APPENDIX TO CHAPTER FOUR

Applying Supply and DemandAnalysis to Health Care

One out of every seven dollars spent in the United States is spent for health care services. This is a greater percentage than in any other industrialized country.1 The topic of health care arouses deep emotions and generates intense media coverage. How can we understand many of the important health care issues? One approach is to listen to the normative statements made by politicians and other concerned citizens. Another approach is to use supply and demand theory to analyze the issue. Here again the objective is to bring textbook theory to life and use it to provide you with a deeper understanding of health service markets.

THE IMPACT OF HEALTH INSURANCE

There is a downward-sloping demand curve for health care services just as there is for other goods and services. Following the same law of demand that applies to cars, clothing, entertainment, and other goods and services, movements along the demand curve for health care occur because consumers respond to changes in the price of health care. As shown in Exhibit A-1, we assume that health care, including doctor visits, medicine, hospital bills, and other medical services, can be measured in units of health care. Without health insurance, consumers buy Q1 units of health care services per year at a price of P1 per unit. Assuming supply curve S represents the quantity supplied, the market is in equilibrium at point A. At this point, the total cost of health care can be computed by the price of health care (P1) times the quantity demanded (Q1) or represented geometrically by the rectangle 0P1 AQ1.

Analysis of the demand curve for health care is complicated by the way health care is financed. About 80 percent of all health care is paid for by third parties, including private insurance companies and government programs, such as Medicare and Medicaid. The price of health care

1Statistical Abstract of the United States, 2001, Table 119, p. 91 and Survey of Current Business, Table 1.1.

services therefore depends on the copayment rate, which is the percentage of the cost of services consumers pay out-of-pocket. To understand the impact, it is more realistic to assume consumers are insured and extend the analysis represented in Exhibit A-1. Because patients pay only 20 percent of the bill, the quantity of health care demanded in the figure increases to Q2 at a lower price of P2. At point B on the demand curve, insured consumers pay an amount equal to rectangle 0P2BQ2, and insurers pay an amount represented by rectangle P2P3CB. Health care providers respond by increasing the quantity supplied from point A to point C on the supply curve S, where the quantity supplied equals the quantity demanded of Q2. The reason that there is no shortage in the health care market is that the combined payments from the insured consumers and insurers equal the total payment required for the movement upward along the supply curve. Stated in terms of rectangles, the total health care payment of 0P3CQ2 equals 0P2BQ2 paid by consumers plus P2P3CB paid by insurers.

CONCLUSIONCompared to a health care market without insurance, the quantity demanded, the quantity supplied, and the total cost of health care are increased by copayment health care insurance.

[Exhibit A-1]

Finally, note that Exhibit A-1 represents an overall or general model of the health care market. Individual health care markets are subject to market failure. For example, there would be a lack of competition if hospitals, doctors, health maintenance organizations (HMOs), or drug companies conspired to fix prices. Externalities provide another source of market failure, as illustrated for vaccinations in Exhibit 7 of Chapter 4. We are also concerned that health care be distributed in a fair way. This concern explains why the government Medicare and Medicaid programs help the elderly and poor afford health care.

SHIFTS IN THEDEMAND FOR HEALTH CARE

While changes in the price of health care cause movements along the demand curve, other factors can cause the demand curve to shift. The following are some of the nonprice determinants that can change the demand for health care.

Exhibit A-1 The Impact of Insurance on the Health Care Market

Without health insurance, the market is in equilibrium at point A, with a price of P1 and a quantity demanded of Q1. Total spending is 0P1AQ1. With copayment health insurance, consumers pay the lower price of P2, and the quantity demanded increases to Q2. Total health care costs rise to 0P3CQ2, with 0P2BQ2 paid by consumers and P2P3CB paid by insurers. As a result, the quantity supplied increases from point A to point C, where it equals the quantity demanded of Q2.

Number of Buyers

As the population increases, the demand for health care increases. In addition to the total number of people, the distribution of older people in the population is important. As more people move into the 65-and-older age group, the demand for health care services becomes greater because older people have more frequent and prolonged spells of illness. An increase in substance abuse, involving alcohol, tobacco, or drugs, also increases the demand for health care. For example, if the percentage of babies born into drug-prone families increases, the demand for health care will shift rightward.

