Chapter 1

Introduction.

In modern societies the level of health of the population is determined by a complexset of activities developed in the framework of a social structure. This has led theWorld Health Organization to refer to the health system as a set of interrelatedelements (environment, education, labor conditions, etc. (see Sen (1979)) havingas objective the transformation of some sanitary resources (inputs) into a healthstatus (final output) through the production of health services (intermediate output).Following Cuervo (1994),

... a system of sanitary atention is part of the health system andbehaves as an organized set of resources in which every element iscoordinated through a logic and scientific order that links their actstowards a common end1.

In other words, in Health Economics, health is the variable to maximize. Inturn, health is the outcome of the sanitary services (intermediate output) obtainedfrom the combination of factors of production of health. This approach is whatOrtun (1990) labels as “the approach of enlarged welfare” as alternative to the ap-proach of the strict welfare where the sanitary services are the final output. Theapproach of the enlarged welfare presents the difficulty of defining the concept ofhealth, while the approach of the strict welfare has to be restricted to purely eco-nomic considerations. In the former approach health, health care, and health statusare to be distinguished (see McGuire et al. (1994, pp. 1-5). Health is a difficultconcept to frame. A usual way to define it is as the lack of illness, leading usto the definition of illness. Again different definitions of illness are used by themedical profession (pathologically based), or according to the restrictions imposedon the development of daily activities (functionally based). The broadest defini-tion of health encompasses all aspects affecting the health status of the individual.Under this view, health has value in use but has no value in exchange as it can-not be traded. Health care, instead can be purchased and offered. Accordingly, it

1Cuervo (1994) presents a study of the techniques used in the organization of health systems.Quotation translated from the original in spanish

1

2 Introduction.

can be treated as a regular commodity in the economy with the peculiarity that itis only consumed by the individual in order to improve his health status. As wewill analyze in chapter 2, demand for health care is linked to the wish of healthof the individual. In the pages that follow, we will treat health and health care assynonyms for simplicity. Nevertheless, the reader should bear in mind that strictlyspeaking these two concepts have different meaning.

A working definition of Health Economics would refer to the study of howresources are allocated to and within the health sector in the economy, as well asthe functioning of the health care markets. The pathbreaking contribution givingrise to health economics as a separate discipline is due to Arrow (1963).

It is important to emphasize that the interest of health economics lies in theallocation of resources rather than in the amount of expenditure on health careservices. Thus, the rules governing the allocation are crucial to generate the properincentives to providers and individuals to use the (scarce) resources in the bestpossible (e.g. welfare maximizing) way.

As in general economics, we can also distinguish a normative and a positiveapproach to health economics. The normative approach deals with the use of theresources devoted to the health sector by the government (health policy) to achievethe maximum level of welfare, equity, and efficiency. In this respect health eco-nomics aims at providing the health authority with (theoretically based) sound rulesto implement those decisions. The positive approach deals with the rational choiceof the agents in the health care sector.

We will mainly concentrate in the positive aspect of health economics. Follow-ing Zweifel and Breyer (1997, pp. 4-7), and Phelps (1992, pp. 10-13) a convenientway of thinking of health and health care consists in assuming that every individualwhen born is endowed with a certain stock of health. That is a health status in thesame way consumer theory assumes consumers are initially endowed with a bundleof goods (X). The individual obtains satisfaction (utility) from the flow of servicesproduced by the stock of health (H) and from the flow of services (consumption)of a bundle of goods (C). In describing preferences betweenH and C, it should beclear that the satisfaction the individual can obtain from “consuming” is linked tohis health state. In particular, when the ratio health to consumption becomes small(for instance due to a poor health status) additional consumption does not increaseutility.

Also, it seems reasonable to consider that only healthy enough people can beemployed and thus earn some income. Income (Y ) is spent between medical care(M ) and consumer goods. Taking prices, denoted by q and p respectively, as ex-ogenous, we can construct a budget constraint dependent on the heath status of theindividual.

