Separation of Health Insurance from Employment
Those seeking to redesign a health system can make a good argument for revising or replacing the
prevailing system of employer-provided insurance with either a single-payer system or an individual
mandate. The advantages of employer provision stem from long-term practices that cause economic
distortions. During World War II, the U.S. government froze prices and wages. Competing
for workers, firms expanded their fringe benefits, which were not subject to the freeze. After World
War II, employer contributions to health insurance were, and continue to be, tax-exempt, providing
workers with a substantial discount and inviting inefficiencies of over-insurance and moral hazard.
Meanwhile, many of the unemployed, as well as many low-wage employed, have gone without health insurance. Health insurance problems also occur when workers change jobs. When leaving their previous employer’s health coverage behind them, workers have little choice but to buy an individual policy, a “continuation of benefits” or COBRA, from the previous employer, or do without insurance entirely. Individual policies are often more expensive, sometimes pose administrative problems, and sometimes comprise a lower financial priority for people out of work. Workers often find pre-existing conditions such as heart disease to be uninsurable.
Single Payer versus Multiple Insurers
A move in the United States toward universal coverage also entails the option of a single insurer, presumably the federal government. In the United States, multiple private companies insure a majority of the population. The most prominent single-payer proposal discussed in the U.S. debates has been the Canadian Medicare system. Economic theory suggests that consumers value variety. Numerous restaurants serve different foods, prepared in different ways. American auto manufacturer Henry Ford said (at least apocryphally) that one could have any color of his pioneering Model T, so long as it was black—his company lost its market prominence to General Motors who provided a wider variety of cars (and colors). In principle, a variety of insurers may provide different types of coverage, pool different groups of people, and provide products that more closely match the variety of consumers. However, the multiple-insurer system, as it has evolved, has led to multiple forms and policy rules that face hospitals, clinics, and nursing homes. Patients, as insurance clients, must often provide the same information numerous times, with commensurate possibilities of error. With hundreds of different health insurers, the difficulty of coordinating different policies falls on hospitals and physicians. It is external to the insurance companies and as a result, they do not see the need to reduce it. Nevertheless, it is a real economic cost both to patients and to providers, and the government as single payer could reduce it with fewer and standardized forms. In principle, a consolidation of insurers could reduce such administrative costs if there are economies of scale in administration, or if gains could obtain from pooling those insured. Many economists have tried to estimate the excess administrative costs. Cutler and Ly (2011) partition the $1,589 difference in per capita health care spending between the United States and Canada in 2002. Higher administrative costs accounted for $616, or 39 percent, of the difference. The authors argue that this figure probably underestimates the amount and share, because nurses also spend substantial time on administrative tasks, but accounts typically consider nursing time as clinical care rather than administration. One must be cautious in assuming that a government single-payer system would solve all of the administrative cost problems. The same administrative technology is available to the private sector, and if further economies were possible, and there is appropriate non-monopoly competition, private firms would merge to take advantage of the economies. In addition, the profits that private insurers gain are not a waste to the economy, but rather payments for capital that government also must incur. Moreover, a switch to a single-payer system would greatly diminish, if not eliminate, the very large private health insurance industry. To put the issue in perspective, Cogan, Hubbard, and Kessler (2010) note that of the approximately $2.4 trillion in 2008 U.S. national health expenditures, $830 billion were private insurance premiums. Over one in three dollars of health care expenditures went through private insurance! Private insurers would almost certainly oppose a single payer plan, and they have actively promoted their own cause in the formulation of PPACA. Do health care system problems warrant a change to a single payer? Other reforms may address specific problems. For example, we insure the uninsured through mandated coverage including subsidies for the poor, and provide coverage for people with pre-existing conditions through the individual mandates. Before PPACA passed, beneficiaries used COBRA legislation to address this issue.
A potential benefit of the single-payer system lies with the possibility of common coverage. We may worry now that some insured people have inadequate policies in terms of the depth and breadth of coverage. The single payer could offer one policy or a small number of variations, each variation determined to be adequate by policy makers representing the public. In contrast, the availability of many policies from many companies offers variety, tailoring policies to the individual preferences for cost-sharing features and coverage.
COMPETITIVE STRATEGIES
Regardless of any changes in the direction of U.S. health care policy, governments will remain heavily involved in the financing and delivery of health care. The ideological battle is over the superiority of (1) increased government involvement through both expanded regulation and additional government programs to provide or finance health care or (2) an increased emphasis on market mechanisms and market forces with corresponding decreases in the use of regulatory instruments. This controversy between competition and regulation is not new to the academic and policymaking communities. Those who deny the applicability of the competitive framework will most likely favor regulatory strategies. Proponents of further regulation tend to argue that attempts to promote partial forms of competition will not readily correct information imperfections, flawed agency relationships, and other distortions. Regulation proponents also react to the rapid growth in overall health spending and in spending on Medicare, Medicaid, and other public programs. The spending record in the United States, as compared to other more highly regulated systems, has reinforced beliefs among many that health care markets do not work like most other markets. Many believe that increases in supplies of hospital beds and physicians increase utilization of marginally necessary or even unnecessary services. There are widespread views that physicians can and do create demand and that empty beds in hospitals will be filled through physicians’ discretionary decisions to admit patients. Those who share these views advocate controls limiting hospital capacity and physician supplies, and increasing the monitoring of services provided. We have outlined the general forms of these controls. What is competition in health care? Pauly (1988a) defines competition through the conditions of “free entry and potential entrants willing[ness] to offer goods and services to consumers, with no one firm large enough to have an important influence on levels and quality” (p. 35). From this definition, in a competitive health care industry we would expect (1) price-elastic demands facing providers; (2) a tendency toward marginal cost pricing; (3) efficiency in production— allocative as well as technical efficiency; and (4) the availability of alternatives in terms of price, quality, and form of delivery. Others see competition in a more limited way, largely through the form of government policy rather than the structure or performance of health care markets. A competitive health care policy is one that relies primarily on financial incentives rather than controls to achieve goals. Those supporting this approach believe that market participants respond to changes in prices in a predictable and substantial way. Supporters of competitive approaches also argue that even imperfections in their strategies are preferable to the distortions caused by imperfect regulation. Under either view of competition, certain forms of government intervention such as CON laws, utilization review, and mandated benefits, are anticompetitive because they compel. To be more specific in the distinction between competition and regulation, consider the uninsured. From the competitive point of view, many of the uninsured have insufficient income to purchase insurance. Mandated benefits and other requirements that drive up insurance prices aggravate their dilemma. A competitive solution is to subsidize purchases of insurance for the lower-income uninsured through tax credits, and to deregulate insurers so that lower-priced options become available. In contrast, they view programs that would provide insurance for the uninsured as lacking in incentives for efficient consumer search. Bearing in mind these distinctions, we turn to several broad competitive strategies for reforming the U.S. health care system.
Meanwhile, many of the unemployed, as well as many low-wage employed, have gone without health insurance. Health insurance problems also occur when workers change jobs. When leaving their previous employer’s health coverage behind them, workers have little choice but to buy an individual policy, a “continuation of benefits” or COBRA, from the previous employer, or do without insurance entirely. Individual policies are often more expensive, sometimes pose administrative problems, and sometimes comprise a lower financial priority for people out of work. Workers often find pre-existing conditions such as heart disease to be uninsurable.
