HMGT 435 WK 1 PART 1

Assignment 1: Applying Economic Concepts Relevant To Health Care Spending

This assignment will be submitted to Turnitin™.

Instructions

Course Objectives for Assignment:

· Explain how economic decisions are made and what economic concepts are used to evaluate economic trade-offs.

· Evaluate the economic impact of the major components of the healthcare system and assess their relative effect on health services management.

As you learned in Week 1, health care spending is growing faster than overall growth in the economy (as measured by GDP) and by 2026 is expected to consume 20 percent of GDP.

For this assignment use the course readings in Week 1 to answer the following questions:

1) Why do we care that health care spending is growing faster than growth in the overall economy as measured by GDP? Support your conclusions with evidence.

2) What are the unique characteristics of health care sector that creates inefficiencies in the market? What kind of inefficiencies? Why?

3) In general, what two metrics would you use to evaluate trade-offs of spending more on health care vs. other non-health care goods? Why?

4) From a government (policymakers) perspective, apply these two metrics to the current excessive health care spending and explain your conclusions.

This report should be at least five double-spaced pages, include a reference page, and cover page. In writing, your report you should rely largely on reference material in the course readings and summary slides in Week 1.

EXTRA READING RESOURCES FOR ASSIGNMENT 1

CMS Website: National Health Expenditures (NHE) Landing Page

CMS Website: NHE Projections Landing Page

Interactive Tool KFF Website: National Health Spending Explorer Landing Page

PDF- CMS Publication NHE 2020 Highlights PDF

National Library of Medicine Website: Key General Economics Concepts Landing Page

PDF- The Hamilton Project – March 2020 Publication: A Dozen Facts about the Economics of the U.S. Healthcare System PDF

Economics Theory through Applications – Supplemental Reading: A Helpful Course Resource

HMGT 435 Week 1 Summary_RevisedSummer2022_ PPT.pptx

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Assignment rubric 2185 star

Course: HMGT 435 6380 Healthcare Economics (2232)

Outstanding 90-
100

Superior 80-89% Good 70-79%
Below Standard 60-
69%

Failure 0-59%
Criterio

Scor

/ 52.552.5 poin

Student

demonstrates a

high degree o

critical thinking, is

consistent in

accurately

interpreting

questions

material; provides

solid

assumptions,

reasoning &

claims

; provides

thorough analysis

evaluation with

sound

conclusions

46.725 points

Student shows

good critical

thinking;

accurately

interprets mo

questions &

material; usually

identifies

relevant

arguments/reaso

ning/claims;

offers good

analysis &

evaluation with

fairly sound

conclusions

41.475 points

Student shows

occasional critical

thinking;

questions &

material are

accurately

interpreted ay

times;

arguments/reaso

ning/claims are

explained

occasinall

offers fair

analysis &

evaluation with a

conclusion

31.5 points

Student shows

little critical

thinking,

misinterprets

questions or

material; ignores

superficially

evaluates;

justifies little and

explains

reasoning seldom;

draws

unwarranted

conclusions

7.35 points

Student lacks

critical thinking,

consistently

offers biased

interpretations;

ignores or

superficially

evaluates; argues

using poor

reasoning, and/or

unwarranted

claims

1/5/23, 3:20 PM Assignment 1: Applying Economic Concepts Relevant To Health Care Spending – HMGT 435 6380 Healthcare Economics (2232) – …

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Cri

ter

Outstanding 90-
100%

Superior 80-89% Good 70-79%
Below Standard 60-
69%

Failure 0-59%
Criterion
Score

/ 52.552.5 points

Student’s

arguments or

positions are

well-supported

with evidence

from the

readings/experien

ce; ideas go

beyond the

course

material

and recognize

implications and

extensions of the

material and

concepts to the

real life and

industry.

46.725 points

Student’s

arguments or

positions are

mostly supported

by evidence from

the readings and

course content;

ideas

presented

demonstrate

student’s

understanding of

the material and

concepts and

may relate to the

real life and

industry

occasionally

41.475 points

Student’s

arguments are

more often based

on opinion or

unclear views

than on position

grounded in the

readings of

material or

external sources

of material

31.5 points

Student’s

arguments are

frequently

illogical and

unsubstantiated;

student may

resort to ad

hominem attacks

on the author

instead of making

meaningful

application of the

material

7.35 points

There is no

meaningful

attempt to explain

or support

ideas or the

application/exam

ples are

superficial and

unrelated to the

material/industry

1/5/23, 3:20 PM Assignment 1: Applying Economic Concepts Relevant To Health Care Spending – HMGT 435 6380 Healthcare Economics (2232) – …

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Cri

ter

Outstanding 90-
100%

Superior 80-89% Good 70-79%
Below Standard 60-
69%

Failure 0-59%
Criterion
Score

/ 22.522.5 points

Student

demonstrated full

understanding of

requirements;

responded to

each

aspect of

assignment:

correctly

developed

required

document format

20.025 points

Student

demonstrated

general

understanding of

requirements;

missed one minor

aspect of

assignment; the

document format

is missing one

element

17.775 points

Student

demonstrated

some

understanding of

requirements;

missed a key

element or two

minor

aspects of

assignment; the

document format

is missing two or

more elements

13.5 points

Student failed to

show a firm

understanding of

requirements;

missed two key

elements or

several minor

aspects of

assignment; the

document format

is not complete or

partially incorrect

0 points

Student did not

demonstrate

understanding of

assignment

requirements; the

document format

is not followed

1/5/23, 3:20 PM Assignment 1: Applying Economic Concepts Relevant To Health Care Spending – HMGT 435 6380 Healthcare Economics (2232) – …

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Total / 150

Overall Score

Cri

ter

Outstanding 90-
100%

Superior 80-89% Good 70-79%
Below Standard 60-
69%

Failure 0-59%
Criterion
Score

/ 22.522.5 points

Student’s writing

is clear and easy

to follow;

grammar and

spelling are all

correct;

formatting gives a

professional look

and adds to

readability, no

APA style errors

20.025 points

Most ideas are

presented

clearly;

occasional

spelling and/or

grammar issues

(no more than 3),

attempts in-text

citation and

reference list but

1 or 2 APA style

errors are

present

17.775 points

Wordy; some

points require

rereading to

understand fully;

more than 3

occasional

spelling and/or

grammar errors,

attempts in-text

citation and

reference list;

APA style errors

are present;

inconsistencies in

citation usage

can be found

throughout the

document

13.5 points

Unclear and

difficult to

understand;

frequent spelling

and grammar

issues (more than

6), attempts

either in-text

citation or

reference list but

omits the other

0 points

Very difficult to

understand,

poorly written in

terms of

mechanics and

structure

Level 5
135 points minimum

Level 4
120 points minimum

Level 3
105 points minimum

Level 2
90 points minimum

Level 1
0 points minimum

CHAPTER

HOW MUCH SHOULD WE SPEND ON
MEDICAL CARE?

The United States spends more on medical care than any other coun-
try—17.9 percent of its gross domestic product in 2016—and this per-
centage is expected to continue to grow. Can we afford to spend this

much of our resources on medical care? Why do we view the growth of expen-
ditures in other areas (e.g., the automotive industry) more favorably than the
growth of expenditures in healthcare? Increased medical expenditures create
new healthcare jobs, do not pollute the air, save rather than destroy lives, and
alleviate pain and suffering. Why shouldn’t society be pleased that more
resources are flowing into a sector that cares for the aged, the poor, and the
sick? Medical care would seem to be a more appropriate use of a society’s
resources than cars, electronics, or other consumer products, yet increased
expenditures on these goods do not prompt the concern that growth in health-
care spending causes.

Are we concerned about rising medical costs because we believe we are
not receiving value for our money—that more medical services and technolo-
gies are not worth the cost when compared with other potential uses of those
resources? Or is there a fundamental difference of opinion among members
of society regarding the rate at which medical expenditures should increase?

To answer these questions, we must define what we consider an appro-
priate expenditure; only then can we evaluate whether we are spending too
much on medical care. If we determine that we are spending too much, how
must public policy change to achieve the right expenditure level?

Consumer Sovereignty

The appropriate amount of health expenditure is based on a set of values and the
concept of economic efficiency. Resources are limited, so they should be used
for what consumers believe to deliver the most value. Consumers decide how
much to purchase on the basis of their perceptions of the value they expect to
receive and the price they have to pay, knowing that buying one good or service
means forgoing other goods and services. Consumers differ greatly in the value
they place on medical care and what they are willing to forgo to receive that care.
In a competitive market, consumers receive the full benefits of their purchases

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EBSCO Publishing : eBook Collection (EBSCOhost) – printed on 1/5/2023 8:32 AM via UNIVERSITY OF MARYLAND GLOBAL CAMPUS
AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition
Account: s4264928.main.eds

Health Pol icy Issues: An Economic Perspect ive20

and, in turn, pay the full costs of those benefits. If the benefits received from the
last unit used (e.g., the last visit to a physician) equal the cost of that unit, the
quantity consumed is said to be optimal. If more or fewer services are consumed,
the benefits received are said to be greater or less than the cost of that service.

Consumer sovereignty is most easily achieved in a competitive market
system. Through their purchases, consumers communicate their desires regard-
ing goods and services. In response, producers use their resources to produce
the goods and services consumers desire. If producers are to survive and profit
in competitive markets, they must use their resources efficiently and produce
the goods and services for which consumers are willing to pay; otherwise, they
will be replaced by producers that are more efficient and in tune with what
consumers want.

Some people believe that consumer sovereignty should not determine
how much we as a society spend on medical care. Patients lack information and
have limited ability to judge their medical treatment needs. Other concerns are
the quality of care patients receive and the quantity of care that is appropriate.

Consumer sovereignty may be imperfect, but the alternatives are equally
imperfect. If medical care were free to all and physicians (paid on a fee-for-
service basis or salaried) decided the quantity of medical care to provide, the
result would be “too much” care. Physicians are likely to prescribe services
as long as they perceive them to be even slightly beneficial to their patients
because the physicians are not responsible for the cost of that care.

The inevitable consequence of a free medical system is a government-
imposed expenditure limit to halt the provision of too much care. Although
physicians still would be responsible for determining who receives services and
for which diagnoses, “too little” care likely would be provided, as is sometimes
the case in government-controlled health systems such as those in Canada
and Great Britain. Medical care would be rationed, and waiting times and age
would become criteria for allocating resources.

No government that funds healthcare spends sufficient resources to
provide all the care demanded at the going price. Like individuals, govern-
ments make trade-offs between the benefits received from additional health
expenditures and the cost of those expenditures. However, the benefits and
costs to the government are different from those consumers consider in their
decision-making processes. To the government, benefit means the political
support it gains by increasing health expenditures, and cost means the political
support it loses when it raises taxes or shifts resources from politically popular
programs to fund additional medical services.

Let us, therefore, assume that consumer sovereignty will continue to guide
the amount we spend on medical care. Having consumer sovereignty as a guide,
however, does not mean that the United States is spending the right amount on
medical services. This judgment is influenced by another factor: economic efficiency.

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Chapter 2: How Much Should We Spend on Medical Care? 21

Economic Efficiency

Efficiency in the Provision of Medical Services
If medical services were produced in an inefficient manner, medical expenditures
would be excessive. For example, rather than treating a patient for ten days in
the hospital, a physician might be able to achieve the same outcome and same
level of patient satisfaction by treating the patient in the hospital over fewer
days, sending the patient home, and having a visiting nurse complete the treat-
ment. Similarly, it might be possible to treat the patient in an outpatient setting
rather than in the hospital. Physicians’ practice patterns vary greatly across the
country, causing medical expenditures to vary widely with no apparent differ-
ence in outcomes. Unless providers have appropriate incentives to be efficient,
economic efficiency in providing medical services is unlikely to be achieved.

When hospitals were paid on a cost-plus basis, they had an incentive to
raise their costs. Subsequent events changed those incentives, and since the early
1980s both the federal government and the private sector have been pressing
for greater efficiency of the delivery system. Cost-based payment to hospitals
under Medicare gave way to fixed payment based on diagnosis-related groups.
Price competition has escalated not just among hospitals and physicians but
also among insurance companies, which must compete on the basis of premi-
ums in the sale of group health insurance. Preferred provider organizations,
health maintenance organizations, and managed care systems have expanded
their market share at the expense of traditional insurers. Hospitalization rates
have declined as utilization review mechanisms have increased, and the trend
toward implementing case management for catastrophic illness and monitor-
ing providers for appropriateness of care and medical outcomes has grown.

Few would contend that the provision of medical services is as efficient
as it could be. Waste exists in the healthcare system, and it is difficult to define
(Brook 2011; Lallemand 2012). Is waste any medical intervention that provides
no medical benefit, or is it a medical intervention in which the potential for a
negative outcome exceeds the potential for the patient to benefit? (Fuchs 2009).
Economic waste occurs when the expected benefits of an intervention are less
than the expected costs. Remember that waste is also a provider’s income.

The current movement by managed care plans, Medicare Advantage,
and accountable care organizations (ACOs) away from fee-for-service and
toward episode-based payment and capitation is changing provider incentives.
Providers now have a financial incentive to focus on coordination of care and
management of chronic diseases, resulting in less use of costly inpatient set-
tings, greater use of physician extenders, and better outcomes at a lower cost.
It will take a number of years, however, for these new payment schemes and
outcomes to become widespread throughout the medical care system. Despite
the difficulty in defining and reducing waste, the emphasis on cost containment

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Health Pol icy Issues: An Economic Perspect ive22

and the growth of managed care are efforts to decrease inefficient use and
delivery of medical services.

Inefficiency, although important, is not the main cause for concern
about the rise of medical expenditures.

Efficiency in Use of Medical Services
Inefficiencies in the use of medical services result when individuals do not
have to pay the full cost of their choices; they consume too much medical care
because their use of services is based on their out-of-pocket price, and that
price is less than the cost of providing the service. Consequently, the cost of
providing the service exceeds the benefit the patient receives from consum-
ing additional units of the service. The resources devoted to providing these
additional services could be better used for other services, such as education,
that would provide greater benefits.

The effect of paying less than the full price of a service is easy to under-
stand when the concept is applied to some other consumer product, such as
automobiles. If the price of automobiles were greatly lowered for consumers,
they would purchase more automobiles (and more expensive ones). To produce
these additional automobiles, manufacturers would use resources that could
have been used to produce other goods. Similarly, if the price for services is
decreased, people will use more services. Studies have shown that patients who
pay less out of pocket have more hospital admissions, visit physicians more
often, and use more outpatient services than patients who pay higher prices
(Feldstein 2011). This relationship between price and use of services also holds
for patients classified by health status.

Inefficient use is an important concept in healthcare because the price of
medical services has been artificially lowered for many consumers. The govern-
ment subsidizes medical care for the poor and the aged under Medicaid and
Medicare. Those eligible for these programs use more services than they would
have if they had to pay full price. Although the purpose of these programs is
to increase the use of medical services by the poor and the aged, the artificially
low prices also promote inefficient use—for example, when a patient uses the
more expensive emergency department rather than a physician’s office in a
nonemergent situation.

A greater concern is that the working population contributes to use inef-
ficiency. An employer-purchased health plan is not considered taxable income
for employees. If an employer gave the same amount of funds to an employee
in the form of higher wages, the employee would have to pay federal and state
income taxes as well as Social Security tax on the additional income. Because
employer-purchased health insurance is not subject to these taxes, in effect
the government subsidizes the purchase of health insurance and, when the
employee uses that insurance, the purchase of medical services. Employees do

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Chapter 2: How Much Should We Spend on Medical Care? 23

not pay the full cost of health insurance; it is bought with before-tax dollars, as
opposed to almost all other purchases, which are made with after-tax dollars.

The greatest beneficiaries of this tax subsidy are employees in higher income
tax brackets. As discussed in chapter 1, rather than receive additional income as
cash, which is then subject to high taxes (in the 1970s, the highest federal income
tax bracket was 70 percent), these employees choose to receive more of their addi-
tional wages in the form of more health insurance coverage. Instead of spending
after-tax dollars on vision and dental services, they can purchase these services more
cheaply with before-tax dollars. The price of insurance is reduced by employees’
tax bracket; as a result, they purchase more coverage than they otherwise would
have, and the additional coverage is worth less to employees than its full cost.

With the purchase of additional coverage, the out-of-pocket price paid
for medical services declined, prompting the increased use of all medical ser-
vices covered by health insurance. As employees and their families became less
concerned about the real cost of medical services, few constraints limited the
growth in medical expenditures. Had the inefficient use of medical services
(resulting from the tax subsidy for the purchase of health insurance) been less
prevalent, medical expenditures would have risen more slowly.

Inefficiencies in the provision and use of medical services are legitimate
reasons for concern about the amount spent on medical care. Public policy
should attempt to eliminate these government-caused inefficiencies. However,
other, less valid reasons for concern exist.

Government and Employer Concerns over Rising Medical
Expenditures

As payers of medical expenditures, federal and state governments and employ-
ers are concerned about growing medical costs. State governments pay half
the costs of caring for the medically indigent in their state, while the federal
government pays the remaining half. Medicaid expenditures have gone up
more rapidly than any other state expenditure and, to avoid raising taxes,
caused states to reduce funding for other politically popular programs. At the
federal level, the government is also responsible for Medicare (acute medical
services for the aged). The hospital portion of Medicare (Part A) is financed
by a specific payroll tax that has been raised numerous times, and the physi-
cian and prescription drug portions (Parts B and D) are financed with general
income taxes. Medicare expenditures have also risen rapidly.

As a result of the Affordable Care Act (ACA), government subsidies
have greatly increased to pay for expanded Medicaid eligibility and for those
whose income is between 138 and 400 percent of the federal poverty level and
who buy health insurance on healthcare exchanges.

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Health Pol icy Issues: An Economic Perspect ive24

As shown in exhibit 2.1, federal health spending as a proportion of total
federal spending is skyrocketing—from 12 percent in 1985 to 20 percent in
1995 to 30.9 percent in 2015 and to a projected 30.9 percent in 2021. The
oldest of the baby boomers began retiring in 2011 and became eligible for
Medicare, which will dramatically boost Medicare expenditures over the com-
ing years. Unless the federal government can reform Medicare and reduce its
growth rate, the Medicare payroll tax on the working population will be sharply
raised to prevent the Medicare trust fund from going bankrupt. Funding Part
B, Part D, and the subsidies under the ACA will require raising income taxes,
adding to an already large federal deficit, or reducing funding for other federal
programs.

Thus, even if inefficiencies did not exist in the provision or use of medical
services, large increases in Medicare and Medicaid enrollments and expenses—
together with the additional costs to finance the ACA subsidies—will lead to
federal expenditures that exceed the government’s ability to pay for them. The
consumer products comparison presented earlier can be applied here: If the
government purchased 50 percent of all automobiles, it would become con-
cerned with the price and use of automobiles and the associated expenditures.
The pressure to continue funding Medicaid, Medicare, and the new healthcare
entitlements through higher taxes or greater budget deficits is driving the federal
government to seek ways to limit medical spending increases.

Similarly, unions and employers are concerned with the rise in employee
medical expenditures for reasons other than the inefficiencies in the provision
or use of services. The business sector’s spending on health insurance premiums

1965 1975 1985 1995 2005 2015 2021a

Total federal
spending

118.2 332.3 946.3 1,515.7 2,472.0 3,688.3 5,124.2

Federal health
spending

3.1 29.5 117.1 307.1 614.0 1,138.4 1,584.8

Medicare n/a 12.9 65.8 159.9 298.7 546.2 856.1

Medicaid 0.3 6.8 22.7 89.1 181.7 349.8 474.4

Veterans
Administration

1.3 3.7 9.5 16.4 28.8 61.9 72.4

Other 1.5 6.1 19.1 41.7 105.0 180.5 287.0

Federal health
spending as a
percentage of total
federal spending

2.6% 8.9% 12.4% 20.3% 24.8% 30.9% 30.9%

aProjected data.

Note: n/a = not applicable.

Source: Data from Office of Management and Budget (2017, tables 1.1 and 15.1).