One preliminary question though is why health economics has developed intoa discipline itself. The answer contains two elements. On the one hand, we findthe differential characteristics of the health care sector within the economy. On theother hand, we have the importance, in terms of size, of the health care sector in theeconomy. Figure 1.1 (see OECD (2001)) shows the increasing share of health care

Introduction. 3

spending in % of the GDP for a selection of OECD countries (top) and non-OECDcountries (bottom) in the period 1950-1998.

This trend in spending, in the context of the OECD countries is consistent withthe aging of population and the technological development. Figure 1.2 shows inthe upper part the life expectancy at age of 65 in the OECD countries in 2000. Thelower part of the figure compares the trend in life expectancy2 between the OECDaverage and Japan in the period 1970-2000 (see OECD (2004)).

The control of these expenses given the constraints on public spending imposedby the Treaty of Maastricht constitutes one of the main problems governments face.Thus, the design of health policies soundly based on formal economic thinking isan important element of health economics. Figure 1.3 shows at the OECD level,the Health expenditure by source of funding in 2000 where countries are ranked byper capita health expenditure (top), and the changes in the public share of healthexpenditure comparing 1970 and 2001 (see OECD (2004)).

Pharmaceutical expenditure is an important component of the increase in healthbudget. Figure 1.4 shows for a selection of OECD countries, (see OECD (2003),p.66) the pharmaceutical expenditure per capita in 2001 and its growth in real termsbetween 1990 and 2001. This ranges from 111% for Sweden, 99% for Australia,or 90% for the US to 9% for Luxemburg or 7% for Japan. Also, Figure 1.4 showsthe share of pharmaceutical expenditures in the total health expenditure between1990 and 2001 .

The recent history of modern societies has allowed an obvious progress in theaccess and equity of health systems. This access, in turn, has generated a variationin the population pyramid with a higher participation of the elder population (thattogether with infancy are the most demanding groups of medical services). Asis well-known, there is a positive relationship between health status and income.There are two explanations for this phenomenon. One says that because technolog-ical innovations and investment in public infrastructures, higher health levels areeasier to attain and maintain over time. The second explanation appeals to chang-ing preferences of individuals over time. Accordingly, for a given level of income,individuals become more concern about their health status. Either way, this rela-tion bears two consequences. Following Jack (1999, chapter 3), on the one hand,as populations become healthier, they also age. This is known as the demographictransition. On the other hand, the pattern of diseases changes. This is known asepidemiological transition.

Finally, we should not forget the technological progress that has made availableto physicians more effficient treatment possibilities and diagnosis techniques (e.g.cobalt bomb, ecography, magnetic resonance). All these factors have generated asubstantial increase of the expense in the health care sector3 threatening the futureof the so-called welfare state. Therefore we face a dilemma between efficiency4

2Formal definitions of mortality, life expectancy, and hazard rate can be found in Jack (1999, pp.9-14).

3see Artells (1994) pp. 3-7.4On the different definitions of efficiency see Ortun (1990) pp. 49-51.

4 Introduction.

Figure 1.1: Share of health care spending in % of GDP 1950-1998.

Introduction. 5

Figure 1.2: Population aging in the OECD countries.

6 Introduction.

Figure 1.3: Sources of funding of health expenditure.

Introduction. 7

Figure 1.4: Pharmaceutical expenditure.

8 1.1 Differential characteristics of health economics.

and equity of the health system that has generated a debate on the reform of thehealth systems in western countries.

To summarize all the elements appearing in health economics we borrow fig-ure 1.5 from Culyer and Newhouse (2000), where an overall scheme of the ele-ments configuring health economics is depicted. We can read the scheme as com-posed of three parts. The economic analysis, the economic evaluation, and thepolicy analysis. The starting point of the economic analysis is box A “What ishealth?”. From here we move to study the elements of the demand for health care(box C) and other elements influencing health (boxB). Next come the elements ofthe supply of health care (boxD). The combination of demand and supply leads usto the analysis of the health care market equilibrium (box E). The economic evalu-ation contemplates both the microeconomic level (box F ) and the macroeconomiclevel (box G). Finally, policy analysis is found in box H .

