Order Code RL33759
Health Care and Markets
Updated January 5, 2007
D. Andrew Austin
Analyst in Public Economics
Government and Finance Division

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Health Care and Markets
Summary
Health care spending is one of the most rapidly growing portions of the federal
budget. Projections suggest if the rapid growth in health care costs is not curtailed,
governments at all levels will face an uncomfortable choice between significant cuts
in other spending priorities or major tax increases. This report examines the
economic justification for government intervention and involvement in health care
markets.
Many analysts claim market-oriented policies, in certain instances, could lower
costs and enhance efficiency in health care. This report discusses the Invisible Hand
Theorem, which states that when certain assumptions hold, market outcomes will be
efficient. These assumptions require that no one has an informational advantage over
another, that no spillover effects exist in consumption or production, that no one
exerts market power, and that no scale economies exist in production.
Many characteristics of health care markets fail to satisfy the assumptions of the
Invisible Hand Theorem. Moreover, fundamental characteristics of health care (such
as informational asymmetries between patients and health care professionals and
between payers and providers, as well as ethical and distributional concerns)
complicate efforts to expand the use of market or market-like incentives in health
care.
Rising health care costs in part reflect the cost of technological advances, whose
benefits exceed their costs, and the aging of the U.S. population. The growing role
of third-party reimbursement over the past half century weakened incentives to
minimize costs and thus has also led to higher health care costs. Many analysts have
called for initiatives which would improve the functioning of health care markets,
such as improving consumer information and allowing greater use of bargaining.
These initiatives may help reduce or slow the growth of health care costs, but may
also have unintended negative consequences. Greater use of market-like incentives
can improve the efficiency of the health care system, but only if they take into
account the special characteristics of health care.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
International Comparisons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Health Care Costs and Public Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Market Failure and Health Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Externalities and Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Informational Advantages and Market Failure . . . . . . . . . . . . . . . . . . . . . . . 7
The Principal-Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Adverse Selection and Splintering of Risk Pools . . . . . . . . . . . . . . . . . 8
Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Pressures on the Employer-Provided Health Insurance . . . . . . . . . . . . 14
Changing Incentives for Technological Innovation . . . . . . . . . . . . . . . 16
Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Efficiency and Redistribution in Health Care . . . . . . . . . . . . . . . . . . . . . . . 18
The Federal Budget and Market-Oriented Health Care Reform . . . . . . . . . . . . . 19
Improve Health Consumer Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Information on Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Information on Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Make Extras Cost Extra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Expand Use of Information Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Concluding Thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

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Health Care and Markets
Introduction
Many analysts, policy makers, and politicians argue that the U.S. health care
system would perform better if market or market-like institutions played a larger role.
This view is based on the belief held by economists that markets generally work most
efficiently when left alone, provided that certain conditions are met. These
conditions essentially state that consumption or production by one person does not
affect others, that no one has a privileged position in the market, and that property
rights are well-defined. If those conditions are violated, however, markets may
function inefficiently, which is what economists call “market failure.” Government
intervention may enhance economic efficiency, although in other cases government
action may exacerbate market failure. The special characteristics of health care often
lead to market failures. The extent of government activity vis-a-vis the health system
is seen by many economists and health care analysts as a policy response to the
inequalities and inefficiencies associated with such market failures.
Health care professionals often view a market orientation as a threat to their
traditions, ethics, and culture. A bottom-line mentality, they argue, cannot deliver
the same high quality of care as the so-called traditional approach based on
professional ethics and responsibilities. Critics such as Arnold Relman, editor
emeritus of the New England Journal of Medicine, denounce the “medical-industrial
complex” for its dedication to profitability rather than patient well-being.1
Nevertheless, health care institutions have always cared both about profits and
patients. As one historian noted, “in many respects [hospitals] have behaved as
businesses. But, ... hospitals have simultaneously carried symbolic and social
significance as embodiments of American hopes and ideals.”2
Even if some view market forces and the use of the price system to allocate
health care services as an intrusion, consumers and providers of health care are
strongly affected by economic incentives. Hospitals cut the average length of an
inpatient stay sharply after Medicare switched from cost-based reimbursement to
paying a flat diagnosis-related fee.3 Physicians increased the volume (i.e., number
of patient visits) and intensity of patient care (i.e., number or complexity of services
1 Arnold S. Relman, “The New Medical-Industrial Complex,” New England Journal of
Medicine, vol. 303 (Oct. 1980), pp. 963-970.
2 Rosemary Stevens, In Sickness and Wealth, (New York: Basic Books, 1989), p. 6.
3 Louise B. Russell, Medicare’s New Hospital Payment System: Is It Working?
(Washington, DC: Brookings, 1989), pp. 25-46,

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provided in an average visit) seen after reductions in Medicare Part B payments.4
Consumers use less health care when they must pay a larger share of the cost. These
behavioral responses, although predicted by economic theory, do not necessarily
enhance economic efficiency. The challenge for those who wish to expand the use
of market incentives in health care is to design policies that align material incentives
facing consumers and providers of health care so that changes in behavior enhance
economic efficiency.
Both friends and foes of the expanding role of markets have sometimes relied
on crude ideas about what markets can or cannot accomplish. This report explains
what well-grounded economic theory has to say about the limits and capabilities of
the market in the health care sector. These limits and capabilities then outline what
the government can or cannot do to improve the health care system’s performance.
The report provides an overview of efforts to expand the use of market or market-like
institutions in health care and considers effects of these initiatives or proposals on the
federal budget. Reforms that are designed to address sources of market failure have
better chances of enhancing economic performance than those that are not.
Nonetheless, improving the performance and efficiency of the health system presents
significant policy and political challenges even to well-designed reforms.
The U.S. Health Care System
The U.S. health care system is a complex mixture of public and private
providers of care, paid for by a mixture of public and private payers, staffed by
dozens of health professionals working in clinics, hospitals, nursing homes, private
offices, health maintenance organizations, work sites, and home settings, among
other venues. This patchwork system provides patients with a broad set of
alternatives; gives health professionals in general, and physicians in particular, a
substantial degree of autonomy; and assigns separate, if often overlapping,
responsibilities among various levels of government. The complexity of the U.S.
health system, which gives it considerable flexibility, is also one of the principal
causes of its inefficiencies. Dissatisfaction with the performance of the U.S. health
care system has spurred interest in using market or market-like institutions to
generate better results and lower costs.
International Comparisons
While the U.S. is a leader in areas of medical technology, outcomes for several
key public health indicators, such as average longevity and infant mortality, are
among the bottom quarter of the 30 advanced industrial countries that comprise the
4 Centers for Medicare and Medicaid Services, “Physician Volume and Intensity Response,”
memorandum from Volume-and-Intensity Response Team, Office of the Actuary, HCFA,
to Richard S. Foster, Chief Actuary, August 13, 1998; available at [http://www.cms.hhs.gov/
ActuarialStudies/downloads/PhysicianResponse.pdf.]

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Organization for Economic Cooperation and Development (OECD).5 Comparisons
of specific conditions or procedures find the U.S. health system does better in some
areas and worse in others. An OECD study of ischemic heart care found that the
United States used more intensive procedures and had lower mortality rates for older
patients, but had higher mortality rates for younger (40-64) patients compared to
other OECD countries.6 Another study used data from Australia, Canada, England,
New Zealand, and the United States to compare quality. Twenty-one quality of care
indicators were selected on the basis of comparability and importance. These
researchers found that each country was best on at least one indicator and worst on
at least one indicator. Among these five countries, the United States did worst on
kidney transplant survival rates, second worst on liver transplants, and worst on
incidence of Hepatitis B, but did best for breast cancer survival, incidence of measles,
and the cervical cancer screening rate.7
The United States spends far more on health care by any measure than any other
country in the world.8 National health expenditures per capita reached $7,256 in
2006.9 One of every six dollars spent in the United States is spent on health care.
That proportion is projected to rise to one in five by 2015.10 In 2004, U.S. health
care spending was $6,102 per person, about a third higher than Switzerland, which
had the second highest level of spending at $4,077 per person.11 This spending is not
due either to differences in the proportion of population aged over 65 or higher direct
costs of malpractice claims.12
While the United States spends more on health care than other countries, fewer
health care resources per capita are available compared to many other advanced
5 Uwe E. Reinhardt, Peter S. Hussey, and Gerard F. Anderson, “Cross-national Comparisons
of Health Systems Using OECD Data, 1999,” Health Affairs, vol. 21, no. 3 (May/June
2002), pp. 169-181.
6 Pierre Moise, Stéphane Jacobzone, et al., OECD Study of Cross-national Differences in
the Treatment, Costs and Outcomes of Ischaemic Heart Disease, (Paris: OECD, May 2003),
p. 8.
7 Peter S. Hussey et al., “How Does The Quality Of Care Compare In Five Countries?”
Health Affairs, vol. 23, no. 3 (May/June 2004), pp. 89-99.
8 Gerard F. Anderson, Peter S. Hussey, Bianca K. Frogner and Hugh R. Waters, “Health
Spending In The United States And The Rest Of The Industrialized World,” Health Affairs,
vol. 24, no. 4 (July/Aug. 2005), pp. 903-914.
9 Population Projections Branch, U.S. Census Bureau, U.S. Interim Projections by Age, Sex,
Race, and Hispanic Origin, released May 11, 2004, and Christine Borger et al., “Health
Spending Projections Through 2015: Changes On The Horizon,” Health Affairs, vol. 25, no.
2 (2006), pp. 61-73.
10 Ibid., pp. 61-73.
11 The city-state Luxembourg, which spent $5,089 per person, is excluded. All data were
taken from the OECD Health Database, June 2006.
12 Gerard F. Anderson et al., “Health Spending In The United States And The Rest Of The
Industrialized World,” Health Affairs, 24, no. 4 (July/Aug. 2005), pp. 903-914 and Uwe E.
Reinhardt, Peter S. Hussey, and Gerard F. Anderson, “U.S. Health Care Spending In An
International Context,” Health Affairs, vol. 23, no. 3 (May/June 2004), pp. 10-25.

