Key Terms

ECO 332 Week 12 Precept
Fernanda Sobrino
Princeton
May 2017
Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 1 / 56

Outline
Key concepts and definitions.

Exercises.

General Econ concepts
1 Moral hazard: moral hazard occurs when one person takes more risk
because someone else bears the cost of those risks.
2 Information asymmetries: one party has more or better information
than the other.
3 Agency problem: conflict of interest inherent in any relationship
where one party is expected to act in anothers best interests.
4 Externalities: a side effect or consequence of an industrial or
commercial activity that affects the parties without being reflected in
the cost of the good or services involved.
5 Vertical integration: the combination of a company of two or more
stages of production normally operated by different companies.

6 Adverse Selection: a situation where sellers have some private

information that the buyers do not, or vice versa. Patients usually
have more information about their health than the insurance
companies can easily observe.
7 Capitation: the payment of a fee or grant to a doctor, school, or
other person or body providing services toa number of people, such as
the amount paid is determined by the number of patients, students,
or customers.
8 Selection bias: different types of patients or consumers tend to select
themselves into different types of services. Healthier patients may
select themselves into a different type of insurance than sicker or
riskier ones.

9 Economies of scale: when the long run average costs decline as

output increases.
10 Economies of scope: when jointly produce two or more goods more
cheaply than under separate production of the goods.
11 Public goods: a good which consumption is
Non-rival: consumption by one individual does not reduce someone
elses consumption
Non-excludable: a consumer cannot be excluded from consuming the
good either by having to pay or through some other mechanism.

12 Market power: the ability of a firm to raise and maintain price above
the level that would prevail under competition.
13 Market discipline: market based promotion of the transparency and
disclosure of the risks associated with business or entity.
14 Market segmentation: the process of dividing a market into potential
customers into groups or segments, based on different characteristics.
15 Take-up: become interested in a program.

16 Crowd out: rises in public sector spending drive down or even

eliminate private sector spending.
17 Monopoly power: degree of price setting power held by a supplier on
the bases of its market share.
18 Merit goods: commodities thought to be good for someone regardless
of the persons own preferences.
19 Incomplete markets: consumers would be willing to pay for a good
that the market is not providing. Insurance markets are usually
incomplete.

Managed Care
1 Free-for-service (FFS): doctors and other health providers are paid for
each service performed.
Popular before 1990
Pros: doctors and patients have more autonomy.
Cons: asymmetric information, agency problems, moral
hazard,increasing costs.

Managed Care
2 Managed Care (MC): range of activities, organizational structures,

and financial incentives designed to better integrate health insurance
and health care delivery.
organized as a network (insurers, payment mechanisms, physicians and
hospitals) and vertical integrated.
utilization review
quality assurance
monitoring
selective contracting
Gatekeeper
Doctors payment: capitation.

Managed Care
3 Health Maintenance Organizations (HMOs): subscribers pay a

predetermined fee in return for a range of medical services from
physicians and healthcare workers registered with the organization.
(gatekeeper)
4 Preferred Provider Organization (PPO): is a managed care
organization of medical doctors, hospitals, and other health care
providers who have agreed with an insurer or a third-party
administrator to provide health care at reduced rates to the insurers
or administrators clients.
insurer can choose between use in network providers (low pay) or use
outside providers (high pay). More flexible than HMO.

Managed Care
5 Point of service (POS): hybrid between HMO and PPO.Two tier

coverage plus gatekeeper.
6 High Deductible Health Plan(HDHP): low monthly premium but high
deductible. Form of catastrophic coverage.
7 Contracts with physicians: HMO and POS use capitation, PPO rarely
involve capitation.
8 Contracts with hospitals: HMO and POS just contract a subset of
providers. The type of contract with a hospital depends on:
plan characteristics
hospital characteristics
market characteristics.

Managed Care
9 Problems with MCO.

Dumping: refusing to treat less healthy patients who might use services
in excess of their premiums.
Creaming: seeking to attract more healthy patients who will use
services costing less than their premiums.
Skimping: providing less than optimal quantity of services for any given
condition.
Poor quality
10 Managed care practices vs FFS.
11 Health externality model of HMO: social marginal benefit and private
marginal benefit will be different generating a shortage of HMO
supply compared with the optimal one. Positive externality.