Single Payer versus Multiple Insurers
A move in the United States toward universal coverage also entails the option of a single insurer, presumably the federal government. In the United States, multiple private companies insure a majority of the population. The most prominent single-payer proposal discussed in the U.S. debates has been the Canadian Medicare system. Economic theory suggests that consumers value variety. Numerous restaurants serve different foods, prepared in different ways. American auto manufacturer Henry Ford said (at least apocryphally) that one could have any color of his pioneering Model T, so long as it was black—his company lost its market prominence to General Motors who provided a wider variety of cars (and colors). In principle, a variety of insurers may provide different types of coverage, pool different groups of people, and provide products that more closely match the variety of consumers. However, the multiple-insurer system, as it has evolved, has led to multiple forms and policy rules that face hospitals, clinics, and nursing homes. Patients, as insurance clients, must often provide the same information numerous times, with commensurate possibilities of error. With hundreds of different health insurers, the difficulty of coordinating different policies falls on hospitals and physicians. It is external to the insurance companies and as a result, they do not see the need to reduce it. Nevertheless, it is a real economic cost both to patients and to providers, and the government as single payer could reduce it with fewer and standardized forms. In principle, a consolidation of insurers could reduce such administrative costs if there are economies of scale in administration, or if gains could obtain from pooling those insured. Many economists have tried to estimate the excess administrative costs. Cutler and Ly (2011) partition the $1,589 difference in per capita health care spending between the United States and Canada in 2002. Higher administrative costs accounted for $616, or 39 percent, of the difference. The authors argue that this figure probably underestimates the amount and share, because nurses also spend substantial time on administrative tasks, but accounts typically consider nursing time as clinical care rather than administration. One must be cautious in assuming that a government single-payer system would solve all of the administrative cost problems. The same administrative technology is available to the private sector, and if further economies were possible, and there is appropriate non-monopoly competition, private firms would merge to take advantage of the economies. In addition, the profits that private insurers gain are not a waste to the economy, but rather payments for capital that government also must incur. Moreover, a switch to a single-payer system would greatly diminish, if not eliminate, the very large private health insurance industry. To put the issue in perspective, Cogan, Hubbard, and Kessler (2010) note that of the approximately $2.4 trillion in 2008 U.S. national health expenditures, $830 billion were private insurance premiums. Over one in three dollars of health care expenditures went through private insurance! Private insurers would almost certainly oppose a single payer plan, and they have actively promoted their own cause in the formulation of PPACA. Do health care system problems warrant a change to a single payer? Other reforms may address specific problems. For example, we insure the uninsured through mandated coverage including subsidies for the poor, and provide coverage for people with pre-existing conditions through the individual mandates. Before PPACA passed, beneficiaries used COBRA legislation to address this issue.
A potential benefit of the single-payer system lies with the possibility of common coverage. We may worry now that some insured people have inadequate policies in terms of the depth and breadth of coverage. The single payer could offer one policy or a small number of variations, each variation determined to be adequate by policy makers representing the public. In contrast, the availability of many policies from many companies offers variety, tailoring policies to the individual preferences for cost-sharing features and coverage.
COMPETITIVE STRATEGIES
Regardless of any changes in the direction of U.S. health care policy, governments will remain heavily involved in the financing and delivery of health care. The ideological battle is over the superiority of (1) increased government involvement through both expanded regulation and additional government programs to provide or finance health care or (2) an increased emphasis on market mechanisms and market forces with corresponding decreases in the use of regulatory instruments. This controversy between competition and regulation is not new to the academic and policymaking communities. Those who deny the applicability of the competitive framework will most likely favor regulatory strategies. Proponents of further regulation tend to argue that attempts to promote partial forms of competition will not readily correct information imperfections, flawed agency relationships, and other distortions. Regulation proponents also react to the rapid growth in overall health spending and in spending on Medicare, Medicaid, and other public programs. The spending record in the United States, as compared to other more highly regulated systems, has reinforced beliefs among many that health care markets do not work like most other markets. Many believe that increases in supplies of hospital beds and physicians increase utilization of marginally necessary or even unnecessary services. There are widespread views that physicians can and do create demand and that empty beds in hospitals will be filled through physicians’ discretionary decisions to admit patients. Those who share these views advocate controls limiting hospital capacity and physician supplies, and increasing the monitoring of services provided. We have outlined the general forms of these controls. What is competition in health care? Pauly (1988a) defines competition through the conditions of “free entry and potential entrants willing[ness] to offer goods and services to consumers, with no one firm large enough to have an important influence on levels and quality” (p. 35). From this definition, in a competitive health care industry we would expect (1) price-elastic demands facing providers; (2) a tendency toward marginal cost pricing; (3) efficiency in production— allocative as well as technical efficiency; and (4) the availability of alternatives in terms of price, quality, and form of delivery. Others see competition in a more limited way, largely through the form of government policy rather than the structure or performance of health care markets. A competitive health care policy is one that relies primarily on financial incentives rather than controls to achieve goals. Those supporting this approach believe that market participants respond to changes in prices in a predictable and substantial way. Supporters of competitive approaches also argue that even imperfections in their strategies are preferable to the distortions caused by imperfect regulation. Under either view of competition, certain forms of government intervention such as CON laws, utilization review, and mandated benefits, are anticompetitive because they compel. To be more specific in the distinction between competition and regulation, consider the uninsured. From the competitive point of view, many of the uninsured have insufficient income to purchase insurance. Mandated benefits and other requirements that drive up insurance prices aggravate their dilemma. A competitive solution is to subsidize purchases of insurance for the lower-income uninsured through tax credits, and to deregulate insurers so that lower-priced options become available. In contrast, they view programs that would provide insurance for the uninsured as lacking in incentives for efficient consumer search. Bearing in mind these distinctions, we turn to several broad competitive strategies for reforming the U.S. health care system.
The Costs of Universal Coverage
National Health Insurance programs that guarantee universal coverage certainly cost a great deal of
money, but it is important to distinguish which costs are incremental. In other words, what are the
additional costs to society from the imposition of NHI?
From society’s point of view, the incremental cost of NHI in the United States is the extra total
expenditure on health care incurred if we switched to national health insurance. Inasmuch as most
people already have insurance for almost all hospital care and most physician care, the extra cost of
NHI would be much smaller than many expect.
The truly incremental costs stem from several sources. First, the major reason for switching to
a NHI plan is to extend coverage to the 50 million uninsured. It should be understood that the uninsured
already consume health care. Zero insurance does not necessarily mean zero care.
Using data from the 2002–2004 Medical Expenditure Panel Surveys (MEPS), a nationally
representative survey of the civilian, non-institutionalized population, Hadley and colleagues
(2008), in what remains the most comprehensive study to date, estimated that uninsured Americans consumed $86 billion worth of health care in 2008. This total consisted of $30 billion in out-ofpocket costs and $56 billion in uncompensated care. Governments picked up about $43 billion of the latter. The authors then projected that the incremental cost of providing full-year coverage for all uninsured would amount to $123 billion, so that total spending of those currently uninsured would rise from $86 to $209 billion. This incremental cost represented 5.1 percent of total health care spending in the United States and slightly less than 1 percent of its GDP. The authors base their estimates on the utilization patterns of lower-income and lower-middle income individuals. More or less generous plans as well as higher or lower payment rates to providers would raise or lower estimated costs accordingly. Second, the insured population will cost more to the extent that an NHI plan provides greater typical coverage than people already choose to buy or have provided to them by other sources. Third, any tax-supported system of financing care potentially entails a deadweight loss to society, as taxpayers respond to the changed incentives. The deadweight losses that accompany tax increases mean that some efficiency loss will result, caused by the disincentives to work and invest. This is true even if the program is of the employer-mandated type, because a law forcing employers to incur expense is really a tax. The incremental costs constitute real costs to society, because, as noted in Figure 23-1, society must divert resources from elsewhere to pay them. In contrast, differences in financing methods (determining who pays) mean less in economic terms. It may be politically more palatable to choose a plan that does not greatly expand the government budget, and employment-mandated plans may be attractive politically for this reason. Nonetheless, society incurs the cost irrespective of whether it finances it through the government or through mandates to individuals or employers by law.
