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Academic year: 2022



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Sponsored by a Grant TÁMOP-4.1.2-08/2/A/KMR-2009-0041 Course Material Developed by Department of Economics,

Faculty of Social Sciences, Eötvös Loránd University Budapest (ELTE) Department of Economics, Eötvös Loránd University Budapest

Institute of Economics, Hungarian Academy of Sciences Balassi Kiadó, Budapest



Authors: Éva Orosz, Zoltán Kaló and Balázs Nagy Supervised by Éva Orosz

June 2011

Week 2

Markets and market failure in health care and health insurance

Author: Éva Orosz Supervised by Éva Orosz


• Characteristics of markets for health care

• Market failure in health insurance

• Market failure in health service provision

• Professional monopoly and information asymmetry

• Concepts of the role of the government and markets in health systems



Main characteristics of health and health systems

• Good health is intrinsically valued in all societies.

– Ethical notion of fairness: equity in health and equal access to health care

• Health care as a good differs from other essential goods and services.

– Uncertainty

– the likelihood of illness

– the incurring of health expenses – Asymmetry of information

– between physician and patient

– buyers and sellers of health insurance – Externalities

– Hospitals may operate as ”natural monopolies”

Basic assumptions for perfect markets

• Certainty (consumers can calculate their demand)

• No limits to entry / exit from the market

• Sufficient number of suppliers for genuine competition (therefore, prevent collusion)

• Perfect knowledge (information) on the part of consumer

• Consumers act free of self-interested advice from suppliers

• No externalities



Characteristics of markets for health care:


• Demand (illness) is unpredictable for the individual (future health status is uncertain)

• Risk of the death or long-term disability

• The product (health care) cannot be tested before use

• Uncertainty about the effectiveness of medical therapies (only part of them are evidence-based)

– Great variety of medical practice in the treatment of the same conditions – Consequences: health-gain (welfare) loss

Characteristics of markets for health care:

asymmetry of information

• The doctor has more knowledge (than the consumer) of the technical relationship between health care and improvements in health.

• Lack of ability of consumers to judge what types, amounts and qualities of health care to consume

– Limited possibility for the consumer to gain knowledge through experience

• The doctor acts as an ‘agent’ for the patient (principal – agent relationships).

– The doctor can influence with his advice the patient’s demand (has the power to induce demand for his own services).



Asymmetry of information (cont.)

• Mistakes being made by the consumer can be serious and unredeemable (even fatal) – there is a need for standards and control over conduct in health care.

• Licensure: requirement of minimum qualification for permission to practice (limits to enter the market).

• This gives some degree of market power to doctors holding licences (professional monopoly).

Asymmetry of information – supplier- induced demand

• Asymmetry of information between the doctor and the patient – the doctor has an agent role

• Supplier induced demand (IVa, IVb)

• Effectiveness – whether the treatment resulted in an improvement in the patient’s health status (“(A)” in the table)

• Efficiency of the ‘agent’ role – whether the patient made the same decision if he had the same knowledge as the doctor has? (“(B)” in the table)

(A) Yes (A) No

Neutral effect on health Adverse effect on health

(B) Yes I IIIa IIIb

(B) No II IVa IVb



Characteristics of the health insurance markets

Key differences between health insurance and insurance for nonhuman assets (such as homes, vehicles)

• Insurance for nonhuman assets: the value of the assets, therefore the costs of insurance is usually related to income.

• Medical care allows for preventive maintenance and for repair, but not for complete replacement of the damaged capital.

• Insurance for nonhuman assets protect against the loss of the asset but not paying for its upkeep.

• Risks are harder to estimate for health insurance (inherently much greater complexity).

Market failures in health insurance

• Uncertain and unpredictable demand for health care – results in insurance

• Asymmetry of information between the buyers and sellers of insurance

• Market failures in health insurance:

– Moral hazard – Adverse selection

– Diseconomies of small scale



Moral hazard

• Cause: the ‘third-party payer’ (insurer) pays for the health service (No market price signal for the consumer at the point of consumption)

• Consumer’s moral hazard

– The financial incentive to adopt healthier life lifestyle is diminishing – Incentives to over-consume

• Provider’s moral hazard (lack of price-competition in attracting consumers) – Lack of cost-consciousness

– Incentives to oversupply (in particular, under fee-for-service payment methods)

Consequences: the incentives to oversupply (generated by the asymmetry of information) can be aggravated by the system of ‘third-party payer’

Effect of insurance on demand of health care

Source: (Donaldson, 2004), p. 36



Adverse selection

The theoretical model: Due to asymmetry of information, the insurer applies the same insurance premium reflecting the average risk level (community rating) → the lower than average risk drops out the insurance → to cover the projected health care costs of the population remaining insured must rise → (and so on) → the best risks are selected out of the insurance.

• Market response: experience rating (based on the health risks)

• Government response: making the insurance compulsory

Characteristics of private health insurance market

Unregulated private health insurance market: experience-rating; exclusion of pre- existing conditions from the insurance; insurance companies can deny high risks individuals.


• High-risk individuals (the elderly, the poor, the chronically ill) are underinsured or even are not able to buy insurance policies.

• Low-risk individuals tend to be underinsured or be ”free-rider”.

• Insurance companies compete for good-risks (”cream-screaming”).

• High administrative costs (high share of insurance fees are not spent on health care).



Diseconomies of small scale

• Economies of scale: the relationship between fixed cost and output. Distribution of fixed cost across products in a bigger organisation results in smaller unit costs (up to a certain level of output).

• Health insurance markets with several competing insurance companies result in high marketing and administration costs (high share of these costs in health spending).


”Spillovers” from other people’s production or consumption which affect an individual (in a negative or positive way), but are out of the individual’s control.

In case of externalities, the level of production is below or above of the optimal.

Positive externalities in health care:

• vaccination: others’ consumption reduce the risks of the individual,

• ”caring externalities”: an altruistic type of benefit may arise from knowing that others have access to needed health care.

Concepts of the role of the government and markets in health systems

• Government intervention due to market failure

Due to extensive market failures, government intervention can result in greater benefits (health-gain) to the community than could be achieved by an


10 unregulated market (with minimal government regulation).

• Government failure

• ”Quasi-market” (market incentives under a publicly financed system)

”Quasi-market” in health care

• Split of the roles of purchaser and provider

• The consumer and payer are usually not the same actor.

• The government (or compulsory insurance) act as the purchaser of health care.

• Public providers with monopoly position are replaced by competing providers. (The providers can be for-profit, non-profit and public organisations.)

• Providers are competing for financial resources (money follows the patient). In contrast to traditional public systems with input-based allocation of financial resources.


• Barr, N.(2009) A jóléti állam gazdaságtana (Economics of the Welfare State).

Akadémiai Kiadó, Budapest (12. Egészség és Egészségügy)

• Donaldson, C. et al (2004) Economics of health care financing: the visible hand.

2nd edition, Basingstoke, UK, Palgrave Macmillan

• Orosz É.: Félúton vagy tévúton? Egészségügyünk félmúltja és az egészségpolitika alternatívái. Budapest, 2001. Egészséges Magyarországért Egyesület. (1.3. Az állam és a piac szerepe az egészségügyben)

• http://egk.tatk.elte.hu/index.php?option=com_content&task=view&id=17&Itemid=42



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