Tastes and Preferences

Changes in consumer attitudes toward health care can also change demand. For example, television, movies, magazines, and advertising may be responsible for changes in people's preferences for cosmetic surgery. Moreover, medical science has improved so much that we believe there must be a cure for most ailments. As a result, consumers are willing to buy larger quantities of medical services at each possible price.

Doctors also influence consumer preferences by prescribing treatment. It is often argued that some doctors guard against malpractice suits or boost their incomes by ordering more tests or office visits than are really needed. Some estimates suggest that fraud and abuse account for about 10 percent of total health care spending. These studies reveal that as many as one-third of some procedures are inappropriate.

Income

Health care is a normal good. Rising inflation-adjusted incomes of consumers in the United States cause the demand curve for health care services to shift to the right. On the other hand, if real median family income remains unchanged, there is no influence on the demand curve.

Prices of Substitutes

The prices of medical goods and services that are substitutes can change and, in turn, influence the demand for other medical services. For example, treatment of a back problem by a chiropractor is an alternative for many of the treatments provided by orthopedic doctors. If the price of orthopedic therapy rises, then some people will switch to treatment by a chiropractor. As a result, the demand curve for chiropractic therapy shifts rightward.

SHIFTS IN THE SUPPLY OF HEALTH CARE

Changes in the following nonprice factors change the supply of health care.

Number of Sellers

Sellers of health care include hospitals, nursing homes, physicians in private practice, HMOs, drug companies, chiropractors, psychologists, and a host of other suppliers. To ensure the quality and safety of health care, virtually every facet of the industry is regulated and licensed by the government or controlled by the American Medical Association (AMA). The AMA limits the number of persons practicing medicine primarily through medical school accreditation and licensing requirements. The federal Food and Drug Administration (FDA) required testing that delays the introduction of new drugs. Tighter restrictions on the number of sellers shift the health care supply curve leftward, and reduced restrictions shift the supply curve rightward.

Resource Prices

An increase in the costs of resources underlying the supply of health care shifts the supply curve leftward. By far the single most important factor behind increasing health care spending has been technological change. New diagnostic, surgical, and therapeutic equipment is used extensively in the health care industry, and the result is higher costs. Wages, salaries, and other costs, such as the costs of malpractice suits, also influence the supply curve. If hospitals, for example, are paying higher prices for inputs used to produce health care, the supply curve shifts to the left because the same quantities may be supplied only at higher prices.

HEALTH CARE REFORM

In October 1993, the Clinton administration submitted a 1,336-page proposal for health care reform to Congress. After a much-publicized and heated debate, Congress rejected this complex and controversial proposal. The cornerstone of President Clinton's plan was universal health care. First, all employers would be required to provide their employees with health insurance. Second, those persons who were unemployed or not in the labor force would obtain health care through regional health alliances established in each state. In addition, the plan considered taxing destructive personal behavior that increases health care costs, such as cigarette smoking and alcohol abuse.

The critics of the Clinton plan argued that the quantity of health care cannot be extended to meet the demands of everyone without enormous additional costs. The result would be price controls and the rationing of health care (recall Exhibit 4 of Chapter 4 ). In short, critics viewed the Clinton proposal as creating a system of new bureaucracies and employer mandates that would produce an unwarranted increase in the government's role in the health care industry.

In 2003, legislation was passed that will lead to the most far-reaching changes in Medicare since this program was signed into law in 1965. This complex measure for the first time provides a $400 billion prescription drug benefit beginning with a drug discount card for purchase by seniors that might provide savings of 15 percent to 25 percent at retail pharmacies. The next big change for Medicare will be in 2006 when drug benefits begin. As envisioned, private insurers will sell drug coverage policies and seniors can choose a plan for a monthly premium estimated at $35. The most controversial provision of the bill allows private insurers to compete with Medicare in six metropolitan test areas beginning in 2010. Critics argue that this is a major first step toward privatization of Medicare.

4A-1