1

3. HEALTH CARE
MARKETS AND
FINANCING
Demand for Medical Services
An inverse relationship exists between the price and the quantity demanded for
physician services. In the demand curve, price represents per unit out-of-
pocket expenses the consumer incurs when purchasing medical services from
the physician. It equals to the amount the consumer must pay after the impact
of third party payment has been taken into account. If the visit to the physician
is not covered by a third party, the actual price of the visit is equals to the out-
of-pocket expense.
Another way illustrate the inverse relationship between price and quantity
demanded for physician services is through the substitution and income effects
of a price change.

» Substitution Effect: a decrease in
the price of physician services causes
the consumer to substitute away
from the relatively higher-priced
medical goods, such as hospital out-
patient services and purchase more
physician services; hence, the
quantity demanded for physician
services increases as price decreases.
Demand for Medical Services
3
» Income Effect: a lower price
also increases the real consumer
purchasing power. The quantity
demanded for physician services
increases when purchasing
power increases. As price falls,
the real income and quantity
demanded rises.
 4

Demand Shifters:
» Factors shifting the demand curve outward would increase consumers’
income or insurance coverage, reduced opportunity cost, increases in the
price of substitutes, decreases in the price of implements or event that
increase quantity demanded.
» Factors shifting the demand curve inward include decreased consumer
income or insurance coverage, increased consumer opportunity cost,
decreases in price of substitute, increases in the price of complement, or
events that reduce the quantity demanded.

Demand for Medical Services

 5

» Demand shifters: the increase in real income causes the demand for
physician services to rise. The consumer is willing to pay a higher price,
thereby causing the demand curve to shift to the right.

» Complementary Medical Services: refers to two or more goods which

are jointly used for consumption purposes. Because these goods are
consumed together, an increase in the price of one good inversely influences
the demand for the other.

Demand for Medical Services

 6

» Time Cost influences the Quantity Demanded for Medical

Services: it includes the monetary cost such as bus fare or gasoline plus
the opportunity cost of time. Time cost accrue to traveling and expending
delays in securing an appointment to a medical provider affect the quantity
demanded for medical services.

» Health Insurance and Demand for Medical Services: uncertainty is

a fact of life and the need for health care is difficult to predict. The demand
for health and medical care is an interrelated feature of health insurance.

Demand for Medical Services

 7

» Moral Hazard: any change in behavior as a result of becoming insured.

Usually the changes in the behavior that matter most are those that
increase the pure premium of the insurance.

» Events of Various Types: a disaster, such as an earthquake, may

increase the quantity demanded for intravenous fluid and tubing and blood
products.

Demand for Medical Services

Supply of Medical Services
Supply Shifters:
» Cost represents the resources or inputs required to produce a good or
service. Cost is a very important supply shifter because the cost of a
particular level of output is the result of the quantities of resources used to
create it multiplied by their price.
» Changes in technology may shift the amount of quantity supplied. As
technology improves (assuming the improved technology reduces
production cost or increases production), the quantity supplied increases.
» As economies of scale or scope increases, the quantity supplied increases.
 9

Market Failure and Government Intervention

Markets are useful resource allocation

mechanisms because they are automatic,
responsive to changes in consumer
preferences and, under perfect competition,
allocatively efficient.
When perfect competition does not arise,
market failure occurs as the market is unable
to achieve an efficient allocation of resources.
Alongside equity and
redistribution of wealth and
stabilization of the macro
economy, the correction of
market failure is another
reason for government
intervention in the market.
Causes of Market Failure 10

Monopoly Externalities Public Good Asymmetry of

Information
Causes of Market Failure 11

1. Monopoly is characterized by a single supplier

in the market. A natural monopoly is a situation
where one firm can meet market demand at a
lower average cost than two or more firms could
meet that demand.
Monopoly can also occur as a result of barriers to
entry, few providers, and few close substitutes.
 12
▪ Barriers to entry exist in the form of professional bodies so that the supply of
professionals is restricted. This in turn implies higher salaries than there would be
if there were perfect competition – i.e. there is allocative inefficiency. Patents are
also barriers to entry because they prevent other manufacturers from producing a
particular good. Patents are very common in the pharmaceutical industry.
▪ The scarcity of hospitals in rural areas is also a good illustration of few providers.
This might mean that hospital services are priced artificially high, which is
inefficient. However, monopoly pricing may not occur if providers are non-profit-
making.
▪ There are also few close substitutes for many health care goods and services such
as an emergency Caesarean section or anti-retroviral therapy.

