Health Economics

Health Economics: An International Perspective is the only textbook to provide a truly

international, comparative treatment of health economics. Offering an analysis of health
systems across borders, the fourth edition of this key text has been updated and revised to
take account of changes in a host of countries.
This edition features an expanded introduction, providing better grounding for many of the
examples that come in subsequent chapters and making it easier for non-health care experts
to see the links between the theory, the examples and the health care system components. It
also boasts a restructured format, dividing the book into two broad sections: the first focuses
on ideas and principles, along with evidence on their applications in the health sector,
whereas the second focuses on introducing core tools and techniques used in applied health
economics research.
Further updates to this edition include:

• two new chapters on applied econometrics;

• a new chapter on equity, focusing on equity in access to health care, paying particular attention
to how access and need for health care are defined and measured in applied research;
• a new chapter on emerging issues for health systems that are emanating from a series
of global transitions both within (e.g. demographic change, epidemiological change,
the global resolution on universal health coverage) and without the health sector (e.g.
economic transitions).

Throughout the text, examples and illustrations are taken from a wide range of settings and
world regions, providing a unique overview of the performance of different health systems.

Barbara McPake, Professor of Global Health and Director, Nossal Institute for Global
Health, University of Melbourne, Australia.

Charles Normand, Professor of the Economics of Palliative Care and Rehabilitation,

Cicely Saunders Institute, King’s College London, UK, and Professor of Health Policy and
Management, Trinity College, University of Dublin, Ireland.

Samantha Smith, Research Fellow, Centre for Health Policy and Management, Trinity
College, University of Dublin, Ireland.

Anne Nolan, Associate Research Professor, Social Division, Economic and Social Research
Institute, Dublin, Ireland.
Health Economics
An International Perspective

Fourth edition

Barbara McPake, Charles Normand,

Samantha Smith and Anne Nolan
Fourth edition published 2020
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First edition published by Routledge 2002
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British Library Cataloguing-in-Publication Data
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Names: McPake, Barbara, author. | Normand, Charles E. M., author. | Smith, Samantha,
1975– author. | Nolan, Anne, author.
Title: Health economics : an international perspective/Barbara McPake, Charles
Normand, Samantha Smith and Anne Nolan.
Description: 4th edition. | Abingdon, Oxon ; New York, NY : Routledge, [2020] |
Includes bibliographical references and index.
Identifiers: LCCN 2019056465 (print) | LCCN 2019056466 (ebook)
Subjects: LCSH: Medical economics. | Medical economics—Cross-cultural studies.
Classification: LCC RA410 .M398 2020 (print) | LCC RA410 (ebook) | DDC
338.4/73621—dc23
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ISBN: 978-1-138-04920-8 (pbk)
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Contents

List of figuresvii
List of tablesix
List of boxesx
Preface to the fourth editionxii

  1 Introduction: health economics in international perspective 1

PART I
Introductory health economics 11

  2 The demand for health and health services 13

  3 Production, health and health care: efficient use of inputs 25
  4 Cost of delivering health services 32
  5 Basic market models 39
  6 Supplier-induced demand and agency 49
  7 Market failure and government 56

PART II
Further economics of markets and market intervention 65

  8 Contracting 67
  9 Market structures 79
10 Hospital and health provider behaviour and motivation 93
11 The economics of regulation 104
12 Incentives and agency 117
vi  Contents
PART III
The economics of health systems 133

13 Health systems: a framework for analysis 135

14 Tax and social health insurance mechanisms 144
15 Private financing mechanisms 160
16 Health systems around the world: an introduction to variation and
performance 173
17 The economics of health in an era of global transition 191

PART IV
Tools and techniques for measurement and analysis 209

PART IVA
Economic evaluation 211

18 The theoretical bases of economic evaluation 213

19 Issues in the measurement of costs 227
20 Measuring benefits in economic evaluation 238
21 Practical steps in economic evaluation 252
22 Economic evaluation as a framework for choice 261