Also, Fuchs (1993) provides a nice description of the scope of health eco-nomics.

1.1 Differential characteristics of health economics.

What makes health economics different from economics? What features of thehealth care sector makes it sufficiently different from other sector in the economy?Before being precise in answering these questions, is important to advance thatalthough health care has some distinctive features, it is not unique in any of them.Rather, is the combination of these features what makes the sector peculiar. Thesefeatures are5:

The presence of uncertainty. Both in demand (health status of the population)and in supply (e.g. availability and efficacy of treatments). Health statusis uncertain is the sense that it is unpredictable. As a consequence, demand(and supply) of health care services do not follow any foreseeable trend. Thisuncertainty makes decision-making difficult in what agents want to avoidtaking a wrong decision leading to adverse outcomes. Nevertheless, someactions may lower the probability of an ill-episode, such as healthy habits orpreventive health care measures.

The relevance of insurance. The uncertainty regarding the moment when an indi-vidual gets ill gives rise to the possibility of insurance against the occurrenceof a sickness. This insurance breaks the relationship between the price andthe cost of provision of health care services giving rise to situations of moralhazard (associated to the shifting outwards of the budget constraint of theconsumer) and of adverse selection (associated to the selection of profiles ofrisk by the insurers). The intervention of the State tries to generate the rightincentives to minimize the perverse effects of the uncertainty.

5See Phelps (1992, pp.2-10) for a more detailed description.

Introduction. 9

Figure 1.5: The elements of health economics.

10 1.1 Differential characteristics of health economics.

Following Stiglitz (1994) patients in the health care market buy informationon the illness they suffer and its treatment. Moreover, individuals often arerisk averse. Accordingly, they contract health insurance, thus lowering theincentives to take into account the costs of provision of health care services.This fact lays at the root of the moral hazard problems. Another conse-quence of this informational asymmetry is the fact that the patient in hisdemand decisions is conditioned by the decisions of the physician. Hence,there is the possibility that the physician induce demand on their patients inthe sense that a patient demands more services than what would have doneshould (s)he had the same information as the physician. Therefore, togetherwith the moral hazard problem mentioned above, we also face an adverseselection problem in the form of rejection of patients with some peculiarpathologies or, alternatively the shift of patients with expensive treatmentsfrom the private providers to the public provider.

The presence of (asymmetric) information. Patients do not have perfect infor-mation about, e.g. the quality of hospitals or the effectiveness of treatments.In turn, physicians do not know all the characteristics of the patients. Thistogether with the uncertainty mentioned above raises the issue that the dis-tribution of property rights may show some differences with respect to thedistribution of property rights in the standard theory of the consumer. Byproperty rights it is meant the position of each individual with respect to theuse of scarce resources. Regarding consumption of goods, traditional con-sumer theory assumes that each individual uses his resources in his own bestinterest. In health care, there appear many situations where the sovereigntyof the patient in properly evaluating the costs and benefits of the decision-making process is at least questionable.

The role of non-profit institutions. The prevalence of non-profit institutions inthe provision of health care services is particularly important in the healthcare sector.

The extent of regulation in the market. The are restrictions to competition in thehealth care sector, such as the compulsory license for physicians, or the re-striction on advertising, that are accepted to guarantee a minimum level ofquality towards patients. We can also refer here (although we will not an-alyze it) the presence of patents, reference prices, or the development ofgenerics in the pharmaceutical sector.

The existence of need. Although need is a difficult concept to pin down in a def-inition, according to Jeffers et al. (1971), it is generally understood as theamount of medical care that medical experts believe a person should get toremain or become as healthy as possible, based on current medical knowl-edge. Generically it is widely accepted as a principle that people should

Introduction. 11

have access to the health care services they need regardless of their level ofincome.

