A Primer on Health Economics

Lynn Unruh and Joanne Spetz

“All models are wrong, but some are useful.”

—George Box

It would be great if we could provide all the health care we wanted to anyone needing it at any time. It is becoming clearer and clearer, however, that health care resources are limited, and that choices must be made—and are being made—as to what health care is provided, who receives health care, and how much health care is received.

The choices that must be made among scarce resources can be seen from the following: The United States (U.S.) spends more than any other nation on health care, around $2.5 trillion per year. This translates to 17.6% of the Gross Domestic Product, or $8160 per person (Kaiser Family Foundation [KFF], 2009a). Yet around 17% of our population goes without regular care due to lack of health insurance (KFF, 2008), primary care is often difficult to obtain (Schoen, et al., 2004), and many of our health outcomes are worse than those of other countries (The Commonwealth Fund [CWF], 2007).

These realities of our health care system are important to consumers of health care, yet they equally affect nurses as providers of health care. First, they impact the health of nurses’ patients. When someone goes without preventative care because she cannot pay for the services, she may enter the health care system sicker and use more nursing resources. Second, they impact the types of nursing services that are provided. Over the past decades, health care services have moved away from inpatient hospital care toward outpatient care such as home care, same-day surgery, and urgent care centers. Care also has shifted to nursing homes, rehabilitation centers, or other subacute care centers. As a result, demand for nurses has shifted away from inpatient hospital care. Third, they affect the quantity and quality of resources that are available to provide health care, including physical, technological, and human resources. In turn, these resources (such as nurse-to-patient ratios and nursing skills) affect the quality of health care, nurses’ work environments, and nurses’ physical and mental health (Unruh, 2008).

Health economics helps us make decisions about what and how much health care to produce, how to provide it, and to whom to provide it. Health economics strives to provide insight into how our health care system operates, and ways to make it operate better. It assists in quantifying and evaluating the pros and cons of the multiple potential uses of limited resources. While it is useful as an input in decision-making, it should not be seen as the “last word.” Many other considerations are involved, such as cultural, social, and political concerns.

This chapter begins with a discussion about the application of economic theory to health care. Following that, the chapter addresses the following specific topics: the demand for health care, of which insurance and managed care play big roles: the supply of health care, including the roles of hospitals, physicians, and nurses; the markets for hospitals and nurses; the evaluation of costs and benefits of specific health care policies; and the future health care system.

Economic Theory and Reality in Health Care

Economic theory addresses the question of how communities allocate scarce resources. Individuals have different preferences for goods, services, time, and other things of value. Moreover, individuals have different abilities to produce things that people need, such as food, equipment, and services. As a result of these two types of differences, opportunities for trade abound. A highly-productive farmer can trade food she will not eat for a doctor’s services, and a carpenter can trade her construction work for clothing.

In a freely competitive economy, prices can adjust as needed to ensure that the supply and demand for goods and services are balanced. When the demand for a product is greater than its supply, purchasers bid up the price of the scarce product. As the price rises, fewer purchasers are interested in the product, because its cost becomes greater than its value to some buyers. Thus, the demand drops. At the same time, the higher price that can be received for the product causes suppliers to increase their supply, because they can receive greater profit for each item sold. The combined effect of the decrease in demand and increase in supply, caused by the free-market change in price, is that the market will reach an equilibrium point at which supply and demand are equal. When supply exceeds demand, a similar story can be told, with the price falling so that more buyers are interested in the product and sellers want to offer less of it.

A freely competitive market, often called a “perfectly competitive” market, never faces a shortage or surplus of a product. Several conditions must be met for a market to be perfectly competitive, the most important of which are that there must be many buyers and sellers, there is no cost to becoming a seller or buyer, the products must be uniform (“homogenous”), and buyers and sellers must have perfect information about the qualities of products. Some markets exhibit many of these characteristics. For example, the low-wage labor market has many buyers (employers) and sellers (workers), job attributes are generally well-known, employers can assess that workers have few skills, and employers and workers can enter the labor market easily.