PART IVB
Applied econometrics and other tools 269

23 Introductory applied health econometrics 271

24 Methods and applications for causal analysis 281
25 Equity in access to health care: key measurement issues 290

References 307
Index 329
Figures

1.1 Flow of health care resources and services 4

2.1 The demand curve 14
2.2 A shift in the demand curve 14
2.3 Demand for heroin 18
3.1 Combination of units of labour and capital for the immunisation of 1,000
children 26
3.2 Isoquant map 27
3.3 Isoquant map with increasing returns to scale 28
3.4 Rays of capital- and labour-intensive production 28
3.5a Decreasing returns to the labour factor 29
3.5b Decreasing returns to the capital factor 29
3.6 Transformation of production between two services 31
4.1 Production at minimum cost, based on the analysis of isoquants in
Chapter 3 33
4.2 Total cost curve 36
4.3 Average cost trends in different areas of the total cost curve 37
4.4 Average and marginal cost curves 37
5.1 Interaction of demand and supply 40
5.2 The firm under perfect competition 43
5.3 The industry under perfect competition 43
5.4 Monopoly 46
6.1 The difficulty of identifying supplier inducement 52
7.1 Positive externality on the demand side 57
7.2 The public–private good continuum 59
7.3 Welfare loss from setting a price for a public good 60
9.1 The kinked demand curve 80
9.2 The incentive to form a cartel 81
9.3 Pricing under perfect contestability 86
9.4 Contestability and economies of scale 87
10.1 The firm under revenue maximisation 94
10.2 Newhouse model of hospital behaviour 97
11.1 The process of regulating 106
11.2 Potential impact of licensing requirements on physician incomes 108
11.3 Price control in a competitive market 109
11.4 Price control in a monopolistic market 109
12.1 Determining an outcome-dependent contract 119
viii  Figures
12.2 Effect of subsidy on a competitive market 125
12.3 The effect of a flat-rate subsidy on a revenue-maximising firm 126
12.4 A model of a physician’s ‘dual practice’ decision 127
13.1 Health services rationed through the price mechanism 137
13.2 Impact of social demand curve on optimal provision level 139
14.1 Effects of insurance provision on labour market equilibria 148
14.2 The NICE problem with Viagra 153
15.1 Regulating an overvalued pharmaceutical product 162
15.2 Decision to purchase insurance 164
15.3 Moral hazard under full insurance, deductibles and co-payments 166
15.4a  Insurance market with homogeneous risk and perfect information 167
15.4b Insurance market with heterogeneous risk and asymmetrical information 167
16.1 The Lorenz curve 182
17.1 Decadal growth in real GDP per capita: selected countries 192
17.2 Distribution of population living in extreme poverty 192
17.3 Potential impacts of healthy ageing on productivity and cost of
chronic illness 195
17.4 The three dimensions of UHC 204
17.5 An ideal coverage cube for UHC 205
17.6a Global levels and trends of UHC tracer indicators 2000–13 205
17.6b Health expenditure trends 2002–13 206
21.1 CEAC for cataract surgery 257
25.1 Concentration curves, utilisation of antenatal care in Afghanistan, 2010 299
Tables

2.1 Relationship between quantity consumed and price 18

2.2 Effect of raising the tax on cigarettes 21
12.1 ‘Pay-off’ table: moral hazard 119
12.2 ‘Pay-off’ table: adverse selection 121
12.3 Possible schedule of earnings in public and private sectors 128
16.1 Health expenditure, 1975–2015 179
16.2 Inequality and inequity in utilisation, selected OECD countries: need-
standardised utilisation of income quintiles 1 and 5 of the population,
concentration index (CI) and horizontal inequity index (HI) 183
16.3 Inequity in utilisation: selected low- and middle-income countries 185
16.4 Health systems performance, life expectancy and mortality, 2016 188
16.5 Citizens’ views about the health care system, selected European countries,
1999 and 2008 189
17.1 ‘Best Buy’ interventions proposed by the WHO (2011) 199
17.2 A stylised cost-effectiveness ladder for cancers, cardiovascular,
respiratory and related disorders based on low- and middle-income
country evidence 200
17.3 A stylised cost-effectiveness ladder for diabetes interventions based on
high-income country evidence 201
25.1 Characteristics of Andersen’s Behavioural Model of Health Services Use
(Emerging Model – Phase 4) 304
Boxes