The public provision and financing of health care services. Social security inEuropean countries represent a massive presence of the government in theprovision and financing of health care services and also in the organizationof the health care market.

The presence of externalities. Externalities appear when the actions of some agentsin the market have an impact (positive or negative) on the behavior of otheragents. For instance, vaccination programs may avoid the spread of epi-demics (positive externality), pollution may generate illnesses to individu-als exposed to that pollution (negative externality). Then the social benefits(from vaccination) often differ from the private benefits (reduced risk). Ex-ternalities refer to the interdependence of the utility functions of the individ-uals. One of the main of such interdependencies appear when tackling theissue of equity.

All these elements imply that the market will not be able to assign resources effi-ciently in the health care sector. Thus, there is room for regulation.

The characteristics just listed make health care to be a private good6 providedby the State (other examples of this type of goods are education and social secu-rity).

It is important to point out that there are other markets showing similar prob-lems as the ones described (a typical example is the food market) where regulationwhen it exists is minimal. What argument justifies then this differentiated attentionto the health care market? Usually, the answer appeals to a “moral” argument. Thisis the universal access to the health care system.

State intervention appears in different ways. The least level of intervention isthe US model (also Ireland) where health care is privately provided except for poorpeople whose income does not reach a minimum level (Medicare), and the elderpopulation (Medicaid). At the other extreme we find public social security modelof countries like Spain. In between we find mix systems with reference pricesas in Germany, Japan, Canada, France and Belgium. In these systems, the Statefinance the patient a (constant) part of the cost of any medical service. Wheneverthe patient patronizes a provider with a higher tariff, (s)he must bear the difference.

The alternative system is the provision of health care centralized by the State.This scenario is not free of difficulties. Following Ortun (1990),

The non-market health care systems present four failures: lack of re-lation between revenues and costs, lack of objectives of the organiza-

6A public good in contrast with a private good must satisfy two properties. (i) the marginal cost ofintroducing an additional consumer is zero; (ii) the cost of excluding an individual from consumingthe good (or service) is infinite. A (public) park or the public transport are examples of public goods.

12 1.2 The organization of the health care market

tion, externalities induced by the action of the State, and distrributiveinequalities7.

It is important to point out that the role of the State in the economy must not bereduced to its relative size, or to the discussion between liberalism and socialism.In this sense Calsamiglia (1994) says,

Regarding the State intervention the problem is neither how much norwhat, but how. This is the fundamental problem. It is necessary tobe aware of the limitations of the State and the objectives pursued todetermine the type of intervention allowing to improve performance.(...) The important factor is not the size of the public sector, but itsmanagement8.

1.2 The organization of the health care marketA proper description of the health care market must start by the description of theagents interacting in it. Figure 1.6 borrowed from Narciso (2004) illustrates. Theseare the health authority, the national health service, providers, third-party payers,patients, and the pharmaceutical sector.

The Health Authority has a strong regulation role that works in severaldirections. One task of this Health Authority is to stipulate the typeand/or value that patients have to pay for medicines and for the severalservices in the NHS providers (arrow 1). It also defines the organi-zation of this public health system (arrow 2), for example, it decideswhich types of appointments and treatments are provided in the hos-pitals or by other providers and the geographical distribution of thepatients through the health providers (arrow 4). Finally, the HealthAuthority regulates the pharmaceutical sector (arrow 3) concerningthe prices of medicines, both the pricing to the pharmacies and alsothe prices that patients must pay.Both hospitals and other public providers (such as health centers) hirephysicians, nurses and other staff (arrow 5) who deal directly withpatients.The Pharmaceutical Industry produces and sells the medicines to thepharmacies which, in turn, sell them to the patients (arrows 7 and 8).The agency relationship between physicians and patients creates in thePharmaceutical Industry the incentives to promote their products to thephysicians with the purpose of influencing their choice of medicines(arrow 6). Nevertheless, when the countries have substitution laws it

7Translated from the original in spanish.8Translated from the original in catalan.