ENSURING ACCESS TO CARE
In this section, we group reforms by their two main motivations: the desire to see that sick people get health care, and the desire to control the rising cost of health care
Employer versus Individual Mandates
The country that wishes to provide universal coverage for health care must choose one scheme or another to extract resources from its households. Schemes for employers or government to pay the bills are only mechanisms by which households ultimately pay. The U.S. debate features and contrasts two mechanisms: employer versus individual mandates. Employer mandates form the backbone of the health systems in Europe, Latin America, and Asia (Krueger and Reinhardt, 1994). Under employer mandates, employers must procure health insurance for their employees and their dependents. Although the employer writes the check, the firm undoubtedly will pass on as much of this cost as it can to customers in the form of higher prices or to employees in the form of lower wages. The individual mandate, in contrast, obligates all residents to purchase health insurance for themselves and their families, either from private insurance (individually purchased) or through a group, such as a work group, professional organization, or religious group. The government subsidizes the poor in their purchases through taxation of those who have more money. In Chapter 11, we showed that a lower market money wage rate leads an employer to hire more workers. Assuming at the outset that there are no benefits and that the market wage is $20 per hour, employers will hire workers as long as the marginal revenue from the goods those workers produce exceeds the $20 per hour wage. To begin, assume that the employer hires 1,000 workers. Suppose that an NHI mandates the provision of a health benefit for all workers that costs $1 per hour of work. If the mandated benefit is worth at least $1 per hour to the workers, and costs exactly $1 per hour for the employer to provide, employers who were previously willing to pay $20 will now pay $20 less the $1 cost to provide the mandated benefit. Other points on the demand schedule will also change by the $1 cost of the benefit. Workers previously willing to accept a wage of $20 will now be willing to supply their labor for $1 less since they value the mandated benefit at $1. The net wage (money wage + the value of the benefit) remains unchanged at $20, but the equilibrium money wage falls to $19, or by exactly the amount of the benefit. Workers accept lower money wages, and the same 1,000 workers are employed at the same net wage, $19 in money wages plus the $1 benefit. The workers are no worse off at a wage of $19 with the mandated benefit than at $20 without the mandated benefit because the benefit is worth the $1 that it cost in reduced wages. Business leaders often complain that employer mandates either will reduce profits or force firms out of business. Such responses implicitly assume that their firm is the only one affected by the mandate. If all firms faced the same labor costs, it is doubtful that closings would result. In the short run, firms would pay workers less, take less in profits, and/or raise prices to consumers. “Economists are convinced, however, that in the longer run more and more of the cost of the employer mandate would likely be shifted backward to employees . . . through smaller real (inflation-adjusted) increases in wages than would have been warranted by long-run productivity gain” (Krueger and Reinhardt, 1994, p. 44). If the labor supply is very unresponsive to the wage rate, the employer’s lower wage expenditures will offset extra health benefit costs regardless of whether the laborers value the benefit highly or not at all. Most economists would agree that the aggregate labor supply, at least in the long run, is nearly vertical (totally inelastic) for men, and also highly inelastic for women. In this scenario, the mandate has little effect on producers, their competitive position, or their customers. Whether the program helps or harms the well-being of society under conventional economic analysis depends largely on whether workers value their health insurance as much as or more than they did their foregone wages. The individual mandate provides the same result with a clearer pathway, because its costs fall on the beneficiary who pays them directly. Pauly (1994b, 1997) describes an individual mandate, enforced by employers and subsidized for the poor, requiring all individuals to purchase a minimum health plan or better. He argues that this approach is desirable so that people can relate their taxes to what they are paying to obtain benefits. In this scheme, individuals are required to purchase health insurance. They may in fact acquire it through their workplaces, or they may buy it explicitly in a market setting. During the U.S. debate of 1993–1994, disputes arose frequently over the fraction that the employer pays as opposed to the fraction paid by the individual. The presumption in these arguments is that the chosen fraction reflects the burden. Economists, however, tend to agree that the fraction chosen does not matter. The discussion presented above (regarding the $20 per hour wage) says nothing about fractions. The economic logic suggests that those who are least able to avoid a tax will bear its burden, irrespective of who writes the check. Some argue that it is a political necessity to overlook the economics, but others insist that an open public discussion of the genuine issues would improve the quality of national debate.
(2008), in what remains the most comprehensive study to date, estimated that uninsured Americans consumed $86 billion worth of health care in 2008. This total consisted of $30 billion in out-ofpocket costs and $56 billion in uncompensated care. Governments picked up about $43 billion of the latter. The authors then projected that the incremental cost of providing full-year coverage for all uninsured would amount to $123 billion, so that total spending of those currently uninsured would rise from $86 to $209 billion. This incremental cost represented 5.1 percent of total health care spending in the United States and slightly less than 1 percent of its GDP. The authors base their estimates on the utilization patterns of lower-income and lower-middle income individuals. More or less generous plans as well as higher or lower payment rates to providers would raise or lower estimated costs accordingly. Second, the insured population will cost more to the extent that an NHI plan provides greater typical coverage than people already choose to buy or have provided to them by other sources. Third, any tax-supported system of financing care potentially entails a deadweight loss to society, as taxpayers respond to the changed incentives. The deadweight losses that accompany tax increases mean that some efficiency loss will result, caused by the disincentives to work and invest. This is true even if the program is of the employer-mandated type, because a law forcing employers to incur expense is really a tax. The incremental costs constitute real costs to society, because, as noted in Figure 23-1, society must divert resources from elsewhere to pay them. In contrast, differences in financing methods (determining who pays) mean less in economic terms. It may be politically more palatable to choose a plan that does not greatly expand the government budget, and employment-mandated plans may be attractive politically for this reason. Nonetheless, society incurs the cost irrespective of whether it finances it through the government or through mandates to individuals or employers by law.
