Capital: Medical Education as an Investment 264 248 CONTENTS Risk 265 Valuing Assets 12.3 267 UNCORRELATED (INDEPENDENT) AND CORRELATED (SYSTEM) RISKS 268 Which Is Riskier: Nursing Homes or Drug Companies? Assessing Business Risk 269 12.4 xvii OWNERSHIP AND AGENCY 269 270 Equity and Debt 271 Who Owns the Business? Who Owns the Patient? Agency Issues The Role of Financial Intermediaries 273 12.5 CAPITAL FINANCING: HOSPITALS 12.6 HMO OWNERSHIP AND CAPITAL MARKETS: SUCCESS AND FAILURE 277 272 274 Business Risks for an HMO 277 Kaiser Health Plan: The Evolution of an HMO 277 Group Health Association: A Consumer Co-op Gets Bought Out by a Franchise Chain 280 12.7 ENTREPRENEURSHIP AND PROFITS 280 U.S. Healthcare: A Profitable Growth Company 12.8 HEALH CARE FOR PROFIT, OR NOT 281 283 Differences Between For-Profit and Nonprofit Behavior 285 Charity Care: For Real or for Show? 285 For-Profit or Not-for-Profit: Which is Better? 285 Medical Care is Difficult: Risk, Information Asymmetry, Social Justice 286 Suggestions for Further Reading Summary 287 Problems 288 Endnotes 289 13 287 Macroeconomics of Medical Care 292 Questions 13.1 292 WHAT IS MACRO? 292 Micro and Macro Perspectives on Spending 13.2 THE CONSUMPTION FUNCTION 293 294 The Permanent Income Hypothesis 296 Shared Income 296 Public and Private Decisions 298 Budget Constraints: Borders that Matter 298 13.3 ADJUSTING TO CHANGE: DYNAMICS 299 Permanent Income and Adjustment of Health Spending to GDP 301 xviii CONTENTS Adjustment to Inflation 302 Adjustment to GDP: Rates of Change and Time Series Analysis 304 13.4 FORECASTING FUTURE HEALTH EXPENDITURES 13.5 COST CONTROLS: SPENDING GAPS AND THE PUSH TO REGULATE 307 Capacity Constraints and Budget Constraints 13.6 309 WORKFORCE DYNAMICS: “SPENDING” IS MOSTLY LABOR Employment Wages 312 309 309 Suggestions for Further Reading Summary 315 Problems 315 Endnotes 317 14 306 314 The Role of Government and Public Goods 319 Questions 14.1 319 THE ROLES OF GOVERNMENT 320 Markets are Perfectly Efficient, but Only with Perfect Competition 320 Government in a Mixed Economy 321 How Government Works 321 The Voluntary Sector 322 Government is Necessary, and Costly 322 Markets are Costly, Limited, and Always Regulated 323 14.2 GOVERNMENT HEALTH FINANCING 14.3 LAW AND ORDER 14.4 PUBLIC GOODS AND EXTERNALITIES 323 325 326 Privatizing Public Goods 327 Insurance Makes Any Good More Public 327 Externalities 327 The Coase Theorem: Transaction Costs and Property Rights 14.5 MONOPOLY AND MARKET FAILURE 14.6 INFORMATION 328 330 Rational Consumer Ignorance 331 Social Costs Depend on the Number of People 331 Milk or Bread: Which Is More Public? 332 Infectious Disease Externalities 333 Epidemics 333 The Sanitary Revolution: A Moral Campaign for Public Health 334 Formation of the U.S. Public Health Service 335 328 CONTENTS 14.7 DRUGS, SEX, AND WAR: PUBLIC HEALTH IN ACTION 335 Addiction 336 Sexual Behavior 336 Who Counts as a Citizen? Abortion and Other Dilemmas War and Public Health 337 14.8 POLITICS, REGULATION, AND COMPETITION xix 336 338 Politicians: Entrepreneurs Who Try to Get Votes 338 Government as the Citizen’s Agent 339 Public Goods Make Almost Everybody Better Off But Nobody Happy 341 Winners and Losers 341 14.9 TRUST, CARE, AND DISTRIBUTION Suggestions for Further Reading 343 Summary 343 Problems 344 Endnotes 346 15 341 History, Demography, and the Growth of Modern Medicine 347 Questions 347 15.1 ECONOMIC GROWTH HAS DETERMINED THE SHAPE OF HEALTH CARE 347 15.2 BIRTH RATES, DEATH RATES, AND POPULATION GROWTH 15.3 THE STONE AGE 15.4 THE AGRICULTURAL AGE 348 349 Investment and Trade 349 Civilization, War, and Government 350 The Decline of Civilizations Leads to Population Declines The Plague 351 Food Supply Determines Population 352 The Rise of Economics 352 The Malthusian Hypothesis 353 15.5 348 THE INDUSTRIAL AGE 351 354 Why Malthus Was Wrong 354 Demographic Transition 355 Demographic Change, Income Distribution, and the Rise of the Middle Classes 357 15.6 THE INFORMATION AGE 358 15.7 INCOME AND HEALTH 15.8 REDUCING UNCERTAINTY: THE VALUE OF LIFE AND ECONOMIC SECURITY 361 359 The Value of Risk Reduction 361 Social Security and Health Insurance 362 xx CONTENTS 15.9 THE RISE OF MODERN MEDICINE 363 Preconditions for Change 363 The Growth of Medical Science and Technology 363 Did Better Medical Care Increase Life Expectancy? 365 Suggestions for Further Reading Summary 366 Problems 368 Endnotes 369 16 366 International Comparisons of Health and Health Expenditures 372 Questions 16.1 372 WIDE DIFFERENCES AMONG NATIONS Size of the Market 372 374 16.2 MICRO VERSUS MACRO ALLOCATION: HEALTH AS A NATIONAL LUXURY GOOD 375 16.3 CAUSALITY: DOES MORE SPENDING IMPROVE HEALTH? 16.4 LOW-INCOME COUNTRIES Health Care in Ghana Sudan 382 16.5 378 379 MIDDLE-INCOME COUNTRIES 383 China 384 The Health Care System of Mexico Poland 389 16.6 16.7 377 HIGH-INCOME COUNTRIES 388 391 Health Care in Japan 392 The Health System in Germany 395 The Expensive Exception: The United States 399 INTERNATIONAL TRADE IN HEALTH CARE 401 People and Ideas 402 Services 402 Equipment 402 Pharmaceuticals 403 Suggestions for Further Reading Summary 404 Problems 405 Endnotes 406 17 404 Economic Evaluation of Health Policy: The Patient Protection and Affordable Care Act of 2010 408 Questions 17.1 408 PPACA 2010: DESCRIPTION OF MAIN ELEMENTS Coverage Rules 410 409 xxi CONTENTS State Health Insurance Exchanges 411 Individuals 412 Employers: Positive and Negative Incentives to Provide Benefits 413 Medicare: ACOs, IPAB, Bundled Payments, and the Donut Hole 414 Medicaid: Major Expansions with Federal Funding 415 Prevention and Other Provisions of PPACA 415 Still Uninsured: The Undocumented and Some Other Outsiders 416 17.2 STATEMENT OF THE PROBLEM: AFFORDABILITY 416 Rising Costs Slowly Create a Crisis 416 The Middle Class Gets Stretched: A Leveraged Gap in Coverage Macro Affordability: The Growth Gap 418 17.3 USING EXISTING PLANS AS MODELS 419 States 419 The Federal Employees Health Benefits Plan 17.4 UNRESOLVED ISSUES 417 419 420 Equity 420 Defining Essential Benefits 421 The OPM Legacy: Third-Party Payment and Cost Shifting 421 Price Transparency: A Conspiracy of Silence 421 The Uninsured: Still There, Still Have to be Paid For 422 Unfunded Health and Retirement Benefits 422 Defined Benefits, Defined Services, or Defined Contribution 423 Who Bears the Risk? 423 Suggestions for Further Reading Summary 424 Problems 425 Endnotes 425 18 424 Value for Money in the Future of Health Care 427 Questions 427 18.1 FORCING THE QUESTION: WHO GETS HEALTHY AND WHO GETS PAID? 427 18.2 SPENDING MONEY OR PRODUCING HEALTH? 