1.1 Realism and the need for simplification – the use of models in economics 1
2.1 Estimates of elasticities of demand for health services in rural Tanzania 23
5.1 Consumer surplus 41
5.2 Perfect competition and general equilibrium analysis 44
6.1 Trying to find supplier-induced demand 52
6.2 Provider reimbursement 54
8.1 Contracting out in hospitals in Vancouver and Bangkok 67
8.2 Contracts in health service provision in Cambodia 74
8.3 Explaining organisational forms and modes of governance in contracts for
provision through private insurance in Australia 75
9.1 Market structure and competitive strategy in Taiwan 83
9.2 Competition and cost in the US health care system 84
9.3 Measuring hospital competition in Greece and the USA 88
9.4 Networks and health sector reform in the English NHS 91
10.1 Are the behaviours and motivations of for-profits and not-for-
profits different? 98
10.2 Changes to decision rights in hospitals arising from corporatisation
programmes 102
11.1 Regulating prices of pharmaceuticals in Norway 109
11.2 Public or self-interest? 115
12.1 Incentive regulation in the health sector 121
12.2 Traditional healers and incentives in rural Cameroon 123
13.1 A social demand curve? 138
14.1 Setting the pattern of supply in public systems – geographical resource
allocation 152
14.2 The dynamics of waiting lists 155
14.3 Access to health services under universal health insurance in South Korea 158
15.1 Voluntary health insurance mechanism – implications for equity 165
15.2 The long-term uninsured in the USA and adverse selection 169
16.1 The ‘segmented’ health systems of Latin America 175
16.2 Caesarean births in Latin American countries 181
16.3 Analysis of equity of health care delivery in Peru 186
17.1 Income inequality and economic development 193
17.2 Effects of healthier ageing on dependency ratios in Europe 196
17.3 UN monitoring framework for progress towards Universal
Health Coverage 201
 Boxes xi
18.1 Efficiency in exchange 213
18.2 Efficiency in production 214
18.3 Efficiency in production and exchange 214
18.4 Scitovsky paradox 218
18.5 Welfare economics and income distribution 219
18.6 Social welfare functions 220
18.7 Five ways of paying for a vehicle – an illustration of the time value
of money 224
19.1 Opportunity costs or health service costs? 228
19.2 Economic evaluation of renal services for older people (I) 235
20.1 Willingness to pay and measurement of benefits 240
20.2 Economic evaluation of renal services for older people (II) 245
20.3 The composition of a DALY 247
21.1 Calculating QALYs from data on longer life and better quality of life 254
21.2 Presenting options in terms of ICERs 255
21.3 Calculating net benefit 257
22.1 Economic evaluation of renal services for older people (III) 265
22.2 Uncertainty and the value of information 267
23.1 British Birth Cohort Studies 272
23.2 Subjective assessments of health 273
23.3 Interpreting regression output 275
24.1 RAND Health Insurance Experiment 283
24.2 Investigating the causal impact of education on health 284
25.1 Reasons for assessing geographic equity in health care access 293
25.2 Needs-adjusted geographic distribution of GPs in the UK 294
25.3 Decomposition techniques for analysing equity in health care delivery 295
25.4 Normand and McPake disagree on need 300
25.5 Defining unmet need in health care 301
Preface to the fourth edition

The authors of this textbook apply health economics in their day-to-day work. The content of
this book is aimed at those who wish to apply economic principles to health and those who
use health economics evidence to improve the delivery of health services. Working in a range
of settings from advanced high-income economies to low- and middle-income countries, we
recognise that the principles are largely the same, but their application needs to be adapted to
the different contexts. We believe that we understand the principles better when we see them
applied to different problems and challenges.
Scarcity is not new to health systems, but in many cases it has become more visible.
Countries struggle to find resources for the health system, to find better ways to pay for care,
to deliver services in more efficient ways and to set priorities that will increase the impact
on health. Needs for health services increase as populations grow and age. The capacity to
improve health increases with new treatments and more effective drugs. Although ageing
and improved technology are to be celebrated, they bring new challenges. Reform of health
systems has been widespread, often continuous and to a large extent has failed to meet the
expectations in terms of greater efficiency and equity. Although there is no single best way
to organise the funding and operation of health systems, a good understanding of economic
principles can help policy makers and system managers to make better choices.
This book is aimed at a wide audience, and can be used at different levels. Where possible
the exposition of principles aims to be accessible and intuitive, but where there are advan-
tages in a fuller and more technical treatment of the subject this is provided outside the main
text. Examples and small case studies are used to show the principles in practice in a wide
range of settings. The aim is to provide a full treatment of each of the topics covered, but
where narrower and deeper understanding is needed for practitioners the reader is referred
to specialised textbooks. Readers with no previous exposure to economics should find the
level accessible, and those who have studied economics in other fields should benefit from
the application to health and health care topics.
In this fourth edition a fourth author, Anne Nolan, has joined the team. We have all had
extensive experience using the previous editions, and have tried to take on board the sugges-
tions of the many students and teachers who used the book. We are grateful to those who have
taken the time to suggest ways in which the exposition could be made more interesting or
accessible, and to those who have confirmed that the existing presentation works well. Eco-
nomics has been called the dismal science. We find it stimulating, interesting and often fun. We
hope that the readers will share our enthusiasm and sometimes our enjoyment of the subject.
BM
CN
SS
AN
1 Introduction
Health economics in international
perspective

1.1  The role of economists in the health sector

1.1.1  A framework for assessing choices

Why do economists work in health? The health sector is not usually the first place people
associate with economists. It is not supposed to be about money, profit, production and mar-
kets. Should it not be about medicine, nursing, caring and the difference between life and
death? Surely, an economist has no wisdom to bring to bear here? Such views were virtually
universal until quite recently but they demonstrate a limited understanding of the role and
content of economics. In principle economists are concerned with better choices and in par-
ticular making the best use of existing resources and growth in the availability of resources.
As economists started to work on problems in the health sector, the new discipline of health
economics emerged. Many of the concerns in health economics are also those of other health
scientists – how can we improve survival, quality of life and fairness in access to services?
What economics brings is a different framework for analysing such questions. We think this
framework offers important and useful insights.
Economists in all sectors are concerned with the allocation of resources between compet-
ing demands. Demands are assumed to be infinite – there is no end to consumption aspira-
tions. Resources (like labour, raw materials, production equipment and land), in contrast,
are always finite. Thus scarcity of resources (not in the sense of ‘rarity’ but in the sense of
resource availability relative to demand) becomes the fundamental problem to which econ-
omists address themselves. Some readers will have difficulty with this description of the
world. It is not necessarily ‘true’ but is, in a broad sense, a model on which economics is
based. See Box 1.1 for further discussion of the nature and purpose of models, and of this
one in particular.

