Economics of Medical Care

Abstract

This essay examines the application of economic norms and theories to the study of medical care and medical care costs. Using a landmark article published in 1963 by Nobel Prize winning economist Kenneth J. Arrow as a launching point, the analysis of medical economics is presented from the perspective of medical care in a competitive market. A series of retrospective articles presented in the Journal of Health Politics, Policy and Law provides further perspectives on Arrow's article. The essay concludes with a brief look at work in the area of market forces in the medical care market and a consideration of the role of the Internet in providing information on quality and price to medical providers and consumers.

Keywords Adverse Selection; Asymmetrical Information; Health Insurance; Managed Care; Managed Competition; Medical Economics; Medical Insurance; Moral Hazard; Pareto Optimality; Price Elasticity of Demand

Healthcare Management > The Economics of Medical Care

Overview

Is the medical care market a "competitive" market as defined by the discipline of economics? Can the general norms and theories of economics be applied to medical care? These are the questions that are discussed in this article. First, it is important to note that the language used here is medical economics and not health economics. Medical economics refers to the study of the medical industry as represented by goods and services produced and provided by physicians, ancillary providers, clinics, and hospitals. Health economics implies a state of being that includes factors such as diet, exercise, and individual risk behaviors such as smoking, drinking, non-seat belt use, etc. The exploration of health economics is not considered in the scope of this article.

The Birth of Medical Care Economics

In December 1963, the American Economic Review published an article by noted economist Kenneth J. Arrow, "Uncertainty and the Welfare Economics of Medical Care," marking the beginning of the study of medical economics (Hammer, Haas-Wilson & Sage, 2001). The importance of Arrow's article was observed some forty years later as the October 2001 issue of the Journal of Health Politics, Policy and Law provided a series of retrospective articles examining the thesis set forth in Arrow's article in light of the tremendous changes in medical care delivery and finance in subsequent decades.

First, to put his article in context, Arrow was writing before the era of health maintenance organizations (HMOs), managed care, and many of the major technological advances in medicine that have since become commonplace. These include advanced imaging such as magnetic resonance imaging (MRI), as well as new classes of drugs used in infection control, cancer treatment, mental health, and other conditions. Thus, the retrospective analysis published in October 2001 sheds additional information on Arrow's original thesis in the context of contemporary understanding of medical economics.

Arrow's thesis in his 1963 article was that, "the role of moral hazard in medical insurance arises from inequalities of information between the insurer on the one hand and the physician and patient on the other" (as restated in Arrow, 2001). The concept of moral hazard is defined as the effect of insurance on the behavior of the insured (Nicholson, 1990). In general, the availability of insurance creates the potential for increased demand. This is clearly seen in the medical care market where the spread of insurance, in particular Medicaid and Medicare, has created an increased demand for medical services (Millenson, 2001; Arrow, 1963). Arrow and others argue that medical care markets fail to address increased demand through increased prices because medical care is a noncompetitive market. Arrow's contention that medical care is a special market distinct "from the norms of welfare economics" is explored in the following sections (Reinhardt, 2001).

Pareto Optimality & the Healthcare Market

The concept of Pareto optimality, as first described by Vilfredo Pareto in 1897, states that competitive equilibrium exists in a market when an allocation of resources is such that giving one additional allocation to one person results in making another person worse off. Stated another way, a condition of Pareto optimality resource allocation is such that all participants in a market are in equilibrium and a change to make one better off makes another one worse off. Pareto optimality can be further understood by examining the First and Second Theorems of Optimality.

First Theorem of Optimality

The First Theorem of Optimality states, "If a competitive equilibrium exists at all, and if all commodities relevant to costs and utilities are in fact priced in the market, then equilibrium is necessarily optimal: There is no other allocation of resources to services which will make all participants in the market better off" (Arrow, 1963, p. 942). Reinhardt (2001) further states that the assumptions underlying the First Theorem are:

• Both buyers and sellers understand fully the goods and services available in the market.
• Both buyers and sellers are price takers because neither has influence over prices in the market.
• All relevant prices are known to all participants before a purchase transaction takes place.

Second Theorem of Optimality

The Second Theorem of Optimality states, "If there are no increasing returns in production, and if certain other minor conditions are satisfied, then every optimal state is a competitive equilibrium corresponding to some initial distribution of purchasing power" (Arrow, 1963, p. 943). To apply this theorem to the reality of the medical care market, one assumes that an equal distribution of purchasing power exists to insure a state of equilibrium. In its most practical sense, an equal distribution of purchasing power is achieved through taxes and subsidies. Thus, the question of how the purchasing power gets redistributed becomes a question of politics and social justice and not necessarily economics.