18.3 DYNAMIC EFFICIENCY 18.4 DISTRIBUTION, DISTRIBUTION, DISTRIBUTION 18.5 PATH DEPENDENCE AND THE POSSIBILITIES FOR REFORM 429 430 432 How Did We Get Here? 433 What Did Medicine Miss? 434 What Went Wrong? Notable Failures and Unresolved Dilemmas 434 18.6 THE PATH FORWARD: STEP BY STEP 436 433 xxii CONTENTS 18.7 THE SHAPE OF HEALTH CARE SPENDING TO COME 18.8 THE LONG RUN: 2050 AND BEYOND Suggestions for Further Reading 439 Summary 439 Problems 440 Endnotes 441 Glossary Index 453 443 438 437 PREFACE Health Economics and Financing is a primer for the economic analysis of medical markets. Its intended audiences are students of medicine, public health, policy, and administration who wish to engage the central economic issues of their field without prolonged preparatory work; beginning students in economics who wish to study an applied area in detail without recourse to extensive mathematical manipulation; and more advanced students in economics who may be familiar with analytical techniques but lack knowledge of the many institutional features that make the study of health and health care so unique and rewarding.1 This book draws upon the work of many scholars, but in keeping with its design as a primer for introducing students to the principles and concepts of health economics rather than its literature and research methods, the use of attribution, footnotes, and references is purposely limited. Suggestions for additional reading and more advanced source materials and databases are listed at the end of each chapter and are available on the text website at www.wiley.com/college/getzen or from the author at getzen@temple.edu. The first eleven chapters use a flow-of-funds approach to investigate the sources and uses of financing and to explore the incentives and organizational structure of the health care system. Transactions between patients and physicians (and others) are examined to see how profits are made, costs covered, contracts written (or implied), and regulations formed. The long-term consequences of exchanging services for money in a particular way are revealed by exploring the historical development of those distinctive features that characterize the industrial organization of health care: licensure, third-party insurance, nonprofit hospitals, and government regulation. The last seven chapters take a wider macroeconomic perspective in order to explore the dynamics of change within the health care system and to explicitly consider determinants of national health spending and the role of governments in public and private health. The introductory chapter lays out the overall flow of funds, schematically presents the complexity of medical care transactions, and introduces the basic principles that form the toolkit for economic analysis. Chapter 2 examines the economic concept of demand and compares it to the medical concept of need. Chapter 3 applies the basic principles of supply and demand, marginalism and equilibrium, using a cost–benefit approach in a clinical context. The more detailed investigation of medical care organization begins in Chapters 4 and 5 on insurance and third-party reimbursement, which has become the dominant source of funds in medical care. The physician whose role as the patient’s agent and a central player in all medical care transactions is the subject of the next two chapters. Chapters 8 and 9 cover the reimbursement, regulation, and cost structure of hospitals. Nursing homes, long-term care, and the effects of aging on medical costs are covered in Chapter 10. In Chapter 11, pharmaceuticals provide an exemplar of the modern “information economy,” where the fixed costs of research and marketing outweigh the cost of production and where competition relies on continuous 1 The special features, which make medical care so interesting as a subject for economic analysis, also tend to make the application of simple models difficult or implausible. Students who have the desire and opportunity to do so are well advised to get a firm grasp of basic principles using a text such as Heyne’s The Economic Way of Thinking or Samuelson’s Economics before attempting to grapple with the complexities and ambiguities of medical care. xxiii xxiv PREFACE innovation. In Chapter 12, the means and consequences of access to capital for health care providers are briefly reviewed, with particular attention to the implication of nonprofit status and ownership structure. To understand the interactions between component parts of the system, it is necessary to place health care in a macroeconomic context that includes redistribution, taxation, inflation, and growth. The dynamics of national health expenditure are presented in Chapter 13 as an application of the permanent income hypothesis. Chapter 14 explores the role of government, public goods, and public health. The economic history of health is traced in Chapter 15, drawing on the contributions of demography and the cliometric work of Fogel and North. Chapter 16 provides international comparisons of health and medical care expenditures, taking Ghana, Sudan, China, Mexico, Poland, Germany, and Japan as illustrative examples. Health policy, reform, and the Patient Protection and Affordable Care Act of 2010 are described and discussed at length in Chapter 17. A final chapter addresses the probable trends in health care spending, suggesting that the primary barrier to increased effectiveness and efficiency is poor allocation and problems of