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nations. The number of physicians per capita in the U.S. is about two-thirds of the
OECD average, and the number of hospital beds per capita is lower than the OECD
average, so greater use of medical care cannot explain the spending difference
between the United States and other OECD countries. A 1996 McKinsey research
project found that health care providers in the United States were more efficient, in
the sense of producing more outputs for a given amount on inputs, than those in
Germany and to some extent than those in the United Kingdom. However, prices of
medical inputs and administrative costs were much higher in the United States.13
Health Care Costs and Public Spending
Health care costs take up a large and growing part of the economy and of public
budgets. The two largest health programs in the federal budget, Medicare and
Medicaid, will cost together $582 billion, or 4.5% of gross domestic product
(GDP).14 Medicare Part A costs per beneficiary grew on average 4.66% a year
between 1970 and 2005, and Part B costs grew on average 8.76% a year over the
same period.15 One Congressional Budget Office (CBO) scenario anticipates that in
2050 Medicare spending will take up 8.6% of GDP, with Medicaid taking up another
4.0% of GDP, even aside from state contributions to Medicaid.16 Medicaid is one
of the largest and fastest growing components of state spending budgets. In FY2004,
Medicaid accounted for 22.3% of total state spending, which was slightly larger than
the 21.4% spent on elementary and secondary education. The size and rapid growth
of Medicaid spending led the National Governors’ Association and the National
Association of State Budget Officers to call the program “the dominant force in state
spending.”17
Governments in general and the federal government in particular are deeply
involved in health care markets. Public spending in 2004 accounted for 45% of
national health expenditures, up from 38% in 1970. Federal spending alone was 32%
of national health expenditures, up from 24% in 1970. Furthermore, federal
involvement in health care extends well beyond spending. Health care markets are
extensively regulated, and the federal tax code affects health care markets in
important ways. In particular, the cost of the federal tax exemption for employer-
paid health insurance premiums exceeds that of any federal health program other than
13 McKinsey Global Institute, Healthcare Productivity, Oct. 1996, available at
[http://www.mckinsey.com/mgi/publications/healthcare.asp].
14 Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2007 to
2016,” Jan. 2006, p. 52 et seq.
15 Author’s calculation using data from Table V.B1, “HI and SMI Average per Beneficiary
Costs” in the 2006 Annual Report of the Boards of Trustees of the Federal Hospital
Insurance Trust Fund and the Federal Supplementary Medical Insurance Trust Fund and
GDP deflator data from the Bureau of Economic Analysis.
16 See the discussion of the intermediate spending/lower revenues scenario in the CBO
Report, The Long Term Outlook, Dec. 2005.
17 National Governors Association and the National Association of State Budget Officers,
The Fiscal Survey of States, June 2006, pp.vii and 10.

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Medicare and Medicaid. CBO estimates that limiting this exemption could increase
federal revenue by $706 billion for the 10-year period 2005-2014.18
The pace of health care costs and the expanding public role in health care have
stoked interest in using market incentives to slow or limit costs and to improve
quality of outcomes. The nature of health care, however, provides some inherent
limits to the effectiveness of the market.
Market Failure and Health Care
Economists’ belief in the efficiency of markets is based on the Invisible Hand
Theorem, which states that market outcomes are efficient, so long as certain
conditions hold.19 These conditions are:
! No externalities. An externality, or spillover effect, exists when
one’s consumption or production affects the ability of another to
consume or produce. Public goods, defined as goods which more
than a single person can enjoy at the same time, are a special type of
externality.20
! Symmetric information. Everyone knows the same things. No one
has an informational advantage over others.
! No market power. No one acts as if he can influence prices
through his actions.
! Voluntary trade. Property rights are well-defined and individuals
can refuse trades that make them worse off.21
The Invisible Hand theorem takes the distribution of buying power as given.
However, to the extent society cares about fairness or the evenness of distribution,
18 See discussion of “Revenue Option 15” in the CBO Report Budget Options, Feb. 2005.
This option would treat employer contributions for health insurance or health care above
$720 a month for families or above $310 a month for individuals as taxable income. For a
comprehensive discussion of tax benefits for health spending, see CRS Report RL33505,
Tax Benefits for Health Insurance and Expenses: Overview of Current Law and Legislation,
by Bob Lyke.
19 Among economists, the Invisible Hand Theorem is called the First Welfare Theorem. See
Gerard Debreu, Theory of Value, (New Haven: Yale, 1959), pp. 94-96 for a proof.
20 More precisely, a good is considered a pure public good if the cost of allowing one more
person to enjoy its benefits is zero. For example, a radio broadcast can be considered a pure
public good because the cost of adding one listener is zero.
21 A technical condition on consumer preferences (non-satiation) that rules out “bliss
points,” is also required. This discussion uses the assumption of symmetric information,
rather that the assumption that individuals possess perfect information used in standard
proofs. A proof of the First Welfare theorem with symmetric information requires slightly
stronger conditions on consumer tastes.

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it may wish to use taxes and transfers to alter the distribution of buying power. If
transfers and taxes could be made without economic distortions, then society could
move to another distribution of buying power, and the economy would run at full
efficiency.22 In practice, however, all taxes and transfers will cause some economic
distortions. Thus, society alters the distribution of buying power to a more “fair”
allocation, but at some cost of economic efficiency.
Externalities and Public Goods
Epidemics are a classic example of externalities. Without some form of
coordination, individuals will contribute inefficiently small amounts for the
prevention of contagious diseases. Therefore, an efficient government can improve
public well-being by imposing taxes and spending an appropriate amount on
prevention and public health.
Information gained through medical research is an example of a public good,
because the same information can benefit many people simultaneously. Individual
donations, however, would yield an inefficiently low level of support for medical
research. Charging those who benefit from better medical technology or procedures
can provide a partial solution; but, to the extent that some patients will be priced out
of the market, economic inefficiencies will persist. What economists define as public
goods are often financed by private individuals or groups. For example, privately
supported basic research is an example of a privately funded public good. Many
goods provided by governments are private goods, not public goods. Extending the
benefits of police, fire, and municipal trash collection to more people generally
requires a proportionate increase in resources, so such services would not be
considered a public good by economists.23
Redistribution of resources to the poor, according to some economists, can also
be considered a public good.24 In this view, each member of society would benefit
by the knowledge that all other members were kept from falling below some
minimum standard of living. However, the “warm glow” that each member might
feel from redistribution that ensured that minimum standard often falls short of an
intensity sufficient to induce opening of one’s own pocketbook. Compulsory
taxation provides a way to finance redistribution by sharing the cost among all
taxpayers. Many people would derive some satisfaction from knowing that a health
care system fulfilled the ethical norm that access to medical care was available
regardless of ability to pay. Supporting such a system, as a practical matter, requires
government intervention.
22 This is the Second Welfare Theorem.
23 Tom Means and Stephen Mehay, “Estimating the Publicness of Local Government
Services: Alternate Congestion Function Specifications,” Southern Economic Journal, vol.
61, no. 3 (Jan. 1995), pp. 614-627.
24 Mark V. Pauly, “Income Distribution as a Local Public Good,” Journal of Public
Economics, vol. 2 (1973), pp. 35-58.