Box 1.1  Realism and the need for simplification – the use of
models in economics

In the teaching of health economics, we have found that students often raise objec-
tions to the assumptions of economic models and the characterisation of all-pervasive
scarcity on which economics is based. Others object to the concept of the ‘rational
economic man’ that underlies demand theory (see Chapter 2), and the assumptions of
the theory of perfect competition (see Chapter 6).
2  Introduction

At least part of the concern comes from a misunderstanding of the role and useful-
ness of theories and models. Models are not intended to describe reality. They delib-
erately abstract from it, in order to simplify the relationships between key variables
so that we can see them clearly and analyse them. Models should never be ‘realistic’,
they should always be simplifications. Models deliberately ignore variables we are less
interested in, or consider to play only a small role, either by holding them constant or
by setting them to zero. Economists use the expression ‘ceteris paribus’ (all the rest the
same) to indicate that all variables which haven’t been included in the model should
be assumed to be constant. By simplifying, we aim to focus on the relationships we are
interested in, examine the interactions between these variables, and avoid the ‘noise’ of
the hundreds of other variables which will otherwise confuse those key relationships.
An extreme position is that of Milton Friedman (1953), who has argued that a model
is good if it predicts accurately. Its assumptions may bear no relationship with reality.
Friedman uses the example of leaves deliberately seeking to arrange themselves so as
to maximise the sunlight each receives. The assumption of ‘deliberating’ leaves may
be unrealistic, but a model based on that assumption predicts accurately the pattern
of leaf growth and development on a tree. Others (e.g. Hodgson 1988) consider that a
model which predicts on the basis of very unrealistic assumptions fails to explain the
relationships in question. We do not understand much about the process of leaf growth
and distribution starting from this assumption. Explanation is often as useful a function
of models as prediction.
Take the particular assumption that demands are ‘infinite’. Are they really? Levels
of consumption enjoyed in the rich economies of the world have grown beyond the
imaginations of previous generations. The consumption levels of the richest in the
world demonstrate that when resource constraints are low, people consume goods that
would in other circumstances be considered of very low priority. If demand exists
for psychiatric services for pet dogs, cars capable of speeds exceeding the maximum
permitted on public roads, and dancing snowmen singing ‘Jingle Bells’, where can
limits be found? Observing some spectacles of consumption, one might conclude that
increased wealth and command of resources increase greed and aspirations to consume
even more.
In the health sector, one might reach similar conclusions based on the rapid develop-
ment of technology, which makes available almost unlimited opportunities to extend
and improve the quality of life. There seems no limit to the resources that might be
consumed with the objective of improving the health of a population.
However, it is also clear that not all members of the world’s population aspire to
such levels of consumption. Many widely held systems of philosophic and religious
belief from Calvinism to Islam eschew consumerism. And even if the levels of demand
which might potentially be expressed are very large indeed, could they really be infi-
nite? Is there not a maximum rate at which any individual could possibly consume
resources?
The discipline of economics needs an assumption which is realistic enough to gener-
ate useful analysis and conclusions. What is unarguable, is that the extent of demands
on resources far outstrips the capacity of available resources to deliver, and does so
to such a great extent that there is no prospect of ever meeting all demands with the
available resources. This is sufficient to make the economist’s characterisation of all-
pervasive ‘scarcity’ a reasonable basis on which to proceed.
 Introduction  3

Of course, the current distribution of resources leaves some high-priority demands

unmet at the expense of some of the low-priority demands listed above. For the cost of
the dancing snowman, several people might have their sight restored through cataract
surgery. In this insight lie the concerns of economists. Why do the current resource allo-
cation mechanisms choose snowmen over cataract surgery? If we take the normative
perspective that surgery is ‘better’ than snowmen as a starting point, what kinds of inter-
vention might help us move towards a situation in which more demands for surgery and
fewer demands for snowmen are met? These questions are the business of economics.