effective political alignment. Health economics is fascinating to study, but it is not easily summarized or readily captured in neat equations. In part, this is because the study of health economics is relatively new and still in the process of refinement, but primarily it is because the transactions made by doctors and hospitals are not simple, and they cut to the heart of what it means to be human. What is the value of life? Who pays the price of pain, and what does it mean to trust a surgeon who profits because of a crisis? Because most medical care is funded through taxes and insurance, there is no direct linkage between the amount paid and the resources used in treatment. As a consequence, “prices” become more ambiguous and are often of less immediate relevance to the trading parties than ongoing relationships of trust and professional behavior. It is important to understand how economic forces continue to operate when markets are indirect and inefficient, and how other organizing principles (professionalism, licensure, agency, regulation) act as substitutes for prices. Although most of the special features of medical markets are there to make people better off, they have also been shaped by groups who had the power to modify the rules in their own interest, subject to the controls of economic and political competition. Tracing the economic rationale and development of medical care licensure and organization and making those forces more clearly visible and amenable to analysis is the purpose of this book. CHANGES FOR THE FIFTH EDITION As this preface is written (April 2012) the United States once again appears to be standing on the cusp of a major change in health care and medical financing—but such moments have come and gone before. The potential for change, and the well-grounded expectation that any changes will grow out of what has come before (a process known as “path dependence”) is addressed in Chapter 18. Forecasts of the future are necessarily somewhat speculative, but this chapter does offer students and instructors some chance to step back and think about some general policy principles and the practical aspects of forecasting in an economy for which change is constant. It can also provide a brief introduction to behavioral economics, the dynamics of technological change, the expansion of welfare to include “happiness” and alternative valuations of “GDP,” disequilibrium, and some other issues that are now at the forefront of contemporary economics research. Most students need to obtain a set of skills, an economics toolkit, in order to work. This fifth edition continues to emphasize basic “principles” (opportunity cost, scarcity, demand, marginal revenue, value, fundamental theory of exchange) in Chapters 1 and 2. For classes emphasizing economic evaluation, a more detailed quantitative and diagrammatic presentation can be quite useful. For general classes directed toward clinicians, administrators, or policy makers, it can be a bit too long and dry, severely taxing their enthusiasm for health PREFACE xxv economics before they have fully worked through the mechanics of determining the marginal rate of technical substitution. I usually find time to review this material in most classes by adjusting the length of the presentation and the number of illustrative examples to the extent of familiarity within that particular class setting. Teaching notes, presentation slides, and problem sets for all chapters can be found online at http://www.wiley.com/college/getzen. World Wide Web references are used throughout the text to provide access to constantly updated material. There are links to a variety of major sources of health economics data and commentary such as the National Center for Health Statistics, World Health Organization, Organisation for Economic Cooperation and Development, Centers for Disease Control and Prevention, Centers for Medicare and Medicaid Services, Government Accountability Office, and others. Your comments and queries are welcome. For adopting professors, online help, answers to all problems, and chapter teaching guidelines are available through the text website and also through email at getzen@temple.edu. ACKNOWLEDGMENTS The writing of this book incurred intellectual and personal debts sufficient to preclude any complete listing of those who have contributed. My family and extended family (Rufus and Beverley Getzen, Sydney White, Bill W.) come first. My initial research on these topics began at the University of Washington, with the assistance of Yoram Barzel, Gardner Brown, Steve Shortell, Bill Richardson, and Mike Morrisey and while working under Gordon Bergey, who was an exemplar of the concerned physician and administrator. I am indebted to the efforts of Joe Newhouse, Mark Pauly, Tony Culyer, Morris Barer, Mike Drummond, Bill Swan, and others who have done so much to build the field and create a rigorous body of literature in health economics, and I thank them for their service to i HEA. Patrick Bernet of Florida Atlantic University created and revised the Instructor’s Manual, and Laura Shinn (CHERP) and Maia Platt of University of Detroit-Mercy created and updated the new Test Bank and PowerPoint slides. David Barton Smith, Bill Aaronson, Chuck Hall, Jackie Zinn, and other colleagues at Temple have shaped the health economics course as it was taught. Alan Maynard sheltered and inspired me during my sabbatical at York, during which the first edition was begun, Richard “Buz” Cooper schooled me on workforce projections, and Uwe Reinhardt has always kept me informed, amused, and concerned. The numerous reviewers over five editions have provided invaluable feedback and suggestions. The usual and heartfelt disclaimer applies: All remaining errors are mine. ABOUT THE AUTHOR Thomas E. Getzen is Emeritus Professor of Risk, Insurance, and Health Management at Temple University and the founder and Executive Director of i HEA, the International Health Economics Association. After receiving an undergraduate degree in literature from