If one argues that the medical market operates in such a manner as to efficiently meet the needs of both patients and providers, e.g., buyers and sellers, one must also argue that the medical market meets the criteria of a market in a state of competitive equilibrium, e.g., fulfills the assumptions of the First and Second Theorems of Optimality.

The significance of the Arrow article is that he was the first to systematically apply the standard norms and assumptions of economics to the medical market, especially with respect to competitive equilibrium and Pareto optimality. His work opened the door for subsequent important research and theoretical discourse that continues in the literature.

Asymmetrical Information

Arrow and subsequent researchers theorize that it is the asymmetry of information between patients and providers, mainly physicians, that cause the medical market to be characterized as a noncompetitive equilibrium. Researchers, economic and non-economic alike, contend that medical economics are "different" because of the role of information (Robinson, 2001). Asymmetrical information means that the distribution of information between buyers or sellers is skewed, i.e., not equal. In the case of the medical market, the distribution of information is not equal. Buyers, e.g., patients, do not have access to all or the same information as sellers, e.g., physicians. The healthcare delivery system is built on the assumption that doctors are more knowledgeable about medical diagnosis and treatments than their patients. Because of that knowledge, as a society, doctors are given the medical, legal, and political authority to not only provide medical care but also to set policy and determine the pricing structure of medical care.

Uncertainty in Medical Care

This imbalance, or asymmetry, of information is manifest along several dimensions. First is the role of uncertainty in medical care. According to Arrow, uncertainty occurs in two ways. When a patient sees a doctor, they are uncertain about the consequences of their decision to purchase treatment in the first place and uncertain about the effectiveness of that treatment in the second place. At the time that Arrow was writing, there was almost no way for a patient to obtain information about their own condition prior to seeing the doctor, no way to determine which doctor was best suited to treating the condition, and no way to evaluate treatment options or outcomes of the treatment (Haas-Wilson, 2001). The Internet has provided an avenue for patients to gain a great deal more information about diagnosis and treatment options, but by and large, physicians still hold a monopoly on medical information.

This information monopoly on the part of physicians is an outcome of the growth and development of medicine as a profession. As scientific treatments evolved and medical education became more sophisticated, physicians sought to withhold this specialized knowledge from anyone other than a trained physician. This was accomplished by strict licensure requirements and by increasing levels of specialization within the profession (Starr, 1982). Additionally, mistakes made by doctors regarding diagnosis or treatment outcome are kept within the community of physicians. Unethical behavior is also withheld from the public by the bonds of the professions (Starr, 1982).

Value of Treatment

Second, related to uncertainty in diagnosis and treatment is the observation that patients lack an understanding of the value of what they purchase. Certainly, if the disease is cured and they feel better, the patient values the treatment. But what the patient may not know is what alternative treatments exist and what the cost of those alternative treatments may have been. This raises the question, did the patient get the best treatment for the dollar amount expended? An impediment to this knowledge is the fact that the treatment was most likely paid by a health insurance plan. The patient may have no knowledge of what the total cost of the treatment was and little incentive to find out since their co-payment would likely vary little, no matter which treatment alternative their doctor may have selected.

Physician Knowledge & Practice

Lack of information about outcomes is not restricted to patients. Surprisingly, physicians often lack knowledge about specific outcomes from the treatments they prescribe. In 1989, the federal government established the Agency for Healthcare Research and Quality (AHRQ) for the purpose of evaluating clinical treatments and their outcomes. An initial round of research looked at four treatments—smoking cessation, chlamydia screening of adolescents, diabetes care in underserved areas, and treatment of respiratory distress syndrome in preterm infants. Among the findings of the initial round of research was that there was wide geographic variation in what treatments were prescribed and what the outcomes of those treatments were. In addition to the government, health plans have also been collecting data from within their provider and enrollee panels to determine which treatments appear to have the greatest effectiveness and at what cost.

There is growing acceptance in both medical practice and medical education for the application of evidence-based medical treatments (EBM). EBM refers to the application of medical treatment based on evidence of clinical effectiveness as determined and validated by extensive scientific study. Although treatments have historically been evaluated for effectiveness by conducting clinical trials, these trials are frequently conducted on a smaller scale, from a few dozen to a few thousand subjects. EBM goes a step further by formulating standardized treatment recommendations that emerge from meta-analysis of the scientific literature and rigorous statistical analysis of datasets compiled from insurance claims, hospital records, and medical expenditure data.