ENSURING ACCESS TO CARE
In this section, we group reforms by their two main motivations: the desire to see that sick people get health care, and the desire to control the rising cost of health care
Employer versus Individual Mandates
The country that wishes to provide universal coverage for health care must choose one scheme or another to extract resources from its households. Schemes for employers or government to pay the bills are only mechanisms by which households ultimately pay. The U.S. debate features and contrasts two mechanisms: employer versus individual mandates. Employer mandates form the backbone of the health systems in Europe, Latin America, and Asia (Krueger and Reinhardt, 1994). Under employer mandates, employers must procure health insurance for their employees and their dependents. Although the employer writes the check, the firm undoubtedly will pass on as much of this cost as it can to customers in the form of higher prices or to employees in the form of lower wages. The individual mandate, in contrast, obligates all residents to purchase health insurance for themselves and their families, either from private insurance (individually purchased) or through a group, such as a work group, professional organization, or religious group. The government subsidizes the poor in their purchases through taxation of those who have more money. In Chapter 11, we showed that a lower market money wage rate leads an employer to hire more workers. Assuming at the outset that there are no benefits and that the market wage is $20 per hour, employers will hire workers as long as the marginal revenue from the goods those workers produce exceeds the $20 per hour wage. To begin, assume that the employer hires 1,000 workers. Suppose that an NHI mandates the provision of a health benefit for all workers that costs $1 per hour of work. If the mandated benefit is worth at least $1 per hour to the workers, and costs exactly $1 per hour for the employer to provide, employers who were previously willing to pay $20 will now pay $20 less the $1 cost to provide the mandated benefit. Other points on the demand schedule will also change by the $1 cost of the benefit. Workers previously willing to accept a wage of $20 will now be willing to supply their labor for $1 less since they value the mandated benefit at $1. The net wage (money wage + the value of the benefit) remains unchanged at $20, but the equilibrium money wage falls to $19, or by exactly the amount of the benefit. Workers accept lower money wages, and the same 1,000 workers are employed at the same net wage, $19 in money wages plus the $1 benefit. The workers are no worse off at a wage of $19 with the mandated benefit than at $20 without the mandated benefit because the benefit is worth the $1 that it cost in reduced wages. Business leaders often complain that employer mandates either will reduce profits or force firms out of business. Such responses implicitly assume that their firm is the only one affected by the mandate. If all firms faced the same labor costs, it is doubtful that closings would result. In the short run, firms would pay workers less, take less in profits, and/or raise prices to consumers. “Economists are convinced, however, that in the longer run more and more of the cost of the employer mandate would likely be shifted backward to employees . . . through smaller real (inflation-adjusted) increases in wages than would have been warranted by long-run productivity gain” (Krueger and Reinhardt, 1994, p. 44). If the labor supply is very unresponsive to the wage rate, the employer’s lower wage expenditures will offset extra health benefit costs regardless of whether the laborers value the benefit highly or not at all. Most economists would agree that the aggregate labor supply, at least in the long run, is nearly vertical (totally inelastic) for men, and also highly inelastic for women. In this scenario, the mandate has little effect on producers, their competitive position, or their customers. Whether the program helps or harms the well-being of society under conventional economic analysis depends largely on whether workers value their health insurance as much as or more than they did their foregone wages. The individual mandate provides the same result with a clearer pathway, because its costs fall on the beneficiary who pays them directly. Pauly (1994b, 1997) describes an individual mandate, enforced by employers and subsidized for the poor, requiring all individuals to purchase a minimum health plan or better. He argues that this approach is desirable so that people can relate their taxes to what they are paying to obtain benefits. In this scheme, individuals are required to purchase health insurance. They may in fact acquire it through their workplaces, or they may buy it explicitly in a market setting. During the U.S. debate of 1993–1994, disputes arose frequently over the fraction that the employer pays as opposed to the fraction paid by the individual. The presumption in these arguments is that the chosen fraction reflects the burden. Economists, however, tend to agree that the fraction chosen does not matter. The discussion presented above (regarding the $20 per hour wage) says nothing about fractions. The economic logic suggests that those who are least able to avoid a tax will bear its burden, irrespective of who writes the check. Some argue that it is a political necessity to overlook the economics, but others insist that an open public discussion of the genuine issues would improve the quality of national debate.
Health System Reform
Examined national health insurance (NHI) programs in several major industrialized countries.
Although the United States established a more comprehensive health care system in 2010, many issues
(as well as court challenges) remain. In 2011, 50 million Americans were still without health insurance
at any given time. Many favor universal health care coverage as a solution to the problems of access and costs.
Others argue that we can meet health care objectives more effectively through reforms that reduce the role of
government and instead take advantage of market forces. The basic issues in health system reform and alternative
reform proposals are the focus of this chapter. We finish the chapter by evaluating the 2010 Patient
Protection and Affordable Care Act (PPACA).
GOALS OF REFORM
Most would agree that a national health system reform needs to address these four elements: • A health “safety net” for all residents, irrespective of age, health status, or employment status • Mechanisms that promote cost containment • Choice for patients and providers • Ease in administration Consider the four elements in order: Safety net—Large portions of the U.S. population receive inadequate health care by almost any criteria. While Medicare provides almost universal health care for those over age 65 and Medicaid/CHIP are making great inroads into the population under age 18, millions of Americans lack access to levels of health care that even the most conservative analysts would view as adequate.
Cost containment—The United States spends well over one in six dollars of its GDP on health care, and expanded coverage will almost certainly increase that ratio. While some analysts have argued that this amount may reflect consumer preferences for high quality health care, there are clearly avenues relating to administrative costs, and ineffective treatment, that could reduce overall health care costs. Further, few Americans would desire cost containment at the expense of the quality of the health care. Choice for patients and providers—The failure of President Clinton’s reform initiative in 1994 made it clear that Americans will reject any national health insurance policy that can be characterized as “one size fits all.” A successful plan must provide choices of providers and treatments. Ease in administration—Consider the weekly trip to the supermarket. The decision as to where to shop and what to buy, while constrained by budgets and the prices of the goods, is administratively simple. People go where they shop, buy what they need, and need not deal with bureaucrats. Contrast that to current health insurance systems, with different application forms, insurance forms, cards, and a myriad of questions about who pays for what, and whether what one has paid will be reimbursed. While purchasing health care is obviously more complicated than purchasing food, any national health care policy that simplifies the process would be desirable. Many reform proposals face the dilemma whether to fund coverage by individual mandate, employer-employee mandate, or general revenues. An individual mandate is a law that requires individuals to buy health insurance for themselves, with subsidies for those who cannot afford it. The subsidies usually would be funded out of general revenues. Employer-employee mandates would require taxes on wages for the employee’s share. The employer’s share may also fall on the employee in the form of lower wages. Subsidies out of general revenues would provide for the unemployed. Those who advocate a Canadian-style system seek a single-payer system with government revenues providing most of the NHI. Yet another alternative is the medical savings accounts method of payment that would allow people to set up a tax-free savings account out of which they can pay the out-of-pocket costs of their health care. Usually, these systems entail health insurance with high deductibles and coinsurance. Some plans define a minimum acceptable insurance level, with people allowed to purchase more extensive coverage if desired and if they can afford it. Others define one plan to fit all. In early debates, many plans featured universal coverage. As support for universal coverage waned in Congress, more plans offered lesser goals for reaching the population.
Basic Issues in Reform
Any reform program must difficult questions. One fundamental question is service coverage. Clearly, as more services are covered or mandated and more provider types are included, the costs will increase. Figure 23-1 shows a health care system that allocates its resources to goods and health at Point A. It would be best, of course, if A were on the production possibility frontier of efficient production for health and all goods, the solid line PP, but there are many reasons that it is probably not. Ineffective treatments, needless tests, and excessive paperwork, may all provide less health (and other goods) than possible, so that we see an interior frontier indicated by the dashed line PP. 1 Assume that the society determines to provide a safety net for all residents, increasing the amount of health goods provided from H0 to H1. The economic cost of providing H = H1 - H0 of health is the amount of G given up, or ¢G = G0 - G1 at point B. If we could control costs, or provide health more efficiently, society might plausibly reach a point like B or B, on the efficient frontier. One of the underlying goals of reform would be to move to a more efficient production of health from health care. A related issue is whether there will be cost-sharing for covered services and, if so, what type of cost-sharing arrangement will occur. The question of who is covered can be equally difficult to address. At any time in the United States, there are millions of foreign students, visitors, and temporary workers as well as millions of illegal immigrants. The difficulty of determining the covered population in some cases is evidenced by the acrimonious debate over care provided (and paid by governments) to undocumented workers and their families. A third major issue is how to fund health reform. Will it rely on general tax revenues or will funding come from mandates on businesses and/or individuals? In either case, where will the burden of funding ultimately rest? The most challenging issue is to determine whether health reform will build largely on the existing framework of government programs and private employment-based insurance with most of the reform effort aimed at cost-containment and reducing the pool of uninsured. Other proposals, especially market-oriented proposals, attempt to attain these goals by weakening the link between private insurance and employment.