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Informational Advantages and Market Failure
The lack of symmetric information is the source of many of the key problems in
health care. When consumers know the quality and price of goods, they can search
to find higher-quality and lower-priced goods. This puts pressure on firms to
increase quality and reduce price. When consumers cannot see prices or quality,
however, markets work less well. In general, when one party knows more than
another party, market failure can occur. Economists distinguish among several
different types of asymmetric information, which are considered as follows.25
The Principal-Agent Problem. The principal-agent problem occurs when
one person, the principal, must delegate some decision or activity to an agent, who
has special knowledge. If the principal can directly assess outcomes and effort, then
no problem exists. However, if the principal cannot observe how hard the agent
works or if the principal is unable to tell the difference between incompetence and
bad luck, then market failure can result. The interaction of a patient and a physician
is an example of principal-agent relationship. The patient goes to a physician
because the physician has special knowledge. The physician, however, faces different
incentives that are not always aligned with the patient’s best interests. For example,
the physician may be paid more by ordering a test whose costs exceed its benefit. Or
the physician may have a patient make additional visits, whose benefits fall short of
their costs.
A physician’s reputation can provide one solution to the principal-agent
problem. If a good reputation brings benefits to a physician, and if patients
occasionally get some information of whether a physician is acting in their best
interests or not, then physicians will have an incentive to avoid actions which would
damage their reputations. However, if patients rarely obtain information on whether
a physician acts in their best interest, or if the penalty of losing a good reputation is
too small, then the agents will have weak incentives to be faithful to their principal,
and the principal will use physicians less often.
Centralized tracking of physicians is another possible solution. Centralized
mechanisms, such as licensure requirements, exist to certify that physicians have
received appropriate training. The National Practitioner Data Bank (NPDB) contains
information on malpractice claims and disciplinary actions against health care
professionals. Governments, hospitals, health plans, and related organizations can
access specific records, but individuals cannot. Some consumer groups have
attempted to compile their own databases that would allow consumers to assess the
quality of different physicians. (So far, these databases are fragmentary and limited.)
Third-party monitoring can also give incentives for health care providers to
maintain and improve quality. Accreditation or certification of health care providers
gives consumers and payers a seal of approval for institutions that meet certain
25 This discussion follows Kenneth Arrow, “Uncertainty and the Welfare Economics of
Medical Care,” American Economic Review, vol. 53, no. 5 (1963). For a modern analysis
of market failure in health care markets see Peter Zweifel and Friedrich Breyer, Health
Economics, (New York: Oxford Univ. Press, 1997), ch. 5.

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standards. The National Committee on Quality Assurance (NCQA) conducts
research on managed care plans and performs accreditation audits, and the Joint
Commission on Accreditation of Healthcare Organizations (JCAHO) accredits
hospitals and related institutions.
Adverse Selection and Splintering of Risk Pools. Adverse
selection
occurs when some personal characteristics which affect health care costs are hidden
from others. Pricing of insurance contracts cannot then depend on differences in
those characteristics. If sicker and healthier persons are indistinguishable, they will
pay the same health insurance premiums. Legal or administrative measures can also
induce insurers to charge the same premiums to individuals with differing
characteristics, which is called “community rating” in the context of health insurance.
If sicker and healthier persons face the same premiums, sicker persons face stronger
incentives to enroll in insurance plans and to choose more generous health plans.
Health plans that attract a higher proportion of sicker enrollees will have higher
average costs. If health insurers are unwilling to sustain losses, higher average costs
lead to higher premiums, which gives healthier individuals incentive to purchase less
insurance relative to a situation in which adverse selection were absent.
Insurance companies in a competitive market face strong incentives to attract
low-risk customers and avoid high-risk customers, which they can do through
underwriting. Underwriting is the process of assessing levels of risk associated with
different insurance contracts and setting terms, conditions, and prices for those
contracts. Underwriting splinters the insured population into smaller and smaller risk
groups, and reduces risk sharing across a broader population. For auto and property
insurance this is standard. Adverse selection is less of a problem because insurers
can predict risk using observable characteristics of drivers and their claims history.
Pooling careful and careless drivers in effect compels careful drivers to subsidize
careless drivers. This pooling would be inefficient if such implicit subsidies caused
careless drivers to either drive more or drive less well, or if resulting increases in
premiums caused careful drivers to buy less insurance. To the extent the risk of
having auto insurance claims is associated with choices, including the choice of
whether to drive or not, underwriting raises no strong issues of fairness.
Health care is often viewed differently than other kinds of goods, and health
insurance has always worked differently than other lines of insurance. Few would
argue that anyone has a right to be a careless driver. On the other hand, differences
in health costs are often presumed to stem from factors which are beyond the control
of individuals.26 The idea that access to health care should be equal has had
enormous influence on health policy. The need to use health care is typically viewed
as a result of bad luck or genetics, rather than carelessness. To the extent that
individual demand for health care is unaffected by insurance status, the costs of
providing health care can be considered a fixed sum. In this case, the practice of
medical underwriting, which consists of offering better prices and conditions to the
healthy, rearranges the cost burden of health care but does not affect overall costs.
26 For example, few employers offer plans which charge non-smokers lower premiums than
smokers, suggesting a strong reluctance to use experience rating within groups even when
cost differences are strongly associated with behavioral choices.

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That is, while an individual insurer earns higher profits by attracting a healthier risk
pool via medical underwriting, total costs are not reduced. Because underwriting
consumes real resources, administrative costs in a system with medical underwriting
will be higher than when all risks are pooled.
Pooling dissimilar risks may be unsustainable in competitive markets. If the
proportion of sicker people in a pool is small enough and if economies of scale make
larger plans more efficient, then a mixed insurance pool will be stable. If healthier
persons remain in the same plans as sicker people, then in effect they subsidize sicker
persons. If the proportion of sicker persons is sufficiently large, however, private
insurance providers can earn a profit by introducing plans that attract a
preponderance of healthier people.27 As healthier people leave the mixed insurance
pools, average costs for remaining enrollees increase, leaving more individuals
unable to afford health insurance. This dynamic is often termed a “death spiral.”
The ability to organize large pools of diverse individuals is a central advantage
of employer-based health insurance, which has dominated the U.S. health care system
for the past half century.28 Blue Cross/Blue Shield’s adherence to the “community
rating” principle spreads risks across large, heterogenous pools, but was vulnerable
to for-profit insurers’ pricing strategies that offered lower rates for firms with
healthier employees. Some see the shift of market share from Blue Cross plans that
use community rating to for-profit insurance plans, which offer lower premiums to
healthier groups, as an example of a death spiral.29 Other researchers, however,
contend the introduction of community rating need not result in a death spiral.30
The tax exemption for employer-provided health care was a major factor in the
expansion of employee-based health insurance. While linking health insurance with
employment has advantages of low administrative costs and broad pooling of risks,
the tax exemption gives the largest subsidies to those with the most generous health
plans, and for employees with a choice of plans, encourages the choice of more
generous plans. Tying health insurance to employment, which the tax exemption
encourages, can discourage employees from switching jobs, a problem know as “job
lock.” To address this problem, the President’s Advisory Panel on Tax Reform
recommended capping this tax exemption.31
27 For a presentation of the economic theory of insurance in the presence of information
asymmetries, see Michael Rothschild and Joseph E. Stiglitz, “Equilibrium in Competitive
Insurance Markets: An Essay on the Economics of Imperfect Information,” Quarterly
Journal of Economics, vol. 90, no. 4(1976), pp. 630-49.
28 For an overview of the U.S. health insurance market, see CRS Report RL32237, Health
Insurance: A Primer, by Bernadette Fernandez.
29 Paul Starr, The Social Transformation of American Medicine, (New York: Basic, 1983),
pp. 327-331.
30 Thomas C. Buchmueller and John E. DiNardo, “Did Community Rating Induce an
Adverse Selection Death Spiral? Evidence from New York, Pennsylvania and Connecticut,”
American Economic Review, vol. 92, no. 1. (Mar. 2002), pp. 280-294.
31 President’s Advisory Panel on Tax Reform, Simple, Fair, and Pro-Growth: Proposals
(continued...)

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Organizing government-sponsored risk pools is another way to ensure that the
risks of incurring major health care costs are spread across a large population. In
single-payer systems, such as Canada’s, all eligible persons are in the same pool.
Putting all Canadians in a single pool and the ban on private health insurance
prevents any splintering of the health insurance market that could trigger a death
spiral, and ensures that the health care costs of the sickest patients are borne by the
whole population.
A more limited approach is to set up risk pools, which allow those with serious
medical problems to obtain health insurance.32 As of 2005, 33 U.S. states had set up
risk pools that offer insurance to individuals denied insurance due to an existing
medical condition. Despite subsidies from state funds, risk-pool premiums are much
more expensive than premiums paid by healthy individuals who have employer-
provided insurance.33 In 2004, state subsidies totaled more than $0.5 billion, and
premiums typically cost 125% to 150% of comparable individual market premiums.
The number of enrollees in risk pools (about 180,000 in 2004) comprises only a
small fraction of the pool of uninsured.34 Adjusting payments to plans and providers
based on characteristics of enrollees, a method Medicare uses to set rates for its HMO
capitation program, can provide incentives for private insurers to treat a pool of
patients more efficiently rather than to focus on attracting a healthier pool of patients.
If insurers were paid less for covering healthy patients and more for covering sicker
patients, insurers would have a weaker incentive to attract the healthy and avoid the
sick. So far, however, Medicare uses crude rules of thumb to set reimbursement
adjustments, which do not appear to have changed incentives facing insurers in
significant ways.
Providing people with the opportunity to extend or renew their health insurance
coverage can provide some protection against the effects of splintering risk pools.
If insurance plans are subject to frequent renewal decisions that may depend on past
claims history, then insurance becomes less of a shield against financial calamity and
more of an installment plan. Congress and several states have enacted reforms
intended to preserve enrollees’ ability to renew coverage. The Consolidated
Omnibus Budget Reconciliation Act of 1985 (COBRA, P.L. 99-272) contains
provisions which allow retirees, former employees, and dependents to pay 102% of
the full, normal premium to continue coverage. Terminated employees may obtain
COBRA coverage for 18 months, and in other circumstances COBRA benefits are
31 (...continued)
to Fix America’s Tax System: Report of the President’s Advisory Panel on Federal Tax
Reform, Nov. 2005.
32 For state-level details, see CRS Report RL31745, Health Insurance: State High Risk
Pools, by Bernadette Fernandez.
33 Mark Merlis, “Fundamentals of Underwriting in the Nongroup Health Insurance Market:
Access to Coverage and Options for Reform,” National Health Policy Forum Background
Paper, Apr. 13, 2005, pp. 19-21. A list of state risk pools is available at
[http://www.healthinsurance.org/riskpoolinfo.html].
34 Bruce Abbe, “Overview — State High Risk Health Insurance Pools Today,” available at
[http://www.selfemployedcountry.org/riskpools/overview.html].