Further Insights

While many medical economics researchers have focused on the role of asymmetrical information and competitive equilibrium in medical care markets, additional research is ongoing regarding other important issues in medical economics.

Moral Hazard & Adverse Selection

The first of these are the issues of moral hazard and adverse selection. Moral hazard is the effect of insurance on the behavior of the uninsured. Medical insurance does not have the same effect in the market as other types of insurance. Insurance is generally purchased to protect the insured against financial risk in the event of a catastrophic incident, for example, the repair or replacement of a car in the event of a collision. Medical insurance does not provide a straightforward transfer of money to the insured, but rather is used to reduce the cost of medical care on a more or less continuous basis, such as for the costs of preventive care and ongoing treatment. Because the true cost of care is typically unknown to the patient, there is overconsumption of services. Despite the emergence of insurance products, medical savings accounts, for example, where there is a tax benefit for consumers and increased awareness of true costs, enabling consumers to make more informed treatment purchase decisions, there has been reluctance for consumers to fully embrace this type of insurance product (Nichols, 2004). Part of this reluctance may be that, despite the tax and savings benefit, consumers also assume more risk with this type of insurance product.

Adverse selection refers to the behavior of insurance companies to insure only the consumers with the lowest risk. With respect to medical care, this means that it is beneficial for insurers to refuse coverage to all but the very healthy. One possible explanation for this was the transaction costs involved with writing policies for high-risk patients (Glied & Remier, 2002). In the 2020s, there are laws and regulations which help mitigate this issue.

Price Elasticity of Demand

A third consideration is price elasticity of demand in medical care. Price elasticity of demand is defined as the percent change in quantity of goods or services demanded in response to a corresponding percent change in its price (Nicholson, 1990). Price elasticity is expressed as the change in quantity demanded by each 1 percent change in price. Studies have suggested that spending on medical care is highly inelastic. In other words, the quantity of medical care demanded does not change an appreciable degree regardless of price change (Phelps, n.d.; Nicholson, 1990; Arrow, 1963; Aron-Dine, Einav & Finkelstein, 2013).

Price Competition

A fourth consideration regarding the study of medical economics is the issue of price, namely price competition and physician pricing behavior. There is little price competition among physicians, nor do they make their fees known to the public. The consumer typically does not know in advance what the price of a treatment will be, and, typically, they do not ask. Their particular medical insurance plan obscures the true cost of medical care. Physician fees may be predetermined on a contractual basis. Physicians may also adjust their fees based on the financial circumstances of their patients. This practice was especially prevalent prior to the enactment of Medicaid and Medicare in 1965. Fee adjustment, or a sliding fee scale, masks the true price of medical care in a medical market.

Government intervention in the market also violates the assumptions of a truly competitive market. Federal and state governments are major figures in the medical market. Medicare and Medicaid are the major health programs, but others include the Veterans Administration, Social Security, and public health programs at state and federal levels. It has been well-documented that medical expenditures increased dramatically with the enactment of Medicare and Medicaid. Initially, providers (physicians and hospitals) were reimbursed on a 'usual and customary' basis. There was little question about the claims that were submitted for payment. As costs continued to escalate, Medicare implemented a prospective payment system based on diagnosis related groups (DRGs). DRGs created approximately 500 groups of related diagnoses based on comparative hospital resource use. This prospective payment system was implemented in 1983 and became a model for the future development of managed care plans. While initially, prospective payment systems appeared to have some effect on cost containment, that effect leveled off and healthcare costs continued to escalate.

In the 2010s, patients and internists, who make patient referrals, began pushing for greater transparency in medical costs. As a result, some insurers launched online databases to communicate the price of common medical procedures at various hospitals and clinics in their coverage areas. Consumer advocates have warned that such pricing data may be unhelpful if it is not given in the context of other information, such as the frequency with which the test or procedure is ordered and the quality of care, as defined by patient outcomes (Herman, 2015). There is some hope that increased transparency in both price and quality will increase competition in this historically noncompetitive market. In January 2021, the Hospital Price Transparency Final Rule went into effect in the US, requiring hospitals to disclose pricing information online either as a machine-readable file or as a shoppable service user-friendly format. Due to resistance to compliance, non-compliant hospitals began being charged substantial fees each day they did not post their pricing beginning January 2022. Regardless, as of June 2022, only around 60 percent of hospitals were in compliance (Jiang et al., 2023).