EXHIBIT 2.1
Federal

Spending on
Health, Fiscal

Years 1965–
2021 (in Billions

of Dollars)

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Chapter 2: How Much Should We Spend on Medical Care? 25

has increased over time, both as a percentage of total employee compensa-
tion and as a percentage of business profits. Health insurance, when offered,
is part of an employee’s total compensation. Employers are interested only in
the total cost (income) of an employee, not in the form of the income (i.e.,
wages or health benefits). Thus, the employee bears the cost of rising health
insurance premiums because higher premiums mean lower cash wages. Large
unions, whose members receive generous health benefits, want to slow the
rate of growth of medical expenditures because they have seen more of their
compensation gains spent on health insurance than paid out as wages.

Large employers were seriously affected by the Financial Accounting
Standards Board ruling (Employee Benefit Research Institute 1992). Starting in
1993, employers that promised medical benefits to their retirees were required
to list these unfunded liabilities on their balance sheets. Employers previously
paid their retirees’ medical expenses only as they occurred and did not set aside
funds (as is done with pensions). By having to acknowledge these liabilities on
their balance sheets, many large corporations, such as automobile companies,
have seen their net worth decline by billions of dollars. Furthermore, because
these companies have to expense a portion of these future liabilities each year
(not only for their present retirees but also for future retirees), they have to
report lower earnings per share. If employers were to reduce the rate of increase
in their employees’ medical expenditures, the net worth of companies with
large unfunded retiree liabilities would rise, as would their earnings per share.

These differing reasons for concern over rising medical expenditures
are important to recognize. Which concern should drive public policy—the
government’s desire not to raise revenues to fund its share of medical services,
unions’ and employers’ interest in lowering employee and retiree medical
expenses, or society’s desire to achieve the appropriate rate of increase in medi-
cal expenditures? The interests of government, unions, and large employers
have little to do with achieving an appropriate rate of growth. Instead, their
particular political and economic burdens drive their proposals for limiting
increases in medical expenditures.

Approaches to Limiting Increases in Medical Expenditures

The United States should strive to reduce inefficiencies in both the provision
and use of medical services. Inefficiencies in provision, however, are decreas-
ing as managed care plans are forced to compete for enrollees on the basis of
price. The large variations in physicians’ treatment patterns should decrease as
more information on outcomes becomes available through the analysis of large
insurer data sets. Vigilant application of antitrust laws is needed to ensure that
healthcare markets remain competitive and that providers, such as hospitals and
ACOs, do not monopolize their markets. Inefficiencies in use are also declining

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Health Pol icy Issues: An Economic Perspect ive26

as managed care plans control use of services through utilization management
and patient cost sharing. As these inefficiencies are reduced, the growth rate of
medical expenditures will approximate the “correct” rate of increase.

Naturally, the public would like to pay lower insurance premiums and
out-of-pocket costs and still have unlimited access to healthcare and the lat-
est medical technology. As in other sectors of the economy, however, choices
must be made.

Medical expenditures have consistently grown faster than inflation,
sometimes several times faster and sometimes by just several percentage points.
Exhibit 2.2 shows the annual percentage change in national health expenditures
and the consumer price index since 1965. During the mid-1990s, expenditures
moderated as managed care enrollment rose. By the late 1990s, however, they

9.0

10.1

11.9

13.3
1

2.9

13.1

11.0

2.0

11.0

13.4

14.4
14.6

13.8

12.4

13.4

15.3

6.0

12.8

10.1
10.1

9.4

7.2

8.8

12.2

11.3

11.9

9.2

8.4

7.3

5.5
5.6

5.2
5.7

5.8

6.3

7.2

8.5

9.6

8.5

7.3
6.86.5 6.5

4.5

4.0

4.1

3.5
4.0

2.9

5.1

5.8

4.3

–2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

‘66 ‘68 ‘70 ‘72 ‘74 ‘76 ‘78 ‘80 ‘82 ‘84 ‘86 ‘88 ‘90 ‘92 ‘94 ‘96 ‘98 ‘00 ‘02 ‘04 ‘06 ‘08 ‘10 ‘12 ‘14 ‘16

P
er

ce
nt

ag
e

Ch
an

Year

National health
expenditures

CPI(U)

Note: CPI(U) = consumer price index for all urban consumers.

Sources: Data from Bureau of Labor Statistics (2017); Centers for Medicare & Medicaid Services (2017).

EXHIBIT 2.2
Annual

Percentage
Changes in

National Health
Expenditures

and the
Consumer

Price Index,
1965–2016

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Chapter 2: How Much Should We Spend on Medical Care? 27

increased more rapidly as a result of the backlash against managed care and
the consequent relaxation of managed care’s cost-containment methods. In
the past decade, expenditures have moderated as the economy experienced
problems (e.g., the Great Recession) and unemployment and the number of
uninsured surged. In the foreseeable future, medical expenditures are expected
to continue rising faster than inflation and will be driven by higher incomes,
medical advances, federal health reform subsidies, and a greater number of
elderly people.

Some politicians believe they will receive the public’s political support
by proposing additional discounts on drug prices for the aged, managed care
regulations that give enrollees freer access to specialists and other healthcare
providers, and arbitrary limits on the amount by which medical expenditures
and premiums can increase. What would be the consequences of limiting
expenditure and premium increases to a rate lower than what would otherwise
occur in an aging population and a technologically advanced healthcare system?

The United States is undergoing important demographic changes. The
population is aging and will require more medical services, both to relieve
suffering and to cure illnesses. Furthermore, the most important reason for
the rapid rise in medical expenditures has been the tremendous advances in
medical science. Previously incurable diseases can now be cured, and other ill-
nesses can be diagnosed and treated at an earlier stage. Although cures remain
elusive for some diseases (e.g., AIDS and various cancers), life for those with
these diseases can be prolonged with expensive drugs. Limiting the growth of
medical expenditures to an arbitrarily low rate will decrease investment in new
medical technologies and restrict the availability of medical services.

Proposed cost-containment methods can reduce the rate of increase.
Insurers and payers could impose higher out-of-pocket payments; managed
care organizations could require physicians to follow evidence-based medicine
guidelines and disease management protocols; or plans could restrict enrollees
to using only participating primary care providers, specialists, and hospitals.

The middle class, however, appears unwilling to make these trade-offs; it
wants both lower expenditures and unlimited access. (Politicians are responding
to these concerns by indicating their willingness to regulate broader access to
providers and services, but without acknowledging the higher premiums that
would result.) Significantly lowering the rate of increase and funding universal
access, however, will require more than implementing these cost-containment
measures. To achieve these ends, services and technology will have to be made
less available to many people (Fuchs 1993).

Some politicians have led the public to believe these trade-offs are not
necessary; they claim that by eliminating waste in the healthcare system, uni-
versal coverage can be achieved and everyone can have all the medical care
they need at a lower cost. Such rhetoric merely postpones the time when the
public realizes it must make the unpleasant choice between spending and access.

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Health Pol icy Issues: An Economic Perspect ive28

Summary

Who should decide how much is to be spent on medical care? All countries face
this basic question, and they have made different choices. In some countries,
the government determines the allocation of resources among the medical
sectors and controls medical prices. When the government makes these deci-
sions, the trade-offs between cost and access are likely to be different from
those that consumers would make.

In the United States, consumer sovereignty has been the guiding prin-
ciple in allocating resources; consumers (except those enrolled in Medicare
and Medicaid) determine the amount of their income to be spent on medical
services. Yet, consumers have not always received value for their money. Inef-
ficiencies in the medical sector, inappropriate provider incentives, and certain
government regulations have made medical services more costly. Furthermore,
subsidies for the purchase of health insurance (tax-exempt, employer-paid health
insurance) have resulted in greater use of services. Thus, the debate over the
appropriate amount to be spent on medical services is likely to be clarified only
when these two issues—consumer sovereignty and efficiency of the current
system—are separated.

Discussion Questions

1. How does a competitive market determine the types of goods and
services to produce, the costs to produce those goods and services, and
who receives them?

2. Why do economists believe the value of additional employer-paid health
insurance is worth less than its full cost?

3. Why do rising medical expenditures cause concern?
4. Why do inefficiencies exist in the provision and use of medical services?
5. Why are unions and the government concerned about rising medical

expenditures?

References

Brook, R. H. 2011. “The Role of Physicians in Controlling Medical Care Costs and
Reducing Waste.” Journal of the American Medical Association 306 (6): 650–51.

Bureau of Labor Statistics. 2017. “Databases, Tables, and Calculators, by Subject.”
Accessed August. http://data.bls.gov.

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Chapter 2: How Much Should We Spend on Medical Care? 29

Centers for Medicare & Medicaid Services. 2017. “National Health Expenditure Data,
Historical.” Accessed December. www.cms.gov/Research-Statistics-Data-and-
Systems/Statistics-Trends-and-Reports/NationalHealthExpendData/National
HealthAccountsHistorical.html.

Employee Benefit Research Institute. 1992. “An EBRI Special Report.” EBRI Issue
Brief 124. Published March. www.ebri.org/pdf/briefspdf/0392ib .

Feldstein, P. J. 2011. “The Demand for Medical Care.” In Health Care Economics, 7th
ed., 114–38. Albany, NY: Delmar.

Fuchs, V. R. 2009. “Eliminating Waste in Health Care.” Journal of the American
Medical Association 302 (22): 2481–82.

———. 1993. “No Pain, No Gain—Perspectives on Cost Containment.” Journal of
the American Medical Association 269 (5): 631–33.

Lallemand, N. C. 2012. “Reducing Waste in Health Care.” Health Affairs health policy
brief. Published December 13. www.healthaffairs.org/healthpolicybriefs/brief.
php?brief_id=82.

Office of Management and Budget. 2017. Fiscal Year 2017 Historical Tables: Budget
of the U.S. Government. Accessed August. www.govinfo.gov/content/pkg/
BUDGET-2017-TAB/pdf/BUDGET-2017-TAB .

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CHAPTER

WHY HEALTH ECONOMICS?

Learning Objectives

After reading this chapter, students will be able to

• describe the value of economics for managers,
• identify major challenges for healthcare managers,
• find current information about health outcomes, and
• distinguish between positive and normative economics.

Key Concepts

• Economics helps managers focus on key issues.
• Economics helps managers understand goal-oriented decision making.
• Economics helps managers understand strategic decision making.
• Economics gives managers a framework for understanding costs.
• Economics gives managers a framework for understanding market

demand.
• Economics gives managers a framework for assessing profitability.
• Economics helps managers understand risk and uncertainty.
• Economics helps managers understand insurance.
• Economics helps managers understand information asymmetries.
• Economics helps managers deal with rapid change.

1.1 Why Health Economics?

Why should working healthcare managers study economics? This simple
question is really two questions. Why is economics valuable for managers?
What special challenges do healthcare managers face? These questions moti-
vate this book.

Why is economics valuable for managers? There are six reasons. We
will briefly touch on each of them to highlight the themes we will develop
in later chapters.

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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
Account: s4264928.main.eds

Economics for Healthcare Managers2

1. Economics helps managers focus on key issues. Economics helps
managers wade through the deluge of information they confront and
identify the data they need.

2. Economics outlines strategies for realizing goals given the available
resources. A primary task of economics is to explore carefully the
implications of rational decision making.

3. Economics gives managers ground rules for strategic decision making.
When rivals are not only competing against them but watching what
they do, managers must be prepared to think strategically.

4. Economics gives managers a framework for making sense of costs.
Managers need to understand costs because good decisions are unlikely
to be made without this understanding.

5. Economics gives managers a framework for thinking about value.
The benefits of the goods and services that successful organizations
provide to customers exceed the costs of producing those goods and
services. Good management decisions require an understanding of how
customers perceive value.

6. Most importantly, economics sensitizes managers to fundamental ideas
that affect the operations of every organization. Effective management
begins with the recognition that consumers are sensitive to price
differences, that organizations compete to advance the interests of
their stakeholders, and that success comes from providing value to
customers.

1.2 Economics as a Map for Decision Making

Economics provides a map for decision making. Maps do two things. They
highlight key features and suppress unimportant features. To drive from Des
Moines, Iowa, to Dallas, Texas, you need to know how the major highways
connect. You do not want to know the name and location of each street in
each town you pass through. Of course, what is important and what is unim-
portant depend on the task at hand. If you want to drive from West 116th
Street and Ridgeview Road in Olathe, Kansas, to the Truman homestead in
Independence, Missouri, a map that describes only the interstate highway
system will be of limited value to you. You need to know which map is the
right tool for your situation.

Using a map takes knowledge and skill. You need to know what infor-
mation you need, or you may choose the wrong map and be swamped in
extraneous data or lost without key facts. Having the right map is no guar-
antee that you can use it, however. You need to practice to be able to use a
map quickly and effectively.

cost
The value of a
resource in its next
best use.

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Chapter 1 : Why Health Economics? 3

Like a map, economics highlights some issues and suppresses others.
For example, it tells managers to focus on marginal or incremental costs,
which makes understanding and managing costs much simpler, but econom-
ics has little to say about the belief systems that motivate consumer behavior.
If you are seeking to make therapeutic regimens easier to adhere to by mak-
ing them more consistent with consumers’ belief systems, economics is not
a helpful map. If, on the other hand, you want to decide whether setting up
an urgent care clinic is financially feasible, economics helps you focus on how
your project will change revenues and costs.

Economics also gives managers a framework for understanding rational
decision making. Rational decision making involves making choices that
further one’s goals given the resources available. Whether those goals include
maximizing profits, securing the health of the indigent, or other objectives, the
framework is much the same. It entails looking at benefits and costs to realize
the largest net benefit. (We will explore this question further in section 1.5.)

Managers must understand costs and be able to explain costs to others.
Confusion about costs is common, so confusion in decision making is also
common. Confusion about benefits is even more widespread than confu-
sion about costs. As a result, management decisions in healthcare often leave
much to be desired.

Economists typically speak about economics at a theoretical level,
using “perfectly competitive markets” (which are, for the most part, mythi-
cal social structures) as a model; as a result, application of economics can be
difficult for managers competing in real-world markets. Yet, economics offers
concrete guidance about pricing, contracting, and other quandaries that
managers face. Economics also offers a framework for evaluating the strategic
choices managers must make. Many healthcare organizations have rivals, so
good decisions must take into account what the competition is doing. Will
being the first to enter a market give your organization an advantage, or
will it give your rivals a low-cost way of seeing what works and what does
not? Will buying primary care practices bring you increased market share or
buyer’s remorse? Knowing economics will not make these choices easy, but it
can give managers a plan for sorting through the issues.

1.3 Special Challenges for Healthcare Managers

What special challenges do healthcare managers face? Healthcare managers
face five issues more than other managers do:

1. The central roles of risk and uncertainty
2. The complexities created by insurance
3. The perils produced by information asymmetries

marginal or
incremental cost
The cost of
producing an
additional unit of
output.

rational decision
making
Choosing the
course of action
that offers the best
outcomes, given
the constraints
one faces.

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Economics for Healthcare Managers4

4. The problems posed by not-for-profit organizations
5. The rapid and confusing course of technical and institutional change

Let us look at each of these challenges in more depth.

1.3.1 Risk and Uncertainty
Risk and uncertainty are defining features of healthcare markets and health-
care organizations. Both the incidence of illness and the effectiveness of
medical care should be described in terms of probabilities. For example, the
right therapy, provided the right way, usually carries some risk of failure. A
proportion of patients will experience harmful side effects, and a proportion
of patients will not benefit. As a result, management of costs and quality pres-
ents difficult challenges. Has a provider produced bad outcomes because he
was unlucky and had to treat an extremely sick panel of patients, or because
he encountered a panel of patients for whom standard therapies were inef-
fective? Did his colleagues let him down? Or was he incompetent, sloppy, or
lazy? The reason is not always evident.

1.3.2 Insurance
Because risk and uncertainty are inherent in healthcare, most consumers
have health insurance, and healthcare organizations have to contend with
the management problems insurance presents. First, insurance creates confu-
sion about who the customer is. Customers use the products, but insurance
plans often pay most of the bill. Moreover, most people with private medi-
cal insurance receive coverage through their employer (in large part because
the tax system makes this arrangement advantageous). Although economists
generally agree that employees ultimately pay for insurance via wage reduc-
tions, most employees do not know the costs of their insurance alternatives
(and unless they are changing jobs, they have limited interest in finding out).
As a result of this situation, employees remain unaware of the true costs of
care and are not eager to balance cost and value. If insurance is footing the
bill, most patients choose the best, most expensive treatment—a choice they
might not make if they were paying the full cost.

In addition, insurance makes even simple transactions complex. Most
transactions involve at least three parties (the patient, the insurer, and the
provider), and many involve more. To add to the confusion, most providers
deal with a wide array of insurance plans and face blizzards of disparate claim
forms and payment systems. Increasing numbers of insurance plans have
negotiated individual payment systems and rates, so many healthcare provid-
ers look wistfully at industries that simply bill customers to obtain revenues.
The complexity of insurance transactions also increases opportunity for error
and fraud. In fact, both are fairly common.

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Chapter 1 : Why Health Economics? 5

Despite this bewildering array of insurance plans, many providers
still rely on a few plans for their revenue (a circumstance most managers
seek to avoid). For example, most hospitals receive at least a third of their
revenue from Medicare. As a result, changes in Medicare regulations or pay-
ment methods can profoundly alter a healthcare organization’s prospects.
Overnight, changes to reimbursement terms may transform a market that
is profitable for everyone to one in which only the strongest, best-led, best-
positioned organizations can survive.

1.3.3 Information Asymmetries
Information asymmetries are common in healthcare markets and create a
number of problems. An information asymmetry occurs when one party
in a transaction has less information than the other party. In this situation,
the party with more information has an opportunity to take advantage of the
party with less information. Recognizing a disadvantage, the party with less
information may become skeptical of the other party’s motivation and decline
a recommendation that would have been beneficial. For example, physicians
and other healthcare providers usually understand patients’ medical options
better than patients do. Unaware of their choices, patients may accept rec-
ommendations for therapies that are not cost-effective or, recognizing their
vulnerability to physicians’ self-serving advice, may resist recommendations
made in their best interest.

From a manager’s perspective, asymmetric information means that
providers have a great deal of autonomy in recommending therapies. Because
providers’ recommendations largely define the operations of insurance plans,
hospitals, and group practices, managers need to ensure that providers do
not have incentives to use their superior information to their advantage.
Conversely, in certain situations, patients have the upper hand and are likely
to forecast their healthcare use more accurately than insurers. Patients know
whether they want to start a family, whether they seek medical attention
whenever they feel ill, or whether they have symptoms that indicate a poten-
tial condition. As a result, health plans are vulnerable to adverse selection,
meaning that high-risk consumers are more likely to seek insurance whereas
healthier individuals are more likely to go without.

1.3.4 Not-for-Profit Organizations
Most not-for-profit organizations have worthy goals that their managers take
seriously, but these organizations can create problems for healthcare manag-
ers as well. For example, not-for-profit organizations usually have multiple
stakeholders. Multiple stakeholders mean multiple goals, so organizations
become much harder to manage, and managers’ performance becomes
harder to assess. The potential for managers to put their own needs before

information
asymmetry
When one party in
a transaction has
less information
than the other
party.

adverse selection
A situation that
occurs when
buyers have
better information
than sellers. For
example, high-
risk consumers
are willing to pay
more for insurance
than low-risk
consumers are.
(Organizations
that have difficulty
distinguishing
high-risk from low-
risk consumers
are unlikely to be
profitable.)

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Economics for Healthcare Managers6

their stakeholders’ needs exists in all organizations but is more difficult to
detect in not-for-profit organizations because they do not have a simple bot-
tom line. In addition, not-for-profit organizations may be harder to run well.
They operate amid a web of regulations designed to prevent them from being
used as tax avoidance schemes. These regulations make setting up incentive-
based compensation systems for managers, employees, and contractors (the
most important of whom are physicians) more difficult. Further, when a
project is not successful, not-for-profit organizations have greater difficulty
putting the resources invested in the failed idea to other uses. For example,
the trustees of a not-for-profit organization may have to get approval from
a court to sell or repurpose its assets. Because of these special circumstances,
managers of not-for-profit organizations can always claim that substandard
performance reflects their more complex environment.

1.3.5 Technological and Institutional Change
This fifth challenge makes the others pale in comparison. The healthcare
system is in a state of flux. Virtually every part of the healthcare sector is
reinventing itself, and no one seems to know where the healthcare system is
headed. Leadership is difficult to provide if you do not know where you are
going. Because change presents a pervasive test for healthcare managers, we
will examine it in greater detail.