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CRS-11
available for 36 months or longer if the employer is willing to continue coverage.
Because employers typically contribute a portion of the cost of premiums, obtaining
insurance under COBRA usually costs former employees much more than what
current employees pay for health insurance, but less than individual health insurance
plans.35 On average, employees pay 16% of premium costs for individual coverage
and 27% for family coverage.36
The Health Insurance Portability and Accountability Act of 1996 (HIPAA, P.L.
104-191), also known as the Kassebaum-Kennedy bill, restricted preexisting
condition exclusions and limited insurers’ ability to deny coverage. HIPAA also
guaranteed eligible employees’ ability to renew coverage and to carry over coverage
when changing employers, a provision intended to reduce job lock.37 HIPAA,
however, set no limits on premium increases, so insurers could discourage HIPAA-
eligible persons from enrolling by setting premiums at high levels.38
Almost all state governments have enacted reforms to to limit experience rating
of small group and nongroup health insurance. Some states also require insurers to
issue policies, and many more have extended COBRA and HIPAA provisions
regarding continuation of health insurance coverage.39
Despite various federal and state measures intended to limit experience rating
and expand health insurance coverage, many people, especially those with
preexisting conditions, have trouble finding affordable health insurance.40 The health
insurance trade association reported in 2002 that 71% of applicants were offered
standard premiums and 12% were rejected.41 A 1996 GAO study found that insurers
on average rejected 18% of applications.42
35 U.S. Dept of Labor, Employee Benefits Security Administration, “FAQs About COBRA
Continuation Health Coverage,” available at [http://www.dol.gov/ebsa/faqs/
faq_consumer_cobra.html].
36 Kaiser Family Foundation, Employer Health Benefits 2006 Annual Survey, Sept. 2006,
sec 6.
37 For an account of the passage of this bill see Brian K. Atchinson and Daniel M. Fox, “The
Politics Of The Health Insurance Portability and Accountability Act,” Health Affairs, vol.
16, no. 3 (May/June 1997).
38 Merlis, op. cit., pp. 13-14.
39 Merlis, op. cit., pp. 15-16.
40 Merlis, op. cit., pp. 10-12.
41 Thomas Musco and Thomas Wildsmith, “Individual Health Insurance: Access and
Affordability,” Health Insurance Assoc. of America Brief Analysis, Oct. 2002, available at
[http://www.heartland.org/Article.cfm?artId=15320].
42 U.S. General Accounting Office, Private Health Insurance: Millions Relying on
Individual Market Face Cost and Coverage Tradeoffs, GAO/HEHS-97-8, Nov. 1996, p.43.

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Moral Hazard. Moral hazard occurs when a person’s actions are
unobservable, so that changes in behavior cannot be observed.43 In particular, moral
hazard refers to changes in behavior that affect the risks being insured. For example,
after a person obtains health insurance she may take less care to remain healthy or
may visit her physician more often than necessary. Moral hazard in health insurance
may be limited by non-insurable costs. For instance, going to the physician takes
time, having procedures performed is painful, and neglecting one’s health can cause
problems which medical care cannot easily cure.
Copayments and deductibles are standard methods to limit moral hazard.
Efficient insurance policies, according to economic theory, require individuals to pay
for relatively small, regularly occurring expenses, such as eyeglasses and routine
dental care, but pay a major part of large, unexpected expenses. The value of
insurance is higher for rare or unusual expenses which would cause serious financial
disruption for a household. The high administrative costs of handling small claims
lowers the value of insurance for small, routine costs. Thus economic theory
suggests that if consumers are informed and rational then insurance with “doughnut”
provisions, which cover small- and high-cost claims, but which fail to cover claims
over some intermediate range, are inefficient.44 The Medicare Part D drug coverage
is one example of health insurance with a doughnut provision.
Empirical evidence shows that patients who do not pay copayments and
deductibles receive more health care. The RAND Health Insurance Experiment,
which randomly assigned families to insurance plans, found that free care encouraged
health care use. Families that paid nothing for their health care were about 10% more
likely to use medical care, and incurred about 25% more medical expenses than
families with 25% copay plans. Families with 50% and 95% copay plans were less
likely to use medical care and incurred fewer medical expenses.45 Health status for
those receiving free care was little different than health status for those in copay
plans, with two exceptions. First, people with poor vision and free care had slightly
improved vision compared to others. Second, low-income populations with free care
had fewer problems with high blood pressure. Within that high-risk group, better
control of high blood pressure appeared to lessen mortality risks.46 Another study,
using data from the Medical Outcomes Study, found that older patients with chronic
conditions who had zero or low copayments consumed more medical care than those
with high copays.47
43 Pauly, Mark V. 1974. “Overinsurance and Public Provision of Insurance: The Roles of
Moral Hazard and Adverse Selection.” Quarterly Journal of Economics vol. 88, pp. 44-62.
44 Arrow (1963), op. cit., Appendix.
45 W. G. Manning et al, “Health Insurance and the Demand for Medical Care,” American
Economic Review, vol. 77, no. 3 (June 1987).
46 R.H. Brook et al., “Does Free Health Care Improve Adults Health?” New England Journal
of Medicine, vol. 309 (1983), pp. 1426-34.
47 Mitchel D. Wong et al., “Effects of Cost Sharing on Care Seeking and Health Status:
Results from the Medical Outcomes Study,” American Journal of Public Health, vol. 91,
no.11 (Nov. 2001), pp. 1889-1894.

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Requiring families to pay a portion of their health care costs, according to the
usual theory of supply and demand, reduces demand for low-benefit care. To the
extent that costs of some types of care exceed their benefits, excluding such items is
a more efficient way to design insurance plans. Demand for health care items whose
benefits greatly exceed their costs should be affected to a lesser degree, if patient
behavior conformed to standard economic assumptions. There is mixed evidence,
however, that higher copayments have different effects on low-benefit and high-
benefit care. The RAND Health Insurance Experiment and the Medical Outcomes
Study found that higher patient copays and deductibles reduced use of low-benefit
items, but also reduced consumption of some high-benefit items as well. That
suggests demand for health care responds to monetary incentives, but that patients
often have difficulty in distinguishing high-benefit and low-benefit care, or that some
portion of the patient pool responds to monetary incentives and another portion does
not. On the other hand, a 1996 study found that requiring Kaiser-Permanente HMO
enrollees to pay $25 to $35 for emergency room visits reduced overall emergency
room visits by 15%, while the reduction in emergency room visits for conditions
classed as “always an emergency” was small and statistically insignificant.48
The extraordinary cost of a major medical intervention presents a difficult
dilemma to those who design cost-sharing provisions in health insurance plans.
While few patients incur huge charges, that small percentage of cases accounts for
a large proportion of total health care costs. On one hand, a health insurance plan has
limited value if it does not prevent a health emergency from becoming a financial
calamity. Forcing families to pay even a fraction of the costs of an expensive
medical episode could strain the finances of most families, even to the point of
bankruptcy.49 On the other hand, if insurance pays all, or nearly all, of the charges
associated with a major health episode, then patients, their families, and their
physicians have little incentive to control costs, even if the resulting benefits are
minimal.50 One study found no correlation between spending on care for terminal
patients and regional mortality rates, suggesting that either higher spending yields
little or no benefit in mortality or that data aggregated by region are too crude to
identify effects.51 Many plans have out-of-pocket limits that commit the insurer to
pay all charges above a certain level, which provides families with substantial
protection against financial calamity at the cost of eliminating monetary incentives
to avoid items or procedures with only low or speculative benefits. In some cases,
administrative and financial incentives may induce terminal patients to be treated in
48 Joe V. Selby et al., “Effect of a Copayment on Use of the Emergency Department in a
Health Maintenance Organization.” New England Journal of Medicine, vol. 334, no. 10
(Mar. 7, 1996), pp. 635-642.
49 David Himmelstein, Elizabeth Warren, Deborah Thorne, and Steffie Woolhandler, “Illness
and Injury As Contributors To Bankruptcy,” Health Affairs, vol. 24 (2005), pp. 63-73.
50 One solution that preserves the value of insurance while introducing price incentives
would be to allow families to receive cash in lieu of aggressive treatment. See Margaret M.
Byrne and Peter Thompson, “Death and Dignity: Terminal Illness and the Market for
Non-treatment,” Journal of Public Economics, vol. 76, no. 2 (May 2000), pp. 263-294.
51 J. Skinner and John E. Wennberg, “How Much is Enough? Efficiency and Medicare
Spending in the Last Six Months of Life,” National Bureau of Economic Research Working
paper 6513, 1998.