Patient Protection and Affordable Care Act

In 2010, US President Barack Obama signed the Patient Protection and Affordable Care Act (PPACA) (also known as the Affordable Care Act or Obamacare) into law. The act faced considerable resistance in Congress and from conservative bodies due to some of its elements, including its individual mandate. The act officially went into effect on January 1, 2014. The act requires that Americans be insured (or else face a penalty), changes the qualifications for Medicare, has affected premiums, and prevents insurers from denying coverage for pre-existing conditions, among many other provisions. The goal of the Affordable Care Act is to lower the number of uninsured by reducing costs and expanding coverage—it is expected to reduce healthcare inflation and lower government spending for Medicare and Medicaid. Notably, the act also includes insurance exchanges and mandates. During Donald Trump's presidency, the Affordable Care Act came under fire. After repealing critical mandates in the act and reducing the penalties for failing to have health insurance to $0, the act survived several lawsuits and changes. In 2021, President Joe Biden reversed these changes and opened enrollment.

Other Directions

Economists continue to grapple with the issue of competitive markets in the context of "market forces," addressing many of the same issues originally presented by Arrow in his 1963 article (Hammer, Hass-Wilson, & Sage, 2001). One researcher, Alain Enthoven, has espoused the development of managed competition to use market forces to create quality and efficiency in the medical market. The features of the managed competition model are the provision of a standard set of benefits covering routine doctor visits, hospitalization, and surgery; acceptance of all applicants regardless of pre-existing conditions; and price competition with complete cost information available to both providers and patients. The approach is a means of building on the model of market-based private health insurance and operated within certain government restraints. Managed competition was first put forth in the early 1990s and was a key component of proposed healthcare reform under President Clinton.

Nichols et al. conducted a series of longitudinal surveys tracking changes in healthcare markets in sixty communities. In their 2004 paper "Are market forces strong enough to deliver efficient healthcare systems? Confidence is waning," they focus their analysis on twelve healthcare markets and conclude that, even with changes in the market since the early 1990s, there was still a need for stronger government intervention. Their findings showed that there were still limited choices offered by employer-based health plans, with most consumers choosing a preferred provider organization (PPO)—little different from traditional fee-for-service plans. Employers had a disincentive to offer fixed-benefit plans due to the tax benefit of offering company-paid insurance. Finally, there was still a lack of information available for employers and consumers to make meaningful decisions about the price and quality of medical care.

The issue of information and its role in the medical market appears as persistent and pervasive in the twenty-first century as it was at the time of Arrow's landmark article. Despite changes, such as the introduction of prospective payment, rise of managed care and health maintenance organizations, and early attempts at strengthening market forces, access to solid data on medical care quality and price remain at the heart of medical economics. Data from research, such as that promoted by the Agency for Healthcare Research and Quality, is promising. In the twenty-first century, the field of health informatics grew to integrate medicine and information science for things like medical records, patient and doctor communication, and clinical guidelines.

Terms & Concepts

Adverse Selection: Market bias towards either the buyer or the seller depending on which party has the best information on the quality of the product.

Asymmetrical Information: The imbalance of information between buyers and sellers in a market.

Managed Care: A type of healthcare management where a third-party, a health maintenance organization, for example, acts as an intermediary between a healthcare provider and a patient for the purpose of controlling access and payment for healthcare.

Managed Competition: An approach to healthcare management where independent companies, HMOs, and medical insurance companies, for example, compete for patients in an environment of universal coverage and limited market intervention by the federal government.

Medical Economics: A subfield of economics that examines production and markets in health and medicine.

Medical Insurance: Insurance that is purchased to be used in the event of illness, injury, or disease.

Moral Hazard: The effect of having insurance on the behavior of the insured.

Pareto Optimality: The allocation of resources distributed in such a way that no one person is better off or worse off given a change in that allocation.

Price Elasticity of Demand: The percent change in quantity demanded in response to a 1 percent change in price.

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Suggested Reading

Agency for Healthcare Research and Quality. (2022, Feb.). About AHRQ. Retrieved June 24, 2023, from http://www.ahrq.gov/about/profile.htm

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Communicating costs to patients. (2015). Health Care Registration: The Newsletter for Health Care Registration Professionals, 24(7), 1-12. Retrieved December 9, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=102239027&site=bsi-live

Fuchs, V. R. (1986). The health economy. Harvard University Press.

Kapoor, R., & Lee, J. M. (2013). Coordinating and competing in ecosystems: How organizational forms shape new technology investments. Strategic Management Journal, 34. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85018755

McCue, M. (2012). Financial performance of health plans in Medicaid managed care. Medicare & Medicaid Research Review, 2, E1–E9. Retrieved December 2, 2013, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=90410953

Phelps, C. E. (2017). Health economics (6th ed.). Routledge.