1.4 Turmoil in the Healthcare System

Why is the healthcare system of the United States in such turmoil? One expla-
nation is common to the entire developed world: rapid technical change. The
pace of medical research and development is breathtaking, and the public’s
desire for better therapies is manifest. These demands challenge healthcare
managers to regularly lead their organizations into unmapped territory. To
make matters worse, changes in technology or changes in insurance can
quickly affect healthcare markets. In healthcare, as in every other sector of
the economy, new technologies can create winners and losers. For example,
between 2000 and 2007, Medicare payments to ambulatory surgery centers
more than doubled. Medicare changed its policy, and growth slowed down
(Medicare Payment Advisory Commission 2018). What appears profitable
today may not be profitable tomorrow if technology, competition, rates, or
regulations change significantly.

The Affordable Care Act (ACA) has resulted in a wave of innovations
by providers, insurers, employers, and governments. (See chapter 6 for more
detail.) Which of these innovations will succeed is not clear. In addition,
some healthcare organizations will thrive in the environment of the ACA,

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Chapter 1 : Why Health Economics? 7

and some will fail. The passage of the ACA appears to have been transforma-
tive, but its repeal might not undo the changes it led to.

1.4.1 The Pressure to Reduce Costs
The economics of high healthcare costs is far simpler than the politics of
high healthcare costs. To reduce costs, managers must reallocate resources
from low-productivity uses to high-productivity uses, increase productivity
wherever feasible, and reduce prices paid to suppliers and sectors that have
excess supply. They also must recognize that cost cutting is politically diffi-
cult. Reallocating resources and increasing productivity will cost some people
their jobs. Reducing prices will lower some people’s incomes. These steps are
difficult for any government to take, and many of those who will be affected
(physicians, nurses, and hospital employees) are politically well organized.

Why Is the Pressure to Reduce
Healthcare Costs So Strong?

The United States spends far more than other wealthy industrial
countries but has poorer outcomes. Spending per person is more than
double the spending per person in Canada, France, and the United
Kingdom (see exhibit 1.1). Differences this large should be reflected in
the outcomes of care.

Country 2011 2016

Canada $4,248 $4,644

France $4,031 $4,600

Germany $4,588 $5,501

Switzerland $6,048 $7,919

United Kingdom $3,084 $4,193

United States $8,145 $9,892

Source: Data from Organisation for Economic Co-operation
and Development (OECD 2017).

Note: Spending has been converted into US dollars.

EXHIBIT 1.1
Healthcare
Spending per
Person

Case 1.1

(continued)

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Economics for Healthcare Managers8

1.4.2 The Fragmentation of Healthcare Payments
The fragmented payment system compounds the political problem. Most
Americans see only a fraction of their total spending. A typical American pays
for care through a mixture of direct payments for care; payroll deductions for
insurance premiums; lower wages; higher prices for goods and services; and
higher federal, state, and local taxes. Because so much of the payment system
is hidden, few can effectively track healthcare costs. The exceptions, notably

However, of the six countries listed in exhibit 1.2,
the United States has the shortest life expectancy
at birth. In part, this difference is because the

United States invests relatively little in improving the social determi-
nants of health and reducing inequality. Adler, Glymour, and Fielding
(2016) note that the life expectancy of 40-year-old men at the bottom
of the income distribution is 14.6 years shorter than for men in the top
of the income distribution. Greater spending should not produce these
results.

Country Males Females

Canada 79.6 years 83.8 years

France 79.6 years 85.5 years

Germany 78.3 years 83.1 years

Switzerland 80.8 years 85.1 years

United Kingdom 79.5 years 82.8 years

United States 76.5 years 81.2 years

Source: Data from OECD (2017).

Discussion Questions
• Why is spending so much more than other countries a problem?

• What can Americans not buy because of high spending on
healthcare?

• What factors other than healthcare affect population health?

• Does this evidence suggest that the American healthcare system is
not efficient?

• What are the most important social determinants of health?

social
determinants of
health
Factors that
affect health
independently of
healthcare (e.g.,
education and
housing).

EXHIBIT 1.2
Life Expectancy

at Birth, 2015

Case 1.1
(continued)

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Chapter 1 : Why Health Economics? 9

employers who write checks for the entire cost of insurance policies and the
trustees of the Medicare system, understand the need to reduce costs.

1.5 What Does Economics Study?

What does economics study? Economics analyzes the allocation of scarce
resources. Although this answer appears straightforward, several defini-
tions are needed to make this sentence understandable. Resources include
anything useful in consumption or production. From the perspective of a
manager, resources include the flow of services from supplies or equipment
the organization owns and the flow of services from employees, buildings, or
other entities the organization hires. A resource is scarce if it has alternative
uses, which might include another use in the organization or use by another
person or organization. Most issues that managers deal with involve scarce
resources, so economics is potentially useful for nearly all of them.

Economics focuses on rational behavior—that is, it focuses on indi-
viduals’ efforts to best realize their goals, given their resources. Because time
and energy spent in collecting and analyzing information are scarce resources
(i.e., the time and energy have other uses), complete rationality is irrational.
Everyone uses shortcuts and rules to make certain choices, and doing so is
rational, even though better decisions are theoretically possible.

Much of economics is positive. Positive economics uses objective
analysis and evidence to answer questions about individuals, organizations,
and societies. Positive economics might describe the state of healthcare, for
example, in terms of hospital occupancy rates over a certain period. Positive
economics also proposes hypotheses and assesses how consistent the evidence
is with them. For example, one might examine whether the evidence sup-
ports the conjecture that reductions in direct consumer payments for medical
care (measured as a share of spending) have been a major contributing factor
in the rapid growth of healthcare spending per person. Although values do
not directly enter the realm of positive economics, they do shape the ques-
tions economists ask (or do not ask) and how they interpret the evidence.

Normative economics often addresses public policy issues, but not
always. The manager of a healthcare organization who can identify addi-
tional services or additional features that customers are willing to pay for is
demonstrating normative economics. Likewise, the manager who can identify
features or services that customers do not value is also demonstrating norma-
tive economics.

Normative economics takes two forms. In one, citizens use the tools
of economics to answer public policy questions. Usually these questions
involve ethical and value judgments (which economics cannot supply) as well

scarce resource
Anything useful
in consumption or
production that
has alternative
uses.

positive
economics
Using objective
analysis and
evidence to
answer questions
about individuals,
organizations, and
societies.

normative
economics
Using values to
identify the best
options.

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Economics for Healthcare Managers10

as factual judgments (which economics can support or refute). A question
such as “Should Medicare eliminate deductibles?” involves balancing benefits
and harms. Economic analysis can help assess the facts that underlie the ben-
efits and harms but cannot provide an answer. The second form of norma-
tive economics is the basis for this book’s content. This form tells us how to
analyze what we should do, given the circumstances that we face. In this part
of normative analysis, market transactions indicate value. For example, we
may believe that a drug is overpriced, but we must treat that price as a part
of the environment and react appropriately if no one will sell it for less. Most
managers find themselves in such an environment.

To best realize our goals within the constraints we face, we can use the
explicit guidance economics gives us:

1. First, identify plausible alternatives. Breakthroughs usually occur when
someone realizes there is an alternative to the way things have always
been done.

2. Second, consider modifying the standard choice (e.g., charging a
slightly higher price, using a little more of a nurse practitioner’s time).

3. Next, pick the best choice by determining the level at which its
marginal benefit equals its marginal cost. (We will explain these terms
shortly.)

4. Finally, examine whether the total benefits of this activity exceed the
total cost.

Skilled managers routinely perform this sort of analysis. For example,
a profit-seeking organization might conclude that a clinic’s profits would be
as large as possible if it hired three physicians and two nurse practitioners
but that the clinic’s profits still would be unacceptably low if it did. Profits
would fall even further if it increased or decreased the number of physicians
and nurse practitioners, so the profit-seeking organization would choose to
close the clinic.

Let us define some terms to make this discussion clearer. Cost, as
noted previously, is the value of a resource in its next best use. For example,
the cost of a plot of land for a medical office would be the most another
user would pay for it, not what it sold for 20 years ago. The next best use
of that land might be for housing, for a park, for a store, or for some other
use. Usually the next best use of a resource is someone else’s use of it, so a
resource’s cost is the amount we would be paid when we sell it or the price
we have to pay to buy it. Benefit is the value we place on a desired outcome.
We describe this value in terms of our willingness to trade one desired out-
come for another. Often, but not always, our willingness to pay money for
an outcome is a convenient measure of value. A marginal or an incremental

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Chapter 1 : Why Health Economics? 11

amount is the increased cost we incur from using more of a resource or the
increased benefit we realize from a greater outcome. So, if a 16-ounce iced
tea costs $1.49 and a 24-ounce iced tea costs $2.29, the incremental cost
of the larger size is ($2.29 − $1.49) ÷ (24 − 16), or 10 cents per ounce. A
rational consumer might

1. conclude that the incremental benefit of the larger iced tea exceeds its
incremental cost and buy the larger size;

2. conclude that the incremental cost of the larger iced tea exceeds its
incremental benefit and buy the smaller size; or

3. conclude that the total benefit of both sizes was less than their total
cost and buy neither.

Remember, however, that rational decisions are defined by the goals that
underpin them. A consumer with a train to catch might buy an expensive
small drink at the station to save time.

Why Does the United States Spend
So Much More?

Case 1.1 noted that the United States spends far more per person on
medical care than other wealthy countries. Is that because Americans
are wealthier, because they have worse habits, or because they use
more services?

Income is a possible explanation. Income per capita is higher in
the United States than in the other five countries discussed in case 1.2
(World Bank 2017). This extra income could result in Americans’ using
more services or paying higher prices. Part of the answer, it turns out,
is that Americans pay higher prices. Americans use fewer pharmaceuti-
cals, make fewer physician visits, and spend less time in hospitals but
spend more on each of these items than residents of other countries
do (OECD 2017).

Higher prices for inputs, such as pharmaceuticals, hospital ser-
vices, and physician services, help drive higher spending in the United
States. For example, the average amount private insurers pay hospitals
and physicians for knee replacement surgery is $28,184 in the United
States and $20,132 in Switzerland, whereas the National Health Ser-
vice pays an average of $18,451 in the United Kingdom (International

Case 1.2

(continued)

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Economics for Healthcare Managers12

Federation of Health Plans 2016). Prices in the
United States are 40 percent higher than prices in
Switzerland and 53 percent higher than prices in

the United Kingdom. Similarly, Harvoni, a drug used to treat hepatitis
C, costs $32,114 in the United States versus $22,554 in Switzerland
and $16,861 in the United Kingdom’s National Health Service (Inter-
national Federation of Health Plans 2016). Prices for Harvoni in the
United States are 42 percent higher than in Switzerland and 90 per-
cent higher than in the United Kingdom. Most governments negotiate
input prices, but in the United States private insurers with limited
leverage negotiate prices. Governments in the United States do negoti-
ate physician and hospital prices for Medicare and Medicaid, but not
pharmaceutical prices.

The United States also has a more intensive mix of services.
Compared with the average European country, the United States
uses 88 percent more MRI (magnetic resonance imaging) scans per
person, 76 percent more CT (computed tomography) scans, and 15
percent more cesarean sections (OECD 2017). In addition, the physi-
cian workforce has far fewer primary care physicians than in other
wealthy countries. Although primary care physicians are well paid
by international standards, earning an average of $217,000, this
average salary is more than 40 percent less than specialists earn
(Grisham 2017).

To understand the higher prices and more intensive service mix
in the United States, one needs to understand the unique history
of American health insurance. Blue Cross was started by hospitals
in 1929 to bolster sagging hospital revenues, and Blue Shield was
started by physicians in 1939 (Rothman 2017). Both were designed
to limit price competition, and neither covered primary care services.
Although health insurance is changing rapidly now, for many years the
models set up by Blue Cross and Blue Shield persisted.

For the most part, Americans do not have worse habits than the
citizens of other wealthy countries. Americans smoke and drink less
than average (OECD 2017). Americans are much more likely to be
obese than average, which contributes to high blood pressure, high
cholesterol, diabetes, and a host of other complications. Increases in

cesarean section
Surgical delivery of
a baby.

CT scan
An imaging
method in which
a computer
processes multiple
X-rays to produce
virtual cross-
sectional images.

MRI scan
An imaging
method that uses
magnetic fields
to align hydrogen
atoms. A computer
processes the
resulting signal to
produce images
of hard and soft
tissues. Unlike
X-rays, MRI scans
do not expose
patients to ionizing
radiation.

Case 1.2
(continued)

(continued)

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Chapter 1 : Why Health Economics? 13

1.6 Conclusion

Why should healthcare managers study economics? To be better manag-
ers. Economics offers a framework that can help all managers simplify and
improve their management decisions. It is especially valuable to clinicians
who assume leadership roles in healthcare organizations. Managers are rou-
tinely overwhelmed with information, yet they often lack the key facts that
they need to make good decisions. Economics offers a map that makes focus-
ing on essential information easier.

Exercises

1.1 Why is the idea that value depends on consumers’ preferences
radical?

1.2 Mechanics usually have better information about how to fix
automobiles than their customers do. What problems does this
advantage create? Can mechanics or their customers do anything to
limit these problems?

1.3 A mandatory health insurance plan costs $4,000. One worker earns
$24,500 in employment income and $500 in investment income.
Another worker earns $48,000 in employment income and $2,000
in investment income. A third worker earns $68,000 in employment
income and $7,000 in investment income. A premium-based system
would cost each worker $4,000. A wage tax–based system would
cost each worker 8.5 percent of wages. An income tax–based system

obesity have increased costs by hundreds of bil-
lions of dollars (Biener, Cawley, and Meyerhoefer
2017).

Discussion Questions
• Why are prices so much higher in the United States?

• Why is the intensity of care higher in the United States?

• Should Medicare negotiate drug prices?

• Why does the history of health insurance matter?

• How does obesity increase costs?

Case 1.2
(continued)

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Economics for Healthcare Managers14

would cost each worker 8 percent of income. For each worker,
calculate the cost of the insurance as a share of total income.

Worker 1 Worker 2 Worker 3

E = Employment income $24,500 $48,000 $68,000

I = Investment income $500 $2,000 $7,000

P = Premium cost of insurance $4,000 $4,000 $4,000

Premium as a percentage of income = P/(E + I)

W = Wage tax cost of insurance = 0.085 × E

Wage tax cost as a percentage of income = W/(E + I)

T = Income tax cost of insurance = 0.080 × (E + I)

Income tax cost as a percentage of income = T/(E + I)

1.4 Which of the plans in exercise 1.3 would impose the larger burden
on those with incomes under $25,000: a mandatory insurance plan
financed via premiums, via the income tax, or via a payroll tax?

1.5 Which of the plans in exercise 1.3 would be fairest?
1.6 Which of the preceding questions can you answer using positive

economics? For which of the preceding questions must you use
normative economics?

1.7 The following table shows data for Australia, the United Kingdom,
and the United States.
a. How did life expectancy at birth change between 2010 and 2015?
b. How did expenditure per person change between 2010 and 2015?
c. What conclusions do you draw from these data?
d. If you were the “manager” of the healthcare system in the United

States, what would be a sensible response to data like these?

Life Expectancy (Years) Expenditure per Person

2010 2015 2010 2015

Australia 81.8 82.5 $3,893 $4,493

United Kingdom 80.6 81.0 $3,281 $4,125

United States 78.6 78.8 $8,559 $9,507

Source: Data from OECD (2017).

Note: Expenditure per person has been translated into US dollars and adjusted for inflation.

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Chapter 1 : Why Health Economics? 15

References

Adler, N. E., M. M. Glymour, and J. Fielding. 2016. “Addressing Social Determi-
nants of Health and Health Inequalities.” JAMA 316 (16): 1641–42.

Biener, A., J. Cawley, and C. Meyerhoefer. 2017. “The High and Rising Costs of
Obesity to the US Health Care System.” Journal of General Internal Medicine
32 (Suppl. 1): 6–8.

Grisham, S. 2017. “Medscape Physician Compensation Report 2017.” Medscape. Pub-
lished April 5. www.medscape.com/slideshow/compensation -2017 -overview
-6008547.

International Federation of Health Plans. 2016. 2015 Comparative Price Report.
Accessed October 4, 2018. https://fortunedotcom.files.wordpress.com/2018
/04/66c7d-2015comparativepricereport09-09-16 .

Medicare Payment Advisory Commission. 2018. “Ambulatory Surgical Center Ser-
vices.” Published March. www.medpac.gov/docs/default-source/reports
/mar18 _medpac_ch5_sec .

Organisation for Economic Co-operation and Development (OECD). 2017. “OECD
Health Statistics 2017.” Accessed August 16, 2018. www.oecd.org/els/health
-systems/health-statistics.htm.

Rothman, L. 2017. “The American Health Care System Has Lots of Problems. Here’s
When They Started.” Time. Published July 13. http://time.com/4837864
/healthcare-history-beginning-obamacare-ahca/.

World Bank. 2017. “GDP per Capita (Current US$).” Accessed August 16, 2018.
https://data.worldbank.org/indicator/NY.GDP.PCAP.CD.

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CHAPTER

2AN OVERVIEW OF THE US HEALTHCARE
SYSTEM

Learning Objectives

After reading this chapter, students will be able to

• apply marginal analysis to a simple economic problem,
• articulate the input and output views of healthcare products,
• find current national and international information about healthcare,
• compare the US healthcare system to those in other countries, and
• identify major trends in healthcare.

Key Concepts

• Healthcare products are inputs into health.
• Healthcare products are also outputs of the healthcare sector.
• The usefulness of healthcare products varies widely.
• Marginal analysis helps managers focus on the right questions.
• Life expectancies have increased sharply in the United States in recent

years.
• Other wealthy countries have seen larger health gains with smaller cost

increases.
• The healthcare sector is changing radically in response to technology

and policy changes.

2.1 Input and Output Views of Healthcare

This chapter describes the healthcare system of the United States from an
economic point of view and introduces tools of economic analysis. It looks at
the system from two perspectives. The first perspective, called the input view,
emphasizes healthcare’s contribution to the public’s well-being. The second
perspective, called the output view, emphasizes the goods and services the

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AN: 2144510 ; Robert Lee.; Economics for Healthcare Managers, Fourth Edition
Account: s4264928.main.eds

Economics for Healthcare Managers18

healthcare sector produces. In the language of economics, an input is a good
or service used in the production of another good or service, and an output
is the good or service that emerges from a production process. Products
(goods and services are considered products) are commonly both inputs and
outputs. For example, a surgical tool is an input into a surgery and an output
of a surgical tool company. Similarly, the surgery itself can be considered an
output of the surgical team or an input into the health of the patient.

2.1.1 The Input View
The input view of the healthcare system stresses the usefulness of healthcare
products. From this perspective, healthcare products are neither good nor
bad; they are simply tools used to improve and maintain health. The input
view is important because it focuses our attention on alternative ways of
achieving our goals, and healthcare products are only one of many inputs into
health. Others, such as exercise, diet, and rest, are alternative ways to improve
or maintain health. From this perspective, a switch from medical therapies for
high blood pressure to meditation or exercise would be based on the follow-
ing question: Which is the least expensive way to get the result I want? This
apparently simple question can be difficult to answer.

The input view stresses that the usefulness of any resource depends on
the problem at hand and other available resources. Whether the health of a
particular patient or population will improve as a result of using more health-
care products depends on a number of factors, including the quality and
quantity of healthcare products already being used, the quality and quantity
of other health inputs, and the general well-being of the patient or popula-
tion. For example, the effect of a drug on an otherwise healthy 30-year-old is
likely to be different from its effect on an 85-year-old who is taking 11 other
medications. Increasing access to medical care is not likely to be the best
way to reduce infant mortality in a population that is malnourished and lacks
access to safe drinking water, given the powerful effects of better food and
water on health outcomes. What is the best way to use our resources, given
that most preventable mortality is a result of risky behavior? Sometimes, more
medical care is not the answer. All these examples illustrate that the usefulness
of resources varies with the situation.

