Health Economics- Lecture Ch08

8/3/2019 Health Economics- Lecture Ch08

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Demand and Supply

Of Health Insurance

Dr. Katherine Sauer

Metropolitan State College of Denver

Health Economics



Chapter outline:

I. Risk and Insurance

II. The Demand for Insurance

III. The Supply of Insurance

IV. Moral HazardV. Deductibles, Coinsurance, and Secondary Insurance

VI. Income Transfer Effects of Insurance



I. Risk and Insurance

A. Desirable Characteristics of an insurance arrangement

1. large number of insured who are independently

exposed to the potential loss

2. covered losses should be clearly defined in terms of

time, place, and amount

3. probability of loss should be measurable

4. loss should be accidental from viewpoint of the insured



B. Insurance vs Social Insurance

Insurance is provided through markets in which buyers protect themselves against events with probabilities that

can be estimated statistically.

Social Insurance programs are insurance with thegovernment as insurer and are distinguished by two

features:

Premiums are heavily and often completely (as in the

case of Medicaid) subsidized.

Participation is constrained according to government-

set eligibility rules.



C. Expected Value

Expected value incorporates the probability of an

occurrence of an event with its outcome.

E = p1R 1 + p2R 2 + « + pnR n

pi is the probability of an event

R i is the outcome associated with an event

The probabilities must always sum to 1.



You are considering playing a game where the flip of a

coin determines whether you earn a reward or not.

heads: you win $1

tails: you win $0

How much would you pay to play this game?

If you are risk neutral, you should be willing to pay up to

the expected value of the game.

E = (pr. of heads)($1) + (pr. of tails)($0)

E = (0.5)($1) + (0.5)($0)

E = $0.50



If the expected payouts from an insurance policy are

exactly equal to the premiums taken in, then the policy is

called actuarially fair .

- use as a benchmark

- in reality, other administrative costs



What if the size of the bets are changed?heads: win $100

tails: win $0

Are you willing to pay $50 to play?- refuse an actuarially fair bet

The disutility from losing money is larger than the utility

of winning the same amount!- risk averse



D. The Utility of Wealth

This utility of wealth

function exhibits

diminishing marginal

utility.

- 2x the wealth

doesn¶t make you

2x as happy

- describes an individual

who is risk averse (will

not accept an actuarially

fair bet) Wealth

Total Utility of

Wealth

10,000 20,000

140

200 TU



Suppose that John¶s income is $20,000.

He has a 10% chance of becoming sick.

If he becomes sick, he will spend $10,000 as he pays

medical expenses and misses work.

Let¶s calculate his expected utility and expected wealth.



EU = (0.90)(200)

+ (0.10)(140)

= 194

EW = (0.90)(20,000)

+ (0.10)(10,000)

= 19,000

Wealth

Total Utility of

Wealth

10,000 20,000

140

200 TU

194

19,000

EU



In a world with risk,$19,000 of wealth would

give John an expected

utility of 194.

In a world without risk,

the same $19,000 would

yield a higher utility.

Wealth

Total Utility of

Wealth

10,000 20,000

140

200 TU

194

19,000

EU



The horizontal distance

between the expectedutility line and the total

utility line represents

John¶s risk aversion.

At point A, he would be

willing to pay up to

$4,000 for insurance that

protects against areduction in wealth from

illness.Wealth

Total Utility of

Wealth

10,000 20,000

140

200 TU

194

19,000

EU

A

16,000



Insurance can be sold only in circumstances where the

consumer is risk averse.

Expected utility is an average measure.

If insurance companies charge more than the actuarially

fair premium, people will have less expected wealthfrom insuring than from not insuring.

increased well-being comes from the elimination

of risk

The willingness to buy insurance is related to the

distance between the total utility curve and the expected

utility line.



II. The Demand for Insurance

Suppose John¶s wealth is $20,000. He has a 10% chance

of becoming sick. If he does, his wealth will be reduced

by $10,000. He is considering buying $500 worth of insurance at a premium of 20%.

If John stays healthy, his wealth is

20,000 - (0.20)(500) = $19,900



If John gets sick his wealth is

$20,000 - $10,000 +$500 - $100 = $10,400

So, the insurance provides him with an additional $400 if

he is ill.