Managed Care
12 Adverse selection in HMO and FFS: sicker consumers will self select
towards FFS care and healthier patients toward HMOs.
13 Selection bias in health care: people with different characteristics will
choose different health plans. FFS vs MC.
14 The impacts of competition in the Health care market: the impact of
HMOs/PPOs on hospitals and insurance markets. Plus their impact
on technology adoption.
15 The managed care backlash: public anxiety.

Non Profit
1 Non-profit: no one has a legal claim on the profits.
They are exempt for corporate income taxes and often from property
and sales taxes
donations receive favorable tax treatment.
cannot sell stock or distribute profits to owners.
2 Externalities: example of positive externality vaccination. Free
markets tend to underproduce goods that generate positive
externalities.
3 Donations are considered public goods. There are free riders and the
market provides too little of them.
4 Contract failures: when enforcement is costly non profits can help
solve the asymmetric information problem between donors and firms
delivering donations.

Non Profit
5 Models of non profit hospitals:

Quality-quantity non profit theory: hospital preferences are defined over
quantity and quality of output.The hospital decision makers have
altruistically internalized the community benefit. Hospitals select a
combination of quantity and quality that maximizes utility.
The profit deviating Non profit hospital: hospital maximizes their
profits, non profit hospitals have additional income from donations.
Theres entry and exit of profit deviating hospitals. Then the entry
threshold for non profits is lower than that of for profit hospitals. The
two types coexist when there is scarcity of entrepreneurs with profit
deviating preferences.

Non Profit
Hospital as Physicians Cooperative: hospitals are controlled by

physicians and they maximize their incomes. The maximization of net
revenue per physicians give us the optimal staff size which is usually
smaller than the social optimum under free physician entry.

Hospital and long term care
1 Types of hospitals: 4 types.

Length of stay (short or long)
Type (community, teaching, mental,etc.)
Ownership(private for profit or public non profit)
Size (number of beds)
2 Type of care provided by hospitals:
Primary care: preventive and curative care received by patients that are
not hospitalized.
Secondary care: consisting in most common surgical and medical
procedures.
Tertiary care: consist of the most complex procedures such as organ
transplant and open heart procedures.

3 Outpatient care decrease:

technological change
insurance companies change the way they compensate hospitals, from
FFS to the DRG (diagnosis related groups) system.
4 Cost increases in hospitals are driven by increases in cost per day and
cost per admission and the shift to outpatient services = high
fixed costs.
5 Medical arms race (MAR): encourage by hospital competition.
Hospitals compete for doctors affiliations and for patients by offering
specialized high tech services. This duplicates expensive capital.

6 Hospital Cost Shifting: hospitals provide substantial amounts of

uncompensated care. The hospital decision for private and Medicare
patients are usually unconnected. The hospital is a monopoly in the
private sector and in the public one takes as many patients as it can
without losing revenue. (this is from the model).
7 Hospital quality:
The availability of high tech units and services
In terms of hospital mortality and error rate, readmission rates, and the
rates at which hospital meets established treatment processes and
protocols.

8 Nursing homes: big trend, increase in long term care

Demographic shift
Relationship between type of ownership and quality: ambiguous.
problems with financing long term care (LTC).
Alternatives to nursing home care: hospice, home health and informal
care.

The government in the Health care market
1 Economic rationale for government intervention in the health sector:

Monopoly power
Public goods (information and redistribution)
Externalities.
Merit goods
Incomplete markets

The government in the Health care market
2 Forms of government intervention

Commodity taxes and subsidies.
Public provision
Transfer programs
Regulation

Social insurance in the US
1 Social insurance programs: government sponsored programs that have

clear elegibility criteria, are funded by tazes and/or subsidized
premiums paid by participants, serve a defined population and
participation is either compulsory or heavily subsidized.
Types:
Poverty
Old age
Disability
Health
Unemployment

2 History of social insurance (European beginnings, universal service)

3 The American model: lacks universal guaranteed insurance for all
citizens. Most americans find insurance coverage through:
employer-based insurance, Medicare and Medicaid.
Private health insurance markets
Partial universal health insurance
Private health care provision

Medicare
1 Eligibility: citizens who worked and payroll taxes for 10 years, who are
retired, 65 years or more and some disable under 65.
2 Part A: hospitalization, long term care, financed from payroll taxes.
Also called Hospital Insurance (HI)
3 Part B: physicians, outpatient hospital expenditures, financed from
enrollee premiums and general tax revenues. Supplementary Medical
Insurance (SMI).
4 Part C: created in 1997 provides an option for Medicare enrollees to
receive their health insurance from a private plan, rather than through
parts A and B.
5 Part D: prescription drug expenditures, financed from enrollee
premiums and general revenues.