Yale University, he worked for the U.S. Public Health Service Centers for Disease Control venereal disease program in New York and Los Angeles, and then obtained a Master of Health Administration degree in Medical Care Organization and a Ph.D. in Economics from the University of Washington. Dr. Getzen’s main research contributions have been in the areas of contracting, price indexes, and forecasting of health care spending. His consulting work has included employee benefit negotiations, projections of health care cost trends and premiums, laboratory diagnostics, risk assessment, and capital financing for managed care. Dr. Getzen has been a visiting professor at the University of Toronto, the Center for Health and Wellbeing of the Woodrow Wilson School at Princeton University, the Wharton School at the University of Pennsylvania, and the University of York (UK). He has served on the boards of Covenant House, a local community health center in northwest Philadelphia; MSI, a venture capital–financed managed behavioral health care corporation; and CHE, a multi-institutional health provider system with more than 30 hospitals and nursing homes. He is the editor-in-chief for the “HEN -Health Economics Network” in collaboration with SSRN, associate editor for Health Economics, and a reviewer for a number of medical, health services, and economics journals. Professor Getzen periodically updates the forecasting model of “Long Run Medical Cost Trends” for the Society of Actuaries, and he currently serves on the National Academy of Sciences IOM Committee on the Future of Public Health. xxvi FOREWORD Public policy in almost any field depends on specific knowledge of the field, but it usually also depends (or should depend) on general principles of economics. For example, the building of a bridge requires knowledge of engineering to know what is feasible; it requires knowledge of traffic patterns; and it requires knowledge of economic principles, to see whether the traffic that will use the bridge and the value of the time saving to that traffic will justify the costs imposed by the engineering requirements. So, too, there is a need of economic analysis to help in the construction of a system of health care. First of all, indeed, we must know what medical care can do, and how much in the way of skilled professionals, other workers, machinery, and buildings it takes to achieve any given level of medical care. But second, we must analyze how the payment mechanisms to compensate for these supplies affect the delivery of medical care. Medical care is indeed a more complex economic problem than bridge-building. Like some other professions but unlike many other goods and even services, it is difficult for the consumer (here the patient) to evaluate the quality of the services received. Much depends on the self-control and reliability of the individual practitioner, the supplying group, and the medical profession as a whole in ways that the patient cannot readily check. Then, too, the service provided is needed only at unpredictable intervals, but it frequently is very important when it is needed. Further, the costs, a reflection of the resources used, are uncertain be very high. All these reasons lead to the use of some form of insurance, a natural economic institution for improving everyone’s welfare. But insurance reduces the incentive of an individual patient or physician to seek the most economical means of treatment. As a result, new institutions and regulations develop to overcome this “moral hazard,” as it has been termed—institutions such as health maintenance organizations, managed care by insurance companies, and regulations such as those that govern Medicare expenditures. The standard paradigms of economics have been enriched to discuss problems such as this. The difficulties of quality evaluation and moral hazard are special cases of a more general phenomenon, differences in information between the two sides of a transaction. These differences, though not confined to medical practice, are especially important there, and have further consequences beyond those already noted, as in the need for licensing physicians or the specially important role of nonprofit institutions. The economic problems of allocating resources to medical care have long been a major part of government economic policy, more in other countries than in the United States. The steady rise in the expenditures on medical care, outstripping the rise in national income by a considerable margin, has brought these issues to the fore of public attention. Equally important has been the increase of explicit consideration of costs within the medical profession; the historically unwelcome trade-off between costs and treatment has come forcibly to the fore. The need for good education and good texts has become acute, and Professor Getzen’s book is a welcome attempt to meet this strongly felt need. Kenneth J. Arrow xxvii This page is intentionally left blank CHAPTER 1 CHOICES: MONEY, MEDICINE, AND HEALTH QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. 9. Who pays when you skip a workout to watch television? Is health scarce? Do some people pay more (or less) than their fair share? Does everyone get the same kind of care? Who decides: the patient, the doctor, the hospital, or the government? Who is made better off: the surgeon or the patient? Why does health care cost so much? Are there futures contracts in health care? Why is health care bought and sold differently from other goods and services? What to do, how to do it, and for whom are core issues of economics. Should Melanie go to the emergency department to have her twisted knee examined now, or should she wait until Tuesday when she already has an appointment with the doctor? Is it better to get medication or surgery for that injury? Which seriously ill patient should get the kidney transplant? Is it worth extending the Supplemental Children’s Health Insurance Program (SCHIP) legislation to cover legal immigrants? Questions like these are dealt with