This chapter attempts to explain to physicians how economists think about physicians and medical care. Economists' mode of thinking has shaped health care policy and institutions and thus the environment in which physicians practice. As a result, it may be useful for physicians to understand some aspects of this way of thinking even if at times it may seem foreign or uncongenial.
Physicians see themselves as professionals and as healers, assisting their patients with their health care needs. When economists are patients, they probably see physicians the same way, but when they view doctors through the lens of economics as a discipline, they see them as economic agents. In other words, economists are interested in the degree to which physicians respond to various incentives, both those that they face and those facing their patients, in deciding how to deploy the resources they control. Examples include how much of their own time to devote to seeing a patient; which tests to order; what drugs, if any, to prescribe; whether to recommend a procedure; whether to refer a patient; and whether to admit a patient.
This interest stems from fundamental economic questions: What goods and services are produced and consumed? In particular, how much medical care is available, and how much of other goods and services? How is that medical care produced? For example, what mix of specific services is used to treat a particular episode of illness? Who receives particular treatments?
Physicians in all societies live and function in economic markets, although those markets differ greatly from the simple competitive markets depicted in introductory economic textbooks and also differ from country to country, depending on an individual country's institutions. Many of the differences between actual medical markets and textbook competitive markets cause what economists term market failure, a condition in which some individuals can be made better off without making anyone else worse off.
This chapter explains two features of health care financing that cause market failure: selection and moral hazard. A common response to market failure in medical care is what economists term administered prices, which is another concept this chapter describes. Administered prices also exact an economic cost, leading to what economists call regulatory failure. All developed societies seek a balance between market failure and regulatory failure, a topic addressed in this chapter's conclusion.
In the idealized competitive market found in economic textbooks, buyers and sellers know the same amount about the good or service they are buying and selling. When one party knows more—or when goods of different quality are being sold at the same price, which is analytically similar—markets can break down in the following sense: There may be a price at which an equally well informed buyer and seller could make a transaction that would make them both better off, but the transaction does not occur because one party knows more than the other. Hence, both the potential buyer and the potential seller are worse off.
The used car market is a classic example of differential information. Owners of used cars (potential sellers) know more about the quality of their cars than do potential buyers. At any specific price for a certain make and model of car, the only used cars offered will be those whose sellers value them at less than that price. Such cars will differentially be of low quality (“lemons”) relative to the given price; in fact, assuming a continuum of quality, the average cars offered will be those which are valued at or less than the price in the market. However, that means that any potential buyer, lacking information about the quality of a car, would potentially pay (much) more than that car is worth. Because buyers know that the sellers know more about the quality of the car, transactions that would occur if a buyer and seller had equally good information about the quality of the car may not occur. (It is for this reason that sellers may offer warranties and guarantees.)
The same thing happens when goods of different quality are sold at the supermarket at the same price. Shoppers are happy to take quickly any box of a particular brand of breakfast cereal or bottle of soft drink on the shelf because the quality of any box or bottle is the same, but they will take their time inspecting produce to make sure that the apple they pick up and put in the cart is not bruised or the banana is not overly ripe. At the end of the day, it is the bruised apples and overly ripe bananas that are left in the store. In effect, the seller has not used all the information in pricing the produce, and buyers exploit that information differential.
Selection affects markets for individual and, to some degree, small group health insurance in a fashion similar to the used car market and the produce stand, but in this case it is the buyer of insurance who has more knowledge than the seller. Individuals who use above-average amounts of care—for example those with a chronic disease or a strong proclivity to seek care for a symptom—will value health insurance more than will those who are healthy or who for various reasons shun medical care even if they are symptomatic. However, the insurer does not necessarily know the risk of those it insures, and so it gears insurance premiums to an average risk or sometimes an average risk conditional on certain observable characteristics, such as age. Just as shoppers do not want the bruised apples and used car buyers do not want lemons, many healthy people will not want to buy insurance voluntarily if its price mainly reflects the use of those who are sick. (Healthy but very risk averse individuals still may be willing to pay premiums well above their ...