In the health sector, such scarcity can be recognised in a host of questions that concern all
who work there or use its services. Why has the volume of resources absorbed by the sec-
tor increased so fast over the last four decades worldwide? Why does it seem that no matter
how many nurses and doctors are employed, new technologies adopted, new drug therapies
introduced, even the rich countries of the world do not seem to be able to provide the highest
quality of care for all citizens? Are we investing in the wrong kinds of health services? Are
we organising services so as to best improve the health of the population? Are we investing
in technologies that have a low health output compared with alternative investments? In
poor countries, questions of resource scarcity are starker still. Can we afford, at all, universal
access to high-cost services such as cancer care?
All societies must make choices as to how to allocate whatever resources are available to
the production of health services, and how to distribute those health services. These choices
are the subject of the discipline of health economics. Health economics (and economics in
general) is often seen as having two branches: the positive branch, which is concerned with
describing and explaining how such choices are actually made; and the normative branch,
which is concerned with judging which choices should be made. For example, a health econo-
mist might be concerned with the health insurance coverage of a population. She might take a
positive perspective. Why are there so many uninsured? What are the characteristics of those
that are uninsured (are they unable to afford the cost of insurance premiums, or do they judge
themselves unlikely to need health services)? From a normative perspective it is necessary to
establish criteria according to which the situation can be judged. If equity of access to health
services is one criterion, and inability to pay is a dominant explanation of non-coverage, the
situation might be judged ‘bad’, and alternative interventions to reduce the problem evaluated.

1.1.2  Planned versus market – alternatives for organising resources

There are two ways in which society can make choices about the collection of resources and
allocation of resources to production in the health sector, and the distribution of the services
that are produced among those that want them. A society can leave these decisions to the
market – letting demand, supply and prices determine resource allocation – or it can plan,
usually by giving its government the task of collecting resources from the population, allo-
cating those to defined production activities and distributing the produced services among
the population.
Figure 1.1 gives a stylised overview of the structure of a health care system. The diagram
shows the flow of resources (black arrows) and services (grey arrows) through any health
sector. Ultimately, resources from individuals in society are used to pay, either directly or via
intermediaries, providers such as primary care providers or hospitals to deliver health care
services to individuals in society.
4  Introduction

Individuals Intermediaries Providers

= resources
= services

Figure 1.1  Flow of health care resources and services

Source: Brick et al. (2010).

Describing the above choices in terms of Figure 1.1, where society leaves the decisions to
the market, resources flow directly from individuals to providers (i.e. bottom black arrow)
who in turn produce health care for those who are willing to pay at that market price. In a
planned health care system, resources are collected from individuals by an agreed intermedi-
ary (e.g. government tax collector, social health insurance fund), which in turn pays provid-
ers (e.g. via annual budgets, capitations, or fee-for-service) to deliver health care services in
accordance with specified health care delivery principles (e.g. services allocated on the basis
of need).
The debate as to which approach is best has divided the world’s population through the
whole of the twentieth century, underlying the formation of political parties, coups d’état,
and hot and cold war, and will not be settled in this volume! Societies worldwide have taken
different stances on the question, and have evolved a wide array of mixes of plan and mar-
ket in the attempt to reach a satisfactory choice as to how to produce and distribute health
services. Thus, even in the most highly planned health systems, market forces can be found
to operate in some parts of the system, for example for specific services (e.g. a market for
drugs for which prescriptions are not required operates in almost all countries), or for specific
groups in the system.
Health economists have evolved different approaches to analysing and evaluating resource
allocation in the health sector which reflect the plan–market dichotomy. In societies in which
health services have been largely planned (e.g. Europe), the main activity of health econo-
mists has been the development and application of a set of tools which collectively make up
the field of economic evaluation. Economic evaluation aims to consider whether appropriate
services have been adopted in the health sector, or whether there is a mix of technologies and
interventions which would better meet health sector objectives, such as the improvement of
the population’s health, or the equity of access to care. You might notice that in terms of the
positive–normative dimension, this is an essentially normative activity. It requires the defini-
tion of objectives and asks: ‘What should we do?’
Where there has been a greater role for the market in health sector resource allocation (e.g.
in the United States), more effort has been made by economists to understand that market in
order to predict its pattern of development, and to analyse the implications of interventions
such as regulation, subsidy of insurance coverage or the introduction of planned activities.
Even in the most market-reliant health sectors, such interventions are always present. Under-
standing markets involves the understanding of demand (how consumers of health services
express their preferences through their ability and willingness to pay), supply (conditions
 Introduction 5
in input markets, cost and how provision is organised, e.g. by one big firm or by many) and
their interactions. This is essentially a positive activity – explaining what is happening and
predicting the effects of introducing a change – but it can be normative. If it is decided that a
particular effect is desirable, such analysis can be used to evaluate whether a change should
be introduced.
As health sectors have evolved, especially over the last two decades, richer mixes of plan-
ning and markets have been developed in a large number of countries. In health sectors
which have traditionally been planned, elements of market mechanisms have been intro-
duced, for example through ‘internal markets’ (i.e. focusing on the interaction between inter-
mediaries and some providers, see Figure  1.1). In health sectors which have traditionally
relied to a greater extent on market mechanisms, more planning has been introduced – for
example through more intrusive public regulation, or through the use of capitation payment
mechanisms (consumers pay the provider a fee per year rather than per service) which shift
risk on to providers and thereby pass on the planning role usually carried out by a public
sector body. This has led to a certain cross-over of interests in the health economics fields.
US health economists are now much more interested in the techniques of economic evalu-
ation which can assist Health Maintenance Organisations (providers paid by capitation) in
developing their strategies, and economists interested in the welfare state health provision of
northern European countries are increasingly interested in the operation of markets and the
implications of different kinds of regulation and other public intervention for market behav-
iour. On both sides of the Atlantic there is now interest in capturing the insights of economic
evaluation to enable better planning by actors in the market place, and to better understand
how public intervention can improve outcomes associated with health markets.
These two traditions of health economics can be detected by comparing the outputs of
health economists in northern Europe, Australia and New Zealand (largely planned health
sectors), and the United States (where market forces have been allowed greater rein). Cana-
dian health economics has perhaps been least categorisable, located in a health sector which
is characterised by planned approaches to resource allocation, but strongly influenced by the
academic environment of the United States. Some prominent contributions to health eco-
nomics from Canada have provided a critique of US analysis.
Although most work in health economics has been produced in these regions, trends in
health sector development affect those conducting economic analysis in the health sectors
of almost all countries. It is no longer safe to assume that when one is working in a planned
environment, an understanding of market forces is unnecessary, and that topics in economic
evaluation provide the only useful tools required. Similarly, it is unlikely that the United
States will ever return to the market conditions of the 1970s. Technology assessment, facil-
ity planning and the mandate of insurance packages are likely to feature for the foreseeable
future, and economic evaluation will continue to play a major role in the operation of these.
It is therefore increasingly the case that, wherever their work takes them in the world, a
health economist needs grounding in both branches of the discipline. This book is founded
on that belief. It aims to explain basic health economics across the spectrum of the discipline
and to demonstrate applications on a worldwide basis. The work of the authors of this book
covers a wide geographic span, taking in Western Europe, the United States, Canada and
Australia, many of the countries of the former Soviet Union and Eastern Europe, Uganda,
Zambia and Zimbabwe, Bangladesh, Cambodia, India, Colombia and Peru – in fact coun-
tries from all continents except Antarctica. Obviously, the problems faced by these differ-
ent countries in trying to ensure that public health problems are thoroughly addressed and
that all citizens receive high-quality health services are quite different – in type and degree.
6  Introduction
Nevertheless, the tools of economic analysis presented in this book have provided us with a
good basis for seeking to understand and evaluate the problems encountered and the meas-
ures taken to respond to them irrespective of the context. We believe that contrasting expe-
rience of applying these tools in different countries is helpful in understanding issues and
undertaking analysis in any particular country. The aim of this book is to provide an intro-
duction to these tools and to show ways that the same approach can inform health policy in
widely differing contexts.