GOALS OF REFORM
Most would agree that a national health system reform needs to address these four elements: • A health “safety net” for all residents, irrespective of age, health status, or employment status • Mechanisms that promote cost containment • Choice for patients and providers • Ease in administration Consider the four elements in order: Safety net—Large portions of the U.S. population receive inadequate health care by almost any criteria. While Medicare provides almost universal health care for those over age 65 and Medicaid/CHIP are making great inroads into the population under age 18, millions of Americans lack access to levels of health care that even the most conservative analysts would view as adequate.
Cost containment—The United States spends well over one in six dollars of its GDP on health care, and expanded coverage will almost certainly increase that ratio. While some analysts have argued that this amount may reflect consumer preferences for high quality health care, there are clearly avenues relating to administrative costs, and ineffective treatment, that could reduce overall health care costs. Further, few Americans would desire cost containment at the expense of the quality of the health care. Choice for patients and providers—The failure of President Clinton’s reform initiative in 1994 made it clear that Americans will reject any national health insurance policy that can be characterized as “one size fits all.” A successful plan must provide choices of providers and treatments. Ease in administration—Consider the weekly trip to the supermarket. The decision as to where to shop and what to buy, while constrained by budgets and the prices of the goods, is administratively simple. People go where they shop, buy what they need, and need not deal with bureaucrats. Contrast that to current health insurance systems, with different application forms, insurance forms, cards, and a myriad of questions about who pays for what, and whether what one has paid will be reimbursed. While purchasing health care is obviously more complicated than purchasing food, any national health care policy that simplifies the process would be desirable. Many reform proposals face the dilemma whether to fund coverage by individual mandate, employer-employee mandate, or general revenues. An individual mandate is a law that requires individuals to buy health insurance for themselves, with subsidies for those who cannot afford it. The subsidies usually would be funded out of general revenues. Employer-employee mandates would require taxes on wages for the employee’s share. The employer’s share may also fall on the employee in the form of lower wages. Subsidies out of general revenues would provide for the unemployed. Those who advocate a Canadian-style system seek a single-payer system with government revenues providing most of the NHI. Yet another alternative is the medical savings accounts method of payment that would allow people to set up a tax-free savings account out of which they can pay the out-of-pocket costs of their health care. Usually, these systems entail health insurance with high deductibles and coinsurance. Some plans define a minimum acceptable insurance level, with people allowed to purchase more extensive coverage if desired and if they can afford it. Others define one plan to fit all. In early debates, many plans featured universal coverage. As support for universal coverage waned in Congress, more plans offered lesser goals for reaching the population.
Basic Issues in Reform
Any reform program must difficult questions. One fundamental question is service coverage. Clearly, as more services are covered or mandated and more provider types are included, the costs will increase. Figure 23-1 shows a health care system that allocates its resources to goods and health at Point A. It would be best, of course, if A were on the production possibility frontier of efficient production for health and all goods, the solid line PP, but there are many reasons that it is probably not. Ineffective treatments, needless tests, and excessive paperwork, may all provide less health (and other goods) than possible, so that we see an interior frontier indicated by the dashed line PP. 1 Assume that the society determines to provide a safety net for all residents, increasing the amount of health goods provided from H0 to H1. The economic cost of providing H = H1 - H0 of health is the amount of G given up, or ¢G = G0 - G1 at point B. If we could control costs, or provide health more efficiently, society might plausibly reach a point like B or B, on the efficient frontier. One of the underlying goals of reform would be to move to a more efficient production of health from health care. A related issue is whether there will be cost-sharing for covered services and, if so, what type of cost-sharing arrangement will occur. The question of who is covered can be equally difficult to address. At any time in the United States, there are millions of foreign students, visitors, and temporary workers as well as millions of illegal immigrants. The difficulty of determining the covered population in some cases is evidenced by the acrimonious debate over care provided (and paid by governments) to undocumented workers and their families. A third major issue is how to fund health reform. Will it rely on general tax revenues or will funding come from mandates on businesses and/or individuals? In either case, where will the burden of funding ultimately rest? The most challenging issue is to determine whether health reform will build largely on the existing framework of government programs and private employment-based insurance with most of the reform effort aimed at cost-containment and reducing the pool of uninsured. Other proposals, especially market-oriented proposals, attempt to attain these goals by weakening the link between private insurance and employment.
RATIONALES FOR PUBLIC INTERVENTION
Are cigarette smokers well-informed about the risks of smoking so they can make rational choices?
Some economists (Lundborg and Lindgren, 2004; Viscusi, 1995) have challenged the common wisdom
that smokers are illinformed, reporting smokers’ knowledge and responses to risk to be similar
to that of nonsmokers. Despite this, findings from various fields regarding smoker and nonsmoker
behavior more often suggest that smokers differ from nonsmokers on these bases.
Consider nonsmokers first. We mentioned that another justification for intervention is that
smoking has detrimental side effects on others, or “external costs.” Much then depends on the size
of these costs. These externalities come from two principal sources: the passive smoking incurred
by people nearby, and various other external costs caused by health hazards to the smoker. Manning
et al. (1991) estimated the external costs at the equivalent of $0.33 per pack for a new smoker
evaluated in 1995 dollars, though he did not examine passive smoking costs. Viscusi (1995) also estimated
the external costs per pack to be in this range, though lower than Manning’s, and near zero
under some scenarios.
Because economic efficiency is only one economic criterion (the other is equity), because
experts may dispute data issues, and because economics is not the only basis to consider, many
choose to intervene in tobacco and alcohol use. Economics offers two major tools that may be effective
in curbing consumption of a targeted bad: restrictions on advertising and imposition of excise
taxes. Advertising can be restricted by tax code revisions, but most often the public issue is whether
to restrict advertising by selective or total bans. The excise tax tool is theoretically effective to the
degree that demand is more elastic for a given supply. These two principal tools of intervention
form the subject of our next investigations. First, however, consider why we have chosen not to
address the several other tools.
Other Interventions
Two other potential forms of intervention are prohibitions on the consumption of the product and penalties for consumption or misuse of the product. Outright prohibition of cigarettes is unlikely to occur in the United States. Accounts of 1920s Prohibition in the United States seem to point to that clear conclusion. Furthermore, alcohol prohibition of that era probably was not even effective in reducing alcohol consumption (Miron, 1999; Dills, Jacobson, and Miron, 2005). Lesser prohibitions, however, often have been accepted and proven effective. These include the effect of lower speed limits on rates of fatal accidents involving alcohol, as well as bans on smoking in public places.3 Many countries, especially in Scandinavia, apply much more severe penalties for drunk driving than does the United States. These include stiff jail sentences for alcohol offenses, offenses that many Americans regard as less serious. Mullahy and Sindelar (1994) showed for U.S. data that legal penalties affect drunken-driving behavior. Increased fines and license revocations significantly reduce the individual’s probability to drive drunk. Regulation of smoking sometimes fails to work, although some research has found reductions in smoking after the passage of clean air restrictions. Tax effects might even be somewhat overestimated if part of the “tax effect” is really due to unmeasured local clean air restrictions. However, a recent Canadian study provides an example of research that finds regulation to be relatively ineffective (Lanoie and Leclair, 1998).