The economic perspective of marginal analysis challenges us to exam-
ine the effects of changes on what we do. Marginal analysis proposes ques-
tions such as these: How much healthier would this patient or population
be if we increased use of this resource? How much unhealthier would this
patient or population be if we reduced use of this resource? Most manage-
ment decisions are made on the basis of marginal analysis, although the ques-
tions used to arrive at the decisions are often more concrete. For example,
what costs would we incur if we increased the chicken pox immunization rate

input
A good or
service used in
production.

output
A good or service
produced by an
organization.

marginal analysis
The analysis of
the effects of
small changes in a
decision variable
(e.g., price or
volume of output)
on outcomes (e.g.,
costs, profits,
or probability of
recovery).

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Chapter 2: An Over view of the US Healthcare System 19

among three-year-olds from 78 to 85 percent, and how much would increas-
ing immunization reduce the incidence of chicken pox among preschoolers?

Reasonable answers to these questions tell us the cost per case of
chicken pox avoided, and we can use that information to decide whether
we want to use our resources for this proposition. Managers who focus on
healthcare products as outputs of their organizations ask the same types of
questions, although they frame them differently: How much will profits rise
if we increase the number of skilled nursing beds from 12 to 18? What costs
would we incur if we added a nurse midwife to the practice, and how would
this addition change patient outcomes and revenues? In any setting, marginal
analysis helps managers focus on the right questions.

Exhibit 2.1 illustrates how variable the effects of medical interventions
can be. The data indicate that spending $1 million on an intervention to
reduce childhood obesity would save 1,292 life years, whereas spending $1
million on colonoscopies for 81-year-old African American men would save
one life year. Exhibit 2.1 also reminds us that effectiveness does not always
determine what services are offered. Interventions to reduce childhood obe-
sity are not common, but colonoscopies for 66-year-olds are.

We have to make some choices. Colonoscopies for 81-year-olds save
only a few life years. However, this screening may allow children multiple
happy years with a grandparent. We cannot avoid a decision about whether
the benefits of this intervention are large enough to justify its substantial costs.

life year
One additional
year of life. It can
equal one added
year of life for an
individual or an
average of 1/nth of
a year of life for n
people.

Intervention Life Years Source

Antismoking intervention 2,545 Xu et al. (2015)

Intervention to reduce childhood
obesity

1,292 Sharifi et al. (2017)

Multidisciplinary management for
heart failure

995 Dang et al. (2017)

Colonoscopies for 66-year-old
African American men

40 van Hees et al. (2015)

Multidisciplinary heart failure
management plus exercise

28 Dang et al. (2017)

Colonoscopies for 76-year-old
African American men

10 van Hees et al. (2015)

Colonoscopies for 81-year-old
African American men

1 van Hees et al. (2015)

EXHIBIT 2.1
How Many Life
Years Will $1
Million Save?

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Economics for Healthcare Managers20

The input view also stresses that changes in technology or prices may
affect the mix or amount of healthcare products citizens want to use. For
example, lower surgery costs will increase the number of people who choose
vision correction surgery rather than eyeglasses. Conversely, advances in
pharmaceutical therapy for coronary artery disease might reduce the rate of
bypass graft surgeries (and reduce the number of attendant hospital stays).

In the past, healthcare managers did not spend much time on the
input view. They were charged with running healthcare organizations, so
products that their organizations did not produce were of little interest. This
perception is changing. Our collective rethinking of the role of health insur-
ance makes the input view practical. For example, if offering instruction on
meditation reduces healthcare use enough, the chief executive of an insur-
ance plan, the medical director of a capitated healthcare organization (one
in which payments are made per person, regardless of the services provided),
or the benefits manager of a self-insured employer will find it an attractive
option. Increasingly, healthcare managers must be prepared to evaluate a
wide range of options.

2.1.2 The Output View
New ways of thinking do not always invalidate former perspectives. The out-
put view of the healthcare sector is more relevant than ever. The importance
of producing goods and services efficiently has increased. Those struggling
with the rising cost of healthcare are increasingly purchasing care from low-
cost producers. Currently, third parties (i.e., insurers, governments, employ-
ers) have difficulty distinguishing between care that is inexpensive because
it is of inferior quality and care that is inexpensive because it is produced
efficiently, but their ability to make this distinction is improving.

To succeed, managers must lead their organizations to become effi-
cient producers that attract customers. In many organizations, this task will
be formidable.

2.2 Health Outcomes

Americans often celebrate their healthcare system as “the best in the world.”
While parts of the system are superb, the system as a whole needs improve-
ment. As indicated in chapter 1, the American healthcare system incurs high
costs and produces mediocre outcomes. Although the United States spends
far more on healthcare per person than any other large, developed coun-
try, American life expectancy at birth ranks twenty-seventh among the 34
members of the Organisation for Economic Co-operation and Development
(OECD). Only the Czech Republic, Poland, Estonia, the Slovak Republic,

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Chapter 2: An Over view of the US Healthcare System 21

Hungary, Turkey, and Mexico trail the United States (OECD 2017). Given
the political decision to subsidize healthcare resources for the elderly, life
expectancy at age 65 might represent a fairer test. On this measure, the
United States ranked twenty-first in 2015. The health of the American public
is not the best in the world.

This caustic appraisal should not hide the fact that the health of Ameri-
cans has improved dramatically. Between 2000 and 2015, life expectancy at
birth rose from 76.7 years to 78.8 years, an increase of 2.1 years (OECD
2017). From one perspective, this increase in life expectancy reflects impres-
sive performance. From another, it does not compare well to the performance
of other industrialized countries. For example, French life expectancy at birth
rose from 79.2 years in 2000 to 82.4 years in 2015, and costs increased less
than half as much in France as in the United States (OECD 2017).

This conclusion rests on a simple marginal analysis in which we com-
pare the change in spending to the change in life expectancy. What appears
to be higher spending, however, might just be the effects of inflation. To
avoid inaccuracies resulting from changes in the value of money, economists
use two strategies. The simplest and most reliable strategy to report spend-
ing uses shares of national income, or gross domestic product (GDP). This
examination of shares removes the effects of inflation (see exhibit 2.2).

2000 2002 2004 2006 2008 2010 2012 2014 2016

10%

12%

14%

16%

18%

20%

12.

14.0%
14.5% 14.

15.

16.4% 16.4% 16.5%

17.2%

10.0% 10.1% 10.0% 10.1% 10.7% 10.8%
11.

11.0%
9.5%

France

United States

EXHIBIT 2.2
US and
French Health
Expenditures
as a Share of
Gross Domestic
Product

Source: Data from OECD (2017).

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Economics for Healthcare Managers22

2.3 Outputs of the Healthcare System

In 2015, Americans spent $3.2 trillion on healthcare, meaning that it aver-
aged $9,892 per person or 17.2 percent of the nation’s output (see exhibit
2.2). The French spent $4,530 per person or 11.0 percent of national
income. In both countries, the share of national income spent on healthcare
has risen, but the increase has been much larger in the United States. Why
is how much we spend interesting? Is there anything wrong with spending
that much? Why has spending been rising around the world? Why has it been
rising faster in the United States?

2.3.1 Why Is How Much We Spend on Healthcare Interesting?
The amount we spend on healthcare matters for two reasons. First, although
healthcare claims an increasing share of national income worldwide, other
industrialized countries have realized larger health gains while spending less
than the United States. Second, the rising share of national income claimed
by healthcare has prompted most governments and employers to question
whether the benefits of this increased spending warrant it. If not, something
is wrong with healthcare spending. If the benefits of healthcare spending are
smaller than the benefits of using our resources in other ways, a shift would be
in order. For example, would we be better off if we had spent less on educating
new physicians and more on educating new teachers? The opportunity cost
of producing a product consists of the other goods and services we cannot
make instead. Stating that the benefits of healthcare are less than its costs does
not imply that it is bad or worthless, only that it is worth less than some other
use of our resources.

2.3.2 Why Is Healthcare Spending Rising More Slowly Than
Anticipated?
Between 2010 and 2015, healthcare spending grew more slowly than fore-
cast. Spending covered by private insurance, by Medicare, by Medicaid, and
by other insurers came in below estimates (Holahan et al. 2017). Higher
healthcare spending is driven by changes in prices and quantities, and we will
explore both.

Prices for services covered by private insurance are set via negotiation
and have historically risen much faster than other prices. But as exhibit 2.3
shows, since the onset of the Great Recession of 2007–2009, medical prices
have increased relatively slowly. Indeed, medical prices increased at a slower
rate than prices in general during 2014 and 2015 (Keehan et al. 2017). This
difference may be due to reductions in Medicare payments put in place by
the Affordable Care Act (ACA), given that private insurers often base price

opportunity cost
The value of what
one cannot do as a
result of making a
choice.

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Chapter 2: An Over view of the US Healthcare System 23

negotiations on Medicare rates. In addition, the ACA created new insurance
plans for those without access to employer-sponsored plans. Most of these
plans were targeted at consumers with modest means and negotiated well-
below-market prices with providers. The slowing of medical inflation may be
due to low overall rates of inflation or to changes brought about by the ACA.

Comparing Health Outcomes in
Adjoining Counties

Johnson County and Wyandotte County are adjacent counties in the
Kansas City metropolitan area. Despite significant progress in recent
years, the rate of premature death in Wyandotte County is more than
double the rate in Johnson County (University of Wisconsin Population
Health Institute 2018). What causes such large differences? Causes

Case 2.1

(continued)

2000 2002 2004 2006 2008 2010 2012 2014 2016
0%

10%

4.7%
4.4%

4.0%

3.7%

3.4%

3.7%

2.4%

3.8%
4.1%

EXHIBIT 2.3
Medical
Inflation in the
United States

Source: Data from Bureau of Labor Statistics (2017).

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Economics for Healthcare Managers24

might include weaknesses in the primary care sys-
tem or differences in health behaviors. The con-
sensus is that diet and activity are the most impor-

tant behaviors, tobacco use is second, and alcohol use makes a much
smaller contribution (Institute of Medicine and National Research
Council 2015).

How do these two counties compare? Even though the University
of Kansas Health System is based in Wyandotte County, the county has
far fewer primary care physicians and dentists per resident than aver-
age. Johnson County has far more primary care physicians and dentists
per resident than average. Residents of Wyandotte County are 37
percent more likely to be obese (37% vs. 27%), 72 percent more likely
to be physically inactive (31% vs. 18%), and 92 percent more likely to
smoke (23% vs. 12%) but 25 percent less likely to drink excessively
(15% vs. 20%) (University of Wisconsin Population Health Institute
2018).

Before labeling these as lifestyle differences, note that the eco-
nomic circumstances are different in the two counties. Median house-
hold income is 48 percent lower in Wyandotte County (reflecting lower
earnings and a higher proportion of single-parent households). The
share without health insurance is 183 percent higher, and the share
with a high school diploma is 19 percent lower. In addition, 23 per-
cent of Wyandotte residents are African American and 29 percent are
Hispanic, making it a much more diverse county (US Census Bureau
2018).

The government of Wyandotte County has launched a number of
projects to improve the health of its citizens since 2009 (Healthy Com-
munities Wyandotte 2016). Its 20-20-20 Movement seeks 20 new miles
of trails, 20 miles of bikeways, and 20 miles of sidewalks by 2020.
The Tobacco Free Wyandotte Action Team seeks to enhance resources
for quitting tobacco, preventing young people from starting to use
tobacco, and protecting residents from secondhand smoke. The Food
Systems Action Team has promoted urban agriculture, farmers’ mar-
kets, community gardens, school-based gardens, summer meals for
students, and nutrition education. Wyandotte County has also actively
encouraged residents to sign up for insurance.

Case 2.1
(continued)

(continued)

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Chapter 2: An Over view of the US Healthcare System 25

2.4 The Shifting Pattern of Healthcare Spending

With total revenues of more than a trillion dollars, hospitals claim nearly a
third of total annual healthcare spending in the United States. What hospitals
produce is changing, however. Since 1995, inpatient days have been slowly
trending down, and outpatient visits have been trending up briskly (American
Hospital Association 2016). Many hospitals now derive more revenue from
outpatient care than from inpatient care. Hospitals’ share of total spending
has risen by 2.0 percent since 2000, reflecting the continuing consolidation
of services into health systems (Centers for Medicare & Medicaid Services
[CMS] 2016). Rapid increases in prices and intensity (which we cannot
separate at this point) explain most of this increase (Dieleman et al. 2017).

As exhibit 2.4 shows, spending for physicians’ services claims nearly
a fifth of total spending. The share has fallen since 2000 as a result of

Discussion Questions
• What are the main inputs to health mentioned

in this case?

• Are there important inputs to health that the case does not
mention?

• What health behaviors should get priority?

• Is there evidence that reducing smoking improves health?

• Is there evidence that reducing obesity improves health?

• Does income play any role in improving health?

• How important is health insurance in improving health?

• Wyandotte County has relatively few primary care physicians.
Should the number of primary care physicians be a priority?

• Can you find any evidence that improving primary care improves
health?

• What role, if any, should private foundations play in improving
health?

• What role, if any, should state governments play in improving
health?

• What role, if any, should the federal government play in improving
health?

• Which of these questions are examples of positive economics?
Normative economics?

Case 2.1
(continued)

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Economics for Healthcare Managers26

consolidation into systems and increasing spending on pharmaceuticals.
Spending on pharmaceuticals (which does not include pharmaceuticals
administered in hospitals and nursing homes) has risen sharply since 2000.
This increase can be attributed to both the expected effects of public policy
and some unexpected effects. Medicare Part D, the voluntary outpatient
prescription drug benefit for people on Medicare, went into effect in 2006
and now provides coverage for nearly 41 million people. The ACA expanded
Medicaid and established marketplace plans. Both forms of insurance pro-
vided coverage for pharmaceuticals and were designed to increase use of
pharmaceuticals. What was not expected, but should have been, was that
prices increased rapidly as well. As chapter 7 will show, increasing insurance
coverage results in increased sales and higher prices.

The overhead costs of health insurance represent the fourth largest
component of spending. The American approach to health insurance, which
emphasizes subsidies for private coverage, essentially ensures high costs of

Expenditure Amount Percent

Total hospital expenditures $1,036,110 32.3%

Total physician and clinical expenditures $634,919 19.8%

Total prescription drug expenditures $324,551 10.1%

Total net cost of health insurance $252,669 7.9%

Total nursing care and continuing care retire-
ment facility expenditures

$163,322 5.1%

Total other health, residential, and personal
care expenditures

$163,322 5.1%

Total dental services expenditures $117,522 3.7%

Total structures and equipment expenditures $108,018 3.4%

Total home health care expenditures $88,803 2.8%

Total other professional services expenditures $87,715 2.7%

Public health activity expenditures $67,960 2.1%

Other nondurable medical product
expenditures

$59,030 1.8%

Total durable medical equipment expenditures $48,458 1.5%

Research expenditures $46,714 1.5%

Source: Data from CMS (2016).

EXHIBIT 2.4
Annual

Spending
by Sector in

Millions of
Dollars

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Chapter 2: An Over view of the US Healthcare System 27

managing insurance. Having multiple small plans with distinct patterns of
coverage guarantees high overhead rates. However, this total represents only
part of the cost of running American health insurance. Hospitals, practices,
and other organizations incur substantial costs of billing. Jiwani and col-
leagues (2014) estimate that 15 percent of total spending could be saved by
insurance simplification, and this percentage may be an underestimate.

2.5 Disruptive Change in the Healthcare System

For many years six trends were evident in the healthcare system of the United
States. They were

• rapid technological change,
• the shrinking share of direct consumer payments,
• the rapid growth of the healthcare sector,
• the rapid growth of the outpatient sector,
• the slower growth of the inpatient sector, and
• the steady increase in the number of uninsured Americans.

Only three of these trends continue unabated: rapid technological change,
the shrinking share of direct consumer payments, and slower growth of the
inpatient sector.

Exhibit 2.5 depicts the steady decline in the share of direct consumer
payments for healthcare. Broader and more complete insurance coverage
explains this trend. While consumers ultimately pay all healthcare bills,
increasingly they pay indirectly via taxes and premiums.

The most surprising development of recent years has been the slow-
ing growth of the healthcare sector. Rapid expansion of the healthcare sector
has been a feature of American life for most of this century, but its pace has
clearly slowed. As exhibit 2.2 showed, healthcare spending in 2000 claimed
12.5 percent of national income. By 2016, it had risen to 17.2 percent of
national income. However, in contrast to the rapid expansion of previous
years, the share plateaued between 2009 and 2013.

Why spending grew more slowly is not clear. Job loss during the Great
Recession and changes in health insurance benefits played a role, but these
factors explain only part of the slowdown. Costs per case appear to have
decreased for some conditions (Dunn, Rittmueller, and Whitmire 2016),
and the number of Medicare beneficiaries increased by 7 million (medical
needs typically change little after age 65, and Medicare prices are lower than
private prices). Forecasting what will happen during the next several years is
difficult because the healthcare environment appears to have experienced two

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Economics for Healthcare Managers28

major shocks: the implementation of the ACA and the transformation of the
health insurance industry. Section 2.5.2 discusses the ACA, and section 2.5.3
discusses the reconfiguration of the health insurance industry.

2.5.1 Rapid Technological Change
Technological change is pervasive in healthcare. Technological advancement
makes transformation of the healthcare system possible, and policy changes
are apt to make transformation desirable. Only luck will rescue management
decisions that ignore technological change.

Monitoring of implantable cardioverter defibrillators illustrates the
interaction of technological and policy change. Patients with an implantable
cardioverter defibrillator—a small device used to treat irregular heartbeats—
require regular follow-up visits to monitor their health and whether their
device is working properly. The stakes are high. Untreated arrhythmia may be
life threatening, and more than 2 percent of the population experience some
arrhythmia. Although little scientific evidence exists, the professional consen-
sus is that these patients should be seen two to four times per year even if
no difficulties are evident. A recent evaluation of a home monitoring system
concluded that it offered better quality at lower cost (Parahuleva et al. 2017).

2000 2003 2006 2009 2012 2015

14.5% 13.3%
12.7%

11.8% 11.4% 10.5%

10%

15%

20%

25%

30%

35%

40%

EXHIBIT 2.5
Direct Payments

by Consumers
as a Share of

National Health
Spending

Source: Data from CMS (2016).

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Chapter 2: An Over view of the US Healthcare System 29

In volume-based payment environments—in which revenues depend on the
number of visits—providers may not find remote home monitoring attrac-
tive. However, in value-based environments—in which reducing the number
of visits reduces the workload without reducing revenue—providers, patients,
and insurers may have a common interest in expanding remote monitoring.
For reasons discussed more fully in chapter 6, public and private insurers are
trying to move quickly to value-based models.

Other innovations could prove even more disruptive. For example,
pharmacogenomics—the science of predicting differing responses to drugs
based on genetic variations—could have profound effects. Even after indi-
vidual factors such as age, weight, race, sex, diet, and other medications are
taken into account, patients can respond differently to a drug. One patient
may have the desired relief of symptoms, another may have no apparent
response, and a third may have a life-threatening reaction. Obviously this
difference matters a great deal to patients and practitioners. It also matters
to managers. An adverse drug reaction is the fourth leading cause of death in
the United States, and genetic testing to ensure that patients get safe, effec-
tive pharmaceuticals could reduce hospitalization rates by up to 30 percent
(Drew 2016).

Like every sector of society, healthcare illustrates the struggle to take
advantage of the information revolution and demonstrates the paradox of
technological change. The essence of the information revolution is that the
cost of performing a single calculation has dropped precipitously. As a result,
many more calculations are possible, and spending on some types of infor-
mation processing (e.g., computer games) has increased sharply as spending
on other types of information processing (e.g., inventory management) has
plummeted. Technological advances almost always make a process less expen-
sive, yet spending may rise because volume increases dramatically.

The challenges of the information revolution are even greater in
healthcare than in most sectors. Much of the output of the healthcare sec-
tor involves information processing, yet relatively few healthcare workers are
highly skilled users of computerized information. In addition, healthcare
organizations have lagged behind other service organizations in investing in
computer hardware, software, and personnel.