every day in peoples’ homes, in hospitals, and in the halls of Congress. They are the subject of health economics, along with more mundane decisions that cumulatively have an even greater impact on your health: partying until 3 a.m. or getting a good night’s sleep, how much exercise to get, whom to vote for in the next election, whether to major in accounting or enlist in the army reserves, eating more vegetables or less cake, and so on. Economics is often described as the “theory of choice,” and health economics is about the choices people make with regard to health, choices medical providers make in order to care for people and earn money, and choices made collectively (by Congress, community groups, or professional associations). Making a choice means deciding that what is given up—the opportunity cost—is not worth as much as what is obtained. Choosing to go to the doctor for treatment means the time and money it will take is worth less to me than the benefit I expect to receive. A hospital choosing Mark rather than Mary to receive a heart transplant must expect that the therapeutic benefits to (and insurance payments from) Mark are greater than what is lost by leaving Mary on the waiting list. When a patient and a medical provider agree to a transaction, making a trade that exchanges money for services, both have decided that it will make them better off. When Congress votes to expand SCHIP, they have decided that 1 2 CHAPTER 1 CHOICES: MONEY, MEDICINE, AND HEALTH running a temporary deficit, raising taxes, or cutting some other program is less important to the American public than the additional health coverage. 1.1 WHAT IS ECONOMICS? Trade, “making a buck,” is a quintessential economic activity. Its focal point is the market, the place where buyers and sellers exchange dollars for goods and services. Without buyers and sellers there would be no economy: no rich surgeons, no insurance companies, no hospital billing departments (or textbook royalties for economists). To say that there would be no rich surgeons is not a statement of envy but one of fact. Without an advanced economy, a person could not spend 15 years studying and practicing eye surgery, and hence could not provide a highly specialized form of labor that is so much more valuable than digging ditches; therefore, patients could not reap the benefits of so much knowledge and training. For a surgeon to be a seller, the patient must be a buyer. They both must agree on a price so that an exchange can occur. The surgeon would probably prefer that the price be higher and the patient would probably prefer that it be lower, but both must be satisfied in order for a trade to take place. As economists, we can observe that because a transaction took place, there must have been mutual agreement that made both the buyer and the seller better off. If the surgeon would rather have watched television than perform another operation, she would have turned down the case. If the patient would rather have saved the money, or gone to a different surgeon, he could have done so. The insight that both parties must be benefiting if they freely agreed to make a trade is central to an economic vision of the world and is known as the fundamental theorem of exchange. FUNDAMENTAL THEOREM OF EXCHANGE The foundation of market economics is that trade makes both parties better off. People make a deal because they expect it will provide more satisfaction than not making the deal. The surgeon and the patient expect to gain from trade: the surgeon by receiving money and gratitude, the patient by being healed. It might turn out that the patient dies and the surgeon gets sued for malpractice, but both made the transaction with the expectation that they would become better off. Trade does not take advantage of people so that one party is made better off at the expense of the other (that is stealing). Trade takes advantage of differences in skills, endowments, and tastes so that people can make exchanges that are mutually advantageous. Terms of Trade The “terms of trade” specify what the buyer is to give to the seller and what the seller is to give to the buyer in return. When you buy a common item in a store, such as aspirin, a simple price of $1.29 per bottle of 50 might tell you everything you need to know about the transaction. For services, and for medical care in particular, the transaction is apt to be much more complex. For example, consider the transaction for an operation to implant an artificial intraocular lens (IOL) in a patient’s eye to replace the natural lens that has become clouded by cataracts. The patient is to pay a $200 deposit up front and $800 more within 30 days after the surgery is completed and all sutures are removed. Reduced to its most simple element, the terms of trade in this exchange can be expressed as a monetary price of $1,000 for the IOL implant. Yet much more than the $1,000 is being agreed to in this transaction. The physician agrees to provide WHAT IS ECONOMICS? 3 not just any artificial lens but to choose the correct one, continuously monitor the quality of the operation, and control adverse reactions to postoperative medications. The patient agrees to make payment in two parts, with a time limit, and may assume that the operation will be redone without further charges if the first attempt is not satisfactory. Many of the agreed-upon conditions (that the physician is licensed, will use only qualified assistants, will not try to boost the bill needlessly to increase her fees, and will keep the patient informed of any possible adverse consequences, and that the patient will wear bandages as long as necessary and not go skydiving) will never be specified explicitly unless some disagreement and subsequent legal action force the doctor and patient into court. In the simplified neoclassical model of perfectly competitive behavior with which most textbooks begin, price is the only term that matters in a transaction and both the buyer and seller are “price takers.” That is, there are so many buyers