Monopoly in the Health Care

 13
Price and Output Decision Under Monopoly

Monopoly in the Health Care

 Hypothetical Monopoly Market 14

(cervical screening after the introduction of new technology)

The advantage of the new technology is that

potentially we can reduce costs, increasing the
supply of the service. The disadvantage is that it
allows a single provider to exert monopoly power.

Monopoly in the Health Care

Causes of Market Failure 15

2. Externalities. An externality is a cost or a benefit

arising from an economic transaction that falls on
people who do not participate in the transaction.
When there are external costs and benefits, the
parties involved in the transaction do not take these
costs and benefits into account. This failure to place
a value on all costs and benefits can lead the
market to under-provide or over-provide a good.
Positive Externality:
There are private benefits of being vaccinated: most children
get a very high immunity against measles, and thus are
protected from the ill effects of the disease. In addition there
are benefits beyond this to society as a whole: vaccination
reduces the risk of others catching measles as well.
If you relied on markets to deliver goods with positive
externalities like immunization, you would find that the
resulting number of immunizations would be less than the
socially optimal number needed to reach herd immunity levels.
In other words, the market would under-supply immunization.

Externalities in the Health Care

 External Benefits
(market for vaccination against measles)

A typical example of this divergence between the

marginal private costs (or benefits) and the marginal
social costs (or benefits) is vaccinations. The
difference between the private and social benefit of
vaccinations can be well described by the rise in
measles cases in the UK. As a result of a media scare
about the possible dangers to some children of the
measles vaccine, there was a drop in vaccination rates.

Externalities in the Health Care

Negative Externality:
When people smoke there is a cost to themselves
in terms of poorer health outcomes. However,
there is also a cost to other individuals from
second-hand smoke. When people are weighing up
the costs and benefits of smoking, they focus on
the impact on them. The market also doesn’t
consider the cost to others, and therefore the
market over-supplies the good.

Externalities in the Health Care

Causes of Market Failure 19

3. Public good is a good or service that can be consumed

simultaneously by everyone (it is non-rival) and from
which no individuals can be excluded (non-excludable).
Market failure and the suboptimal allocation of a good or
service also occurs with public goods.

If the provider of a public good tries to ask people how

much they are willing to pay to receive it, consumers say
they don’t want it. Why? Because the consumers know
that once the good is provided they can consume it even if
they don’t pay for it. This is called the free-rider problem.
(Parkin 2008)
So, is health care a public good? No, it isn’t.
For one thing, it is rival. If one person consumes a drug (or a consultation, or a vaccination) then
there is one drug (consultation, vaccination) less available for others to consume. Health care is
also excludable – providers can easily prevent individuals from consuming it. However, there are
aspects of health that are public goods:

Infection control such as malarial management

through environmental measures. Everyone in
the community can benefit from having a malaria-
free water supply without stopping anyone else
from benefiting – it is non-rival. Furthermore, no
one can be excluded from this benefit.

Public Goods in the Health Care

 Information,
something that is an
integral part of many
public health
programs, can also
be considered a
public good.
However, this is only
non-excludable if
individuals possess
the access goods
which enable them to
receive that
information.

Public Goods in the Health Care

Causes of Market Failure 22

4. Asymmetry of information exists when one

person in an economic transaction has more
relevant information than the other person. It
requires that the cost to the uninformed person of
accessing this information is prohibitively high.
 Insurance protects individuals from financial risk. However, the market for health
care insurance is not necessarily allocatively efficient. Insurance markets are subject
to particular market failures arising from asymmetry of information.