The rapid pace of change in other areas intensifies these challenges.
Healthcare’s diagnostic and therapeutic outputs are changing even faster
than the organizational structure of the sector, which itself is changing rap-
idly. In some areas (most notably imaging and laboratory services), techno-
logical change is tightly linked to the information processing revolution. In
other areas, the links are much looser. For example, advances in information
processing speed the development and assessment of new drugs, yet because
pharmaceutical innovations can be extremely profitable, a powerful incentive
for pharmaceutical innovation exists regardless of these advances.

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Economics for Healthcare Managers30

2.5.2 Major Features of the Affordable Care Act
The ACA is a complex law with multiple provisions. This section briefly
sketches some of its major provisions, focusing on ones that have the poten-
tial to reshape the healthcare sector.

1. The ACA incorporates several mechanisms for expanding insurance
coverage. These mechanisms include new regulations, state and federal
insurance marketplaces, subsidies for those with low incomes, and
the option for states to expand Medicaid coverage for those with the
lowest incomes.

2. The ACA incorporates several mechanisms for reducing Medicare
spending. These mechanisms include penalties for higher-than-expected
readmission rates, reductions in Medicare payments to hospitals
with large numbers of uninsured patients, reductions in payments to
Medicare Advantage plans (private health insurance plans for Medicare
beneficiaries), and incentive payments for care of high quality or for
significant improvements in quality.

3. The ACA authorizes a number of payment reform demonstrations.
These programs include trials of accountable care organizations,
bundled payments, medical homes, and managed care for beneficiaries
who are eligible for Medicare and Medicaid. Chapter 6 will explore
these programs in depth.

Many years will pass before the full effects of the ACA are understood. This
section briefly notes some ACA provisions that have the capacity to change
incentives and about which there is some evidence. Chapter 6 will explore
these issues in more detail.

Narrow networks are common in ACA marketplace plans (Polsky et
al. 2016). The main motivation for narrow networks (which may be limited
to a single system or may exclude just a few providers) is that some systems
have been able to negotiate high prices—sometimes four or five times Medi-
care rates—with private insurers (Scheffler and Arnold 2017). The benefit to
marketplace insurance customers is sharply lower premiums, often 15 to 20
percent lower than plans with larger networks. The penalty is that market-
place customers may have to use out-of-network providers (and pay much
more) for some care.

Medicare penalties for higher-than-expected readmission rates clearly
give hospitals an incentive to reduce readmissions. A 2 percent reduction in
Medicare payments would have a significant effect on most hospitals’ rev-
enues, so reducing readmissions will be a priority for most hospitals. Even
though reducing readmissions will reduce hospital volumes, most hospitals
have taken steps to reduce readmission rates. Although commonly interpreted

managed care
A loosely defined
term that includes
all plans except
open-ended
fee-for-service.
It is sometimes
used to describe
the techniques
insurance
companies use.

narrow network
A limited group
of providers who
have contracted
with an insurer.
(Patients will
usually pay more
if they get care
from a provider
not in the network.
The network is
usually restricted
to providers with
good quality who
will accept low
payments.)

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Chapter 2: An Over view of the US Healthcare System 31

as a measure of hospital quality, readmissions are clearly influenced by the
quality of postdischarge care (Branowicki et al. 2017).

Bundled payments already have been tested, but the ACA dramati-
cally expands testing of this concept. As a part of the ACA, Medicare has
launched bundled payment trials in more than 400 healthcare organizations.
Termed the Bundled Payments for Care Improvement Initiative, these tri-
als will explore whether paying lump sums for episodes of care will reduce
healthcare costs without harming care. One model, which is being tested
only in New Jersey, lets hospitals give physicians bonuses if they help the
hospital reduce costs and improve quality. A second model puts hospital and
post-acute services in a common bundle. A third model pays a flat fee for all
post-acute care (skilled nursing, inpatient rehabilitation, long-term care hos-
pital, or home health services). A fourth model covers all services provided
during a hospital stay (hospital, physician, and other). A fifth model includes
hospital, physician, other in-hospital services, and post-acute care for patients
who have hip or knee replacement. The common denominator in all these
bundled payment trials is that services become cost centers rather than rev-
enue centers.

2.5.3 The Transformation of the Health Insurance Industry
The health insurance industry looks different than it did a few years ago. To
begin with, its revenues will grow. Analysts forecast that industry revenues
will double by 2025, with most of the growth coming from Medicare Advan-
tage, Medicaid, and ACA marketplace plans (Finn et al. 2017).

Second, the industry’s customers look different. Until fairly recently,
most purchases were made by firms or governments. Americans had coverage
through work, Medicare, or Medicaid. Typically just one plan was offered.
Increasingly, though, individuals are making their own choices. Millions of
Americans have chosen Medicare Advantage plans already, and millions more
have chosen marketplace plans. Both options seem likely to grow, and insur-
ers have begun rolling out private exchanges so that employees can choose
their plans as well (Goth 2017).

Third, the basis for competition seems likely to change. The ACA has
made avoiding risk more difficult and, with other regulations, has made pric-
ing and quality easier for consumers to discern. Starting in 2007, individu-
als seeking Medicare Advantage plans could use summary ratings based on
clinical quality, the experience of patients, and customer service. Customers
are using these ratings in choosing plans, and ratings systems seem likely to
spread.

Fourth, the structure of the industry has changed. The industry has
already consolidated, and this process is likely to continue. If, as many pre-
dict, profit margins will drop, additional mergers and acquisitions seem likely.

bundled payment
Payment of a fixed
amount for an
episode of care.
The payment
might cover just
hospital care or
might include
the physician,
hospital, and
rehabilitation.

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Economics for Healthcare Managers32

Indeed, one of the rationales for the proposed merger of CVS and Aetna was
that providing more care in MinuteClinics (part of CVS) would allow Aetna
to offer insurance with lower premiums (Pinsker 2017).

Fifth, the health insurance industry is increasingly using data to mea-
sure cost and quality. More and more, insurers use data to identify high-risk
beneficiaries, estimate the cost of an entire episode of care, provide feedback
to providers, and make judgments about which providers offer good value.
Underlying insurers’ increasing willingness to create narrow networks and
designate preferred providers of care is the conclusion that cost and quality
are not highly correlated, so steering patients to low-cost providers can be a
winning strategy (Ho and Sandy 2014).

Sixth, benefit designs have changed. The average deductible for an
employment-based plan rose from $343 in 2007 to $1,221 in 2017 (Kaiser
Family Foundation and Health Research & Educational Trust 2017). In
addition, caps on out-of-pocket payments have become nearly universal.

In short, so many changes in health insurance have occurred that they
are hard to track. Chapters 3 and 6 will explore them more fully.

2.6 Conclusion

During the 1980s, a consensus emerged that the US healthcare system
needed to be redirected despite its many triumphs. Underlying this consen-
sus was the recognition that costs were the highest in the world even though
outcomes were not the best in the world.

How the healthcare system should change is much less clear. Man-
aging under such circumstances is stressful, but an awareness of the trends
presented in this chapter should identify a number of strategies (e.g., striving
to be the low-cost producer) that make sense in almost any environment.
These low-risk strategies, and ways to deal with risk and uncertainty, will be
discussed in the next chapters.

Exercises

2.1 Identify a product that is one organization’s output and another
organization’s input.

2.2 Can you think of any initiatives that reflect the input view of
healthcare?

2.3 What is wrong with spending 17.2 percent of GDP on healthcare?

deductible
The amount a
consumer must
pay before
insurance covers
any healthcare
costs.

out-of-pocket
payment
Money a consumer
directly pays for a
good or service.

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Chapter 2: An Over view of the US Healthcare System 33

2.4 Americans spend more on smartphones than the citizens of other
countries do, yet this type of spending is seldom described as a
problem. Why is spending more on healthcare different?

2.5 Should reducing overhead costs associated with insurance be a
priority?

2.6 US national health expenditure was $7,892 per person in 2008
and $10,364 in 2016. The Consumer Price Index had a value of
210.228 in 2008 and a value of 241.432 in 2016. In 2016 dollars,
how much was spending in 2008?

2.7 Spending on pharmaceuticals rose from $253,080 in 2010
to $328,588 in 2016. Go to the inflation calculator (http://
cpiinflationcalculator.com/) and calculate 2010 spending in 2016
terms.

2.8 How did the state and local government share of national health
expenditures change between 2010 and 2016? What accounts
for this change? Go to the “Actuarial Studies” page on the CMS
website (www.cms.gov/Research-Statistics-Data-and-Systems/
Research/ActuarialStudies/index.html) to get data.

2.9 When was the last year that GDP grew faster than national health
expenditure? Go to the CMS website (www.cms.gov/Research-
Statistics-Data-and-Systems/Research-Statistics-Data-and-Systems.
html) to get data.

2.10 Your accountants tell you that the cost to set up an immunization
program at a preschool and immunize one child against polio is
$400. The cost to immunize 20 more children is $460 more. What
is the cost per child for the first child? What is the cost per child
for these additional 20 children? What is the average cost per child?
What concepts do these calculations illustrate?

2.11 Starting a mobile clinic costs $300,000. The additional cost of
serving the first patient is $40. What is the average cost of serving
the first patient?

2.12 Setting up nurse practitioner clinics to serve 20,000 newborns in
Georgia would cost $6 million. This program would increase life
expectancy at birth from 75.1 years to 75.3 years. How many life
years would be gained? What is the cost per life year? Should this
program be started?

2.13 A new treatment for cystic fibrosis costs $2 million. The life
expectancy of 1,000 patients who were randomly assigned to the
new treatment increased by 3.2 years. What is the cost per life year
of the new treatment?

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Economics for Healthcare Managers34

2.14 Why has the share of healthcare output produced by hospitals risen?
Will this trend continue? Can you think of a policy or technology
change that would reduce hospital use? Can you think of a policy
or technology change that would increase hospital use? What
implications do these changes have for the careers of healthcare
managers?

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Economics for Healthcare Managers36

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CHAPTER

4DESCRIBING, EVALUATING, AND
MANAGING RISK

Learning Objectives

After reading this chapter, students will be able to

• describe the key features of a risky choice,
• construct and use a decision tree to frame a choice,
• calculate an expected value and standard deviation, and
• discuss common approaches to managing risk.

Key Concepts

• Clinical and managerial decisions typically entail uncertainty about what
will happen.

• Decision makers often have imprecise estimates of the probabilities of
various outcomes.

• Decision makers must describe, evaluate, and manage risk.
• Risk sharing and diversification are two ways to manage risk.

4.1 Introduction

Clinical and managerial decisions typically entail risk. Important information
is often incomplete or missing when the time to make a decision arrives. At
best, managers know the potential outcomes and the probability that each
will occur. At worst, managers have little or no information about outcomes
and their probabilities. Either way, managers must identify risks that are
worth analyzing, risks that are worth taking, and the best strategies for deal-
ing with them.

When outcomes are uncertain, decision making has three compo-
nents: describing, evaluating, and managing potential outcomes. Because
uncertainty is central to many areas of healthcare, the same techniques (e.g.,

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Economics for Healthcare Managers56

hedging bets, monitoring uncertain situations aggressively) are recom-
mended for describing and evaluating potential outcomes regarding real
investments (e.g., buildings, equipment, training), financial investments
(e.g., stocks, bonds, insurance), and clinical decisions (e.g., testing, therapy).

4.2 Describing Potential Outcomes

The first step in any decision is to describe what could happen, including the
probabilities and value of possible outcomes, and calculate descriptive statis-
tics about the possible outcomes.

Description begins with an assessment of the probabilities of the pos-
sible outcomes. Ideally, the assessment should generate an objective prob-
ability—an estimate based on evidence about the frequencies of different
outcomes. For example, if 250 out of 1,000 patients reported nausea after
taking a medication, a good estimate of the probability of nausea would be
0.25 (250 divided by 1,000). More often, though, description assesses the
subjective probability—the decision maker’s perception of how likely an
outcome is to occur.

In some cases, decision makers have incomplete data. In other cases,
the data do not fit the situation. For example, if a careful study of a drug in
a population of young men finds that the probability of nausea is 0.25, what
value should we use for a sample of women older than 65 years? In still other
cases, individuals may feel that population frequencies do not apply to them.
Someone who claims to have a cast-iron stomach may believe that his prob-
ability of nausea is much less than 0.25. The decision maker with a cast-iron
stomach may be correct in thinking that the population frequency does not
apply to him, or he may just be overly optimistic.

In practice, decision makers predominantly use subjective probabili-
ties. Unfortunately, these subjective probabilities are often inaccurate, even
when the estimates are made by highly trained clinicians or experienced
managers. Studies have found that physicians overestimate the probability of
skull fractures, cancer, pneumonia, and streptococcal infections, and manag-
ers are notorious for being overenthusiastic in their forecasts of how well new
projects will fare (Segelod 2017).

For a variety of reasons, humans routinely misestimate probabilities, so
examining data about population frequencies can significantly improve deci-
sion makers’ choices. For example, even if you believe that your hospital is
less likely than average to lose money on the primary care practices it has just
purchased, knowing that the majority of hospitals lose money tells you that
your hospital is still prone to loss. Moreover, in many cases, an honest assess-
ment of the probabilities results in broad generalizations, not a point estimate

objective
probability
An estimate based
on frequencies.

subjective
probability
An estimate based
on judgment.

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 57

of probabilities. A manager may be able to say only that one scenario seems
more likely than another. This information is still useful; general impressions
can often clarify the situation and help managers make the best decision.

Managing Risk in Medicare
Advantage Plans

Medicare Advantage (private insurance for Medicare beneficiaries)
presents major risks for insurers. First, the Centers for Medicare & Med-
icaid Services annually compiles performance data and assigns every
plan from one to five stars. These star ratings have two effects: Higher-
rated plans get higher payments and more customers. Because star rat-
ings depend on the customer and clinical service offered by providers,
who are usually independent contractors, profitability depends on fac-
tors that insurers control imperfectly. Second, profitability in Medicare
Advantage depends on Medicare spending levels, and no one can really
forecast how payment innovations will change Medicare spending. For
example, Medicare’s bundled payment for joint replacement reduced
costs by 20 percent in some markets (Navathe et al. 2017). Changes
that large could matter. Third, no one knows what will happen to Medi-
care Advantage enrollment if Medicare’s benefits or payment systems
change. Most insurers have profited from Medicare Advantage, benefit-
ing from the enrollment of younger retirees, more efficient use of care,
and more favorable contracts with providers. But some insurers, such
as Catholic Health Initiatives, have posted large losses (Barkholz 2017).

Risk is intrinsic to the health insurance business. Insurers take on
risk by selling coverage for consumers’ variable medical expenditures.
When you average risk over the spending patterns of tens of thousands
of consumers, however, the risk becomes less uncertain—in most
cases. But in Medicare Advantage the insured populations are often
small, and costs may be driven by a handful of beneficiaries.

But the main perils do not come from the operational issues men-
tioned previously. The real risks spring from strategic decisions that
could go wrong if an insurer misjudges the market.

Discussion Questions
• What has happened to Medicare Advantage enrollment during the

past year?

Case 4.1

(continued)

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Economics for Healthcare Managers58

4.3 Evaluating Outcomes

The next step is to evaluate possible outcomes. This chapter focuses on
financial outcomes, typically profits. While easier to forecast than many other
outcomes, financial outcomes are difficult to predict. Skilled analysts com-
monly arrive at different answers when forecasting costs and revenues for
well-established products, and predictions are much less accurate for new
products. A famous quotation, apparently of Danish origin, notes that “pre-
diction is very difficult, especially if it’s about the future.”

The problems mount when no simple measurement system, such as
profits, exists. How valuable is a new surgical procedure that reduces the
chance of abdominal scarring from 0.12 to 0.08 but reduces the chance
that the operation will succeed from 0.68 to 0.66? When a scenario involves
opposing probabilities, evaluation becomes a challenge. Even though schol-
ars have made progress in evaluating complex outcomes, considerable uncer-
tainty remains. Chapter 14 will tackle this problem in more detail.

4.3.1 Expected Values
Calculating descriptive statistics is the final step in the process of evaluating
outcomes. The most common statistic (although not always the most use-
ful statistic) is the expected value. To calculate an expected value, multiply
the value of each outcome by its probability of occurrence and then add the
resulting products. For example, suppose your organization is contemplating
buying a skilled nursing facility that currently has profits of $20,000. The
price of the nursing home is $1 million, meaning that the return on invest-
ment would be only 2 percent, which is too low from your organization’s
point of view. One of your managers, however, has identified a number of
operational improvements that she forecasts will boost profits to $120,000.

expected value
The sum of the
values of each
possible outcome
weighted by
probability.

return on
investment
Annual profit
divided by the
initial investment.

• Have any insurers pulled out of Medicare
Advantage during the past year?

• Have any Medicare Advantage plans lost money
during the past year?

• Is Medicare Advantage riskier than other forms of private health
insurance?

• What other healthcare firms also face risks due to changes in
government policy?

• What are the advantages of having private insurers manage
Medicare? Disadvantages?

Case 4.1
(continued)

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 59

Although this manager’s improvements are reasonable, a consultant points
out that, in his experience, ambitious proposals to increase profits fail about
40 percent of the time. The consultant estimates that the expected profit is
$80,000 = (0.6 × $120,000) + (0.4 × $20,000).

This level of precision (e.g., “about 40 percent of the time”) is repre-
sentative of the reliability of managerial forecasts—they are inexact at best.
Despite imprecise forecasts, managers must make a choice. In many cases,
calculating the expected profit and then conducting sensitivity and scenario
analyses will help managers avoid bad decisions.

An expected value equals P1X1 + P2X2 + . . . + PnXn, where Pi repre-
sents the probability that an outcome will occur and Xi represents the value
of that outcome. An expected value differs from an average because the prob-
abilities of some outcomes will be higher than the probabilities of others, so
they get more weight. For example, the average of $120,000 and $20,000—
the two estimates from our previous example—is $70,000. But the expected
value is $80,000 because the probability of earning $120,000 is larger than
the probability of earning $20,000.

Does buying the skilled nursing home make sense? It might. The
expected return on investment is 8 percent. Given that the worst-case sce-
nario is a 2 percent return on investment, this gamble will seem reasonable to
many firms, depending on the alternative investments the firm is considering.

Good decisions usually require more information than just an
expected value because typically the expected value is not the outcome that
occurs. Most decision makers find that a list of the best and worst outcomes
is valuable. A list of the most likely outcomes can also be useful. Graphs,
too, can help decision makers understand their choices. Many people find a
well-designed graph more valuable than a calculation. Finally, remember that
estimates are estimates; writing them down does not make them more reli-
able. The less mathematically sophisticated your target audience is, the more
you need to emphasize that forecasts are imprecise.

This simple example can be illustrated with a decision tree, which is
a way of presenting information about a choice. A decision tree visually links
a decision maker’s choices with the outcomes that are likely to result. It is
called a tree because the possible outcomes branch from a choice. For the
analyst, much of the value lies in the process of constructing the decision tree
because it highlights the analyst’s perceptions of what will happen and where
the information is weakest. In addition, many people find that examining a
decision tree helps them understand the issues involved because it lays out
their best estimates of the cost or payoff and the probability associated with
each possible outcome. As you can see in exhibit 4.1, the worst-case forecast
is a profit of $20,000, which is less than ideal but not a catastrophe. Similarly,
the best-case forecast is a profit of $120,000, which is good but not superb.

sensitivity
analysis
The process
of varying
an analysis’s
assumptions to
see how outcomes
change.

scenario analysis
Evaluation
of payoffs
under differing
assumptions.

decision tree
A chart that
depicts the values
and probabilities
of the outcomes of
a choice.

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Economics for Healthcare Managers60

As is usually the case, laying out the decision tree helps clarify the situation by
making the probability and profit estimates explicit. It does not tell managers
what decision to make. Alternatives have not yet been laid out, so a sensible
decision cannot be made.

Calculating the expected values of alternatives is sometimes called
rolling back a decision tree. Rolling back a decision tree means calculating its
expected value. In exhibit 4.1, the expected return is $80,000.

Examples as simple as this do not require decision trees, but slightly
more complex examples may require one (see exhibit 4.2). Suppose the
probability that the state will reduce nursing home payments is 25 percent,
or a one in four chance. With lower payments, profits will be $100,000 if
the improvements succeed or $0 if the improvements fail, so expected profits
fall to $75,000. The updated decision tree also displays the profit available
from an alternative investment, in this case a short-term bond that returns
$40,000. Most profit-oriented decision makers would prefer to invest in the
nursing home because its expected profit is higher and the risks are modest.