that whether one person buys or not has little influence on the price in the market; therefore, buyers must “take” the price as given. Similarly, there are so many firms selling the same product that no single firm can affect prices; hence, all firms must take the price as given. This uncomplicated model of perfectly competitive behavior is not too distant from reality when you buy a bottle of aspirin. The model works reasonably well for most of the purchases made by consumers, and thus it can be used to frame the analysis of the economy as a whole. However, buying a bottle of aspirin is not representative of most medical decisions, and an elementary model does not capture many of the essentials when life-and-death decisions are being made by doctors in the operating room (see the more detailed discussion in Section 6.4, “The Medical Transaction”). No one needs a prescription to buy a car or rent a movie. You don’t have to have insurance or sign a consent form to have your car’s fuel pump worked on, and almost anyone can cut your hair without a license. Treating disease requires knowledge and entails risks that are quite special, forcing a patient to trust the judgment of the surgeon and leading to special forms of economic organization and contracts in medicine: professional licensure, hospital staff bylaws, regulatory review. Studying such adaptations reveals the potential of economics as a discipline in a way that the analysis of more standard markets cannot. Value Why does health care cost so much? Because health is so precious that its value exceeds that of all the things we possess. What benefit do I get from spending my money on food or music or cars or clothes if I am dead? Sick and in pain, confronted with the possibility of death, people are willing to spend almost any amount of money to get their health back. Health care costs so much because people are willing to pay so much for it. The many years a surgeon spends in training, the billions of dollars government spends on public health, and the comprehensive health insurance plans provided by employers are consequences of the value we as a society place on health care. They are effects, rather than causes. We are willing to spend so much on physician training, public health, and health insurance because what they produce is valuable to us. If we stopped caring about (or paying for) health, no new magnetic resonance imaging (MRI) scanners are built, surgeons would stop spending years in training, and our taxes would go toward highways or national parks instead of AIDS and cancer research. Cows can get just as many diseases as humans do and we could put all those resources to work saving cows, but we don’t. Cows, I am sure, would set priorities rather differently, but they are not paying the bills. Can We Pay Somebody to Care? Doctors and nurses want to care for patients. Given a chance, they will make extraordinary efforts on your behalf. Medicine is as much about caring as it is about curing. Does paying somebody make them care for you? Probably not. However, not paying people can make it 4 CHAPTER 1 CHOICES: MONEY, MEDICINE, AND HEALTH impossible for them to care for you. If doctors and nurses had to find another way to make a living and pay the bills, then they could not spend their time looking after your health. Do your friends expect to be paid because they care for you? Not precisely, but they do expect to be paid back in kind, by your caring for them. If you treat your friends as if you did not care, eventually you will not have any friends. Parents are a bit more understanding, but in part that is because they know that however ungrateful you may be for their help, you will probably be willing to help your own ungrateful kids (their grandchildren) someday. Medical professionals are even more compassionate. They work for many hours even when a case is nearly hopeless, knowing they will not get additional pay for all the extra effort. However, as professionals, they can expect respect and a reasonable income. The development of medicine as a profession (see Chapters 6 and 7), dedicated to science and caring, is a great social innovation, one of the adaptations of economic organization mentioned earlier. Sometimes it is only the professionalism of the helpers that keeps someone who is poor and sick from being left all alone to deal with an illness. Doctors work on your behalf. Most importantly to an economist, it is doctors who decide what medicine is right or wrong, not you. Although patients do ultimately have the right to make their own decisions, in practice those decisions are made largely by the professionals who take care of the patient. In the operating room, it is not the patient who decides, but the surgeon (in some ways, it is a bit like a family, where the parents make decisions on behalf of their children). In basic trades, all that is required is that a buyer and a seller agree on a price. In medicine, the buyer–seller distinction is not clear. Is the doctor the one who is “buying” the surgery, or the one selling it? A medical “trade” is made on the patient’s behalf by someone who cares about them, not by the patient acting on their own. The situation is complex and involves a set of professional expectations and external forces (quality regulations, consent forms, insurance) as well as the patient’s illness or their personal tastes and preferences. Caring, from an economic point of view, means making decisions for someone else—to help them, rather than just to help yourself. Financing Health Care What does it mean “to finance” something: a house, a car, your education? When you finance a car, you have to make payments over many months. To buy a house, you go to a bank for a loan, which is then usually bundled with other mortgages by Fannie Mae or some other financial entity and sold to many investors. Financing your education often means making tuition payments over time, taking out student loans, getting money from parents, and maybe getting a scholarship from the university. If