1.2 Who and what is in a health system?

Much of this book is concerned with introducing the reader to the workings (and failings) of
markets in the context of health care. Markets are made up of different actors and it is useful
to set out here the key players in a health care system because these crop up throughout the
text, wherein core ideas and theories are illustrated using examples from existing health care
systems.
Figure 1.1 identifies three broad groups of actors within a health care system. Individu-
als in society need and use health services, and are also the ultimate payers for health care
(either directly at the point of use, or indirectly via taxation, social health insurance etc.).
Intermediaries include governments, social health insurance funds, regulatory bodies and
others, who may be involved in collecting resources from individuals, allocating resources
to health care providers, regulating provider behaviour etc. Providers include hospitals (i.e.
hospital managers, doctors, nurses etc.), primary care providers (e.g. solo practitioners, pri-
mary care centres or allied health professionals working out of community-based teams) and
other health professionals. Thus, a health system is made up of users, payers, providers and
regulators, and can be defined by the relations between them. Each part of this book touches
on one or more parts of the overall flow of resources (e.g. contracts and regulation focusing
on intermediary–provider relations; assessment of financing mechanisms focusing on how
resources are collected from individuals to pay for health care; economic evaluation focusing
on how well services are delivered by providers compared with using the resources for other
purposes; equity measurement focusing on how fairly health care resources are delivered).
Changing the nature of the relationship at one part of the system can have implications for
how the rest of the system operates. For example, changing the way in which a health care
provider is reimbursed from direct payment to some form of pre-payment can impact on
how the provider behaves, how the user behaves and how other actors in the system are
affected (e.g. the pattern of use may shift across health care providers). The simple diagram
(Figure 1.1) is useful for keeping in mind the inter-linkages within a health system, and the
various and complicated incentive structures that can arise are key issues of concern for
health economists and discussed at various points throughout the text.