It requires little analysis to recognize that health care markets violate all the basic requirements of perfectly competitive markets. For many types of health care markets, there are not many, but instead few sellers. Hospital or nursing home markets, for example, are closer to “monopolies” or “oligopolies” (characterized by one or only a few sellers in the market, respectively) than to competitive markets. Similarly, health care professionals such as physicians or nurses cannot enter the market freely; most professionals are licensed by state or professional organizations. The health care “product” is not uniform: each physician or hospital provides different care compared to another. Given these characteristics, these health care providers have some degree of market power over the sale of their product. This can lead to shortages and higher prices for care than would exist in a competitive environment. Market power can also extend to the buying of inputs such as labor (“monopsony” or “oligopsony”) and lead to shortages in the labor force because wages and benefits stay below equilibrium levels.

Perhaps more importantly, buyers and sellers do not have perfect information about patients’ need for health care or the quality of health care products. Patients do not know whether or when they will need health care in the future. They may not even be sure that they are ill, nor will they know how to treat their ailments. Providers often do not know what a patient’s ailment is until further tests are conducted. Moreover, providers do not know how effective a course of treatment is for an individual patient.

Most economists agree that policy intervention can be used to address problems in markets that are not perfectly competitive. Some regulations are widely accepted, such as the licensure of health professionals and hospitals so patients have assurance of the quality of their providers. Government provision of health insurance for certain populations—older adults and the poor—is designed to address the fact that these populations cannot obtain insurance otherwise, and is generally accepted. But there is also much debate about the appropriate role of government. Should governments regulate health care prices? To what extent should governments invest in research that leads to new health care treatments? Should employers receive tax breaks for providing health insurance? Most debates about government intervention focus on the question of whether the health care market can be made sufficiently competitive to function with some regulation, or whether the health care market is so dysfunctional that a complete government takeover is needed.

The Demand for Health Care

In recent years, health policy in the U.S. has focused on the needs of those who demand health care services. The demand for health care is often intermediated by the purchase of health insurance. In the U.S., people obtain health insurance in three general ways: their employers offer health insurance as a component of compensation for work; they purchase insurance individually from an insurance company; or they are enrolled in a government-funded program.

Once a person has insurance, she is insulated from the costs of each health care service. Apart from small payments that might be required for each service, the insurance enrollee pays only the fixed cost of the insurance, and in fact might not even pay this if insurance is provided by an employer or government entity. As a result, the enrollee tends to demand more health care than would be demanded without insurance. This is called moral hazard. Moral hazard leads to greater health care demand, and thus greater health care expenditures, than would occur in a perfectly competitive market. A fundamental issue faced by all health care systems is how to reach the socially optimal level of health care utilization given the presence of health insurance.

Insurance companies try to address moral hazard in a variety of ways. Most common is the requirement that the enrollee pay some part of the cost of each health service in the form of co-payment (a flat fee paid for each service) or co-insurance (a fixed percentage of the cost of each service). Many traditional insurance plans also require that the enrollee pay some amount of health care costs before the insurer pays any of the costs; this is called a deductible. Although the RAND Health Insurance Experiment of the 1980s found that increased out-of-pocket expenses were not associated with worse health, other studies indicate that needed health care might be neglected (Karter et al., 2003), which could lead to greater emergency department utilization (Wright et al., 2005) and poorer health outcomes.

Since the 1940s, insurance companies have provided “managed care,” in which the insurance company plays a role in directing the overall care of enrollees. One of the first managed care insurance plans was the Kaiser Foundation Health Plan, which still operates today. In the Kaiser plan, a medical group exclusively contracts with the insurance company to provide health care, and Kaiser Permanente operates its own hospitals. Employees pay small co-payments for health services, and physicians receive extensive education and guidance about providing preventative care and evidence-based practice. A patient must be referred to a specialist by a primary care physician; self-referral is not allowed, and care received outside the Kaiser network is not covered by the insurance.

There were few other insurance companies offering managed care insurance until the past three decades, during which time numerous variants of the managed care concept have evolved. Many new HMOs are not “closed panel,” and allow the physicians with whom they contract to treat both HMO and non-HMO patients. These HMOs maintain control over care provided to patients either directly by placing restrictions on the services offered or indirectly by providing physicians and hospitals incentives to care for patients in certain ways. Enrollees are assigned to primary health care providers, called “gatekeepers,” who manage the overall care of enrollees.