it is a public university, taxpayers are usually covering a large part of the costs. At a private college, donations and income from the endowment are used to supplement student fees (and are indirectly subsidized by tax breaks). Financing means that many parties are involved, not just the buyer and the seller. Often there are financial intermediaries, like banks, that help to make the transaction possible by providing guarantees over time and spreading the risks across many investors. For student loans, Sallie Mae (formerly the Student Loan Marketing Association) is the financial intermediary making loans possible with the backing of the federal government, which is the largest intermediary of all and makes possible the whole banking system as well as all the subsidies from taxpayers for national defense, schools, and health care. The development of medicine as a caring profession is a kind of primitive financial intermediation. Those who can afford to pay extra do so, and therefore those who cannot pay are able to get professional care. With transplants and therapies costing hundreds of thousands of dollars, professional goodwill and charity alone are hardly sufficient, so there are public and private insurance plans pooling funds and sharing risks across millions of people, and these plans provide most of the financing for health care (see Chapters 4 and 5). Looking into the funding of research provides additional insight. The people who benefit from medical research WHAT IS ECONOMICS? 5 are not usually the people who pay for it. A study of brain function or cell structure will do nothing for a patient in the hospital today and not much for the foundation that donated money or the taxpayers funding a research grant. Tomorrow’s miracle drugs are paid for by adding overhead into the price of today’s pharmaceuticals (see Chapter 11), and advances in surgical technique are paid for by adding overhead into the price of an operation. The basic discoveries that make all of this new technology possible are funded by federal grants and other forms of taxpayer support, with benefits coming far into the future, if at all. Only sometimes do the efforts succeed, and those few successes must provide sufficient rewards to make the overall returns on a risky investment worthwhile. The two core concepts of financial analysis are timing and risk. Something that cannot be used until far into the future is not worth as much as something you can start using today (time discounting, or present value; see Chapter 3 and Chapter 12). Uncertainty also makes a thing less valuable (risk adjustment or discounting). Usually the longer you wait for something the more risky it is, so value is discounted both for time and risk. Discounting for uncertainty and the lapse of time are factors that make it hard for college sophomores to spend less so they will have more savings for retirement, or to stop eating french fries so that they can be healthier when they are in their 50s, or for a soldier being sent to war to give up smoking. In health care the benefits are almost never immediate or certain and thus must be discounted, and they are almost always financed by others rather than paid for directly, so that the patient rarely stops to compare costs and benefits before going to the doctor. The fundamental theorem of exchange becomes complicated and diffuse when trades involve millions of people in complex transactions with uncertain effects lasting for decades or generations. Full Cost: Paying for Medical Care All goods and services must be paid for. Many regular goods are paid for by consumers at the point of purchase. Some large purchases, such as cars and houses, are financed by paying over time. Then there are those, like medicine and college, that are mostly paid for with “other people’s money”—from philanthropists, grandparents, or taxpayers. Many people believe that because they pay something for medical care or college, they are bearing the full costs. Usually they are not. The total cost of health care in the United States was about $2.8 trillion in 2012. Thus the various providers that make up the U.S. health care “system” must take in an average of $8,936 from every person in America (man, woman, child; old, young; rich, poor; sick, well; working, disabled—everybody). The average household has 1.9 people and paid less than $350 per month on medications, doctor visits, copayments, and insurance premiums directly (termed “out-of-pocket” or OOP), meaning that most (>75%) of the financing came from “other people’s money.” College students and recent grads are less expensive than the average, but they also pay in much less (Table 1.1). The elderly tend to spend significantly more from their equally limited incomes, but they also cost the system much, much more (more than $3,000 per person; see Chapter 10). The only way we can begin to get a full financial picture of the whole health system is to carefully trace all the payments in and out. TABLE 1.1 Monthly Household “Out-Of-Pocket” Spending young 65 $3,015 $ 72 $ 70 $ 246 12.9% Source: U.S. Bureau of Labor Statistics, “Focus on Prices and Spending: Consumer Expenditure Survey,” 1(8), August 2010. 