ADVERTISING RESTRICTIONS ON CIGARETTES AND ALCOHOL
We begin with the role of advertising on cigarettes. At issue is whether advertising can increase the total consumption of bads like cigarettes. The issues we will address are ones on which people differ and hold strong views. In a report on cigarettes, the surgeon general (1989) concluded at one point that: There is no scientifically rigorous study available to the public that provides a definitive answer to the basic question of whether advertising and promotion affect the level of tobacco consumption. Given the complexity of the issue, none is likely to be forthcoming in the foreseeable future. (pp. 516–517) Even this conclusion was disputed by parties to both sides of the issue. Economists understand that well-intentioned interventions often have unintended consequences. Before blaming advertising for our ills, we should inquire into its nature.
THEORIES OF ADVERTISING Three main theories explain how advertising works and what it does for or to the community. Advertising alternatively is a form of information, a tool for persuasion, or a complementary good. The first two of these represent an old battle in advertising theory with contrasting villains and heroes: Information is generally beneficial, while persuasion is at least more questionable. The most recent addition treats advertising as a complementary good. Finally, Box 24-2 visits the advertisement of worthless goods—patent medicines.
ADVERTISING AS INFORMATION Nelson (1970, 1974) studied the implications of advertising as information. Viewed as information, advertising lowers equilibrium prices, creates better access to the market for new entrants, and provides better matches of consumer preferences with feasible consumption bundles. Informed consumers find that their dependence on or loyalty to Brand A will be weakened by their improved knowledge of alternatives. If consumers find it easy to opt for another brand, then they have flexibility, and flexible consumers will more likely resist undesirable changes
in the brand, such as a drop in quality or an increase in price. This greater responsiveness to price implies a more elastic demand, and it makes possible lower market equilibrium prices. How can the firm’s costly advertising activity help but be passed on to consumers in the form of higher prices? The mistake is that while the price at a given output must rise, the market equilibrium quantity may change due to competition, and the equilibrium price may fall.
ADVERTISING AS A BARRIER TO ENTRY In contrast to advertising as information, Bain (1956) argued that advertising differentiates one brand from another, creating increased brand loyalty. By making consumers more resistant to price changes and demand, advertising can result in greater market power and higher equilibrium prices. Comanor and Wilson (1974) added that the persuasive power of advertising may make it asymmetrically effective for the incumbent versus potential new entrants. Consumers have greater experience with established firms and greater recognition of them. The next advertising dollar spent by the established firm will yield a greater return than the same dollar spent by the newcomer.
ADVERTISING AS A COMPLEMENTARY GOOD Nobel laureate Gary Becker and colleague Kevin Murphy (1993) proposed a theory to account for these competing claims within a single model— one that appeals to an older theory of complements and substitutes. Let advertising be considered a good that is a complement to the good advertised. A consumer might wade through commercials with irritation during a ball game but enjoy the humorous one featuring a favorite beer. The commercial increases the consumer’s marginal utility from consuming that brand and, under this theory, firm advertising will raise total consumption of the product, just as a reduction in the price of mustard will increase the consumption of hot dogs
Other Interventions
Two other potential forms of intervention are prohibitions on the consumption of the product and penalties for consumption or misuse of the product. Outright prohibition of cigarettes is unlikely to occur in the United States. Accounts of 1920s Prohibition in the United States seem to point to that clear conclusion. Furthermore, alcohol prohibition of that era probably was not even effective in reducing alcohol consumption (Miron, 1999; Dills, Jacobson, and Miron, 2005). Lesser prohibitions, however, often have been accepted and proven effective. These include the effect of lower speed limits on rates of fatal accidents involving alcohol, as well as bans on smoking in public places.3 Many countries, especially in Scandinavia, apply much more severe penalties for drunk driving than does the United States. These include stiff jail sentences for alcohol offenses, offenses that many Americans regard as less serious. Mullahy and Sindelar (1994) showed for U.S. data that legal penalties affect drunken-driving behavior. Increased fines and license revocations significantly reduce the individual’s probability to drive drunk. Regulation of smoking sometimes fails to work, although some research has found reductions in smoking after the passage of clean air restrictions. Tax effects might even be somewhat overestimated if part of the “tax effect” is really due to unmeasured local clean air restrictions. However, a recent Canadian study provides an example of research that finds regulation to be relatively ineffective (Lanoie and Leclair, 1998).
ADVERTISING RESTRICTIONS ON CIGARETTES AND ALCOHOL
We begin with the role of advertising on cigarettes. At issue is whether advertising can increase the total consumption of bads like cigarettes. The issues we will address are ones on which people differ and hold strong views. In a report on cigarettes, the surgeon general (1989) concluded at one point that: There is no scientifically rigorous study available to the public that provides a definitive answer to the basic question of whether advertising and promotion affect the level of tobacco consumption. Given the complexity of the issue, none is likely to be forthcoming in the foreseeable future. (pp. 516–517) Even this conclusion was disputed by parties to both sides of the issue. Economists understand that well-intentioned interventions often have unintended consequences. Before blaming advertising for our ills, we should inquire into its nature.
THEORIES OF ADVERTISING Three main theories explain how advertising works and what it does for or to the community. Advertising alternatively is a form of information, a tool for persuasion, or a complementary good. The first two of these represent an old battle in advertising theory with contrasting villains and heroes: Information is generally beneficial, while persuasion is at least more questionable. The most recent addition treats advertising as a complementary good. Finally, Box 24-2 visits the advertisement of worthless goods—patent medicines.
ADVERTISING AS INFORMATION Nelson (1970, 1974) studied the implications of advertising as information. Viewed as information, advertising lowers equilibrium prices, creates better access to the market for new entrants, and provides better matches of consumer preferences with feasible consumption bundles. Informed consumers find that their dependence on or loyalty to Brand A will be weakened by their improved knowledge of alternatives. If consumers find it easy to opt for another brand, then they have flexibility, and flexible consumers will more likely resist undesirable changes
in the brand, such as a drop in quality or an increase in price. This greater responsiveness to price implies a more elastic demand, and it makes possible lower market equilibrium prices. How can the firm’s costly advertising activity help but be passed on to consumers in the form of higher prices? The mistake is that while the price at a given output must rise, the market equilibrium quantity may change due to competition, and the equilibrium price may fall.
ADVERTISING AS A BARRIER TO ENTRY In contrast to advertising as information, Bain (1956) argued that advertising differentiates one brand from another, creating increased brand loyalty. By making consumers more resistant to price changes and demand, advertising can result in greater market power and higher equilibrium prices. Comanor and Wilson (1974) added that the persuasive power of advertising may make it asymmetrically effective for the incumbent versus potential new entrants. Consumers have greater experience with established firms and greater recognition of them. The next advertising dollar spent by the established firm will yield a greater return than the same dollar spent by the newcomer.