Health Insurance
Demand for health care is often manifested as a demand for
health care insurance. Insurance markets evolve as a natural
response to the burden of risk. In fact, insurance is a response
to the market failure related to the uncertainty around the
timing of demand for health care. Consumers, instead of
demanding health care, demand health insurance. The
insurance companies then demand the health care or else the
individuals demand it and the insurers pay for it.

Asymmetry of Information in the Health Care

 24
Market failure occurs in health care insurance markets
in the form of adverse selection and moral hazard.

Asymmetric Information and Health Insurance

https://www.youtube.com/watch?v=pUkRo9COd38

Moral Hazard
https://www.youtube.com/watch?v=5v7TWKlYoN0

Solutions to Moral Hazard

https://www.youtube.com/watch?v=6faL76QZ2AA

Asymmetry of Information in the Health Care

 25
Adverse selection
In the case of insurance, if someone thinks they are a low risk then they are less likely to take up
insurance than someone who believes themselves to be a high risk. This will mean that only
high-risk people will pool their risks and low-risk people will not.
Of the informed group (individuals who know their own health risk), only those who will benefit
most from an agreement will enter the agreement, to the detriment of the uninformed person
(the insurer). The uninformed person cannot tell whether the agreement will be to their own
disadvantage or not because they do not have the necessary information.
In this case, the insurer will not be able to tell if those they insure are high or low risk. If the
insurer could afford to gather information on the risk level of each person they insure then they
could offer a premium that was beneficial to each person.

Asymmetry of Information in the Health Care

 26
Moral hazard
Another form of market failure observed in both health care provision and health insurance
markets is moral hazard. This occurs if the informed person, after the transaction has been
agreed, uses their information to the disadvantage of the uninformed person.
For example, someone who is insured may have an incentive to act recklessly (consumer moral
hazard). This can manifest itself in less effort being made to avoid the need for health care – just
like when individuals might take less care over locking up a bicycle when it is insured, people
might not take exercise, might drink excessive alcohol or smoke.
Under private or social insurance and tax-funded systems, the zero or subsidized price of health
can also result in the over-consumption of health care when ill.

Asymmetry of Information in the Health Care

 Potential Welfare Loss 27

Price below marginal cost (MC – P > 0)

Consumers consume up to the point

where their marginal benefit equals
the marginal cost to them (the price)
resulting in an overall welfare loss.

Asymmetry of Information in the Health Care

 28

The need to risk pool between individuals and across time leads to a demand
for some form of risk sharing for health care costs. The form this takes
depends upon whether the risk sharing evolves in response to individual health
care wants and demands or community need.
Market failure in the provision of health insurance leads to the key problems
of adverse selection and moral hazard. Moral hazard is a general problem of
funding by a third party and can be reduced through both demand and supply
side measures. Adverse selection is a problem of voluntary insurance and leads,
without further action, to partial coverage of risk.

Asymmetry of Information in the Health Care

Government Intervention 29

There are steps that the government can take to make sure that monopoly power
is curbed and service provision is increased:
» they could make the market contestable – offering the monopoly to the provider that
offered to cut prices the most;
» they could put a ceiling on the price to bring it down to the social optimum price, P* –
where there is a monopoly, a price ceiling can lead to increased output (this is unlike a
price ceiling in a competitive market, which will reduce the quantity supplied);
» they could break up the monopoly.
 30

» Government Intervention
The positive externality associated with vaccinations in general leads to governments
introducing different ways to increase the consumption of vaccinations up to the socially
optimal level. These might include voucher schemes, a price subsidy or, as for childhood
vaccinations in most countries, state provision of vaccinations.
» Governments need to raise the price of smoking to reflect the cost to society. Taxes work by
increasing the cost of the consumed goods, which will lead to a lower equilibrium quantity.
In the case of smoking, duties on cigarettes would be charged. Other examples might be
duties on alcohol. In the case of pollution, governments could introduce emission charges.
» Non-excludability leads to free-riding so that individuals consume more than their fair share
of the good. Non-rivalry leads to lower than socially optimal consumption. As a result,
perfectly competitive markets under-supply public goods so that direct delivery or financing
by government is required to reach a socially optimal level of output (Smith et al. 2003).
 Ways of Paying Health Care Services 31