Medicare
6 Medicare coverage gap: the coverage gap begins after you and your
drug plan have spent a certain amount for covered drugs. (donut
hole)
7 Medicare is paid fro through 2 trust fund accounts held by the US
treasury. Hospital Insurance (HI) trust fund and supplementary
medical insurance (SMI)trust fund.
8 Parts A and B beneficiaries are responsible for charges not covered by
Medicare and for various cost sharing features of the plan. These
liabilities may be paid by: the beneficiary, a third party or Medicaid.

Medicare
6 Cost controls and moral hazard mitigation

Cost sharing (deductibles and copayments)
Private supplemental insurance Medigap.
Protective Payment System (PPS) based on Diagnosis Related Group
(DRG)

Medicaid
1 Medicaid: public insurance program that provides highly subsidized

insurance coverage to low income families who have no insurance.
2 Finances jointly by the states and the federal government. Federal
government fraction of costs is inversely proportional to state income.
3 Minimal eligibility; based on income and family structure.
4 All 18 year old are eligible for Medicaid up to 100% of the poverty
line.
5 Children 6 and pregnant women up to 138% of the poverty line.

Medicaid
6 Service coverage: minimal doesnt cover optionals such as prescription

drugs and vision/dental plans, but most states do include does.
7 Providers get paid different rates relative to the private sector in
different states.
8 Take up: targeting is difficult and imperfect.
Impediments to program take up: stigma, information costs.
9 Crowd out: people previously insured by other means switching to the
public insurance.
10 Medicaid-Medicare relationship: they work jointly for many
beneficiaries.

Medicaid
11 Effects of Medicaid
increase in eligibility leads to increase in coverage by increase in take
up for previously uninsured who become eligible, and from crowd out
from previously privately insured who switched to Medicaid.
12 Childrens Health Insurance Program (SCHIP): expanding health
insurance to children whose families earn too much money to be
eligible for Medicaid, but not enough money to purchase private
insurance.

1 Prior to passage of the ACA: 50 million uninsured, unsustainable cost

growth, adverse selection in insurance markets, lack of access to
insurance for many, lack of quality and affordable insurance plans.
2 Health care reform: the patient protection and affordable care act
(PPACA) signed into law on March 23, 2010.
3 Changes from PPACA: expanded health insurance coverage, control
rising costs, improve health care delivery system.

4 ACAs three legged stool

Insurance reforms to make system fairer: bans insurance companies
from discriminating against the sick, spread risk and charges common
premiums.
All in: individual mandate. Requirement to purchase health insurance
Affordability: expand Medicaid for those up to 138% Federal poverty
Level. Sliding scale subsidies 138% to 400% of poverty to help make
private insurance affordable.

5 ACA Expanded Coverage

Health insurance exchanges offer a marketplace for individuals and
small business to compare policies and premiums
Medicaid eligibility expanded to include all individuals and families with
incomes up to 133% of the Federal poverty level (FPL)
Requirement to purchase insurance, coupled with insurance reforms
and tax credits for families with incomes up to 400% FPL and cost
sharing reductions for those under 200% FPL.
Simplified Eligibility and enrollment: no wrong door. Open enrollment
period each year.

6 Medicaid expansion
31 states + DC expanding Medicaid. Recently states expanding
Medicaid using an alternative to traditional expansion. States see
opportunity (and leverage) to innovate using waivers
Several considering expansion
Sticking points: work requirements and consumer contributions.

7 Failure of the American Health Care Act

constrained by budget reconciliation rules
Keep most popular provisions of ACA: coverage for those < 26, no
discrimination based on pre existing conditions
Cut subsidies and replace income based tax subsidies with based tax
subsidies
Allow seniors to be charge more
Cut and transform Medicaid program
Eliminate essential health benefits
Freedom Caucus and moderates opposed.

