Health economics

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Health economics is a branch of economics concerned with issues related to scarcity in the allocation of health and health care.

The scope of health economics is neatly encapsulated by Alan William's "plumbing diagram"[1] dividing the discipline into eight distinct topics:

  • what influences health? (other than health care)
  • what is health and what is its value
  • the demand for health care
  • the supply of health care
  • micro-economic evaluation at treatment level
  • market equilibrium
  • evaluation at whole system level; and,
  • planning, budgeting and monitoring mechanisms.

What influences health?

What is health and what is its value?

The demand for health and health care

The demand for health care is a derived demand from the demand for health, more generally. Health care is demanded as a means for consumers to achieve a larger stock of "health capital." The demand for health is unique, because individuals allocate resources in order to both consume and produce health.

The Grossman Model (JEP, 1972) views health demand this way: as both an investment in human capital to improve market and nonmarket outcomes, as well as a derived demand from the intrinsic value of health in itself. It acknowledges that health care is both a consumption good that yields direct satisfaction and utility, and an investment good, which yields satisfaction to consumers indirectly (more productive, fewer sick days, higher wages, etc.) The model takes into account health production (investments in health such as time spent exercising, money spent on medical care, etc.) as well as the production of non-health goods against the overall utility that results from ones investments. These factors are used to determine the optimal level of health that an individual will demand, taking into account the marginal cost of health capital and depreciation rates.

Citation: Grossman, Michael. "On the Concept of Health Capital and the Demand for Health." Journal of Political Economy. March-April/1972. 80(2): 223-55

The Supply of Health Care

Micro-economic evaluation at treatment level

A large focus of health economics, particularly in the UK, is the microeconomic evaluation of individual treatments. In the UK, the National Institute for Health and Clinical Excellence (NICE) appraises certain new and existing pharmaceuticals and devices using economic evaluation.

Economic evaluation is the comparison of two or more alternative courses of action in terms of both their costs and consequences (Drummond et al.). Economists usually distinguish several types of economic evaluation, differing in how consequences are measured:

In cost minimisation analysis (CMA), the effectiveness of the comparators in question must be proven to be equivalent. The 'cost-effective' comparator is simply the one which costs less (as it achieves the same outcome). In cost-benefit analysis (CBA), costs and benefits are both valued in cash terms. Cost effectiveness analysis (CEA) measures outcomes in 'natural units', such as mmHg, symptom free days, life years gained. Finally cost-utility analysis (CUA) measures outcomes in a composite metric of both length and quality of life, the Quality Adjusted Life Year (QALY). (Note there is some international variation in the precise definitions of each type of analysis).

A final approach which is sometimes classed an economic evaluation is a cost of illness study. This is not a true economic evaluation as it does not compare the costs and outcomes of alternative courses of action. Instead, it attempts to measure all the costs associated with a particular disease or condition. These will include direct costs (where money actually changes hands, e.g. health service use, patient co-payments and out of pocket expenses), indirect costs (the value of lost productivity from time off work due to illness), and intangible costs (the 'disvalue' to an individual of pain and suffering). (Note specific definitions in health economics may vary slightly from other branches of economics.)

Market equilibrium

Health care markets

The five health markets typically analyzed are:

Although assumptions of textbook models of economic markets apply reasonably well to health care markets, there are important deviations. Insurance markets rely on risk pools, in which relatively healthy enrollees subsidize the care of the rest. Insurers must cope with "adverse selection" which occurs when they are unable to fully predict the medical expenses of enrollees; adverse selection can destroy the risk pool. Features of insurance markets, such as group purchases and preexisting condition exclusions are meant to cope with adverse selection.

Insured patients are naturally less concerned about health care costs than they would if they paid the full price of care. The resulting "moral hazard" drives up costs, as shown by the famous RAND Health Insurance Experiment. Insurers use several techniques to limit the costs of moral hazard, including imposing copayments on patients and limiting physician incentives to provide costly care. Insurers often compete by their choice of service offerings, cost sharing requirements, and limitations on physicians.

Consumers in health care markets often suffer from a lack of adequate information about what services they need to buy and which providers offer the best value proposition. Health economists have documented a problem with "supplier induced demand", whereby providers base treatment recommendations on economic, rather than medical criteria. Researchers have also documented substantial "practice variations", whereby the treatment a patient receives depends as much on which doctor they visit as it does on their condition. Both private insurers and government payers use a variety of controls on service availability to rein in inducement and practice variations.

The U.S. health care market has relied extensively on competition to control costs and improve quality. Critics question whether problems with adverse selection, moral hazard, information asymmetries, demand inducement, and practice variations can be addressed by private markets. Competition has fostered reductions in prices, but consolidation by providers and, to a lesser extent, insurers, has tempered this effect.

Competitive equilibrium in the five health markets

While the nature of healthcare as a private good is preserved in the last three markets, market failures occur in the financing and delivery markets due to two reasons: (1) Perfect information about price products is not a viable assumption (2) Various barriers of entry exist in the financing markets (i.e. monopoly formations in the insurance industry)

Efficiency vs equity

The First Theorem of Welfare Economics states that any Walrasian equilibrium (that is, any competitive equilibrium) is Pareto-efficient. Its implications are that competitive markets will always be efficient. This result follows from the definition of a Walrasian equilibrium and the definition of Pareto efficiency. A key assumption to the proof of the theorem is local nonsatiation of consumer preferences. It is that assumption that is often violated in the first two of the health markets and therefore the First Welfare Theorem does not hold for these markets.

In addition, even if the outcome in a health market is Pareto optimal, the government deems it to be inequitable due to vast health disparity or lack of basic healthcare services.

So, government intervention is warranted for two reasons:

  • Absence of Pareto Optimality in a health market
  • Pareto Optimality with socially inequitable health outcome.

Ideological bias in the debate about the financing and delivery health markets

The healthcare debate in public policy is often informed by ideology and not sound economic theory. Often, politicians subscribe to a moral order system or belief about the role of governments in public life that guides biases towards provision of healthcare as well. The ideological spectrum spans: individual savings accounts and catastrophic coverage, tax credit or voucher programs combined with group purchasing arrangements, and expansions of public-sector health insurance. These approaches are advocated by health care conservatives, moderates and liberals, respectively.

Evaluation at a whole system level

Planning, budgeting, and monitoring mechanisms

Other issues

Medical economics

Often used synonimously with Health Economics Medical economics, according to Culyer,[2] is the branch of economics concerned with the application of economic theory to phenomena and problems associated typically with the second and third health market outlined above. Typically, however, it pertains to cost-benefit analysis of pharmaceutical products and cost-effectiveness of various medical treatments. Medical economics often uses mathematical models to synthesise data from biostatistics and epidemiology for support of medical decision making, both for individuals and for wider health policy.


  1. Williams A (1987) "Health economics: the cheerful face of a dismal science" in Williams A (ed.) Health and Economics, Macmillan: London
  2. A.J. Culyer (1989) "A Glossary of the more common terms encountered in health economics" in MS Hersh-Cochran and KP Cochran (eds) Compendium of English Language Course Syllabi and Textbooks in Health Economics, Copenhagen, WHO, 215-234

Further reading

  • Michael F. Drummond (2005) Methods for the Economic Evaluation of Health Care Programmes, Oxford University Press. Preview. ISBN 0-19-852945-7
  • Victor R. Fuchs (1987). "Health economics" The New Palgrave: A Dictionary of Economics, v. 2, pp. 614-19.

See also

External links

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