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high-cost settings, even when patients have expressed a desire to be treated in a low-
cost hospice or home setting.52
Imposing tighter controls on access to medical care by imposing gatekeeper
requirements is another way to limit moral hazard. Most managed care plans require
a primary care physician or insurance plan representative to approve hospital visits,
procedures, and specialist visits. Managed care plans substantially increased their
share of the health insurance market in the late 1980s and early 1990s, a development
driven in part by the belief that managed health care and health maintenance plans
could control costs. Some research suggested that cost growth moderated in markets
where managed care plans had larger market shares.53 Other evidence suggests that
managed care plans do not deliver lower costs.54 In the late 1990s, consumer
dissatisfaction slowed or even reversed the expansion of managed care, although
HMO and managed care plans avoided losing market share by loosening controls on
access to care and by expanding into the Medicare population.55
Pressures on the Employer-Provided Health Insurance. Employer-
based health benefits, the bulwark of the American health insurance system, is
increasingly under strain, threatening the health insurance system’s ability to spread
the financial risks associated with significant medical problems. The number of
people covered by employer-provided health insurance has been dropping since 2000,
as insurers have been willing to trade higher margins for lower enrollments. More
people are buying individual health plans, but this increase is dwarfed by the decrease
in group coverage.56 Many firms have sought to push a greater share of health cost
increases onto employees and retirees, which has become a major source of labor-
management conflict.57 Health benefits remain a standard feature of benefit packages
for nearly all businesses with more than 200 employees and for firms that tend to
employ high-wage employees.58 High-wage employees are more likely to fall within
higher marginal tax brackets, and therefore gain more from the tax exemption of
employer-provided health insurance than low-wage employees. For instance, a high-
52 Melinda Beeuwkes Buntin and Haiden Huskamp, “What Is Known About the Economics
of End-of-Life Care for Medicare Beneficiaries?” The Gerontologist, vol. 42, special issue
III (2002), pp. 40-48.
53 Jack Zwanziger and Glenn A. Melnick, “Can Managed Care Plans Control Health Care
Costs?” Health Affairs, vol. 15, no. 2 (summer 1996), pp. 185-199.
54 J. Sung, M. Wessel, S.F. Gallagher, J. Marcet, M.M. Murr. “Failure of Medicare Health
Maintenance Organizations to Control the Cost of Colon Resections in Elderly Patients,”
Archives of Surgery, vol. 139, no. 12 (Dec. 2004), pp. 1366-70.
55 M. Susan Marquis, Jeannette A. Rogowski, and José J. Escarce, “The Managed Care
Backlash: Did Consumers Vote with Their Feet?” Inquiry, vol. 41, no. 4, pp. 376 — 390.
56 James C. Robinson, “The Commercial Health Insurance Industry in an Era of Eroding
Employer Coverage,” Health Affairs, vol. 25, no. 6 (Nov.-Dec. 2006), pp. 1475-86.
57 Margaret Ann Cross, “Rising Costs Strike Unions As Being Cause for Unrest,” Managed
Care, May 2003.
58 Kaiser Family Foundation/Health Research and Educational Trust 2005 Annual Employer
Health Benefits Survey (Kaiser/HRET) available at [http://www.kff.org/insurance/
chcm091405nr.cfm].

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wage employee whose income puts her in the 35% marginal tax bracket saves 35¢
in taxes for every dollar shifted from post-tax compensation to health insurance paid
in pre-tax dollars. A low-wage employee who pays no federal income tax gains zero
tax advantage from shifting compensation to health benefits. Without some
curtailment of the employer-provided health insurance tax exemption, medium and
large businesses and firms that tend to hire high-wage individuals will continue to
offer health benefits.
Smaller businesses and firms that employ large numbers of low-wage workers,
who gain less from tax exemptions, face a stronger temptation to drop or curtail
health insurance benefits as health premiums rise. The percentage of small
businesses that offer health benefits dropped from 69% in 2000 to 60% in 2005.59
Low-wage workers may be more willing to take the risk of going without health
insurance in exchange for higher take-home pay, although low-wage individuals are
more likely to have poor health status.
For example, in 2005 fewer than half of Wal-Mart employees were in its health
insurance plan. While some worked too few hours or had not worked long enough
to be eligible, many others passed up coverage because of the high cost of benefits
relative to their earnings.60 A large proportion of workers obtained coverage for
themselves or their children through public insurance programs such as Medicaid and
State Children’s Health Insurance Program (SCHIP).61 An internal 2005 Wal-Mart
memorandum stated that 46% of employees’ children were either uninsured or
covered by Medicaid. In April 2006, in the face of pressure from unions and several
state legislatures, Wal-Mart announced changes in its benefits package intended to
increase the attractiveness of its health insurance plan, which shortened waiting
periods and expanded availability of health benefits.62
Public and private health insurance systems do not smoothly conjoin to offer
low-income individuals and their families stable and predictable financial protection
against medical costs. In addition, the interaction of public and private insurance
programs can distort incentives for low-wage individuals and the firms that employ
them. Although enrollments in Medicaid and SCHIP increased in the 1990s, in
recent years some states have tightened eligibility standards while other states have
59 Ibid.
60 Steven Greenhouse and Michael Barbaro, “Wal-Mart Memo Suggests Ways to Cut
Employee Benefit Costs,” New York Times, Oct. 26, 2005. See “Wal-Mart Announces
Additional Health Benefits Improvements and Timeline,” available at
[http://www.walmartfacts.com/articles/1650.aspx]. Under Wal-Mart’s benefit plan
introduced in Apr. 2006, full-time associates become eligible for health benefits in six
months, and part-time associates becomes eligible in one year.
61 Wal-Mart claims that about 80% of their employees have health insurance coverage, either
through family members or public insurance programs such as Medicaid or Veterans’ Health
Administration. See [http://www.walmartfacts.com/FactSheets/832006_Health_Care.pdf].
62 Wal-Mart Fact Sheet, “What’s the Story about Wal-Mart Health Care Benefits?” available
at [http://www.walmartfacts.com/FactSheets/832006_Health_Care.pdf].

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expanded coverage.63 Low-income families lose their eligibility for Medicaid when
their incomes rise above state-specific earnings thresholds, which imposes a high
implicit marginal tax rate on earnings of those families, serving as a deterrent to
work.64 Some firms that tend to hire low-wage workers have trouble offering
insurance plans as attractive to low-income families as public insurance programs
supported by tax dollars. Firms that offer low-wage workers health benefits find that
through the tax system they pay health insurance costs of their competitors’
employees as well as their own. In addition, waiting periods for benefits and other
eligibility hurdles impose barriers to insurance benefits and health care access for
low-wage workers, who change jobs more frequently and are more subject to
economic and social disruptions than workers with greater financial resources.
Changing Incentives for Technological Innovation. Most health
economists and practicing physicians, according to one survey, believe that “the
primary reason for the increase in the health sector’s share of GDP over the past 30
years is technological change in medicine.”65 In other sectors of the economy, most
notably those involving computers and information technology, technological
advances brought better and cheaper products. Asking why technology causes higher
costs in health care but lower costs elsewhere is natural. Part of the answer lies in
how incentives facing developers of new medical technologies interact with the
structure of health care finance.
Inventors and developers, if motivated by profits, must consider who will pay
for new technologies and innovative products. Because of the dominant role of
insurers and governments in health care finance, converting breakthroughs in medical
technology into financial success generally depends on what private and public
insurers are willing to include in their coverage plans. Unlike other lines of
insurance, the limits of health insurance are set by fundamentally ill-defined
contracts. Property insurance contracts promise protection against specifically
defined threats to specific objects. Health insurance contracts cannot specify what
ill-health is or what comprises “routine health care.” Because medical knowledge
and technology are constantly advancing, what is considered experimental medicine
today may become standard tomorrow.66
63 Donna C. Ross and Laura Cox, “In a Time of Growing Need: State Choices Influence
Health Coverage Access for Children and Families,” Kaiser Commission on Medicaid and
the Uninsured Report, Oct. 2005, available at [http://www.kff.org/medicaid/
upload/In-a-Time-of-Growing-Need-State-Choices-Influence-Health-Coverage-Access-fo
r-Children-and-Families-Report.pdf].
64 Statement of Linda T. Bilheimer, Deputy Assistant Director for Health, CBO, in U.S.
Congress, House Committee on Ways and Means, Subcommittee on Health, 106th Cong.,
1st sess., Apr. 8, 1997.
65 Victor R. Fuchs, “Economics, Values and Health Care Reform,” American Economic
Review, vol. 86, no.1 (Mar. 1996), p. 8. A minority of economic theorists, however,
believed technological change was to blame for increasing medical costs.
66 Burton A. Weisbrod, “The Health Care Quadrilemma: An Essay on Technological
Change, Insurance, Quality of Care, and Cost Containment,” Journal of Economic
Literature, vol. 29, no. 2, (June 1991), pp. 523-552.