Early Childhood and later in life well being
7 The first few years of life are particularly important because vital
development occurs in all domains of brain formation. Small
perturbations in these processes can have long term effect on the
brains structural and functional capacity.
8 Fetal origins hypothesis: stimulus or insults during fetal development
has significant impacts on the development health and wellbeing
outcomes for an individual ranging from infancy to adulthood.
9 Baker 1997: used medical records to investigate the association
between birth weight and subsequent adult health outcomes.
Incidence of coronary heart disease falls twofold when birth weight
goes from < 5.5 lbs to 9.5 lbs. Impaired glucose tolerance, diabetes
and insulin resistance are 3 times less likely for normal weight births.

7 Strengths and weaknesses of Bakers work

lower birth weight is generally more common among poor and
undernourished mothers
Correlation are strong but casual pathways remain highly disputed
Low birthweight are weak indicators of fetal nutrition
8 Glukman and Hanson: not restricted to fetal period, includes
preconception, fetal and post natal periods. It is also related to health
promotion and disease prevention.

9 Grossman 1972 human capital formation model

10 Cunha and Heckman (2007): model of Technology of skill formation.
Skills are multidimensional. t = (tC , tS , tH ). Skill gaps among
individuals and across socioeconomic groups open up at early ages
and persist.
11 Returns to investment in early years are higher than returns to
education later in life.

12 Contributions from fetal/developmental origins: improved

identification strategies, analysis of non-health outcomes,
consideration of relatively mild and more varied prenatal exposures.
13 Identification strategies: use natural experiment designs and the
differences in differences.
14 Cohorts potentially affected by a particular shock in utero can be
compared to cohorts born just before or just after the shock. The
fetal origins hypothesis offers the prediction that later-life health
outcomes should be worse only for those cohorts whose pregnancies
overlapped with the shock. Exploit cohort variation as well as
geographic variation.

15 Almond 2006: use 1918 influenza pandemic to test if exposure to

influenza in the utero has any lasting effects on later outcomes.
Cohort and geographic variation. Findings: children born to mothers
exposed to the influenza were about 20 percent more likely to be
disabled. Children born to mothers exposed to the influenza
experienced wage decreases of 5 percent or more. Children born to
mothers exposed to the influenza experienced a reduction in schooling
by 2.2%
16 The Dutch Hunger winter famine. Findings: decrease in maternal
weight during pregnancy, decrease in birth weight for those exposed
to the famine in the third trimester of pregnancy. Increase in
prevalence of overweight at 19 years, life expectancy at age 50 is 3.1
years shorter.

Economics of mental health
1 Metal health problems are a major source of disability and economic

loss.
2 Differences between non cognitive and cognitive skills
3 Measurement issues
4 Importance of mental health in inter generational transmission of
health and socioeconomic status

Exercises
1 Assume a hospital has a demand curve given by P = 403 5Q and

that the total cost curve is given by TC = 125 + 3Q
Write down MR and MC.
What will be the optimal P and Q? What will be their total revenue
and the profit?
Shade in and indicate on the graph the areas that represent the total
revenue and the total variable cost at these optimal P and Q.

Exercises
dTR
TR = PQ = (403 5Q)Q, then MR = dQ = 403 10Q ,
TC = 125 + 3Q, then MC = dTC
dQ = 3
Optimal P and Q, MR = MC 403 10Q = 3 = Q = 40

and P = 203
TR = PQ = (203) 40 = 8120 and
= TR TC = 8120 125 3(40) = 7875

Exercises

Exercises
2 Frank is deciding between getting an HMO or a FFS health plan. The

average client spend for treatment in each of the two plans are
sF = $4200 and sH = $2900, Efficiency is given by = .75 and the
coinsurance rate in both plans is 20%
1 Set up this problem graphically, labelling the E and V curves
2 If Frank expects to spend $1550 on care, will he choose an HMO or a
FFS plan? Why?
3 At which values of s would the client expect to be indifferent between
an HMO and a FFS plan? Why?
4 How would your answers to parts (b) and (c) change if the efficiency
parameter goes up to 1.
5 How would your answers to part (b) and (c) change if the coinsurance
rate decrease to 7%.