ADVERTISING AS A COMPLEMENTARY GOOD Nobel laureate Gary Becker and colleague Kevin Murphy (1993) proposed a theory to account for these competing claims within a single model— one that appeals to an older theory of complements and substitutes. Let advertising be considered a good that is a complement to the good advertised. A consumer might wade through commercials with irritation during a ball game but enjoy the humorous one featuring a favorite beer. The commercial increases the consumer’s marginal utility from consuming that brand and, under this theory, firm advertising will raise total consumption of the product, just as a reduction in the price of mustard will increase the consumption of hot dogs
MODELS OF ADDICTION
Models of addiction come out of both psychology/medicine and economics. Chaloupka and Warner
(1999) identify three types: imperfectly rational, myopic, and rational addiction.
Imperfectly Rational Addiction Models
Imperfect rational addiction models propose that the addict has stable but inconsistent preferences in the short run as opposed to the long run. As Schelling (1978) described this person: Everybody behaves like two people, one who wants clean lungs and long life and another who adores tobacco . . . The two are in a continual contest for control. (p. 290) Are people really like this? Regret, in fact, occurs frequently. In film, there is even the cliché of the hero in comedy who enters the tiger’s cage telling the bystanders to ignore him should he change his mind and even scream for help. Of course, he changes his mind. Is he two different people at those two moments?
Myopic Addiction Models
Nearsightedness about the future harmful effects of the ingested drug provides a variant of the imperfectly rational model. Here, the individuals don’t see the facts clearly; they are naïve about the nature of the drug and its side effects. One may imagine someone easily persuaded by cigarettesmoking friends who may denigrate the societal information about cigarettes. One may see the teenager who only dimly perceives the realities of distant future health events, including cancers, and perhaps fails to connect the experience of smokers in older generations with his or her own behaviors and prospects.
Rational Addiction
Can addiction in some cases be a rational choice? Becker and Murphy (1988) discarded myopic models and investigated addiction by assuming that people incorporate rationally all information, past, present, and future, into their utility calculations. They showed that rationally choosing to ingest an addictive drug was possible under restrictive yet plausible conditions. The discussion here follows work by Becker and Murphy (1988), Becker, Grossman, and Murphy (1991), and MacDonald (2004). Addiction researchers usually speak of “reinforcement” and “tolerance.” Reinforcement means that greater past consumption of addictive goods, such as drugs or cigarettes, increases the desire for present consumption. In short, smoking more now may make us smoke more later. Tolerance occurs if the utility from a given amount of consumption is lower when past consumption is greater. This suggests that the future impacts of smoking or drinking or ingesting drugs decrease, when we consume more now. A single glass of wine may make someone tipsy the first time he or she drinks. Over time, with more drinking experience, the first glass of the evening may have little or no impact. We will use smoking to illustrate important model relationships, although drinking, illicit drugs, or even common substances such as caffeine, can provide similar examples. Becker, Grossman, and Murphy introduce the construct of “addictive capital stock,” S. For example, with more smoking experience, the smoker’s attitude toward cigarette consumption is likely to change. We assume therefore that addictive stock “reinforces” cigarette consumption, C, meaning that the more stock, the more one will smoke, leading to curves A1 and A2 in Figure 24-3. Though not shown in the figure, the utility function shows the smoker as gaining utility from cigarette consumption, C, from the addictive stock, S, as well as from income, which allows the purchase of other goods in addition to cigarettes.
The important questions in the model deal with what happens over time. For example, current
consumption increases the addictive stock. Listening to Mozart at age 21 will likely increase enjoyment
of Mozart at age 22, thus increasing our musical “capital stock.” Most smokers will remember
how bad the first cigarette tasted, but similarly smoking or drinking at age 21 may increase enjoyment
of smoking or drinking in subsequent years. So, a larger addictive stock makes future consumption
more pleasurable.
A myopic, or nearsighted, addict looks solely at the reinforcement effect. A rational addict,
however, also considers the future harmful consequences of current addictive behavior. The rationally
addicted smoker weighs the present pleasure against both the future health consequences and
the beneficial impact of current consumption on future consumption enjoyment.
The rational addiction theorists have drawn several further implications from their analyses.
• Addiction is more likely for people who discount the future heavily, because they pay less
attention to the potential adverse consequences.
• Addiction is more likely when the effects of past consumption depreciate less rapidly.
• Expected rises in future prices will have a dampening effect on current consumption, much
like increases in current prices.
Models examining people’s behavior over time typically search for a “steady state,” an equilibrium
where all “outflows” and “inflows” maintain the system, like the equilibrium of a well-run fish tank.
In the steady state equilibrium proposed here, the system will be maintained over time, provided
that current cigarette smoking adds exactly enough C to the addictive stock to replace the depreciation
δS of that stock during the period. Mathematically, C = δS, where δ is the constant depreciation
rate. The C = δS line in Figure 24-3 depicts all the combinations of C and S that yield a steady state
equilibrium.
Reviewing the elements of the model, we see:
1. Consumption of cigarettes as a function of addictive stock. Curve A1 relates smoking to addictive
stock for a person with a given rate of time preference (relating future utility to present
utility) and a given level of wealth, and who faces a set of prices for cigarettes and nonaddictive
goods. We can think of curve A1 as a cigarette consumption curve, so the more stock S,
the more consumption C. In other words, any given stock S is just sufficient to maintain consumption
level C.
2. Cigarette consumption needed to maintain addictive stock. The stock of addictive capital
depreciates at a rate of δ (between 0 and 1) per year. Depreciated stock is replaced with more
smoking. The ray from the origin, C = δS is the steady state line where current cigarette consumption
just offsets the depreciation of the stock of smoking capital.
The model provides a convenient way to see what happens to the rational addict over time.
Consider a smoker who is on consumption curve A1 (as an exercise, explain why a price increase
from “low” to “high” would shift the consumption curve from A1 to A2
) with addictive stock S1.
This stock implies a cigarette consumption of C1, or point B. Notice, however, that consumption,
C1, will more than replace the depreciation in S1 during the period (point B lies above the steady
state line, C = δS). It follows that addictive stock will grow and exceed S1 in the next period; for
example it may rise to S2 at point B.
Continuing this logic, it follows that whenever consumption, C, lies above the steady state line,
the addictive stock, S, will grow. Finally, stock S3 and consumption C3 give a steady state equilibrium
for case A1
. We label this equilibrium point as D. Compare steady state equilibrium D with another
place where the two curves cross, point E. Notice that D is like a magnet; any stock near S3 is pulled
toward D. That is, any stock a bit to the left of S3 will bring growth in stock up to S3; any stock to the
right will depreciate down to S3. Point D represents a “stable equilibrium.” Try the same experiment with the equilibrium at point E, and see that it is unstable. Any stock slightly to the left of E will be
pulled farther to the left; any stock slightly to the right will eventually increase all the way to S3.
2
This model provides important policy implications about impacts of price changes, often
induced through tax policies. Starting at point D consider a rise in price so that the cigarette
consumption curve shifts from A1 to A2
. With the price rise, smoking decreases at first from C3
(at point D), to point D. It then falls farther over time since D is below the steady-state line.
Equilibrium smoking level falls to C4 at point D. This shows the model to be consistent with our
prior conceptions about price and quantity demanded. The higher the price, all else equal, the
lower the quantity demanded. Moreover, the long-run responses to price changes exceed shortrun
responses. Initial decreases in smoking cause a subsequent decrease in the stocks of addictive
capital, which then stimulate further smoking decreases.
Second, at some point, a rising price will cause all equilibria to disappear. Starting from point
D and letting the price rise even more, a new A3 curve will be everywhere below the C = δS steady
state line. This prediction is unique to the rational addiction model, the prediction that some cigarette
smokers quit “cold turkey,” without gradually reducing consumption down to zero, landing at
a point similar to F where consumption equals 0.