Obtaining more finance for the health

sector is a major pre-occupation for most
governments in both low and middle (and
even high) income countries.
It is increasingly recognised that the state
cannot finance all, or even the majority, of
health care out of the general government
budget. At the same time out of pocket
payments have severe efficiency and
equity implications.
 32

Ways of Paying Health Care Services

Other options for producing extra
funding includes community finance and
medical savings accounts. The finance of
these measures are ultimately derived
from the population who, often, have
access to very limited income.
Any increase in funding for medical
care implies a reduction in expenditure
on other, both health and non-health
related, commodities demanded by the
population.
 33

‘Health system financing is the process by which revenues are collected from
primary and secondary sources, accumulated in fund pools and allocated to
provider activities’ (Murray and Frenk, 2000).
Ultimately, whether through out-of-pocket payments, taxation or health
insurance, financing for the health system originates from households. In a most
basic way, therefore, health care financing represents a flow of funds
from patients to health care providers in exchange for services.
 34

The Economics of Health Care

https://www.youtube.com/watch?v=cbBKoyjFLUY
 Financing Function of the Health Care 35

Within the financing function of the health system

there are three main activities:
» Revenue collection refers to the raising of
funds either directly from individuals seeking
health care or indirectly through
governments or donors.
» Fund pooling refers to the collection of funds
that can be used for financing a given
population’s health care so that contributors
to the pool share risks.
» Purchasing is the process of allocating funds
to the providers of health care.
 36
1. out-of-pocket
payments: this is the
simplest and earliest form
of transaction between
patient and provider;
2. third-party payments:
where providers are paid
by an insurance company
or a government.

Two Ways of Paying Health Services

 37
As there is difficulty in raising sufficient funding from nationally implemented
risk pooling, options for additional funding in developing countries are:
1. User charges are seen to offer
some potential for additional
funding which, while not being
significant in national terms,
could offer individual facilities
valuable additional income to fund
mainly recurrent costs.

Options for Funding Health Services

 38

2. Exemption mechanisms can reduce the problems of reduced access for

certain groups. But, it can be expensive to design and implement, reducing
the net revenue obtained from charging.
Private insurance poses severe problems of access, both for low income and
high risk groups. It is therefore not suitable as a main source of funding, but
is likely to grow as a supplementary source, particularly for higher income
groups and for services which have been excluded from state funding.
Top 5 Life Insurance Companies (2019)

Options for Funding Health Services

 39

3. Community insurance schemes are

becoming increasingly popular in developing
countries. As with user charges the revenue can
be valuable at the local and facility level, and the
emphasis on cross subsidy can avoid some of the
problems of equity encountered with user charges.

The crucial problem is enrolling the low risk in a voluntary scheme that does not risk rate. Ways
round this problem may render the scheme unsustainable. Medical savings accounts offer some
advantage in encouraging individual responsibility. They also have equity implications and are
perhaps most suited to countries experiencing significant economic growth.

Options for Funding Health Services

 40
4. Informal payments do not
constitute an alternative funding
source, their prevalence does
indicate the size of the funding gap
between what is officially covered
and what can be afforded. External
aid provides a critical source of
health financing in many countries.
Such dependency tends to increase
uncertainty about the future flow of
funds into the health sector.

Options for Funding Health Services

References 41

» Folland, S., et.al. (2013) The Economics of Health and Health Care. Seventh
Edition. Pearson
» Guinness, L. & Wiseman, V. (2011) Introduction to Health Economics. Second
Edition. McGraw-Hill
» Geniblazo, A. (2010) Introduction to Health Economics. National Book Store
» Witter, S., et.al. (2000) Health Economics for Developing Countries. Kit Publishers