To make sure that you understand exhibit 4.2, answer the following
questions. Why does the probability that the improvements fail and rates are
cut equal 0.10? Why is expected profit less in exhibit 4.2 than in exhibit 4.1?

4.3.2 Outcome Variation
Managers can use estimates of variability to make comparisons. Variability
is typically measured by listing the range of possible values or by listing the
standard deviation (which is the square root of the variance). If you are
not comparing outcomes, the standard deviation is not helpful. In contrast,
the range can convey useful information even if you are not comparing out-
comes. The range helps you see the best-case and worst-case scenarios. To
know whether a risk is worth taking, you need to know the size of the risk

range
The difference
between the
largest and
smallest values.

standard deviation
The square root of
a variance.

variance
The squared
deviation of a
random variable
from its expected
value. (If a variable
takes the value 3
with a probability
of 0.2, the value 6
with a probability
of 0.3, and the
value 9 with a
probability of 0.5,
its expected value
is 6.9. Its variance
is 5.49, which is
0.2 × [3 – 6.9]2 +
0.3 × [6 – 6.9]2 +
0.5 × [9 – 6.9]2.)

Improvements fail

Expected Profit =
$80,000

Improvements succeed

P = 0.6

P = 0.4

Profit = $120,000
P = 0.60

Profit =

$20,000

P = 0.40

EXHIBIT 4.1
A Nursing Home

Decision Tree

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 61

and the potential payoff. Few people will want to take a risk if the best pos-
sible payoff is small or if the worst payoff is disastrous. On the other hand, if
the best payoff is large, some people will be willing to accept significant risks.

To calculate variance, multiply the squared difference between the
value of each outcome and the expected value by its probability of occur-
rence and then add the resulting products. (Find the appropriate probability
of occurrence by multiplying the probability on the “branch” of the outcome
by the probability on the preceding branch.) So, in our example, the variance
equals 0.15 × ($100,000 − $75,000)2 + 0.45 × ($120,000 − $75,000)2 +
0.10 × ($0 − $75,000)2 + 0.3 × ($20,000 − $75,000)2, or $2,475,000,000.
The standard deviation is the square root of $2,475,000,000, which is
$49,749.

A standard deviation or variance has meaning only when you are
comparing options. If two choices have similar expected values, the one with
the higher standard deviation carries a higher risk because a larger standard
deviation means that the bad outcomes are either more likely or much worse.
For example, a project that has an 85 percent chance of earning $0 and a 15

Profit = $100,000
P = 0.15

Profit = $120,000
P = 0.45

Profit = $0
P = 0.10

Profit = $20,000
P = 0.30

Expected profit of short-term bond = $40,000

Expected Profit =
$75,000

Rate cuts

No rate cuts

P = 0.25

P = 0.75

Rate cuts

No rate cuts

P = 0.25

P = 0.75

Improvements succeed

Improvements fail

P = 0.6

P = 0.4

= 0.15 × $100,000 + 0.45 ×
$120,000 + 0.10 × $0 + 0.30 ×

$20,000

EXHIBIT 4.2
A Nursing
Home Decision
Tree with the
Possibility of
Rate Cuts

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Economics for Healthcare Managers62

percent chance of earning $500,000 also has an expected profit of $75,000.
The standard deviation for this project is $178,536, confirming its higher
risk.

Remember that the point of these calculations is to improve your
analysis. The analysis should include an understanding of the size of the risk,
how likely it is to occur, and whether it is worth taking. If your target audi-
ence, which might include members of the board or nonfinancial managers,
is puzzled by your analysis and does not really understand the issues, you
have failed to present it effectively. Your audience will not be able to offer
useful feedback, and the decision to take or not take the risk will be all yours.
Managers could be terminated for taking risks that the board and other man-
agers understood and approved. Managers will be terminated for taking risks
that the board and other managers did not understand.

4.3.3 Risk Preferences
Risk preferences may influence choices. A risk seeker prefers more variability.
Someone who gambles in a casino must be risk seeking because the expected
payoff from a dollar bet will always be less than a dollar because of taxes and
the casino’s take. Likewise, a patient who can expect to live 18 months if she
undergoes standard therapy may be a risk seeker. She may prefer a therapy
that gives her an expected life span of only 13 months if it increases her
chances of significant recovery. The manager of a nearly bankrupt business is
likely also a risk seeker. Taking chances, even ones with low expected payoffs,
may be the only way to survive.

A risk-neutral person does not care about variability and will always
choose the outcome with the highest expected value. Large organizations
with substantial reserves can afford to be risk neutral. For example, a firm
with $400 million in cash reserves will probably not buy fire insurance for
a $200,000 clinic. If the expected loss is $4,000 per year (a 2% chance of
a $200,000 loss), the organization’s fire insurance will cost at least $4,400
because of processing costs and insurer profits. On average, the firm will have
higher profits if it does not insure this risk, and it can afford not to. Spending
$200,000 for a new clinic will not put much of a dent in the organization’s
reserves.

A risk-averse person avoids variability and will sometimes choose
strategies with smaller expected values to avoid risk. An individual who buys
health insurance is likely to demonstrate risk aversion because the expected
value of the covered expenses will usually be less than the premium. Insurance
premiums must cover the insurer’s expected payout, its cost of operation, and
some return on invested capital. Unless a beneficiary’s expected benefits (the
insurer’s expected payouts) have been incorrectly estimated, the insurer’s

risk seeker
A person who
prefers more risk
to less. (A risk
seeker would
prefer a gamble
with a 50% chance
of getting nothing
and a 50% chance
of getting $10
to getting $5 for
sure.)

risk seeking
When a decision
maker is willing
to accept a lower
payoff in order to
increase risk.

risk neutral
Not caring about
risk. (A risk-neutral
person would
think that getting
$5 for sure is as
good as a gamble
with a 50% chance
of getting nothing
and a 50% chance
of getting $10.)

risk averse
Preferring a
smaller, less risky
payoff to a larger
payoff with more
variability. (A risk-
averse person
would choose
getting $5 for
sure instead of a
gamble with a 50%
chance of getting
nothing and a 50%
chance of getting
$10.)

risk aversion
When a decision
maker is willing
to accept a lower
payoff in order to
reduce risk.

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 63

costs and profits will push insurance premiums above expected losses. By
definition, someone who will pay an insurance premium is risk averse.

4.3.4 Decision Analysis
Decision analysis has three steps, and only one of them is difficult. The steps
are setting up a decision tree, identifying the alternative with the largest
expected value, and using sensitivity analysis to assess the robustness of the
analysis. Setting up a decision tree is the hardest and most important part of
decision analysis. Managers gain the most insights but also make the most
mistakes in this step. Setting up a decision tree requires six actions:

1. Carefully defining the problem. Often this task is harder than it
sounds.

2. Finding alternative courses of action. Serious mistakes are often made
here.

3. Identifying the outcomes associated with each alternative.
4. Identifying the sequence that leads to final outcomes, including choice

and chance events.
5. Calculating the probability of each outcome.
6. Calculating the value of each outcome.

Each of these activities is more difficult than it sounds, so deciding whether
to do a decision analysis at all should be the first step.

4.3.5 Sensitivity Analysis
Whenever the process of setting up and solving a decision tree is worthwhile,
performing a sensitivity analysis is equally worthwhile. A sensitivity analysis
substitutes different, but plausible, values for the values in a decision tree.
Gauging the effects of minor data changes on the results is always helpful.
The data are never perfect, and using them as if they were does not make
sense.

The decision tree for the nursing facility purchase tells us that the
key issue is whether its manager can realize the operational improvements
and product line changes that she is contemplating. If she can, the return
on equity will be no less than 8.3 percent, no matter what Medicare does.
A sensitivity analysis tells us that if she can realize about 70 percent of her
projected gains, she can expect a 7 percent return on equity, no matter what
Medicare does. What could she do to increase the odds of full improvement?
The sensitivity analysis indicates that the gains can fall somewhat short of the
manager’s prediction and still hit the target rate of return.

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Economics for Healthcare Managers64

4.3.6 Scenario Analysis
Just focusing on the expected value of a risky choice is not a satisfactory way
to make a decision. The expected value may not be a possible outcome, and
the best possible and worst possible outcomes matter. One solution is to
model several scenarios. Typically these models include a worst-case scenario,
a most likely scenario, and a best-case scenario. The process of setting up a
decision tree helps identify these scenarios.

In exhibit 4.2, the worst case, which is relatively unlikely, yields a
profit of $0. The best case, which is the most likely scenario, yields a profit of
$120,000. Thus, buying the nursing home has the potential to be profitable
and appears to be low risk. The scenario analysis also reinforces the conclu-
sion that succeeding in making improvements is vital.

4.4 Managing Risk

Risk sharing and diversification are the only two strategies for managing risk.
Buying an insurance policy is the obvious way to share risk, although joint
ventures or options can serve the same function. For insurance, consumers
pay a fee to induce another organization to share risks. Joint ventures or
options share costs and profits with partners.

Diversification can take a number of forms. Horizontal integration
(creating an organization that can offer the full spectrum of healthcare ser-
vices) is one diversification strategy because some products are likely to be
profitable no matter what the environment. All these strategies limit potential
losses, but they also limit potential profitability.

4.4.1 Risk Sharing
Joint ventures and options are common risk-sharing methods in the biotech-
nology and pharmaceutical fields. For example, in 2016 Bayer and start-up
CRISPR Therapeutics launched a joint venture to develop new drugs using
CRISPR, which edits DNA precisely (Orcutt 2016). The US-based firm Kite
Pharma and the Chinese firm Shanghai Fosun Pharmaceutical launched a
joint venture to develop and manufacture cancer drugs. The main goals were
to give Kite access to the Chinese market (plus additional funds for research)
and to give Chinese patients access to advanced medications (BusinessWire
2017). The two firms share product development and marketing decisions.

Biotechnology entails significant risk. Only about 5 percent of
interventions that pass toxicity tests get approved for public marketing

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 65

(Schuhmacher, Gassmann, and Hinder 2016), so reducing the costs of
research and development represents another motive for joint ventures (ide-
ally with a low-cost partner). For example, Amgen reports that it has two
joint ventures, ten partnerships, 15 collaborators, and eight acquisitions
(Amgen 2017). Its partners include investment firms (e.g., venBio), multina-
tional pharmaceutical firms (e.g., Novartis, Dr. Reddy’s Laboratories), small
biotechnology companies (e.g., Xencor), and equipment manufacturers (e.g.,
Illumina). Such partnerships allow Amgen to diversify its portfolio of poten-
tial products and reduce its fixed costs. Both strategies reduce risk.

In a different type of joint venture, two physicians and Eastern Long
Island Hospital agreed to construct a jointly owned ambulatory surgery cen-
ter (Dyrda 2017). The motives for each side are straightforward: Physicians
hope to negotiate higher rates because of the hospital’s ownership, and the
hospital hopes to have a low-cost site for routine surgeries (which is increas-
ingly valuable as value-based payments become more common).

Boston Children’s Hospital and General Electric are producing soft-
ware to improve interpretations of brain scans of young patients (McCluskey
2016). This example illustrates another facet of risk sharing. Often the cost
that an organization seeks to share is the enormous cost of acquiring a key
competency. Working with a knowledgeable partner allows the organization
to gain experience. Much time and money are needed to build expertise, and
joint ventures can reduce the risk of expending these resources needlessly.
Of course the organization must also assess the partner’s likely gains, such as
expertise and profits.

4.4.2 Diversification
Diversification creates a portfolio of projects or therapies that are not highly
positively correlated. Exhibit 4.3 compares investing in a clinic, investing in
an emergency department, and investing in a portfolio of 50 percent shares of
each. Forecasts of return on investment for the projects depend on whether
the growth of accountable care organizations becomes rapid, moderate, or
slow. The clinic is a better investment than the emergency department (higher
expected profits and lower standard deviation of profits). The portfolio is also
a better investment than the emergency department (higher expected profits
and lower standard deviation of profits). The portfolio might be a better
investment than the clinic for a risk-averse investor (lower expected profits
but a lower standard deviation of profits).

Joint ventures can make diversification less risky, as case 4.2 illustrates.
But acquisitions and mergers typically increase risk.

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Economics for Healthcare Managers66

Accountable Care Organization
Growth

Rapid Moderate Slow

Growth
probabilities 0.160 0.700 0.140

Profits Expecteda

Standard
Deviation

Clinic 10.0% 4.0% −1.0% 4.3% 3.0%

Emergency
department −3.0% 2.0% 13.0% 2.7% 4.5%

Portfoliob 3.5% 3.0% 6.0% 3.5% 1.0%

a Expected profits = P
rapid

× Profit
rapid

+ P
moderate

× Profit
moderate

+ P
slow

× Profit
slow

.
b Portfolio profits = 50% of the clinic profits and 50% of the emergency department profits.

EXHIBIT 4.3
Diversification

and Risk
Reduction

Diversification by Joint Venture and
Acquisition

The University of Pittsburgh Medical Center (UPMC) has international
operations in nine countries (UPMC 2017a). It operates cancer centers
and a full-service hospital in Ireland; transplantation, radiotherapy,
and biotechnology centers in Italy; information technology and cancer
centers in the United Kingdom; cancer center consulting in Colombia,
Kazakhstan, and Lithuania; transplantation in Singapore; pathology
consulting in China; and educational training in primary care in Japan.
UPMC is exploring expansion in Cyprus and Qatar. Most of these repre-
sent joint ventures with local partners.

UPMC is headquartered in Pittsburgh, where it has a commanding
presence. The largest employer in western Pennsylvania, with more
than 70,000 employees and nearly $17 billion in revenue, UPMC owns
more than 30 hospitals, 600 outpatient sites, a large insurance plan,
and a number of other healthcare ventures (UPMC 2017b).

Moody’s Investors Services greeted UPMC’s 2017 diversification
with a debt downgrade (Moody’s Investors Services 2017). Rather than

Case 4.2

(continued)

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 67

4.5 Conclusion

The goal of describing, evaluating, and managing risk is improving choices,
not identifying perfect choices. No one can make perfect choices. Even when
managers have good evidence and make good decisions, bad outcomes can
result. More often, though, medical and managerial decisions are made with
inadequate information. For example, managers often must make invest-
ment decisions long before they know how well technology will work, what
volumes will be, and what rivals will do. Even when a manager has access to
good information (which will never be the case with innovative choices), the
possible consequences of the choices remain uncertain.

Good management, however, can reduce risk and reduce the conse-
quences of risk. Managers will avoid some risks because of inadequate payoffs.
Managers will share some risks via joint ventures or insurance. And managers
will hedge some risks via diversification. A balanced portfolio of projects and
lines of business can be profitable in any market environment. Reducing cost
variations or reducing fixed costs can cut risk sharply. Finally, a high margin

a joint venture, it was an acquisition. In summer
2017, UPMC bought Pinnacle Health System, a
seven-hospital system based in Harrisburg, Penn-

sylvania. This acquisition means that UPMC acquired, built, or other-
wise gained access to nine hospitals in 2017, allowing UPMC to sell its
health insurance products outside its core western Pennsylvania mar-
ket. Moody’s noted that the purchases added integration and execu-
tion risk, marked UPMC’s entry into a competitive and rapidly consoli-
dating market, put pressure on profit margins, and increased the ratio
of debt to equity (Moody’s Investors Services 2017).

Discussion Questions
• Why is expansion outside the United States an attractive form of

diversification?

• What are the pitfalls of international expansion?

• What are the potential pitfalls of other diversification efforts?

• Why do small profit margins and a high ratio of debt to equity
increase risk?

• What are the main risks that UPMC faces in its Pittsburgh
operations?

• Why is buying additional hospitals in Pennsylvania risky?

Case 4.2
(continued)

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Economics for Healthcare Managers68

is a great way to reduce risk. If possible outcomes are a 15 percent return
on equity or an 11 percent return on equity, most managers will sleep well.

Exercises

4.1 Five of ten people earn $0, four earn $100, and one loses $100.
What is the expected payoff? What is the variance of the payoff?

4.2 You have a 50 percent chance of making $0, a 40 percent chance of
making $100, and a 10 percent chance of losing $100. Calculate the
expected value and variance of the payoff. How does your estimate
compare to the previous exercise?

4.3 You have a 1 percent chance of having healthcare bills of $100,000,
a 19 percent chance of having healthcare bills of $10,000, a 60
percent chance of having healthcare bills of $500, and a 20 percent
chance of having healthcare bills of $0. What is your expected
spending?

4.4 You have a 2 percent chance of having healthcare bills of $100,000,
a 20 percent chance of having healthcare bills of $10,000, a 60
percent chance of having healthcare bills of $500, and an 18 percent
chance of having healthcare bills of $0. What is your expected
healthcare spending? How does it compare to the answer in exercise
4.3?

4.5 You have a 1 percent chance of having healthcare bills of $100,000,
a 19 percent chance of having healthcare bills of $10,000, a 60
percent chance of having healthcare bills of $500, and a 20 percent
chance of having healthcare bills of $0. What is your expected
spending? Would you be willing to buy complete insurance coverage
if it cost $3,712? Explain.

4.6 Instead of complete insurance as in exercise 4.5, you have a
policy with a $5,000 deductible. What will your expected out-of-
pocket spending be? What will your expected insurance benefits
be? Assuming that the premium equals 116 percent of expected
insurance benefits, do you prefer the policy with a $5,000
deductible or the policy with complete coverage? Explain.

4.7 Your firm, which operates a nationwide system of cancer clinics, has
annual profits of $800 million and cash reserves of $500 million.
Your clinics have a replacement value of $200 million, and fire
insurance for them would cost $5 million per year. Actuarial data
show that your expected losses due to fire are $4 million. Should
you buy insurance?

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 69

4.8 Your firm rents a supply management system to hospitals. You have
received a buyout offer of $5 million. You forecast a 25 percent
chance that you will have profits of $10 million, a 35 percent chance
that you will have profits of $6 million, and a 40 percent chance
that you will have profits of $2 million. Should you accept the offer?
Explain.

4.9 You were given a lottery ticket. The drawing will be held in 5
minutes. You have a 0.1 percent chance of winning $10,000. You
refuse an offer of $11 for your ticket. Are you risk averse? Explain.

4.10 Your house is worth $200,000. Your risk of a catastrophic flood
is 0.5 percent. Such a flood would destroy your house and would
not be covered by homeowner’s insurance. Although you grumble,
you buy flood coverage for $1,200. Are you risk averse or risk
seeking?

4.11 Your firm faces considerable revenue uncertainty because you have
to negotiate contracts with several customers. You forecast a 20
percent chance that your revenues will be $200,000, a 30 percent
chance that your revenues will be $300,000, and a 50 percent
chance that your revenues will be $500,000. Your costs are also
uncertain because the prices of your supplies fluctuate considerably.
You forecast a 40 percent chance that your costs will be $400,000
and a 60 percent chance that your costs will be $250,000. Use
Excel to set up a decision tree for your profit forecast (it does not
matter whether costs or revenues come first). How many possible
profit outcomes do you have? What is your expected profit?

4.12 Your firm has been sued for $3 million by a supplier for breach
of contract. Your lawyers believe that three possible outcomes
could occur if the suit goes to trial. One, which the lawyers term
highly improbable, is that your supplier will win the lawsuit and be
awarded $3 million. Another, which the lawyers term unlikely, is
that your supplier will win the lawsuit and be awarded $500,000.
The third, which the lawyers term likely, is that your supplier will
lose the lawsuit and be awarded $0. You have to decide whether to
try to settle the case. To do so you need to assign probabilities to
“highly improbable,” “unlikely,” and “likely.” What probabilities
correspond to these statements? Going to trial will cost you
$100,000 in legal fees. One of your lawyers believes that your
supplier will settle for $100,000 (and you will have legal fees of
$25,000). Should you settle?

4.13 Why does reducing cost variation reduce risk? Why does reducing
fixed cost reduce risk?

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Economics for Healthcare Managers70

4.14 In a week a clinic sees the following numbers of flu cases per day: 1,
2, 2, 4, 6. What is the average for this sample? What is the standard
deviation for this sample?

4.15 The following data describe the costs for two pediatric clinics
with the same revenue. Calculate the average and sample standard
deviation of weekly costs. Which clinic is riskier?