1.3 Economics, health policy and equity

Economic analysis in health and health care is often undertaken with a view to help govern-
ments and other agencies to better achieve the goals of their health policies. An obvious
requirement is to know what these goals are. Where explicit goals are specified it is com-
mon for two to dominate  – improving the health status of the population and fairness or
equity. Health economists have therefore focused on assessing how to maximise the impact
on health and equity. In economics it is recognised that choices must be made – it is not
possible to get everything you want. Whereas some policies may offer the opportunity to
 Introduction  7
increase both equity and health improvement, others require a choice between equity and
health improvement – in other words we must sometimes choose to trade off efficiency (the
achievement of better health) and equity (the fairer distribution of health).
Fairness and equity are difficult concepts, and a whole literature exists just on how they
should be defined. As ideas they inevitably carry strong moral overtones. To be against fair-
ness seems impossible almost by definition. To be openly in favour of widening gaps in
health between the rich and the poor is understandably uncommon. Being clear about what
is meant by equity or fairness is also uncommon, and it is important to define the concepts
and desired outcomes more precisely. There can be many reasons why health and access to
health care are unequal. Some people happen to be born with diseases or disabilities, or the
predisposition to become ill. Some people are just unlucky, and become ill. Those without
jobs or housing may live in risky or unhealthy conditions. Others take risks, such as rock
climbing or smoking, and the outcomes may be bad. And some people would benefit from
treatment or care but cannot find the resources to pay for it.
A significant part of this book is devoted to analysis of markets in health and health care,
how they work, how they fail and what can be done to make them work better. Even if they
work well, poor people are poor, and without help can afford only limited access to care.
They are also more likely than richer people to have illness and disability. In most countries
in the world there are government measures to reduce the disparity in access to care between
richer and poorer people. Despite this, gaps remain between the health experiences of differ-
ent groups – better health is enjoyed by richer people, by professionals and, in some respects,
by women. Access to care does not reflect fully these differences.
In countries with government funding of health care, or some system of funding that is
heavily regulated by government, it is common for there to be a system of allocating resources
to take account of differences in needs in different parts of the population. The most common
approach is for allocation to be based on population, weighted for need factors such as age,
gender and morbidity. The allocations are then proportionate to the measures of need. This
approach has done much to weight funding towards those with worse health. However, there
are obvious problems, since it is not clear that the appropriate level of funding should be pro-
portionate to a particular measure of need. This illustrates a difficulty in making operational a
desire to create vertical equity (that is, the unequal support for unequals). The other common
notion of equity is horizontal equity, the equal treatment of equals. In principle this is easier,
since all that is needed is the same access to health or health care opportunities for people in
the same situation. Putting it into practice is not so easy.
Economists often focus on the trade-off between efficiency and equity. Take the example
of urban and rural populations and their different perinatal mortality rates. It is common
for rural areas to have worse rates of such deaths, so it might be expected that the efforts of
public health and health services would focus on reducing this difference. However, it is also
likely that the cost of lowering the rate of perinatal deaths in rural areas will be higher (e.g.
because service users are more costly to reach), so that a given expenditure might do more to
lower the number of deaths if applied in the urban area. A real choice might be to lower the
number of deaths by 100 if the focus is on urban areas but only by 80 if the same funds were
spent on the rural programme. A difficult choice faces policy makers – spend the money on
the urban areas and more deaths are prevented, but at the same time the disparity between
urban and rural areas becomes wider. Of course we would all like to see both fewer deaths
and less inequality, but for many spending questions we cannot avoid making this difficult
choice between a more efficient intervention (i.e. fewer deaths) and a more equitable one. Is
the additional fairness worth 20 deaths?
8  Introduction
The example of perinatal deaths is based on a real choice that was faced by a health agency.
It represents one of the most difficult dilemmas. There are also many occasions when there is
no trade-off between efficiency and fairness, since people with worse health have more scope
to recover with treatment. Take another example, based on experience in an urban area in
England. Owing to differences in referral rates, people in the poorest part of the district had
the highest rates of treatable coronary heart disease but were getting less treatment than those
from more prosperous parts. In effect, those with the least capacity to benefit were getting
more, and those likely to benefit more got less. In this case the allocation of resources is inef-
ficient (since more improvement in health could be achieved with the existing budget) and
greater efficiency would also lead to greater equity. Being ill or at risk is a necessary condition
for being able to benefit from treatment, so that it is often the case that those who can ben-
efit most are those with low incomes and above-average morbidity. In some cases it is more
expensive to treat poorer people, since they may need longer time in hospital. There are also
cases where there are higher costs of running a prevention programme for poorer people. For
example, those choosing to attend for screening programmes tend to be those who are richer
and have less disease. Recruiting those from poorer families may be important, since there is
likely to be more disease detected, but it may cost more to organise such a programme.
These examples aim to shed light on several aspects of equity. There is no simple defini-
tion of equity. It is also important to consider equity in the health sector in the context of
overall equity. Poverty leads to ill health and constrains access to health care. Action to
improve equity in access to health services can help, but tackles symptoms more than causes.
To a large extent the problem of health inequalities is a problem of more general economic
and social inequalities, and the solutions lie outside the health sector. There is some evidence
that it is relative (rather than absolute) poverty that is associated with poor health, although
recent studies cast some doubt on this. It is certainly the case that countries with great social
inequalities have worse health on average than those that are more equal. The rapid changes
in Central and Eastern Europe from the 1990s onwards were associated with a rapid increase
in income inequality and worsening of health.
It can be useful to distinguish within the health sector between structures that lead to
unequal access to services and the failure of health systems to work as they are planned to.
Countries with state funding or social insurance funding for health care normally aim to
provide nearly equal access to important services. The rules normally state that care should
be offered on the basis of need and not income or ability to pay. The reality is often different,
since there may be user charges (whether official or unofficial), medicines may not be avail-
able at the hospitals, staff may be rude and careless with poorer patients, and buildings may
be in a poor state of repair. The design may be for a system of equal access, but the reality
is that those with more money get better access. This may be contrasted with systems that
do not aim to provide equal access. In the US access depends on income, employment, age
and disease. Those who are employed and insured get excellent services. Those who are very
poor or old get free or subsidised services. Those with renal failure may get free dialysis, but
those with low-paid jobs and no insurance may be excluded from many parts of the system.
Even if each part of the system were to work as planned, the system does not aim to provide
the same health care opportunities to all users. This is not to argue the superiority of systems
that aim to be equitable but which fail, but in such cases the solution may be to make the sys-
tem work as planned. In a fragmented system such as in the US, any moves towards greater
equity are likely to require some changes in structures.
While Chapter 25 focuses on measuring equity in access to health care, many other chap-
ters in the book touch on these issues. The analysis of markets considers the consequences
 Introduction  9
for who gets what access to what health opportunities. In some cases better management and
implementation of existing policy more fully will also reduce inequalities. Economic evalu-
ation may affect priorities and therefore access. The section on health systems addresses the
implications of different health system structures for rationing principles. Where there is a
trade-off between more health gain and more equality in health, those making policies must
be clear: greater equity will be achieved only at the expense of worsening the overall levels
of health. This may be deemed to be desirable, but equity, like most desirable ends, has a
cost.