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The amorphousness of health insurance affects incentives to engineers and
researchers. Because health insurance makes patients and physicians less sensitive
to price, developers have stronger incentives to invent new treatments or technologies
which do something new or better, rather than invent cheaper ways of doing existing
things. Innovation in computer hardware technology is mainly focused on making
cheaper computers that run faster. If firms and individuals had “computer
insurance,” computers might perform more esoteric tasks, but at a much higher price.
One solution is to design health insurance plans that will pay an amount
equivalent to the cost of an existing technology. If a patient wanted a newer and
better technology, then the patient would have to pay out of her pocket. If the new
technology’s benefits warranted its higher costs, then presumably the patient would
be willing to pay the extra amount. For example, an insurer could set reimbursement
for pharmaceuticals aimed at a specific condition equal to the cost of an existing drug
with known efficacy. If a drug company developed a more effective drug for that
condition that was more expensive, then the patient would pay the difference. If the
gain in efficacy was large compared to the increase in price the consumer would
presumably be more willing to choose that drug. This reimbursement policy would
provide developers of new medical technologies with a powerful incentive to make
newer products better and cheaper.
While fixing reimbursement levels for new pharmaceuticals at the level of
existing approved drugs would give drug developers strong incentives to consider the
costs and prices during the R&D process, it could also create pricing anomalies in the
short run. For instance, a study based on data from the Clinical Antipsychotic Trials
in Intervention Effectiveness (CATIE) found no significant differences in quality-of-
life measures for second-generation drugs and a first-generation drug (perphenazine),
even though newer drugs cost $300 to $600 more per month.67 Thus, for some
patients, switching to an older antipsychotic could yield large cost savings. However,
different patients with the same condition often respond differently to the same drug,
and patients with schizophrenia often must try several different drugs to find one that
is clinically effective and does not create serious side effects. Some patients will do
better with a second-generation drug, while other patients with the same condition
will do better with a first-generation drug. If reimbursement levels of second-
generation drugs were set at the level of first-generation drugs, either some patients
would pay substantially more (or someone would pay more on their behalf) for their
treatment using a second-generation drug, or they would have to use a first-
generation drug which, for them, works less well.
Market Power. Health care providers often have substantial market power.
Shopping around for the most attractive health provider when sick or injured is
difficult or impossible. Switching physicians or health plans is costly and
inconvenient for patients, and changing health insurers is costly and time-consuming
for businesses. Prices for individual health services are difficult to find. Drug and
67 Robert A. Rosenheck, Douglas L. Leslie, Jody Sindelar, et al., “Cost-Effectiveness of
Second-Generation Antipsychotics and Perphenazine in a Randomized Trial of Treatment
for Chronic Schizophrenia,” American Journal of Psychiatry, vol. 163 (Dec. 2006), pp.
2080-2089.

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device manufacturers have legal monopoly powers due to patent protection. While
major buyers, such as governments, have bargaining power which can allow them to
buy at lower prices, individuals have little or no bargaining power.
In other markets consumers can, in effect, hire a firm or organization to bargain
on their behalf. A Wal-Mart shopper enjoys the benefits of the company’s bargaining
power with manufacturers. A union member enjoys the benefits of collective
bargaining, such as better working conditions and higher pay. Similarly, a patient
benefits from the bargaining power of his employer with his insurer, as well as from
the insurer’s bargaining power with health care providers.68 Likewise, a retiree can
benefit from the government’s bargaining power. Lower prices for health care in
other OECD countries are, to a large extent, due to the willingness of governments
to use their bargaining power with providers.69 If consumers have a wide choice of
organizations or firms that can negotiate on their behalf, then competition will ensure
that consumers will reap most of the benefits. If consumers cannot easily choose or
switch among such organizations, however, then the middlemen will capture a larger
portion of those bargaining benefits for themselves. Moreover, while the bargaining
power of employers, insurers, and governments benefits consumers, as compared to
a situation in which consumers face providers directly, bargaining interactions among
employers, insurers, and providers create economic distortions which can reduce
efficiency.70
Efficiency and Redistribution in Health Care
Economists tend to separate questions of efficiency from questions of
redistribution. If market failure occurs, market outcomes are not efficient in the
sense that other outcomes exist that would make some people better off without
making anyone else worse off. Even if markets are efficient, society may decide to
redistribute resources, despite efficiency losses. Designing policy, according to
mainstream view of public economics, is a matter of achieving a given set of
distributional goals with a minimal loss of efficiency.71
The introduction of Medicare and Medicaid in 1965 was in large part motivated
by distributional concerns. Before Medicare, a disproportionate share of the elderly
lived in poverty. A generation later, poverty is less common among the elderly than
68 Henry J. Aaron, “A Funny Thing Happened on the Way to Managed Competition,”
Journal of Health Politics, Policy and Law, vol. 27, no. 1, February 2002.
69 Gerard F. Anderson, Uwe E. Reinhardt, Peter S. Hussey, and Varduhi Petrosyan, “It’s The
Prices, Stupid: Why The United States Is So Different From Other Countries,” Health
Affairs, vol. 22, no. 3 (May/June 2003), pp. 89-105.
70 Mark V. Pauly, “Managed Care, Market Power, and Monopsony — Examining the Role
of Regulation in an Evolving Healthcare Marketplace,” Health Services Research, vol. 33,
no. 5 pt. 2 (Dec. 1998), pp. 1439-1460.
71 In some cases, treating individuals more equally may enhance economic efficiency. If
incomes depend in some part on luck or other random causes, then a social insurance policy
that reduces income inequalities can enhance economic efficiency. For details see Gareth
D. Myles, Public Economics, (New York: Cambridge, pp. 6-7, 470-484).

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among other age classes. The origins of Medicaid stem from various poor-relief
programs, which were extended and embedded in a multi-billion-dollar federal-state
program.72
One interpretation of redistributional programs aimed at the poor is that they act
as an insurance program that all members of society join before birth. Some part of
regular taxes constitutes the premium for this social insurance, and individuals
collect benefits if they suffer bad luck of some sort that makes them poor. Social
insurance provides protection against some consequences of becoming poor, at the
cost of higher taxes for others. Medicaid, because it is aimed at low-income groups
and those impoverished as a result of poor health, provides substantial social
insurance benefits.
The Federal Budget and Market-Oriented
Health Care Reform
The rapid rise in health care costs is straining public budgets at all levels of
government, and projected increases in health care costs promise to intensify
pressures on public budgets.73 If health care costs continue to grow at past rates,
cutbacks in other types of consumption will be inevitable. Even if health care costs
moderate, a substantial portion of the gains from economic growth will be directed
towards the health care system. Rising costs have stemmed in part from the
introduction of medical advances, which have increased longevity and reduced
morbidity.74 Other causes of rising medical costs include demographic changes,
which have increased the proportion of the population which is elderly, and the
weakening of incentives to minimize costs due to third-party reimbursement of health
costs.75
Rising health care costs have cut into the growth of other types of consumption
for most households. In the decades following World War II, productivity and
incomes grew fast enough relative to health care costs to allow steady increases in
health and non-health spending. In more recent decades, real incomes for most
households grew more slowly while health costs continued to rise rapidly and cut into
the growth of non-health expenditures. Since 1972, real incomes for the lower 99%
of household grew on average only 1.2% per year to 2002. Over the same period real
72 See Paul Starr, The Social Transformation of American Medicine, (New York: Basic
Books, 1983) for a description of the enactment of Medicare and Medicaid.
73 See point 10 of the United States of America — 2006 Article IV Consultation, Concluding
Statement of the IMF Mission, May 31, 2006, available at [http://www.imf.org/
external/np/ms/2006/053106.htm] and the GAO report, 21st Century: Addressing
Long-Term Fiscal Challenges Must Include a Re-examination of Mandatory Spending,
GAO-06-456T, Feb. 15, 2006.
74 David M. Cutler, Your Money or Your Life, (New York: Oxford Univ. Press, 2004).
75 Amy Finkelstein, “The Aggregate Effects of Health Insurance: Evidence from the
Introduction of Medicare” Quarterly Journal of Economics, vol. 122, no. 1 (2007).