Week Clinic 1 Clinic 2

1 $21,616 $23,041

2 $21,462 $19,382

3 $20,812 $22,156

4 $19,308 $15,757

5 $20,544 $21,145

6 $19,712 $17,867

7 $18,682 $17,767

8 $19,994 $16,514

9 $19,359 $18,553

10 $19,334 $20,330

11 $20,034 $20,166

12 $20,283 $20,131

13 $19,435 $16,275

14 $21,746 $16,200

15 $18,419 $15,171

16 $19,359 $24,460

17 $19,140 $21,365

18 $18,721 $22,551

19 $18,036 $21,534

20 $19,392 $24,215

21 $21,155 $20,933

22 $21,005 $23,774

23 $21,419 $22,121

24 $19,131 $20,901

25 $20,162 $22,200

26 $21,607 $15,182

27 $21,030 $24,725

28 $19,426 $16,239

(continued)

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Chapter 4: Descr ibing, Evaluat ing, and Managing Risk 71

Week Clinic 1 Clinic 2

29 $21,785 $20,137

30 $18,258 $22,673

31 $18,644 $15,545

References

Amgen. 2017. Partnering with Innovators to Treat Serious Illness. Published March.
www.amgenbd.com/~/media/amgen/full/www-amgenbd-com/accordion
/business_development_capabilites.ashx.

Barkholz, D. 2017. “CHI’s Operating Loss Widens to $585 Million.” Modern
Healthcare. Published September 15. www.modernhealthcare.com/article
/20170915/NEWS/170919912.

BusinessWire. 2017. “Kite Pharma and Fosun Pharma Establish Joint Venture
in China to Develop and Commercialize Autologous T-Cell Therapies to
Treat Cancer.” Modified November 17. www.businesswire.com/news/home
/20170110005587/en/.

Dyrda, L. 2017. “New York State DOH Approves CON for Joint Venture ASC:
5 Things to Know.” Becker’s ASC Review. Published November 8. www
.beckersasc.com/asc-transactions-and-valuation-issues/new-york-state-doh
-approves-con-for-joint-venture-asc-5-things-to-know.html.

McCluskey, P. D. 2016. “GE, Children’s Hospital Form Medical Software
Venture.” Boston Globe. Published November 28. www.bostonglobe.com
/business/2016/11/28/children-hospital-form-medical-software-venture
/pOs3FG7WMkUGOL5cF9BaMI/story.html.

Moody’s Investors Services. 2017. “University of Pittsburgh Medical Center,
PA.” Published September 6. www.upmc.com/about/finances/Documents
/upmc-moodys-2017-0906 .

Navathe, A. S., A. B. Troxel, J. M. Liao, N. Nan, J. Zhu, W. Zhong, and E. J.
Emanuel. 2017. “Cost of Joint Replacement Using Bundled Payment Mod-
els.” JAMA Internal Medicine 177 (2): 214–22.

Orcutt, M. 2016. “Big Pharma Doubles Down on CRISPR for New Drugs.”
MIT Technology Review. Published January 13. www.technologyreview
.com/s/545366/big-pharma-doubles-down-on-crispr-for-new-drugs/.

Schuhmacher, A., O. Gassmann, and M. Hinder. 2016. “Changing R&D Models in
Research-Based Pharmaceutical Companies.” Journal of Translational Medi-
cine 14 (1): 105.

(continued)

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Economics for Healthcare Managers72

Segelod, E. 2017. Project Cost Overrun: Causes, Consequences, and Investment Deci-
sions. New York: Cambridge University Press.

University of Pittsburgh Medical Center (UPMC). 2017a. “International Health
Locations.” Accessed November 11. www.upmc.com/about/international
-services/locations/Pages/default.aspx.

. 2017b. “UPMC Facts & Stats.” Accessed November 11. www.upmc.com
/about/facts/pages/default.aspx.

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CHAPTER

THE RISE OF MEDICAL EXPENDITURES

The rapid growth of medical expenditures since 1965 is as familiar as the
increasing percentage of US gross domestic product (GDP) devoted to
medical care. Less known are the reasons for this continual increase. The

purpose of this introductory chapter is threefold: (1) to provide a historical
perspective on the medical sector; (2) to explain the rise of medical expenditures
in an economic context; and (3) to set forth criteria for evaluating the Patient
Protection and Affordable Care Act (ACA), which has been the most significant
healthcare legislation since Medicare and Medicaid

Before Medicare and Medicaid

Until 1965, spending in the medical sector was predominantly private—80
percent of all expenditures were paid by individuals out of pocket or by private
health insurance on their behalf. The remaining expenditures (20 percent) were
paid by the federal government (8 percent) and the states (12 percent) (see
exhibit 1.1). Personal medical expenditures totaled $35 billion and accounted
for approximately 6 percent of GDP—that is, six cents of every dollar spent
went to medical services.

EXHIBIT 1.1
Personal Health
Expenditures
by Source of
Funds, 1965
and 20

1965 2016

Source of Funds $ (Billions) % $ (Billions) %

Total 34.7 100.0 2,834.0 100

Private 27.6 79.5 1,479.5 52.2

Out-of-pocket 18.2 52.4 352.5 12.

Insurance benefits 8.7 25.1 993.8 35.1

All other 0.7 2.0 133.2 4.7

Public 7.1 20.5 1,354.5 47.

Federal 2.8 8.1 1,093.8 38.6

State and local 4.3 12.4 260.7 9.2

Source: Data from Centers for Medicare & Medicaid Services (2017b).

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AN: 1907359 ; Paul Feldstein.; Health Policy Issues: An Economic Perspective, Seventh Edition
Account: s4264928.main.eds

Health Pol icy Issues: An Economic Perspect ive2

Two important trends are the increasing role of government in financing
medical services and the declining portion of expenditures paid out of pocket
by the public. As shown in exhibit 1.1, the government paid 47.8 percent of
total medical expenditures in 2016; the federal share was 38.6 percent and the
states contributed 9.2 percent. Meanwhile, the private share dropped to 52.2
percent (from 79.5 percent in 1965); of that amount, 12.4 percent was paid
out of pocket (from 52.4 percent in 1965).

The Greater Role of Government in Healthcare

Medicare and Medicaid were enacted in 1965, dramatically expanding the
role of government in financing medical care. Medicare, which covers the
aged, initially consisted of two of its current four parts—Part A and Part B.
Part A is for hospital care and is financed by a separate (Medicare) payroll tax
on the working population. Part B covers physicians’ services and is financed
by federal taxes (currently 75 percent) and by a premium paid by the aged
(25 percent). Medicare Part C and Part D have since been added. Part C is a
managed care option, and Part D is a prescription drug benefit—financed 75
percent by the federal government and 25 percent by the aged. Parts B, C,
and D are all voluntary programs.

Medicaid is for the categorically or medically needy, including the indi-
gent aged and families with dependent children who receive cash assistance.
Each state administers its own program, and the federal government pays, on
average, more than half of the costs. The ACA, enacted in 2010 and imple-
mented in 2014, expanded Medicaid eligibility from 100 to 138 percent of
the federal poverty level (FPL). The federal government reimburses states that
choose to expand Medicaid for up to 90 percent of their costs for the newly
eligible enrollees.

The rapid increase in total national health expenditures (NHE) is illus-
trated in exhibit 1.2, which shows spending on the different components of
medical services over time. Since 2000, NHE per capita has risen from $4,884
to $10,365. During this time frame, hospital care and physician and clinical
services—the two largest components of medical expenditures—surged from
$416 billion to $1.083 trillion and from $291 billion to $665 billion, respec-
tively. These data indicate the enormous amount of US resources flowing into
healthcare.

In 2016, $3.338 trillion (or 17.9 percent of GDP) was spent on medical
care in the United States.1 From 2000 to 2016, these expenditures climbed
by about 9 percent per year. Since peaking in the early part of the decade, the
annual rate of increase in NHE has been declining, although it remains above
the rate of inflation. These expenditures continue to rise as a percentage of GDP.

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Chapter 1 : The Rise of Medical Expenditures 3

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Health Pol icy Issues: An Economic Perspect ive4

The Relationship Between NHE and GDP
The growth in medical expenditures over time can be illustrated by compar-
ing the rate of increase in NHE per capita to the rate of change in GDP per
capita. (To show the relationship between the two series more clearly, a five-
year moving average of the rates of change is used.) If NHE per capita is rising
faster than GDP per capita, the former is becoming a larger share of GDP. If
the two series are moving together, then changes in the economy and health
spending are closely related. Exhibit 1.3 shows the relationship between the
two series from 1965 to 2016.

The only major divergence between NHE per capita and GDP per
capita began in the mid-1990s. Medical expenditures increased at a slower rate
because of the growth of managed care (which emphasized utilization manage-
ment) and price competition among providers participating in managed care
provider networks. By the end of the 1990s, managed care’s cost-containment

10%

12%

14%

‘65 ‘70 ‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘10 ‘16

Year

NHE per capita
GDP per capita

Note: Five-year moving averages.

Source: Data from the Centers for Medicare & Medicaid Services (2017b).

EXHIBIT 1.3
Changes in

National Health
Expenditures

and Gross
Domestic

Product
per Capita,
1965–2016

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Chapter 1 : The Rise of Medical Expenditures 5

approaches lost support because of public dissatisfaction with managed care’s
restrictions on access to specialists, lawsuits against managed care organizations
(MCOs) for denial of care, government legislation, and a tight labor market
that led employers to offer their employees more health plan choices. As a
result, medical expenditures rose at a more rapid rate.

The decline in the annual NHE rate increase from about 2008 to 2013
(exhibit 1.3) can be attributed to the Great Recession, slow economic recov-
ery, high unemployment levels, a large number of uninsured, a decrease in
the number of employers paying for employee health insurance, and the rapid
spread of high-deductible health plans (Fuchs 2013).

NHE is likely to rise at a slightly faster rate in the coming years as the
economy continues to recover; more baby boomers become eligible for Medi-
care; new technology and specialty drugs that improve the quality of life (but
are higher in cost) are developed; and increased demand occurs as a result of
the ACA’s Medicaid eligibility expansion and subsidies for low-income enrollees
on health insurance exchanges.

By 2025, federal, state, and local governments are expected to increase
their share of total NHE, which is expected to reach $2.6 trillion (almost dou-
bling from $1.5 trillion in 2016) and to consume an even greater portion of
GDP (19.9 percent) (Centers for Medicare & Medicaid Services 2017c, table
16). Exhibit 1.4 shows where healthcare dollars come from and how they are
distributed among different types of healthcare providers.

Private
health

insurance
33.7%

Other
private
4.2%Out-of-

pocket
payments

10.6%

Medicare
20.1%

Medicaid
16.9%

Other
government

programs

14.5%

Where It Came From

Other
spending

15.1%

Hospital
care

32.4%Physician
services
19.9%

Nursing
home
care
4.9%

Other
personal

healthcare
27.7%

Where It Went

Notes: “Other personal healthcare” includes dental care, vision care, home health care, drugs, medi-
cal products, and other professional services. “Other spending” includes program administration,
net cost of private health insurance, government public health, and research and construction.

Source: Data from the Centers for Medicare & Medicaid Services (2017b).

EXHIBIT 1.4
The Nation’s
Healthcare
Dollar, 2016

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Health Pol icy Issues: An Economic Perspect ive6

Changing Patient and Provider Incentives

Medical expenditures equal the prices of services provided multiplied by the
quantity of services provided. The rise of expenditures can be explained by
looking at the factors that prompt medical prices and quantities to change. In
a market system, the prices and output of goods and services are determined
by the interaction of buyers (the demand side) and sellers (the supply side). We
can analyze price and output changes by examining how various interventions
change the behavior of buyers and sellers. One such intervention was Medicare,
which lowered the out-of-pocket price the aged had to pay for medical care.
The demand for hospital and physician services went up dramatically after
Medicare was enacted, spurring rapid price increases. Similarly, government
payments on behalf of the poor under Medicaid stimulated demand for medi-
cal services among this population. Greater demand for services multiplied by
higher prices for those services equals greater total expenditures.

Prices also go up when the costs of providing services increase. For
example, to attract more nurses to care for the higher number of aged patients,
hospitals raised nurses’ wages and then passed this increase on to payers in
the form of more expensive services. Increased demand for care multiplied by
higher costs of care equals greater expenditures.

While the government was subsidizing the demands of the aged and the
poor, the demand for medical services by the employed population also was
increasing. The growth of private health insurance during the late 1960s and
1970s was stimulated by income growth, high marginal (federal) income tax
rates (up to 70 percent), and the high inflation rate in the economy. The high
inflation rate threatened to push many people into higher marginal tax brackets.
If an employee were pushed into a 50 percent marginal income tax bracket, half
of his salary in that bracket would go to taxes. Instead of having that additional
income taxed at 50 percent, employees often chose to have the employer spend
those same dollars, before tax, on more comprehensive health insurance. Thus,
employees could receive the full value of their raise, albeit in healthcare benefits.
This tax subsidy for employer-paid health insurance stimulated the demand for
medical services in the private sector and further boosted medical prices.

Demand increased most rapidly for medical services covered by govern-
ment and private health insurance. As of 2016, only 3 percent of hospital care
and 8.9 percent of physician services were paid out of pocket by the patient;
the remainder was paid by a third party (Centers for Medicare & Medicaid
Services 2017b). Patients had little incentive to be concerned about the price
of a service when they were not responsible for paying a significant portion of
the price. As the out-of-pocket price declined, the use of services increased.

The aged—who represent almost 16 percent of the population and use
more medical services than any other age group—accounted for 35.4 percent of

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Chapter 1 : The Rise of Medical Expenditures 7

all hospital stays as of 2015 (Agency for Healthcare Research and Quality 2017).
Use of physician services by the aged (Medicare), the poor (Medicaid), and
those covered by tax-exempt employer-paid insurance also increased as patients
became less concerned about the cost of their care. Historically, advances in
medical technology have been another factor stimulating the demand for medi-
cal treatment. New methods of diagnosis and treatment were developed; those
with previously untreatable diseases gained access to technology that offered
the hope of recovery. New medical devices (e.g., imaging equipment) were
introduced, and new treatments (e.g., organ transplantations) became avail-
able. New diseases (e.g., AIDS) also increased demand on the medical system.
Reduced out-of-pocket costs and increased third-party payments (both public
and private)—in addition to an aging population, new technologies, and new
diseases—drove up prices and the quantity of medical services provided.

Providers (hospitals and physicians) responded to the increased demand
for care, but the way they responded unnecessarily increased the cost of pro-
viding medical services. After Medicare was enacted, hospitals had few incen-
tives to be efficient because Medicare reimbursed hospitals their costs plus 2
percent for serving Medicare patients. Hospitals, predominantly not-for-profit,
consequently expanded their capacity, invested in the latest technology, and
duplicated facilities and services offered by nearby hospitals. Hospital prices
rose faster than the prices of any other medical service.

Similarly, physicians had little cause for concern over hospital costs. Phy-
sicians, who were paid on a fee-for-service basis, wanted their hospitals to have
the latest equipment so they would not have to refer patients elsewhere (and
possibly lose them). They would hospitalize patients for diagnostic workups
and keep them in the hospital longer than necessary because it was less costly
for patients covered by hospital insurance, and physicians would be sure to
receive reimbursement. Outpatient services, which were less costly than hospital
care, initially were not covered by third-party payers.

In addition to the lack of incentives for patients to be concerned with the
cost of their care and the similar lack of incentives for providers to supply that
care efficiently, the federal government imposed restrictions on the delivery of
services that increased enrollees’ medical costs. Under Medicare and Medicaid,
the government ruled that insurers must give enrollees free choice of provider.
Insurers such as health maintenance organizations (HMOs) that precluded
enrollees from choosing any physician in the community were violating the
free choice of provider rule and, thus, were ineligible to receive capitation
payments from the government. Instead, HMOs were paid fee-for-service,
reducing their incentive to reduce the total costs of treating a patient. Numer-
ous state restrictions on HMOs, such as prohibiting them from advertising,
requiring HMOs to be not-for-profit (thereby limiting their access to capital),
and requiring HMOs to be controlled by physicians, further inhibited their

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Health Pol icy Issues: An Economic Perspect ive8

development. By imposing these restrictions on alternative delivery systems,
however, the government reduced competition for Medicare and Medicaid
patients, forgoing an opportunity to reduce government payments for Medi-
care and Medicaid services.

The effects of higher demand, limited patient and provider incentives
to search for lower-cost approaches, and restrictions on the delivery of medi-
cal services were escalating prices, increasing use of services, and resulting in
greater medical expenditures.

Government Response to Rising Costs

As expenditures under Medicare and Medicaid increased, the federal govern-
ment faced limited options: (1) raise the Medicare payroll tax and income taxes
on the working population to continue funding these programs; (2) require
the aged to pay higher premiums for Medicare, and increase their deductibles
and copayments; or (3) reduce payments to hospitals and physicians. Each of
these approaches would cost successive administrations and Congress political
support from some constituents, such as employees, the aged, and healthcare
providers. The least politically costly options appeared to be number 1 (increase
taxes on employees) and number 3 (reduce payments to hospitals and physi-
cians). The aged have the highest voting participation rate of any age group, as
well as the political support of their children, who are relieved of the financial
responsibility to pay their parents’ medical expenses.

Federal and state governments used additional regulatory approaches
to control these rapidly rising expenditures. Medicare utilization review pro-
grams were instituted, and controls were placed on hospital investments in
new facilities and equipment. These government controls proved ineffective
as hospital expenditures continued to escalate through the 1970s. The federal
government then limited physician fee increases under Medicare and Medicaid;
as a consequence, many physicians refused to participate in these programs,
reducing access to care for the aged and the poor. As a result of providers’
refusal to participate in Medicare, many Medicare patients had to pay higher
out-of-pocket fees to be seen by physicians.

In 1979, President Carter’s highest domestic priority was to enact limits
on Medicare hospital cost increases; a Congress controlled by his own political
party defeated him.

The 1980s
By the beginning of the 1980s, political consensus was lacking on what should
be done to control Medicare hospital and physician expenditures, and pri-
vate health expenditures also continued to rise. By the mid-1980s, however,

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Chapter 1 : The Rise of Medical Expenditures 9

legislative changes and other events imposed heavy cost-containment pressures
on Medicare, Medicaid, and the private sector.

Legislative and Government Changes
President Nixon wanted a health program that would not increase federal expen-
ditures. The result was the Health Maintenance Organization Act of 1973, which
legitimized HMOs and removed restrictive state laws impeding the development
of federally approved HMOs. However, many HMOs decided not to seek federal
qualification because imposed restrictions, such as having to offer more costly
benefits, would have caused their premiums to be too high to be competitive
with traditional health insurers’ premiums. These restrictions were removed by
the late 1970s, and the growth of HMOs began in the early 1980s.

To achieve savings in Medicaid, the Reagan Administration removed the
free-choice-of-provider rule in 1981, enabling states to enroll their Medicaid
populations in closed provider panels. As a result, states were permitted to
negotiate capitation payments with HMOs for care of Medicaid patients. The
free choice rule continued for the aged; however, in the mid-1980s, Medicare
patients were permitted to voluntarily join HMOs. The federal government
agreed to pay HMOs a capitated amount for enrolling Medicare patients, but
less than 10 percent of the aged voluntarily participated. (As of 2016, 34 per-
cent of the 48 million aged were enrolled in Medicare HMOs, referred to as
Medicare Advantage plans [Centers for Medicare & Medicaid Services 2017a].2)

Federal subsidies were provided to medical schools in 1964 to increase
the number of students they could accommodate, and the supply of physi-
cians expanded. The number of active physicians grew from 146 per 100,000
civilian population in 1965 to 195 per 100,000 in 1980; it reached 233 per
100,000 by 1990 and 321 per 100,000 in 2013 (American Medical Associa-
tion 1991, 2015). The greater supply created excess capacity among physi-
cians, dampened their fee hikes, and made attracting physicians—and therefore
expanding—easier for HMOs.

