- Use the model of demand and supply to explain the effects of third-party payers on the health-care market and on health-care spending.
There has been much discussion over the past three decades about the health-care problem in the United States. Much of this discussion has focused on rising spending for health care. In this section, we will apply the model of demand and supply to health care to see what we can learn about some of the reasons behind rising spending in this important sector of the economy.
Figure 4.14 “Health-Care Spending as a Percentage of U.S. Output, 1960–2003” shows the share of U.S. output devoted to health care since 1960. In 1960, about 5% of total output was devoted to health care; by 2004 this share had risen to 15.4%. That has meant that we are devoting more of our spending to health care, and less to other goods and services, than we would be had health-care spending not risen so much.
Why were Americans willing to increase their spending on health care so dramatically? The model of demand and supply gives us part of the answer. As we apply the model to this problem, we will also gain a better understanding of the role of prices in a market economy.
The Demand and Supply for Health Care
When we speak of “health care,” we are speaking of the entire health-care industry. This industry produces services ranging from heart transplant operations to therapeutic massages; it produces goods ranging from X-ray machines to aspirin tablets. Clearly each of these goods and services is exchanged in a particular market. To assess the market forces affecting health care, we will focus first on just one of these markets: the market for physician office visits. When you go to the doctor, you are part of the demand for these visits. Your doctor, by seeing you, is part of the supply.
Figure 4.15 “Total Spending for Physician Office Visits” shows the market, assuming that it operates in a fashion similar to other markets. The demand curve D1 and the supply curve S1 intersect at point E, with an equilibrium price of $30 per office visit. The equilibrium quantity of office visits per week is 1,000,000.
We can use the demand and supply graph to show total spending, which equals the price per unit (in this case, $30 per visit) times the quantity consumed (in this case, 1,000,000 visits per week). Total spending for physician office visits thus equals $30,000,000 per week ($30 times 1,000,000 visits). We show total spending as the area of a rectangle bounded by the price and the quantity. It is the shaded region in Figure 4.15 “Total Spending for Physician Office Visits”.
The picture in Figure 4.15 “Total Spending for Physician Office Visits” misses a crucial feature of the market. Most people in the United States have health insurance, provided either by private firms, by private purchases, or by the government. With health insurance, people agree to pay a fixed amount to the insurer in exchange for the insurer’s agreement to pay for most of the health-care expenses they incur. While insurance plans differ in their specific provisions, let us suppose that all individuals have plans that require them to pay $10 for an office visit; the insurance company will pay the rest.
How will this insurance affect the market for physician office visits? If it costs only $10 for a visit instead of $30, people will visit their doctors more often. The quantity of office visits demanded will increase. In Figure 4.16 “Total Spending for Physician Office Visits Covered by Insurance”, this is shown as a movement along the demand curve. Think about your own choices. When you get a cold, do you go to the doctor? Probably not, if it is a minor cold. But if you feel like you are dying, or wish you were, you probably head for the doctor. Clearly, there are lots of colds in between these two extremes. Whether you drag yourself to the doctor will depend on the severity of your cold and what you will pay for a visit. At a lower price, you are more likely to go to the doctor; at a higher price, you are less likely to go.
In the case shown, the quantity of office visits rises to 1,500,000 per week. But that suggests a potential problem. The quantity of visits supplied at a price of $30 per visit was 1,000,000. According to supply curve S1, it will take a price of $50 per visit to increase the quantity supplied to 1,500,000 visits (Point F on S1). But consumers—patients—pay only $10.
Insurers make up the difference between the fees doctors receive and the price patients pay. In our example, insurers pay $40 per visit of insured patients to supplement the $10 that patients pay. When an agent other than the seller or the buyer pays part of the price of a good or service, we say that the agent is a third-party payer.
Notice how the presence of a third-party payer affects total spending on office visits. When people paid for their own visits, and the price equaled $30 per visit, total spending equaled $30 million per week. Now doctors receive $50 per visit and provide 1,500,000 visits per week. Total spending has risen to $75 million per week ($50 times 1,500,000 visits, shown by the darkly shaded region plus the lightly shaded region).
The response described in Figure 4.16 “Total Spending for Physician Office Visits Covered by Insurance” holds for many different types of goods and services covered by insurance or otherwise paid for by third-party payers. For example, the availability of scholarships and subsidized tuition at public and private universities increases the quantity of education demanded and the total expenditures on higher education. In markets with third-party payers, an equilibrium is achieved, but it is not at the intersection of the demand and supply curves. The effect of third-party payers is to decrease the price that consumers directly pay for the goods and services they consume and to increase the price that suppliers receive. Consumers use more than they would in the absence of third-party payers, and providers are encouraged to supply more than they otherwise would. The result is increased total spending.
- The rising share of the output of the United States devoted to health care represents a rising opportunity cost. More spending on health care means less spending on other goods and services, compared to what would have transpired had health-care spending not risen so much.
- The model of demand and supply can be used to show the effect of third-party payers on total spending. With third-party payers (for example, health insurers), the quantity of services consumed rises, as does spending.
The provision of university education through taxpayer-supported state universities is another example of a market with a third-party payer. Use the model of demand and supply to discuss the impact this has on the higher education market. Specifically, draw a graph similar to Figure 4.16 “Total Spending for Physician Office Visits Covered by Insurance”. How would you label the axes? Show the equilibrium price and quantity in the absence of a third-party payer and indicate total spending on education. Now show the impact of lower tuition As a result of state support for education. How much education do students demand at the lower tuition? How much tuition must educational institutions receive to produce that much education? How much spending on education will occur? Compare total spending before and after a third-party payer enters this market.