1.4 The structure of this book

Part I introduces basic micro-economics and its applications in the health sector. These top-
ics – demand and elasticity, production and cost, perfect markets and market failure – provide
the basic building blocks for any more sophisticated micro-economic analysis, whether of the
operations of markets or the economic theory underlying topics in economic evaluation such
as shadow pricing and willingness to pay as a means of valuing benefits. As highlighted in
Figure 1.1, markets exist in most health care systems in some shape or form, and it is impor-
tant to understand the basic theory behind them. It is equally important to learn how markets
can fail in order to understand the rationale behind third-party intervention in a market.
Part II covers topics which enable a more sophisticated analysis of market behaviour and
applications to the evaluation of market intervention such as regulation and contracting. On
the basis of this section, the reader will start to understand the insights that can be gained
from the application of market theory and analysis to health sector scenarios – whether in
more or less planned health sectors.
Part III provides an overview of the insights that economic analysis can provide into the
understanding of health systems at a macro level, i.e. understanding different countries’
choices on the entire flow of resources through the system (Figure 1.1). It starts with a dis-
cussion of the implications of alternative forms of organisation for how much funding is
available for health care, how resources can be rationed, and what are the institutional struc-
tures and incentives to efficiency implicit in alternative systems. This is followed by discus-
sion of the theory and evidence around alternative options for financing a health care system
(who pays, how much and when). The final two chapters consider health systems around the
world, examining historical structures, past and current performance characteristics, reforms
and emerging issues.
Part IV focuses on the empirical side of health economics, introducing the reader to key
tools and techniques for evaluating resource allocation and other micro-level decisions in
health care. Part IVa introduces economic evaluation. We have noted already that any norma-
tive economic analysis must start out with clear criteria by which to evaluate the goodness
or badness of any proposed policy or change in current practice. This section starts with an
introduction to welfare economics, which is the branch of economics which has developed
the system of criteria on which economic evaluation is based. The rest of the section focuses
on the philosophical and practical difficulties encountered in trying to evaluate policy and
practice in the light of these criteria, and provides a running case study through which these
difficulties are exemplified and explored. Part IVb introduces the topic of applied economet-
rics, providing the reader with the tools with which to specify, estimate and interpret a typical
econometric model used in applied health economics research. The final chapter examines
equity in access to health care, paying particular attention to how access is defined and meas-
ured, and how need for health care is controlled for in these analyses.
10  Introduction
The book is designed to be read in different ways. The aim has been to keep the text as
readable as possible and to use technical terminology only where necessary. Where possible
the ideas are illustrated with examples taken from the authors’ experience of applying eco-
nomics to health and health care issues. A more technical approach is provided in parallel.
Text boxes offer fuller explanation of some points, mathematical presentation of some of the
theory and background to some ideas. The presentation in Part I assumes no previous knowl-
edge of economics. Parts II, III and IVa build on this foundation and readers with previous
training in economics should find these quite accessible, but those new to economics should
not attempt to read them without a reasonable grasp of the material in the first section. The
chapters on applied econometrics in Part IVb assume a knowledge of statistics equivalent to
that taught in an introductory masters-level course.
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