The additional cost is the $100 premium.

John¶s marginal benefits are greater than the marginal

costs.



How about purchasing an additional $500 of coverage?

Healthy:

19,900 - (0.20)(500) = $19,800

Sick:10,400 + 500 - 100 = $10,800

Additional Benefit: $10,800 - $10,400 = $400

Additional Cost: $100

Additional benefits outweigh the additional costs.



However, recall that we are now starting from differentincome levels:

$400 benefit to $10,000 is larger than a $400 benefit to

$10,400. (diminishing marginal utility of wealth)

$100 cost to $19,900 is smaller than $100 cost to

$19,800.



MC

MB

Q of insurance purchased

MB,

MC

500 1000

Should John buy

another $500 worth

of insurance?

The optimal amount

of insurance is Q*.

Q*



1. Change in Premiums

Suppose the premium rises to 25% instead of 20%.

Healthy:

20,000 - (0.25)(500) = $19,875

Sick:

20,000 - 10,000 + 500 - 125 = $10,375



MC

MB


MB,

MC

500 1000

The $500 of

coverage now gives

John a lower

marginal benefit.

An increase in

premiums shifts the

marginal benefit

curve to the left.

Q*

MB2



MC

MB


MB,

MC

500 1000

Similarly, the

marginal cost of

$500 of insurance

has increased.

An increase in

premiums shifts the

marginal cost curve

to the left.

Q*

MB2

MC2



MC

MB


MB,

MC

500 1000

The new optimallevel of insurance is

Q2.

Higher premiumsresults in lower

amounts of insurance

being purchased.

Q*

MB2

MC2

Q2



2. Change in Expected Loss

(Start from the original premium of 20%)

Suppose the expected loss from illness increases from

$10,000 to $15,000.

Healthy:

20,000 - (0.20)(500) = $19,900

Sick:

20,000 - 15,000 + 500 - 100 = $5,400



Again, in the case of sickness, insurance provides $400

of benefit vs having no insurance.

But, this $400 must be compared to the $5000 he would

have if he didn¶t have insurance.

$400 extra on $5000 is more than $400 extra on

$10,000.

The marginal benefits are higher.



MC

MB


MB,

MC

500 1000

An increase in the

expected loss will

increase the marginal benefits from having

insurance.

The optimal level of insurance is now

higher.

Q*

MB2

Q2



3. Changes inWealth

(Start from the original premium of 20% and originalloss value)

Suppose John¶s wealth is $25,000 instead of $20,000.

Healthy:

25,000 - (0.20)(500) = $24,900

Sick:

25,000 - 10,000 + 500 - 100 = $15,400



At a higher level of wealth, the insurance policy¶s

benefits of $400 are a lower marginal benefit than at a

lower level of wealth.

At a higher level of wealth, the insurance policy¶s cost

of $100 is a lower marginal cost than at a lower level of

wealth.



MC

MB


MB,

MC

500 1000

The marginal benefits are lower.

The marginal costs

are lower.

The effect on the

quantity of insurance

is ambiguous.

Q*

MB2

MC2



III. The Supply of Insurance

How are premiums determined?

Insurance firms will maximize profits.

profit = revenue - cost



Let a be the premium rate.

Let q be the insurance payout.

Let t be the processing / administrative cost of writing a policy.

Let p be the probability of a payout.

Profit = aq - pq - t

For firms in a competitive market, profits equal zero.

0 = aq - pq ± t

a = p + (t/q)



Suppose that premiums are 20% and policies are written

in $500 increments.

Suppose that the processing costs are $8 per policy.

For those who do not get sick (90% of the policies), the

only cost would be the cost of processing, $8.

For those who do get sick (10% of the policies), the cost

would be the $500 payment plus the $8 processing cost,or $508.



Profit = $100 ± (0.10 )( $508) ± (0.90 )($8)

Profit = $100 - $50.80 - $7.20

Profit = $42

These are positive profits, and they imply that another

similar firm might enter the market.

Such entry into the market would continue until allexcess profit was competed away.



IV. Moral Hazard

- any change in behavior in response to a

contractual arrangement

ex: failure to protect yourself from disease

because you have health insurance

So far we have assumed that the amount of a loss is fixed.

But, buying insurance often lowers the out-of-pocket

price of services.