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national health expenditures rose 4.9% a year.76 Had health care spending in the U.S.
been held to 10% of GDP, a proportion similar that in Canada, France, Germany, and
Switzerland, non-health consumption would have grown about 25% faster.77
To the extent that choices of rational consumers, or of rational voters and
politicians, drive this expansion of the health care system, rising health costs are not
necessarily a cause for concern. In all advanced industrial countries the fraction of
the economy devoted to health care has been rising. If consumers prefer to buy more
technologically advanced medical care rather than more advanced cars or
refrigerators, then higher medical costs are a natural consequence of rising standards
of living. An analysis of medical technology for heart attacks, low-birthweight
babies, depression, and cataracts indicates that increased benefits of better treatment
options far outweigh costs. For breast cancer, increased costs and benefits of new
technologies are roughly of the same magnitude.78
Rising medical costs threaten to price a growing number of Americans out of
the insurance market. In the past few decades, the number of uninsured has hovered
around 40-46 million. Depending on the definitions used, tens of millions more are
underinsured against the risk of having a health emergency become a financial
catastrophe. As health care becomes more expensive, the logic of supply and
demand suggests the pool of uninsured persons will grow. Two health economists
projected that the number of uninsured persons will grow from 45 million in 2003
to 56 million by 2013, largely due to the continually rising costs of health care.79
Absent the political will to increase taxes significantly, rising medical costs will
force major cuts in benefits or fundamental changes in the health delivery system.
Economic theory suggests that addressing the root causes of market failure provides
76 Income data from Table A1 in the Apr. 2006 update of tables for Emmanuel Saez and
Thomas Piketty, “Income Inequality in the United States, 1913-1998,” Quarterly Journal
of Economics, vol. 118, no. 1 (2003), pp. 1-39, available at [http://elsa.berkeley.edu/
~saez/TabFig2004prel.xls]. According to the Saez and Piketty data, real gross income (i.e.,
income before individual income taxes and individual payroll taxes but after employers’
payroll taxes and corporate income taxes and excluding transfers) per tax unit was roughly
the same in 1972 and in 2002. However, the number of tax units per household rose, the
Consumer Price Index (CPI) used to adjust for inflation overstates price changes, and
transfers to households rose. Combining these effects gives a 40% increase in real
consumption per household over this period. National health expenditures from the Centers
for Medicare & Medicaid Services, Office of the Actuary. Prices adjusted using the Bureau
of Economic Analysis’s implicit GDP price deflator, which is less subject to the biases of
the CPI.
77 Calculations based on the following data: real income growth for households outside of
the top 1% was 40% between 1972 and 2002, according to Piketty and Saez, and the
proportion of national health care was 7.5% in 1972 and 15.3% in 2002, according to the
Centers for Medicare and Medicaid Services.
78 David M. Cutler and Mark McClellan, “Is Technological Change in Medicine Worth It?”
Health Affairs, vol. 20, no. 5 (Sept./Oct. 2001), pp. 11-29.
79 Todd Gilmer and Richard Kronick, “It’s The Premiums, Stupid: Projections of the
Uninsured Through 2013,” Health Affairs, Web Exclusive, Apr. 5, 2005.

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the best chance for enhancing system performance. The following discussion
examines the potential of market-based solutions, which address sources of market
failure noted above, to help transform the health care system in ways that would lead
to better performance and lower costs.
Improve Health Consumer Information
Consumers shopping for cars have many sources of information on quality and
price of various models. To the contrary, consumers shopping for health care have
trouble finding basic information about quality and price. Certainly the complexity
and its made-to-order nature ensure that comparing health care will be harder than
comparing mass-produced goods. However, providing health care consumers with
better information can stimulate competition, which in turn can deliver better
performance and prices.
Information on Pricing. More transparent pricing of health care could help
consumers make better decisions. However, transparent pricing is likely to be
effective only when combined with other measures. Often, price information is of
little value without accompanying information on quality.80 Consumers will be
sensitive to prices only if they share a non-trivial portion of their health care costs.
However, the bulk of medical costs stem from a small proportion of high-cost
episodes, often occurring in the last few days of life.81 Insured patients in those
episodes are well above out-of-pocket limits, above which the insurance plan pays
until some very high limit of coverage is reached. For this reason, insurance plans
— not consumers — will be in the best position to put pressure on providers to
lower prices and improve quality for the most expensive types of health care. That
is, better price information for consumers can spur competition among providers of
eyeglasses, teeth cleaning, and routine check-ups, but better price information is
unlikely to sharpen competition among heart surgeons.
Hospitals and other health care providers, in general, have been reluctant to
provide a transparent set of prices for their services. In part, this is a consequence of
their cost structure. Hospitals, for their part, must pay large fixed costs for items
such as buildings, maintenance, equipment, and computer systems. On the other
hand, hospitals provide a perishable service: an empty hospital bed cannot be saved
for tomorrow. Economic theory suggests that industries that have high fixed costs,
and which sell perishable goods or services, face strong pressures to charge different
customers different prices and compete in markets subject to unstable prices.82 In
80 Testimony of Sara R. Collins and Karen Davis entitled “Transparency in Health Care: the
Time Has Come,” in U.S. Congress, House Committee on Energy and Commerce,
Subcommittee on Health, “What’s The Cost? Proposals to Provide Consumers with Better
Information About Healthcare Service Costs,” hearings, 109th Congress, 2nd sess., March 15,
2006.
81 Of course, at the beginning of an episode of care, whether a patient will survive is usually
unknown. Therefore, distinguishing between life-saving care that saves a patient and futile
care for a patient in his last days is difficult.
82 Lester G. Telser, “Competition and the Core.” Journal of Political Economy, 1996, vol.
(continued...)

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addition, many hospitals provide services, such as indigent care and graduate medical
education, for which they are not wholly compensated. Such hospitals must find
other ways to finance these services, which often involves cross-subsidies. In these
conditions, a simple flat-rate price system may not be a viable strategy for hospitals.
Therefore, imposing greater transparency of health care prices may require closer
attention to cross-subsidies and uncompensated training and care.
Information on Quality. Health care consumers have access to little useful
information about quality. In part this is due to the inherent complexity of medical
care and the difficulty of defining and measuring quality. However, the development
of large electronic databases has opened the possibility of creating quality indices
based on sophisticated statistical methods. Large corporations, insurance companies,
and government agencies have developed extensive databases which contain
information reflecting the quality of health care. These data, however, are
unavailable to consumers. Medicare pays $400 million per year to run 53 Quality
Improvement Organizations (QIOs), which work with hospitals to improve quality
of care. Research by academics and the Institute of Medicine has cast doubt on the
efficacy of QIOs.83 Hospital professional organizations in 2002 created the Hospital
Quality Alliance, which provides comparative data. For each hospital, 20 indicators
measuring the proportion of patients who receive specific treatments recognized to
constitute “best practice” in the areas of heart attacks, heart failure, pneumonia, and
prevention of surgical infections are reported.84 For example, one item reports what
percentage of heart attack victims received aspirin upon arrival at the hospital.
Critics say this type of reporting focuses on what a hospital did, rather than what
happened to patients. They note that if food critics operated according to similar
principles, perhaps their reviews would report which restaurants remembered to
include important ingredients of meals or how sophisticated the restaurant stoves
were, while failing to report how meals tasted.

Traditional approaches to quality monitoring in health care focused on
“zero/one” indicators that provide no information on gradations of ability or
competence. Physicians were licensed, and hospitals were accredited, and those who
were not could not legally engage in medical care. Providers were certified for
Medicare reimbursement. Such measures, however, only served to set lower bounds.
The board certification of physicians is a partial exception, which provides
consumers an opportunity to select physicians who have passed a more rigorous set
of standards.
82 (...continued)
104, no. 1, pp. 85-107.
83 Claire Snyder and Gerard Anderson, “Do Quality Improvement Organizations Improve
the Quality of Hospital Care for Medicare Beneficiaries?” Journal of the American Medical
Association, vol. 293, no. 23 (June 15, 2005), pp. 2900-2907; and the Institute of Medicine
of the National Academies, Medicare’s Quality Improvement Organization Program:
Maximizing Potential, Mar. 2006.
84 These data are available at [http://www.hospitalcompare.hhs.gov/].

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Providing consumers with more useful data on outcomes can improve health
care quality.85 Of course, outcome data must include risk adjustments, so that
statistics reflect the fact that healthier patients will on average have better outcomes.
For example, the United Network for Organ Sharing, established by Congress in
1984, collects data on all transplant operations in the United States. Risk-adjusted
outcome data for each transplant center are available at [http://www.unos.org].
Public availability of risk-adjusted outcome data puts pressure on surgeons and
transplant centers to improve performance. New York State has published risk-
adjusted average mortality rates for cardiac surgery since 1991. After starting this
program, the mortality rate among cardiac patients treated in top-performing
hospitals or by top-performing surgeons was about half the mortality rate for patients
treated by a hospital or surgeon rated in the bottom 25% of the rankings.86 A 2003
study, however, contended that publication of performance data gave providers
incentives to avoid difficult cases, leading to worse health outcomes for sicker
patients and higher resource usage.87
In the absence of effective quality-control programs, malpractice and the tort
system act as a rough substitute for quality control.88 Expanding consumer access to
useful medical outcome data would take pressure off the tort system. For instance,
once New York State started publishing cardiac outcome data, surgeons with high
reported risk-adjusted average mortality rates were more likely to retire or stop
performing operations. Giving patients information that allows them to avoid
surgeons with high mortality rates is preferable to having their estates sue.
Make Extras Cost Extra
One strategy for slowing the growth of health care is to make patients pay more
when they choose health care which is more expensive to provide. For example,
many employers tie their contribution to an employee’s health insurance plan to the
cost of the cheapest plan. Employees then face a choice of paying for the incremental
cost of a more generous insurance plan out of their own pocket or spending that
money on other things. The income tax exemption for employer-provided health care,
however, tilts employees towards buying more health insurance.89 To the extent that
85 For a more extensive analysis of the potential of providing consumers with useful outcome
data see Michael E. Porter and Elizabeth O. Teisberg, Redefining Health Care: Creating
Value-Based Competition on Results, (Allston, Mass: Harvard Business School Publishing,
May 2006).
86 Ashish K. Jha and Arnold M. Epstein, “The Predictive Accuracy of the New York State
Coronary Artery Bypass Surgery Report-Card System,” Health Affairs, vol. 25, no. 3 (2006),
pp. 844-855.
87 David Dranove, Daniel Kessler, Mark McClellan, and Mark Satterthwaite, “Is More
Information Better? The Effects of ‘Report Cards,’” Journal of Political Economy, vol. 111
(2003), pp. 555-588.
88 Michelle Mello and Troyen Brennan, “Deterrence of Medical Errors: Theory and
Evidence for Malpractice Reform,” Texas Law Review, vol. 80 (2002), pp. 1595-1637.
89 Mark V. Pauly, “Taxation, Health Insurance, and Market Failure in the Medical
(continued...)