6 CHAPTER 1 CHOICES: MONEY, MEDICINE, AND HEALTH 1.2 THE FLOW OF FUNDS Goods and services are provided in a market economy only if the people who want them are willing to pay for them and if suppliers are willing to accept those payments in return. Exchange is based on voluntary agreement, so that trade between a buyer and seller occurs only when both parties believe that they will be made better off by trading (the fundamental theorem of exchange). In the simplest form of trade, consumers buy from businesses, exchanging money for goods and services in a two-party transaction. Consumers make up the demand side of this simple service market, and firms make up the supply side (see Chapter 2). In legal terms, firms are contractual entities that can own, buy, and sell property and pay taxes just as people do. To get the labor, land, and other inputs needed for production, the firm (the seller) in Figure 1.1 must also be a buyer, as shown in Figure 1.2. These secondary two-party transactions are characteristic of derived demand, purchases made as an intermediate step in production rather than for final consumption. Firms are owned by individuals (or other firms) that provide the capital, labor, and organizational effort necessary to get them started and keep them running. Thus, every dollar that a consumer gives to a firm, whether used for wages, profits, or purchase of input from another firm, ultimately ends up FIGURE 1.1 Two-Party Transaction $$$ Money $$$ Consumers Firms Goods and services FIGURE 1.2 Derived Demand between Firms $$$ Money $$$ Firms Consumers Goods and services $$$ Services Derived demand Firms or Individuals FIGURE 1.3 Circular Flow of Funds $$$ Money $$$ (as consumers) Firms Goods and services Individuals $$$ Derived demand for inputs Services Labor, land, capital (as owners) $$$ Wages, rent, profits $$$ Firms or Individuals THE FLOW OF FUNDS 7 in the hands of someone who wants to spend it. When workers or owners spend money, they become consumers and therefore complete the circular flow of funds through the economy, as shown in Figure 1.3. Health Care Spending in the United States Medical care in the United States is a trillion-dollar business ($2,824,257,000,000), with an estimated average of $8,936 spent per person in 2012.1 The 316 million citizens of the United States received services from more than 5,000 hospitals, 30,000 nursing homes, 800,000 physicians, 2.8 million registered nurses, and 10 million other health care workers. Financial flows, the major sources and uses of health care funding during 2012, are indicated in Table 1.2. Individuals paid $322 billion, or 11 percent of total funding; private (mostly employer-based) health insurance paid 31 percent; and government, the largest payer, paid 50 percent (20 percent Medicare, 16 percent Medicaid, 14 percent other government programs). The remaining 7 percent of total health care financing came from a variety of other private sources (philanthropy, industrial clinics, interest, and rental income of providers). The largest use of funds was the $873 billion spent on hospital care, 31 percent of the total. Figure 1.4 presents this information graphically, highlighting a simple yet important fact about financial balances: the “sources (in)” and “uses (out)” bars are of equal height. Every dollar spent by a patient, insurance company, or government is recorded as a cost but is also recorded as income to a physician, hospital, agency, administrator, or other health employee. Therefore the totals must be equal: Financial flows in and out balance each other. The flow of money is circular. Money itself is only a way of keeping track of all the obligations within the economy. Every dollar spent by one person is, of necessity, a dollar of income for someone else. Tracing the flow of funds through this complex system provides some sense of the forces that shape the economy. Sources of Financing Health care spending has grown enormously. In 2012, it accounted for about 18 percent of the gross domestic product (GDP) and one of every nine employees in the labor force. That growth has been facilitated by the shift from individual payments to third-party financing. TABLE 1.2 Uses of Funds Hospital Physician Dental Other Nursing home Home health Drugs Products Administrative costs Public health Research Construction Total U.S. Health Care Spending, 2012 Percentage of Total Amount per Person 31% 19% 4% 8% 5% 3% 10% 3% 7% 3% 2% 4% $ 2,763 1,718 347 706 477 254 918 269 635 289 179 381 100% $8,936 Sources of Funds Medicare Paycheck deduction Medicaid VA & DOD Other government Total government Employer insurance Tax subsidy Self-paid Charity, etc. Total Percentage of Total Amount per Person 20% $ 1,790 590 1,446 291 966 16% 3% 11% 50% 31% 11% 7% 2,799 455 1,019 626 100% $8,936 Based on a projected U.S. population of 316 million. Source: U.S. Office of the Actuary, National Health Projections, http://www.cms.gov/NationalHealthExpendData/. 8 CHAPTER 1 CHOICES: MONEY, MEDICINE, AND HEALTH FIGURE 1.4 $3,000 Sources and Uses of Health Care Funds, United States, 2012 Uses: $2,824 Billion $2,500 $2,000 Sources: $2,824 Billion Construction Research Public health Admin and insurance Products Other government VA/DOD Medicaid Drugs Home health Nursing home $1,500 $1,000 $500 Medicare Other Dental Physician Employer and individual health insurance Hospital Other private Personal (out-of-pocket) $0 Source: CMS Office of the Actuary, www.cms.gov. In 1929, 81 percent of medical expenditures were financed by individual out-of-pocket payments and only 19 percent from government and other third-party organizations (Table 1.3). By 2012, this ratio had been reversed, with individuals paying only 11 percent directly and the remaining 89 percent of financing coming from third-party transactions involving government, nonprofit organizations, and insurance. All of the elements that characterized health care in 2012 were present in some form one hundred years ago, but their relative importance to the flow of funds has changed so much that the transactions look entirely different today.2 Physicians, who in 1900 were tradespeople sometimes making do with partial payment in eggs or flour, have become highly paid and technologically sophisticated professionals who rarely talk to their patients about paying the bills (see Chapter 7). Hospitals, once minor supports for some disabled and disadvantaged people, are now technological palaces of intensive treatment and the largest users of U.S. health care funds (see Chapter 8). Whereas in 1900 hospitals were financed by a few donors and some patient fees, they are now financed almost entirely by third parties: either by government insurance TABLE 1.3 Sources of Financing 1929, 1970, and 2012 Source 1929 1970 2012 $3,656 $40,070 $330 3.5% $74,894 $357,047 $1,697 7.2% $2,823,587 $2,823,587 $8,936 17.9% 81% 19% 13%