(buy more services!)



Q of health

care

price

Q1 Q2

p1

Suppose you pay all of your

expenses out of pocket. If the

price is p1, then you wouldconsumeQ1 units of health care.

Your total expense

would be (p1)(Q1).

Demand

(assume p1 is

cost of

production)



Suppose the probability you will need to see adermatologist is 0.50.

You should be willing to pay the actuarially fair price of

(0.50)(p1)(Q1)for insurance that would cover all of your losses.

However, now additional medical care costs you nothing.



Q of health

care

price

Q1 Q2

p1

At a price of zero, you would consumeQ2

units of health care.

Your care would cost (p1)(Q2) in terms

of resources.

Demand



If your insurance charged (0.5)(p1)(Q1) they would be

losing money.

The expected payout is larger than the expected

premium.

(0.5)(p1)(Q2) > (0.5)(p1)(Q1)

If the company charged (0.5)(p1)(Q2), then you may not

buy the insurance.



Any insurance premium has two components:- premium for protection from risk

- resource cost due to moral hazard

Moral hazard analysis helps us predict the types of insurance that are likely to be provided.

1.developed first for inelastic services

2. more coverage for inelastic services



V. Deductibles, Coinsurance, and Secondary Insurance

A. Deductibles

Price of care

Quantity

P1

Q1 Q3

With no insurance, if the

price is p1, you consume

Q1 units of care.

With insurance, the price of

care falls to zero so you

consumeQ3 units.



Price of care

Quantity

P1

Q1 Q2 Q3

If you must pay a

deductible before care isfree to you:

then if the deductible is

small you will consume anamount in between Q1 and

Q3.

then if the deductible islarge, you may decide to

³self-insure´ and will

consumeQ1.



A deductible has two potential impacts:

1. Small deductible: some effect on consumption

2. Large deductible: makes it more likely for people to

self-insure and consume the amount of care they would

have consumed with no insurance



B. Coinsurance

Coinsurance is the consumer¶s out-of-pocket payment

rate. (higher coinsurance means consumer pays more)

With marginal cost P1 and

no insurance, the consumer will demand Q1 units of

care.

The consumer¶s marginal benefit will be equal to the

marginal cost.

MC

Demand with 100%

coinsurance (MB)

price

quantity

p1

Q1



With 20% coinsurance, the price the consumer pays out

of pocket falls to P2.

Q2 units will be

demanded

A new demand curve is

generated to reflect the 20%

coinsurance.

MC

Demand with 100%

coinsurance (MB)

price

quantity

p1

Q1

p2

Q2

Demand with 20%

coinsurance (MB)



The additional resource

cost is:

The additional benefits tothe consumer are:

The additional costs exceedthe additional benefits.

MC

Demand with 100%

coinsurance (MB)

price

quantity

p1

Q1

p2

Q2

Demand with 20%

coinsurance (MB)



Consumers are led by insurance to act as though theyare not aware of the true resource cost of their

consumption.

Insurance subsidizes insured types of care at theexpense of other types of care.

Insurance subsidizes insured types of care relative to

non-health goods.



C. Secondary Insurance

Suppose your employer provides health insurance

which pays 60% of all medical expenditure.

You have secondary coverage through your spouse,

which pays 60% of the medical expenditures not

covered by your primary insurance.

The market price of a doctor¶s visit is $50.



Price per visit

Number of visits

50

With no insurance coverage,

you decide to purchase 12doctor¶s visits per year.

Your out-of-pocket expense

will be: (50)(12) = $600

The total cost of providing

this care to you is:

(50)(24) = $600

12

MC

of visit



Price per visit

Number of visits

50

With your employer

sponsored insurance, the

cost of a doctor¶s visit is

now: (0.40)(50) = $20

At this price you consume

24 visits.

Your out-of-pocket expense

is: (20)(24) = $480

The total cost of providing

this care to you is:

(50)(24) = $1,20012

20

24

MC

of visit



Price per visit

Number of visits

50

Of that $1,200, your

employer pays:

(0.60)(50)(24)=$720

Of that $1,200 you pay the

rest:

1200 ± 720 = $480

12

20

24

MC

of visit



Price per visit

Number of visits

50

Suppose you have

supplemental insurance that pays 60% of what your

primary insurance doesn¶t

pay.