Introduction. 13

is possible for the pharmacies to sell a medicine that is different fromthe one prescribed by the physician. That is, under substitution rules,when the doctor prescribes a branded drug, the pharmacy is allowedto sell a generic version of that medicine to the patient (arrow 8) and,in this case, the relationship between the pharmacists and the patientsbecomes closer and more important than when the pharmacist onlyacts as a seller. When substitution is allowed, the pharmacist takesplace in the decision process.However, the medicines that patients consume are typically prescribedby the physicians who act as agents of the patients in the sense thatthey decide the consumption of medicines on their behalf (arrow 9).This is very peculiar to the health care market since the patients whoconsume the good (the medicine) are not the ones who choose thegood to consume. Finally, arrows 10 and 11 represent the central re-lationship in this process: the interaction between patients and physi-cians, which gives us the final outcome of the whole system and thereason for its existence. The patient consults a doctor when he findssome symptoms of illness or when he is advised in a previous ap-pointment to do so. Based on the symptoms reported by the patientand on possible additional examinations, the physician prescribes thetreatment he deems appropriate.It is still possible that patients buy private insurance which will bealternative or cumulative to the public one. In this case, the privateinsurers will contract both with physicians and patients the paymentschemes (arrows 12 and 13). (Narciso (2004, pp. 6-8))

A detailed overview of the relationships among those agents, also including thepharmaceutical industry and the politicians, is provided by Thurner and Kotzian(2001).

We will focus on three types of agents. Patients represent the part of the popu-lation that, facing a certain sickness, demand health care services. Providers supplyhealth care services. Among those, we can distinguish “first level providers” in-cluding general practitioners and primary care services, and “second level providers”where we find the specialized health care, that is hospital and specialists. Fi-nally, the third type of agents are the third-party payers that finance the provisionof health care services. These may be private insurance companies or a publicagency (social security). These third-party payers buy health care services fromthe providers on behalf on their insurees, thus granting the coverage to the insurees,and defining the protocols to reward providers.

Generically, a society faces two alternative ways of allocating its resources: a(decentralized) free market mechanism or a centralized system by means of theState.

A free market mechanism, where patients pay directly the health care servicesis shown in figure 1.7 where section (a) shows a system without insurance and sec-

14 1.2 The organization of the health care market

Figure 1.6: The agents in a health care system

Introduction. 15

tion (b) introduces private insurance companies offering health insurance contractsto the population against a premium, and patients addressing the providers whenill.

A quick glance to the health systems in western European economies presentan important participation of the State. This may just show the peculiarities ofthe health care services that make the proper (efficient) functioning of the healthcare market virtually impossible. These peculiarities may be grouped into threecategories:

1.3 Structure of a health care system

State intervention9 in the health care market consists on the one hand in regu-lating supply (physicians, hospitals, insurance companies) in terms of treatments,pharmaceutical products, insurance premia, and prices for medical services; on theother hand it also regulates demand through e.g. subsidies to health care costs,fiscal advantages, or the universal access to the health care system. We can dis-tinguish three health care systems models: the reimbursement model, the contractmodel, and the integrated model.

1.3.1 The reimbursement model

There are two variants of this model. Public (compulsory health insurance withcompulsory contribution) and private according to whether the payer be a public ora set of private insurance companies. In any case, the fundamental characteristicof this system is the separation between payers and providers. Patients pay theservices that after are reimbursed (totally or partially) by the payer. Figure 1.8shows this model.

The private version of this model represents (grosso modo) the system in theUK. The public version is a close approach to the system in The Netherlands.