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consumers make rational decisions between health and non-health expenditures, the
tax exemption creates an economic distortion that lowers allocational efficiency.
Limiting this exemption would make employees more sensitive to the cost of health
insurance, which would put downward pressure on health care costs.
The Weisbrod proposal, described above, which would tie reimbursement for
new drugs to the level of an existing drug of recognized efficacy, is another
application of the “make extras cost extra” principle.90 Providing drug developers
with a strong incentive to find new drugs that would be cheaper but just as effective
as currently available drugs could help constrain the growth of health care costs.
The same “pay more for extras” approach has been proposed as a basis for
health care reform. A group of leading health economists proposed a plan giving
each household a tax credit at the level of cost of Medicaid coverage.91 Those
wishing for more generous coverage could apply that tax credit to a privately
provided plan. Such an approach would give more people access to health care,
while giving consumers incentives to buy more health insurance if its benefits
exceeded its costs.
Expand Use of Information Technology
Many health analysts contend that more extensive use of information technology
(IT) could improve quality and increase efficiency of medical care. The Veterans’
Health Administration (VHA), which treats about 5 million patients per year, began
an organizational transformation in 1995 that featured a centralized health
information system. This system not only simplified record keeping, giving
physicians instant access to records on all previous visits made by a patient, but also
provided researchers and managers access to treatment and outcome data that
provided hard evidence on clinical effectiveness.92 The VHA is now considered a
leader in the application of IT to health care administration.93 Several studies have
concluded that quality of care in the VHA exceeds that in comparable private health
care providers.94
89 (...continued)
Economy,” Journal of Economic Literature, vol. 24, no. 2 (June 1986), pp. 629-75.
90 Burton A. Weisbrod, “The Health Care Quadrilemma: An Essay on Technological
Change, Insurance, Quality of Care, and Cost Containment,” Journal of Economic
Literature, vol. 29, no. 2 (June 1991), pp. 523-552.
91 Mark V. Pauly, Patricia M. Danzon, Paul J. Feldstein and John Hoff, Responsible
National Health Insurance, (Washington: AEI Press, 1992).
92 Kenneth W. Kizer, John G. Demakis, John R. Feussner, Reinventing VA Health Care:
Systematizing Quality Improvement and Quality Innovation: VA’s Quality Enhancement
Research Initiative,” Medical Care 38(6), Supplement I:I-7-I-16, June 2000.
93 M.W. Morgan, “The VA Advantage: The Gold Standard in Clinical Informatics,”
Healthcare Papers, vol.5, no. 4 (2005), pp. 26-9.
94 Steven M. Asch, et al., “Comparison of Quality of Care for Patients in the Veterans Health
Administration and Patients in a National Sample,” Annals of Internal Medicine, vol. 141,
(continued...)

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Centralized clinical IT systems can also allow payers to link physician
reimbursement with measures of quality of care. The British National Health Service
(NHS) initiated pay-for-performance contracts with family practitioners in 2004,
which tied physician payments to 146 indicators of the quality of clinical care for 10
chronic diseases.95 In the first year of this program, almost 97% of U.K. physicians
met quality targets. While analysis of these initial data cannot determine whether
initial clinical quality targets were set too low or whether clinical quality improved,
the information collected on quality indicators provides the NHS with a powerful tool
to monitor the quality of patient care and to push for further improvements.
The federal government has taken preliminary steps in the same direction. The
federal government has funded demonstration projects for pay-for-performance
contracts with physicians and hospitals.96 The Medicare Prescription Drug,
Improvement, and Modernization Act of 2003 (P.L. 108-173) cuts payments by 0.4%
to hospitals which do not report on 10 quality indicators for acute myocardial
infarction, congestive heart failure, and pneumonia. The Deficit Reduction Act of
2005 (P.L. 109-171) increased that penalty to 2% of payments and authorized the
Department of Health and Human Services to modify the set of quality indicators.
The Tax Relief and Health Care Act of 2006 (P.L. 109-432) ties increases in
physician reimbursement under Medicare Part B to reporting of quality measures
selected by the Centers for Medicare and Medicaid Services’ Physician Voluntary
Reporting Program. At present, this program collects data on 16 quality measures.
In future years, the Secretary of Health and Human Services may select other quality
measures. While the data supplied by U.S. hospitals and physicians is much less
detailed than information supplied by U.K. physicians participating in pay-for-
performance programs, U.S. efforts to collect a basic set of quality indicators in a
systematic way could underpin future efforts to link payments to quality of care.
Concluding Thoughts
Market competition has brought rapid technological change, higher quality, and
lower prices to many parts of the economy, leading many to ask why broader
application of market principles to the health care system could not reduce costs and
improve performance. As many have noted, health care is not a standard commodity.
Unless institutions and reforms are designed to reflect the unique characteristics of
the health care market, failures will continue to be the norm. Certainly past
experience indicates that patients, insurers, and providers all react to financial
incentives. Unfortunately, designing incentives that align behavior of consumers and
health care payers and providers is difficult because of the nature of medical care.
94 (...continued)
no. 12 (Dec. 2004), pp. 938-945.
95 T. Doran, C. Fullwood, H. Gravelle, et al., “Pay-for-Performance Programs in Family
Practices in the United Kingdom,” New England Journal of Medicine, vol. 355 (July 27,
2006), pp. 375-384.
96 Arnold M. Epstein, “Paying for Performance in the United States and Abroad,” New
England Journal of Medicine, vol. 355, no. 4(July 27, 2006), pp. 406-408.

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Broadening financial protection against unexpected health care costs, enhancing
access to routine and preventative care, constraining costs, and setting up economic
incentives that induce efficient behavior among individuals and firms are all
worthwhile goals. Designing policies with a reasonable expectation of reaching each
of those goals is difficult.
Information asymmetries between patients and physicians as well as between
providers and payers stem from the unavoidable need for highly specialized roles.
The specialized expertise of medical personnel gives patients access to sophisticated
therapeutic measures, many of which could hardly have been imagined a generation
ago. This specialization of expertise also necessitates an informational asymmetry
that requires patients to depend on their physicians to guide them through the system.
Thus, the principal-agent relationship lies at the heart of the health care experience.
Similarly, because physicians see patients while payers only see paper claims,
physicians possess an important informational advantage over third-party payers.
Expanded use of performance measurements and information technology has the
potential to reduce these problems.
The health insurance system’s ability to spread risks across a broad pool of
beneficiaries will continue to face challenges as insurers seek to avoid losses through
medical underwriting and related practices. Extending coverage to individuals in
poor health, from the point of view of an insurer, is more akin to providing a subsidy
than insuring a risk. Insuring such individuals may require either subsidies or pricing
schemes that induce private insurers to compete on grounds of efficiency of service
rather than ability to avoid those with greater needs for health care. Alternatively,
health insurance for those in poorer health could be guaranteed by policies that would
create larger and broader pools, such as the Canadian single-payer system. Other
alternatives include the plan recently introduced in Massachusetts, which will require
individuals to obtain health insurance or join a state-sponsored high-risk pool. This
approach parallels the typical automobile insurance system, which requires citizens
to have insurance, but allows them to choose among many approved and regulated
insurance providers. Yet another alternative is the United Kingdom’s two-tier
system, in which all residents are enrolled in the National Health Service, but those
who wish access to more convenient services may buy supplemental policies, such
as provided by the British United Provident Association (BUPA). This system gives
all U.K. residents access to a reasonable standard of care, although this may involve
some level of inconvenience and waiting in some cases, and lack of access to some
care regarded by health planning authorities as of low benefit. Those wishing to
bypass such inconveniences are free to pay for access to more extensive and
comfortable care.
Even if the design of health care policy requires balancing of goals that present
conflicting requirements, policy innovations can deliver better results. Policies that
harness market incentives and recognize the nature of health care can enhance
efficiency and improve performance. Because asymmetric information is a cause of
market failure, policies which provide better information to patients and payers may
improve performance. Because market power often serves as a cause of market
failure, policies which either reduce or counterbalance market power can help
improve performance. Policies which either fail to reflect the nature of the health

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care or which fail to address causes of market failure are unlikely to lead to lasting
improvements.

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