The price of a doctor¶s visit

is now (0.40)(20) = $8.

At that lower price youconsume 29 doctor¶s visits.

12

20

24

MC

of visit

8

29



Price per visit

Number of visits

50

Your out of pocket cost:

(8)(29) = $232

The total cost of providingthese health care services to

you: (50)(29) = $1450

12

20

24

MC

of visit

8

29



Price per visit

Number of visits

50

Of that $1450, your employer pays

(0.60)(50)(29) = $870

Your secondary insurance pays

(0.60)(20)(29) = $348

You pay $232.

12

20

24

MC

of visit

8

29



Price per visit

Number of visits

50

Claims paid by primary

insurance with no secondary

insurance:

Claims paid by secondary

insurance:

Increase in claims paid by

primary insurance due to the

secondary plan:

12

20

24

MC

of visit

8

29



D. The demand for insurance and the price of care

Martin Feldstein (1973) was among the first to show that

the demand for insurance and the moral hazard brought

on by insurance may interact to increase health care

prices even more than either one alone.

More generous insurance and the induced demand in the

market due to moral hazard lead consumers to purchase

more health care.



E.Welfare Loss of Excess Health Insurance

Insurance policies lead to increased health services

expenditures in several ways:- increased quantity of services purchased due to

decreases in out-of-pocket costs for services that

are already being purchased

- increased prices for services that are already

being purchased

- increased quantities and prices for services thatwould not be purchased unless they were covered

by insurance



- increased quality in the services purchased

including expensive, technology-intensive

services that might not be purchased unless

covered by insurance

E i i l E i



Empirical Estimates:

Feldstein found that the welfare gains from raising

coinsurance rates from .33 to .50 would be $27.8 billion per year in 1984 dollars.

Feldman and Dowd (1991) estimate a lower bound for

losses of approximately $33 billion per year (in 1984dollars) and an upper bound as high as $109 billion.

Manning and Marquis (1996) sought to calculate the

coinsurance rate that balances the marginal gain from

increased protection against risk against the marginal loss

from increased moral hazard, and find a coinsurance rate

of about 45 percent to be optimal.



VI. The Income Transfer Effects of Insurance

John Nyman (1999) argues that in contrast to the

conventional insurance theory, we should view insurance

payoffs as income transfers from those who remain

healthy to those who become ill.

These income transfers generate additional consumption

of medical care and potential increases in economic

well-being.



Conventional logic:

Suppose that Elizabeth is diagnosed with breast cancer ather annual screening.

Without insurance, she would purchase a mastectomy for

$20,000 to rid her body of the cancer.

With insurance, Elizabeth purchases (and insurance pays

for) the $20,000 mastectomy, a $20,000 breast

reconstruction procedure to correct the disfigurement

caused by the mastectomy, and an extra two days in the

hospital to recover, which costs $4,000.



Total spending with insurance is $44,000 and totalspending without insurance is $20,000.

It appears that the price distortion has caused $24,000 in

moral hazard spending.

Nyman would ask: Is this spending truly inefficient?



To answer we must determine what Elizabeth would

have done if her insurer had instead paid off the contract

with a check to Elizabeth for $44,000 upon diagnosis.

With her original resources plus the additional $40,000,

we can safely assume that Elizabeth would purchase the

mastectomy and the breast reconstruction. She may or may not purchase the extra recovery days in the hospital.

The $20,000 spent on the breast reconstruction is

efficient and welfare increasing.

The $4,000 spent on the two extra hospital days may be

inefficient and welfare-decreasing.



Summary:

We have characterized risk and have shown whyindividuals will pay to insure against it.

The result, under most insurance arrangements, is the

purchase of more or different services than might

otherwise have been desired by consumers and/or their

health care providers.



Discussion Questions:

1. The deductible feature of an insurance policy can affectthe impact of moral hazard. Explain this in the context

either of probability of treatment and/or amount of

treatment demanded.

2. Because health insurance tends inevitably to cause

moral hazard, will the population necessarily be

overinsured (in the sense that a reduction in insurance

would improve well-being)? Are there beneficial factors

that balance against the costs of welfare loss?

Documents

Health Economics- Lecture Ch08