A new Medicare hospital payment system was phased in during 1983.
Under the new system, hospitals were no longer to be paid according to their
costs. Fixed prices were established for each diagnostic admission (referred to
as diagnosis-related groups [DRGs]), and each year Congress set an annual
limit on the amount by which these fixed prices per admission could increase.
DRG prices changed hospitals’ incentives. Because hospitals could keep the
difference if the costs they incurred from an admission were less than the
fixed DRG payment they received for that admission, they were motivated to
reduce the cost of caring for Medicare patients and to discharge them earlier.
Length of stay per admission fell, and occupancy rates declined. Hospitals also
became concerned about inefficient physician practice behaviors that increased
the hospitals’ costs of care.

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Health Pol icy Issues: An Economic Perspect ive10

In addition, in 1992 the federal government changed its method of
paying physicians under Medicare. A national fee schedule (referred to as
resource-based relative value system [RBRVS]) was implemented, and volume
expenditure limits were established to cap the total rate of increase in physician
Medicare payments. The RBRVS also prohibited physicians from charging
their higher-income patients a higher fee and accepting the Medicare fee only
for lower-income patients; they had to accept the fee for all or none of their
Medicare patients. Medicare patients represent such a significant portion of a
physician’s practice that few physicians decided not to participate; consequently,
they accepted Medicare fees for all patients.

To contain increases in Medicare expenditures during this period, the
federal government imposed price controls and expenditure limits on hospital
and physician payments for services provided to Medicare patients.

Private Sector Changes
In addition to the government policy changes of the early 1980s, important
events were occurring in the private sector. The new decade started with a
recession. To survive the recession and remain competitive internationally, the
business sector looked to reduce labor costs. Because employer-paid health insur-
ance was the fastest-growing labor expense, businesses pressured health insurers
to better control the use and cost of medical services. Competitive pressures
forced insurers to increase the efficiency of their benefit packages by including
lower-cost substitutes for inpatient care, such as outpatient surgery. They raised
deductibles and copayments, intensifying patients’ price sensitivity. Patients
had to receive prior authorization from their insurer before being admitted to
a hospital, and insurers reviewed patients’ length of stay while patients were in
the hospital. These actions greatly reduced hospital admission rates and lengths
of stay. In 1975, the number of admissions in community hospitals was 155 per
1,000 population. By 1990, it had fallen to 125 per 1,000 and continued to
decline thereafter, dropping to 104 per 1,000 in 2015. The number of inpatient
days per 1,000 population declined even more dramatically—from 1,302 in
1977 to 982 in 1990 to 565 in 2015 (American Hospital Association 2017).

Because of the implementation of the DRG payment system, the changes
to private programs, and a shift to the outpatient sector facilitated by techno-
logical change (both anesthetic and surgical techniques), hospital occupancy
rates decreased from 76 percent in 1980 to 63.5 percent in 2015 (American
Hospital Association 2017).

Antitrust Laws
The preconditions for price competition were in place: Hospitals and physi-
cians had excess capacity, and employers wanted to pay less for employee health
insurance. The last necessary condition for price competition occurred in 1982,
when the US Supreme Court upheld the applicability of antitrust laws to the

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Chapter 1 : The Rise of Medical Expenditures 11

medical sector. Successful antitrust cases were brought against the American
Medical Association for its restrictions on advertising; against a medical society
that threatened to boycott an insurer over physician fee increases; against a
dental organization that boycotted an insurer’s cost-containment program;
against medical staffs that denied hospital privileges to physicians because
they belonged to an HMO, and against hospitals whose mergers threatened
to reduce price competition in their communities.

The applicability of antitrust laws, excess capacity among providers, and
employer and insurer interest in lowering medical costs brought about profound
changes in the medical marketplace. Traditional insurance plans lost market
share as managed care plans, which controlled utilization and limited access to
hospitals and physicians, grew. Preferred provider organizations (PPOs) were
formed and included only physicians and hospitals willing to discount their
prices. Employees and their families were offered price incentives in the form
of lower out-of-pocket payments to use these less expensive providers. Large
employers and health insurers began to select PPOs on the basis of their prices,
use of services, and treatment outcomes.

Consequences of the 1980s Changes
The 1980s disrupted the traditional physician–patient relationship. Insurers
and HMOs used utilization review to control patient demand, emphasize out-
comes and appropriateness of care, and limit patients’ access to higher-priced
physicians and hospitals by not including them in their provider networks.
They also used case management for catastrophic illnesses, substituted less
expensive settings for costlier inpatient care, and influenced patients’ choice
of drugs through the use of formularies.

The use of cost-containment programs and the shift to outpatient care
lowered hospital occupancy rates. The increasing supply of physicians—particu-
larly specialists—created excess capacity. Hospitals in financial trouble closed,
and others merged. Hospital consolidation increased. Hospitals’ excess capacity
was not reduced until years later when the demand for care began to exceed the
available supply of hospitals and physicians. Until then, hospitals and physicians
continued to be subject to intense competitive pressures.

Employees’ incentive to reduce their insurance premiums also stimulated
competition among HMOs and insurers. Employers required employees to pay
the additional cost of more expensive health plans, so many employees chose the
lowest-priced plan. Health insurance companies competed for enrollees primar-
ily by offering lower premiums and provider networks with better reputations.

The 1990s
As managed care spread throughout the United States during the 1990s, the
rate of increase in medical expenditures declined (see exhibit 1.3). Hospital
use decreased dramatically, and hospitals and physicians agreed to large price

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Health Pol icy Issues: An Economic Perspect ive12

discounts to be included in an insurer’s provider panel. These cost-containment
approaches contributed to the lower annual rate of increase. However, although
price competition reduced medical costs, patients were dissatisfied. The public
wanted greater access to care, particularly less restriction on referrals to special-
ists. Public backlash against HMOs emerged. HMOs lost several lawsuits for
denying access to experimental treatments, and Congress and the states imposed
restrictions on MCOs, such as mandating minimum lengths of hospital stays
for normal deliveries. Consequently, cost-containment restrictions weakened,
and increases in prices, use of services, and medical expenditures reaccelerated.

The 2000s
The excess capacity that weakened hospitals in their negotiations with insur-
ers dried up during the 2000s. Financially weak hospitals had closed. Because
consolidation reduces the number of competitors in an area, the number of
hospital mergers—which enhance bargaining power—increased. As hospital
prices rose, so did insurance premiums. Previous approaches, such as decreased
hospital use and price discounts, could no longer achieve large cost reductions.
Instead, insurers tried to develop more innovative, less costly ways of manag-
ing patient care.

Newer approaches to cost containment included high-deductible health
plans, reliance on evidence-based medicine, and chronic disease management.
Insurers’ method of shifting a larger share of medical costs to consumers is
referred to as consumer-driven healthcare. In return for lower health insurance
premiums, consumers pay higher deductibles and copayments. Consumers
then presumably evaluate the costs and benefits of spending their own funds
on healthcare. Another approach to lowering medical costs is to use evidence-
based medicine, which relies on scientific evidence and analysis of large data
sets to determine the effect of different physician practice patterns on costs and
medical outcomes. Other insurers emphasize disease management to provide
chronically ill patients, who incur the most medical expenditures, with preven-
tive and continuous care. This approach not only improves the quality of care
but reduces costly hospitalizations.

Pay-for-performance programs also have been developed to lower costs
and improve care. Insurers pay higher amounts to physicians and other health-
care providers if they provide high-quality care, which is usually defined on the
basis of process measures developed by medical experts. Insurers also make
report cards available to their enrollees. Report cards are a means of describing
hospitals and medical groups in the insurer’s provider network according to
medical outcomes, preventive services, and patient satisfaction scores to enable
enrollees to make informed choices about the providers they use.

In the latter half of the decade, rising premiums and increased unem-
ployment (resulting from the Great Recession) prompted people to drop their

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Chapter 1 : The Rise of Medical Expenditures 13

health insurance or switch to plans that charged lower premiums, such as high-
deductible plans. Many Americans became concerned that premiums would
continue increasing, making insurance even less affordable. The recession, a
decrease in the number of insured, and the switch to high-deductible health
plans slowed rising healthcare expenditures (see exhibit 1.3).

In 2015, Congress again revised Medicare payments to physicians with
passage of The Medicare Access and CHIP Reauthorization Act (MACRA).
The law’s provisions are being phased in and will become fully effective for
all physicians by 2019. MACRA is the most substantive change in physician
reimbursement since Medicare was enacted. Congress had previously been
reluctant to enforce the accumulated sustainable growth rate (SGR) cuts, which
would have reduced Medicare payments to physicians. The SGR formula was
eliminated with passage of MACRA. The new law attempts to change physi-
cian incentives by moving payments away from fee-for-service toward financial
accountability for the care they provide. Another objective of MACRA is to
move physicians into alternative payment systems that require them to bear
financial risk. (MACRA is discussed more completely in chapter 10.)

It is too early to judge how physicians will adjust to the new Medicare
payment system, which requires them to submit a great deal of data. This
requirement may force many physicians to decide to become employees of
hospitals and insurers.

The Affordable Care Act

The most significant health policy event of the current decade was the 2010
enactment and 2014 implementation of the ACA. Although implementation
was fraught with website and enrollment problems, the legislation, which did
not receive bipartisan support and has proved to be controversial, has led to
important changes in the financing and delivery of medical services. Sufficient
time has elapsed to examine the extent to which the ACA has achieved its
stated objectives. Consequently, it should be judged according to three criteria.

The first criterion is whether it reduced the number of uninsured, pre-
sumably the major goal of the legislation. Before the ACA was enacted, about
50 million Americans did not have health insurance. Several approaches were
used to decrease the number of uninsured. The ACA expanded Medicaid
eligibility from 100 to 138 percent of the FPL. (However, not all states chose
to expand their Medicaid eligibility levels.) Federal and state health insurance
exchanges were established, primarily for those who purchase insurance in the
individual market. In addition, premium tax credits and cost-sharing subsidies
were provided on a declining scale to those with incomes between 138 and
400 percent of the FPL. The legislation included an individual mandate that

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Health Pol icy Issues: An Economic Perspect ive14

required everyone to buy insurance or pay a penalty. An employer mandate was
imposed that required employers to offer health insurance to their employees
or pay a penalty of $2,000 per employee. Small employers (those with fewer
than 50 full-time employees) were exempted from this mandate and, instead,
were offered a tax credit for providing health insurance to their employees.

In 2010, when the ACA was enacted, the Congressional Budget Office
estimated that these steps to increase insurance coverage, expand Medicaid,
provide health insurance exchange subsidies, include individual and employer
mandates, and provide tax credits for small employers would increase the
number of insured by 23 million, leaving 21 million Americans uninsured by
2016. By 2016, however, only 16 million people gained insurance, leaving 28
million uninsured (Congressional Budget Office 2017, 9).

The second criterion relates to cost. The Obama administration and
Congressional Democrats expected the ACA to increase the demand for health
insurance and, consequently, the demand for medical services without rais-
ing the costs of care. In fact, the ACA was expected to “bend the cost curve
down,” “decrease premiums by $2,500 a year for a family of four,” and “not
add a dime to the deficit.” These promises were made by President Obama
in promoting the legislation’s benefits to the middle class. The Congressional
Budget Office initially calculated the projected cost over a ten-year period and
estimated that it would be budget neutral for this period. Budget neutrality
was to be achieved by increasing ACA taxes for the entire ten-year period but
delaying spending for several years (from 2010 to 2014). Whether the ACA
succeeds in reducing the rate of increase in medical expenditures, reducing
family premiums, and achieving budget neutrality at the end of the decade will
determine if it has met this second objective.3

The third criterion is whether people who already had insurance were
able to keep the coverage they had, as President Obama promised. He stated
numerous times, “If you like your healthcare plan, you can keep your healthcare
plan” and “if you like your doctor, you can keep your doctor.” What made these
promises doubtful was that the ACA made numerous changes to the health
insurance market, such as mandating “essential” (i.e., more comprehensive)
health benefits, requiring a smaller difference in premiums between older and
younger individuals on the health insurance exchanges, establishing gender
equality in premium ratings, and initiating a new health insurance tax on pre-
miums for those buying insurance on the exchanges. Additional regulations,
as well as subsidies, were imposed on health insurers.

Did these and other changes to the health insurance market, particularly
to the individual market, affect the ability of those currently insured to keep
their health plans?

These criteria for evaluating the ACA are discussed in chapter 38, “The
Affordable Care Act: Did It Achieve Its Goals?”

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Chapter 1 : The Rise of Medical Expenditures 15

Finally, any evaluation of the ACA should be based on a comparison—not
with the previous healthcare system, but with other proposed healthcare reform
approaches in achieving the same objectives. Chapter 36 discusses several of
these approaches, including the refundable tax credit.

Summary

The forces that increase demand and the costs of providing care have not
changed. The population is aging (the first of the baby boomers retired in 2011),
technological advances enable early diagnosis, and new treatment methods are
emerging—all of which stimulate increased demand for medical services. Of
these three developments, new technology is believed to be the most impor-
tant force behind rising expenditures. For example, expensive new prescrip-
tion drugs that extend life and alleviate pain have been brought to market. In
addition, the number of people receiving organ transplants, the introduction
of new equipment, and the use of imaging tests have grown dramatically. The
cost of providing medical services is also rising as more highly trained medical
personnel are needed to handle advanced technology and as wage rates increase
to attract more nurses and technicians to the medical sector.

The ACA has further increased demand for medical care. More people
have become eligible for Medicaid, and many previously uninsured individuals
buying insurance on the exchanges receive government subsidies. Everyone is
required to have insurance under the legislation’s individual mandate (in 2019,
the penalty for this mandate ends as a result of legislation passed in December
2017), and under the employer mandate, most employers are required to
provide insurance for employees or pay a fine. However, the ACA provides
no additional patient or provider incentives to encourage them to be more
efficient in use of medical services.

The developing shortage of physicians is a growing concern. The demand
for physician services is increasing faster than the supply of physicians, and access
to care, as indicated by increased waiting times for a physician appointment,
has declined. As the costs of financing expansions of Medicaid eligibility and
new exchange subsidies increase, the already large federal deficit is likely to
grow even faster. The federal government is under great pressure to reduce
the rising deficit and the burden of increasing premiums faced by the middle
class. Will the government rely more on regulatory (provider price controls) or
competitive approaches to reduce medical expenditures and premium increases?

Innovative approaches to reducing healthcare costs are more likely to
be adopted in a system that has price incentives to do so (i.e., enrollees have a
financial incentive to choose less costly health plans, and health insurers compete
for enrollees on the basis of premiums, access to care, and quality) than in a

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Health Pol icy Issues: An Economic Perspect ive16

regulated system. Any regulatory approach that arbitrarily seeks to reduce the
rate of increase in medical expenditures will result in reduced access to both
medical care and new technology.

The United States spends more on healthcare than any other country;
nevertheless, a scarcity of funds exists to provide for all of our medical needs
and population groups, such as the uninsured and those on Medicaid. There-
fore, choices must be made.

The first choice is to determine how much we, as a society, should spend
on medical care. What approach should we use to make this choice? Should
individuals decide how much they want to spend on healthcare, or should the
government decide the percentage of GDP that goes toward healthcare? Our
second choice is to identify the best way to provide medical services. Would
competition among health plans or government regulation and price controls
bring about greater efficiency? The third choice is to determine how rapidly medi-
cal innovation should be introduced. Should regulatory agencies evaluate each
medical advance and decide whether its benefits exceed its costs, or should the
evaluation of those benefits and costs be left to the separate health plans compet-
ing for enrollees? Our fourth choice is to specify how much should be spent on
those who are medically indigent and how their care should be provided. Should
the medically indigent be enrolled in a separate medical system (e.g., Medicaid),
or should they receive subsidized tax credits to enroll in competing health plans?

These choices can be better understood when we are more aware of the
consequences of each approach (such as which groups benefit, and which groups
bear the costs). Economics clarifies the implications of different approaches
to these decisions.

Discussion Questions

1. What are some of the reasons for the increased demand for medical
services since 1965?

2. Why has employer-paid health insurance been an important stimulant of
demand for health insurance?

3. How did hospital payment methods in the 1960s and 1970s affect
hospitals’ investment policies and incentives to improve efficiency?

4. Why were HMOs and managed care not more prevalent in the 1960s
and 1970s?

5. What choices does the federal government have to reduce greater-than-
projected Medicare expenditures?

6. What events during the 1980s in both the public and private sectors
made the delivery of medical services price competitive?

7. What three criteria have been proposed to evaluate the success of the ACA?

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Chapter 1 : The Rise of Medical Expenditures 17

Notes

1. GDP represents the total value of all goods and services produced in
a given year. GDP is also equal to the total income received by the
resources—employees, management, and capital—that produced those
goods and services.

2. Medicare does not place a limit on a Medicare patient’s total out-of-
pocket expenses. Consequently, the out-of-pocket medical payments
for low-income aged have forced many people to rely on Medicaid.
Medicare Advantage plans provide enrollees with additional benefits
and a limit on out-of-pocket expenses (Medicare2017.org 2017).

3. As shown in exhibit 1.3, the slowdown in medical expenditures started
before the ACA was enacted and was the result of many factors; it
should not be attributed solely to the legislation. Proponents of the
ACA claim that part of the slowdown in medical expenditure increases
was a result of the legislation. However, Chandra, Holmes, and Skinner
(2013) reported that the decline started several years before enactment
of the ACA (as shown in exhibit 1.3), and that most of the ACA’s
cost-control measures did not begin until several years after its 2010
passage. In addition, Ryu and colleagues (2013) discuss the reasons for
the decline in medical expenditure increases. More recently, Dranove,
Garthwaite, and Ody (2016) concluded that economic conditions, not
the ACA, accounted for most of the reduction in healthcare spending
during the 2009–2011 period.

References

Agency for Healthcare Research and Quality. 2017. “HCUP Fast Stats—Trends in
Inpatient Stays.” Healthcare Cost and Utilization Project. Updated November.
www.hcup-us.ahrq.gov/faststats/NationalTrendsServlet.

American Hospital Association. 2017. Hospital Statistics, 2017 Edition. Chicago: American
Hospital Association.

American Medical Association. 2015. Physician Characteristics and Distribution in the
United States, 2015 Edition. Chicago: American Medical Association.

———. 1991. Physician Characteristics and Distribution in the United States, 1991
Edition. Chicago: American Medical Association.

Centers for Medicare & Medicaid Services. 2017a. “Medicare Enrollment Dashboard.”
Accessed August 23. www.cms.gov/Research-Statistics-Data-and-Systems/
Statistics-Trends-and-Reports/CMSProgramStatistics/Dashboard.html.

———. 2017b. “National Health Expenditure Data, Historical.” Modified Janu-
ary.https://www.cms.gov/Research-Statistics-Data-and-Systems/Statistics-

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Health Pol icy Issues: An Economic Perspect ive18

Trends-and-Reports/NationalHealthExpendData/NationalHealthAccounts
Historical.html.

———. 2017c. “National Health Expenditure Data, Projected.” Modified January.
www.cms.gov/Research-Statistics-Data-and-Systems/Statistics-Trends-and-
Reports/NationalHealthExpendData/NationalHealthAccountsProjected.html.

Chandra, A., J. Holmes, and J. Skinner. 2013. “Is This Time Different? The Slowdown
in Healthcare Spending.” National Bureau of Economic Research Working Paper
No. 19700. Published December. http://papers.nber.org/papers/W19700.

Congressional Budget Office (CBO). 2017. CBO’s Record of Projecting Subsidies
for Health Insurance Under the Affordable Care Act: 2014 to 2016. Pub-
lished December. www.cbo.gov/system/files/115th-congress-2017-2018/
reports/53094-acaprojections .

Dranove, D., C. Garthwaite, and C. Ody. 2016. “Why Healthcare Spending Has
Slowed.” Kellogg Insight. Published February 1. https://insight.kellogg.north
western.edu/article/why-healthcare-spending-has-slowed.

Fuchs, V. R. 2013. “The Gross Domestic Product and Health Care Spending.” New
England Journal of Medicine 369 (2): 107–9.

Medicare2017.org. 2017. “Close the Medicare Coverage Gap.” Accessed December
11. www.medicare2017.org.

Ryu, A., T. Gibson, M. McKellar, and M. Chernew. 2013. “The Slowdown in Health
Care Spending in 2009–11 Reflected Factors Other Than the Weak Economy
and Thus May Persist.” Health Affairs 32 (5): 835–40.

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