It also follows that expectations about future prices of cigarettes will affect the addicts’ current
decisions about smoking. In Figure 24-3, we would interpret this by saying that a permanent
price increase shifts the consumption curve downward farther than a temporary price increase. Both
the price effect and the probability of going cold turkey are enhanced by permanent price increases.
Likewise permanent restrictions on the advertising of cigarettes would have more effect than temporary
ones.
Imperfectly Rational Addiction Models
Imperfect rational addiction models propose that the addict has stable but inconsistent preferences in the short run as opposed to the long run. As Schelling (1978) described this person: Everybody behaves like two people, one who wants clean lungs and long life and another who adores tobacco . . . The two are in a continual contest for control. (p. 290) Are people really like this? Regret, in fact, occurs frequently. In film, there is even the cliché of the hero in comedy who enters the tiger’s cage telling the bystanders to ignore him should he change his mind and even scream for help. Of course, he changes his mind. Is he two different people at those two moments?
Myopic Addiction Models
Nearsightedness about the future harmful effects of the ingested drug provides a variant of the imperfectly rational model. Here, the individuals don’t see the facts clearly; they are naïve about the nature of the drug and its side effects. One may imagine someone easily persuaded by cigarettesmoking friends who may denigrate the societal information about cigarettes. One may see the teenager who only dimly perceives the realities of distant future health events, including cancers, and perhaps fails to connect the experience of smokers in older generations with his or her own behaviors and prospects.
Rational Addiction
Can addiction in some cases be a rational choice? Becker and Murphy (1988) discarded myopic models and investigated addiction by assuming that people incorporate rationally all information, past, present, and future, into their utility calculations. They showed that rationally choosing to ingest an addictive drug was possible under restrictive yet plausible conditions. The discussion here follows work by Becker and Murphy (1988), Becker, Grossman, and Murphy (1991), and MacDonald (2004). Addiction researchers usually speak of “reinforcement” and “tolerance.” Reinforcement means that greater past consumption of addictive goods, such as drugs or cigarettes, increases the desire for present consumption. In short, smoking more now may make us smoke more later. Tolerance occurs if the utility from a given amount of consumption is lower when past consumption is greater. This suggests that the future impacts of smoking or drinking or ingesting drugs decrease, when we consume more now. A single glass of wine may make someone tipsy the first time he or she drinks. Over time, with more drinking experience, the first glass of the evening may have little or no impact. We will use smoking to illustrate important model relationships, although drinking, illicit drugs, or even common substances such as caffeine, can provide similar examples. Becker, Grossman, and Murphy introduce the construct of “addictive capital stock,” S. For example, with more smoking experience, the smoker’s attitude toward cigarette consumption is likely to change. We assume therefore that addictive stock “reinforces” cigarette consumption, C, meaning that the more stock, the more one will smoke, leading to curves A1 and A2 in Figure 24-3. Though not shown in the figure, the utility function shows the smoker as gaining utility from cigarette consumption, C, from the addictive stock, S, as well as from income, which allows the purchase of other goods in addition to cigarettes.
The Health Economics of Bads
No discussion of the health economy can be complete without addressing one of the most prominent and
controversial issues—the consumption of health bads. In a market economy, we usually regard the consumer’s
sovereignty as given, that is, the consumer is “free to choose.” However, we can find many exceptions
in any society—cases where society encourages or discourages desired choices. We encourage and
promote use of motorcycle helmets, automobile emissions-control devices, old-age pensions, and good prenatal
care. We often discourage the purchase of alcohol, street drugs, and cigarettes.
The reason to intervene in private decisions could be paternalistic, but it also could appeal to economic
efficiency. Cigarette smoking affects not merely the cigarette buyer and seller—effects that are internal to the
cigarette market—but also the health of nonsmokers nearby, an external cost. Since many health insurers do not
distinguish between smokers and nonsmokers, perhaps because of high monitoring costs, nonsmokers may pay
higher premiums than warranted by their actual health risks. The personal hazards of excessive alcohol consumption
are also serious, including disability due to alcoholism and fatality due to liver disease. The external
costs include possible harm to family or neighbors as well as the excessive, dangerous, and often-fatal traffic
accidents due to drunken driving. Finally, when smokers and drinkers underestimate the probabilities of ill
health due to their consumption, the imperfect information provides an efficiency rationale for measures, such
as taxes, that tend to curb the behaviors.
Economists as citizens may choose one side or the other of these controversies because their values are
not determined by their being economists, but economists as scientists can illuminate the issues that are of interest
to the public. For many, the question is not whether to intervene in private decisions to smoke or drink, but
how to do so more effectively and unobtrusively. This hinges on many issues although two economic questions
are central. First, what is the relationship of price to demand? Second, what is the relationship of product advertising
to total consumption?
AN INTRODUCTION TO BADS
Economic reasoning is helpful for any approach to the analysis of bads, such as cigarette smoking and excessive alcohol consumption. Box 24-1 shows how consumption of alcohol and tobacco varies across countries. Economic models of addiction as well as market failure help determine whether intervention is justified on efficiency grounds. Alternatively, models of consumption, advertising, price, and taxation help provide relatively unobtrusive and cost-effective means to intervene, if we choose to do so.
AN INTRODUCTION TO BADS
Economic reasoning is helpful for any approach to the analysis of bads, such as cigarette smoking and excessive alcohol consumption. Box 24-1 shows how consumption of alcohol and tobacco varies across countries. Economic models of addiction as well as market failure help determine whether intervention is justified on efficiency grounds. Alternatively, models of consumption, advertising, price, and taxation help provide relatively unobtrusive and cost-effective means to intervene, if we choose to do so.
Cigarettes qualify as bads, as follows from the high death rates attributed to cigarette
smoking. Deaths per capita from respiratory cancers rank highest among national death rates from
malignancies and rank second only to categories of heart disease overall. Motor vehicle deaths are
less than half this rate, and only a handful of U.S. states have HIV/AIDS death rates that exceed
one-half of the respiratory cancer rate. Cigarette smoking affects other disease categories as well,
such as emphysema and heart disease. There is little doubt that convincing successive generations
of youth to choose never to smoke would lower average population age-adjusted mortality rates
(Table 24-1) substantially. Econometric studies of health production commonly find cigarette consumption
to be a significant and materially important predictor of mortality rates.1
In contrast to smoking, moderate alcohol consumption does not necessarily harm people and
may (according to some studies) benefit some. Yet, substantial harm occurs with excessive consumption
and inappropriate related behaviors, such as drunk driving. Applying a novel means to
identify the effect of drinking on traffic fatalities, Levitt and Porter (2001) found that drivers with
“alcohol in the blood” are eight times as likely to cause a fatal accident as the sober driver. With
“blood alcohol above legally drunk,” the ratio rises to 15 times. Alcohol use among both high
school and college students also raises policy concerns. College students who drink have poorer academic
attainment (Cook and Moore, 1993; Williams, Powell, and Wechsler, 2003). High school
drinkers are more likely to drop out before graduation (Chatterji and DeSimone, 2005).
One approach is to assume that society has no grounds to intervene if the consumer chooses
rationally and voluntarily, understands the risks, and creates no side effects for others. This view implicitly
rejects all arguments not based on economic efficiency, including those grouped together as
equity concerns and typically rejects other grounds as paternalistic. However, because alcohol and
cigarette consumption are addictive, the issues of rationality, volition, and information take on
closer scrutiny
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