Exercises
The extra cost of the FFS plan is defined as E =FFS

deductible-HMO payment+FFS copay
sF
= [(1r ) sH ]+rs = [(1.2)4200.75(2900)]+.2s = 1185+.2s.
Which implies that s = 1481.25
Like 1550 > 1481.25 Frank will prefer the FFS health plan.
Frank is indifferent when s = 1481.25
E2 = [(1 .2)4200 2900)] + .2s = 460 + .2s, then s2 = 575 which
means Frank will buy the FFS.
E3 = [(1 .07)4200 .75(2900)] + .07s = 1731 + .07s, then
s3 = 1861.29 which means Frank will buy the HMO.

Exercises

Exercises
3 Consider an HMO in a monopolistic market with a demand curve

Q = 350 5P, suppose that its marginal an average costs were $25.
1 If the firms maximize profits determine its price, output and profits.
2 If the firm must act as a perfect competitor, in the long run what will
happen to equilibrium price and output?
3 What is the welfare loss of monopoly? Show in a graph.

Exercises
MR = 70 25 Q and MC = 25 then MR = MC = Q = 112.5 and

P = 47.5
In perfect competition P = 25 which mens Q = 225
The welfare loss is given by
DWL = (225 112.5)(47.5 25)/2 = 1265.625

Exercises

Exercises
4 Assume the Net average revenue of a physician cooperative is given

by Y = 40M M 2 and that the supply curve of physicians is given by
x = 100
1 Whats the optimal number of physicians if they want to maximize the
income of the cooperative?
2 Whats the optimal number of physicians if the hospital has an open
staff policy?
3 How would your answer for (a) and (b) change if the supply is now
given by x = 250
4 How would your answer for (a) and (b) change if the supply is now
given by x = 400
5 Show your results in a graph.

Exercises
we need to max Y = 40M M 2 which means

Y 0 = 40 2M = 0 M = 20
The number of physicians in an open staff policy is such that
40M M 2 = 100 M = 37.32
M = 20 and M2 = 32.24
M = 20 = M3

Exercises

Exercises
5 Assume the private marginal benefit of tuberculosis control is given by

pMB = 35 3Q and that the social marginal benefit is
sMB = 38 3Q and let marginal cost MC = 8
1 What is the free market equilibrium and price?
2 What is the social optimal?
3 What happen if the government gives a subsidy of s = 3 for each unit
of tb treatment, whats the new equilibrium?
4 How costly is this policy for the government?

Exercises
qp = 9
qs = 10
q = 10
C = 3 10 = 30

Exercises

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ECO 332 Week 12 Precept

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 1 / 56

Key concepts and definitions.

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 2 / 56

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 3 / 56

6 Adverse Selection: a situation where sellers have some private

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 4 / 56

9 Economies of scale: when the long run average costs decline as

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 5 / 56

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 6 / 56

16 Crowd out: rises in public sector spending drive down or even

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 7 / 56

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 8 / 56

2 Managed Care (MC): range of activities, organizational structures,

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 9 / 56

3 Health Maintenance Organizations (HMOs): subscribers pay a

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 10 / 56

5 Point of service (POS): hybrid between HMO and PPO.Two tier

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 11 / 56

9 Problems with MCO.

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 12 / 56

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Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 14 / 56

5 Models of non profit hospitals:

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 15 / 56

Hospital as Physicians Cooperative: hospitals are controlled by

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 16 / 56

1 Types of hospitals: 4 types.

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 17 / 56

3 Outpatient care decrease:

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 18 / 56

6 Hospital Cost Shifting: hospitals provide substantial amounts of

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 19 / 56

8 Nursing homes: big trend, increase in long term care

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 20 / 56

1 Economic rationale for government intervention in the health sector:

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 21 / 56

2 Forms of government intervention

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 22 / 56

1 Social insurance programs: government sponsored programs that have

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 23 / 56

2 History of social insurance (European beginnings, universal service)

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 24 / 56

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 25 / 56

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 26 / 56

6 Cost controls and moral hazard mitigation

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 27 / 56

1 Medicaid: public insurance program that provides highly subsidized

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 28 / 56

6 Service coverage: minimal doesnt cover optionals such as prescription

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 29 / 56

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 30 / 56

1 Prior to passage of the ACA: 50 million uninsured, unsustainable cost

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 31 / 56

4 ACAs three legged stool

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 32 / 56

5 ACA Expanded Coverage

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Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 34 / 56

7 Failure of the American Health Care Act

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Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 36 / 56

7 Strengths and weaknesses of Bakers work

Fernanda Sobrino (Princeton) ECO 332 Week 12 Precept May 2017 37 / 56