In this model the patient may patronize his(her) preferred provider. In the pri-vate version, the very freedom to choose of the population guarantees a tough com-petition among insurance companies and among providers. However, the switchingcosts associated to changing insurance company and the adverse selection of risksare elements that soften competition. Also, among providers the induced demandeffect mitigates competition.

The public version, considers a compulsory health insurance either througha public system or a network of private companies and mutualities. Now thereis no competition among payers, thus eliminating the adverse selection of risks.Universal access does not interfere with the freedom to choose provider.

9This section is based on Artells (1994), pp.19-28)

16 1.3 Structure of a health care system

Figure 1.7: Private provision with and without insurance.

Introduction. 17

Figure 1.8: The reimbursement model.

1.3.2 The contract model

In contrast with the previous model, the contract model presents a link betweenpayers and providers as shown in figure 1.9.

When payers are private insurance companies, their clients pay premia andare free to choose any provider in the set of providers selected by the insurancecompany. Insurance companies compete among themselves for consumers andalso to contract with providers. Providers in turn, compete among themselves toobtain the best contracts.

The public version of this model corresponds to a social security system whereprovision of health care is universal and free (equity) and patients have a wide arrayof providers to choose among. This corresponds, broadly speaking to the system inGermany, and Ireland. The system is financed out of compulsory contributions andtaxes. Providers are reimbursed by the State or by regulated insurance companiesand reimbursement rates are negotiated at the national (regional) level. Accord-ingly, the only competitive element of the system (efficiency) is quality of healthcare services.

18 1.3 Structure of a health care system

Figure 1.9: The contract model.

1.3.3 The integrated model.The integrated model takes its name from the integration between payers andproviders both at first and second levels. That is, insurance companies and mu-tualities (public or private) own the hospitals and contract physicians. Thus, theinsurer bears the risk not only of cost control of the system but of the use of healthcare services provided as well. Figure 1.10 illustrates.

The private version of the model contemplates a population of consumers con-tracting health insurance withy a private company. This insurance is defined bya premium and the coverage of health care services (free or against a co-paymentfee) provided by those hospitals and physicians contracted by the insurer.

Competition among insurance companies and mutualities allows forcompensating some tendency to restriction of use associated to providersreimbursement through salaries and closed budgets. However, limitingaccess because of reimbursement capacity of users seriously restrictsthe effects on equity and solidarity10 (Artells (1994), p.27.).

The public version of the model reproduces the system of social security in e.g.Spain or Portugal. In this framework, the State acts as main insurer and provider.This guarantees on the one hand universal access (equity) but limits the possibility

10Translated from the original in spanish.

Introduction. 19

Figure 1.10: The integrated model.

of choosing coverage (except for some particular groups of civil servants orga-nized around MUFACE, ISFAS and MUGEJU in the case of Spain) implying lowefficiency due to lack of competition among providers and lack of incentives ofphysicians reimbursed through salaries.

To summarize the different characteristics of the several systems presented,public systems fulfill the equity and solidarity principles as they ensure universalaccess to the health care system. However, those systems do not typically satisfythe principle of efficiency as cost control is difficult to implement. It is preciselythis difficulty of budget containment in the public systems of health care that havegiven rise to the discussion on the design of mechanisms of cost control both onthe demand and supply sides.

On the demand side, incentives to cost containment show in the introduc-tion of copayments. The main forms in which copayments are implemented areco-insurance, sharing the payment of the services, and as deductibles. The co-insurance usually takes the form of a payment by the patient of a fixed proportionof the his(her) expenses in health care services. Sharing the payment means that thepatient pays a fixed amount regardless of the amount spent. Finally, a deductiblemeans that the patient pays the full cost of the health care services and the payerreimburses (a fixed or proportional part) of this bill.

Cost containment on the supply side is usually more effective. Here we find

20 1.3 Structure of a health care system

prospective budgets on hospitals and first level providers, together with the intro-duction of incentives to efficiency and productivity through decentralization andencouragement of competition among providers. These measures often found inprivate systems are being also implemented in public systems as well.