Preferred provider organizations (PPOs) encourage enrollees to select certain care providers by providing lower co-insurance rates if preferred providers are chosen. They allow members to go to specialists without having to use a gatekeeper first. A point-of-service plan (POS) is a hybrid of an HMO and a PPO. Patients are assigned a primary health care provider, as in an HMO, but they can seek care from other providers, albeit at a higher out-of-pocket cost.

The goal of these benefit conscriptions, in-network requirements, gatekeeper requirements, and other enrollee incentives is to control costs by better managing the care of enrollees, and reducing “moral hazard.” In theory, managed care insurance plans focus on preventative health care services and try to eliminate unneeded medical care.

Because people have little information with which to judge the quality of care offered by health care providers and thus by insurance companies, they often select insurance based on price rather than quality. Moreover, a hospital that provides excellent quality care is usually reimbursed at the same rate as a hospital that provides mediocre quality care. When managed care pressures cause providers to focus on reducing costs, they often do so at the expense of quality. At a minimum, amenities are eliminated, and in some cases registered nurse (RN) staff.

These problems arise due to the difficulty of obtaining information about health care products, and are a reason for intervention by governmental regulatory or private credentialing organizations such as The Joint Commission (TJC). Through regulation or certification, quality can be monitored, standardized, and improved, and information about quality can be conveyed to consumers.

This discussion on the demand for health care in the U.S. omits one important issue: the high share of Americans who lack adequate health insurance. About 28% of non-elderly adults did not have health insurance at some time in 2007, while another 20% were underinsured, with a high economic burden of health care relative to income (Schoen et al., 2008). The uninsured tend to be poor or near poor adults in families with at least one wage earner. Most have gone without coverage for at least two years. Rates of uninsurance are higher among minorities. For these people, the primary issue is that they do not use primary and preventative health services as much as they should because they cannot afford the out-of-pocket costs. As a result, health problems that could be treated effectively grow into acute problems that must be treated aggressively, are more costly, and have poorer outcomes. A universal health insurance program continues to be a controversial policy for Americans. The health reform legislation passed in 2010, though not completely universal, will reduce the number of uninsured by about 32 million people.

The Supply of Health Care

The supply of health care also has been a focus of health policy. Direct suppliers of health care are professionals (such as physicians and advanced practice nurses), and institutions of care (such as hospitals, nursing homes, home care, and doctor’s offices). Institutions of care, in turn, employ a number of non-professional and professional staff, such as the nursing staff, who enter into employment through the “derived demand” of their institutional employers.

These suppliers, or providers, of health care offer services in exchange for payment from the various demanders of health care discussed earlier in the chapter. Providers have experienced drastic changes in the reimbursement for their services. In general, payers have moved away from paying providers what they charge after the service is provided (retrospective payment) to amounts set in advance of the service (prospective payment). Both public and private payers have been responsible for these changes, starting with the introduction of Diagnostic Related Groups (DRGs) and Resource Based Relative Value Scales (RBRVS) for payment under Medicare, and continuing with various negotiated fees and charges under managed care. At this time, prospective payment systems (PPSs) exist for all types of health care: inpatient hospital, nursing home, home care, and ambulatory care.

PPSs have, in turn, prompted providers to find efficiencies in delivering care in order to provide care for the agreed-upon amount of money. The search for efficiencies can take the form of technology improvements that reduce the time needed to perform the services, or cost-cutting measures such as staff reductions and substitutions.

One practice that providers may engage in to compensate for reduced payment is “provider-induced demand.” In this practice, providers instruct patients, who generally know less about their health problem and treatment than the providers, to consume more health care than would be demanded if the patient had perfect information. Demand inducement is not necessarily a malicious phenomenon; care providers might encourage patients to seek every medical intervention or test that could have any benefit, even if the benefit is so small that the costs exceed the benefits. Patients do not pay the full cost of health services in most cases, so they do not make cost-benefit comparisons. Demand inducement is a problem because it leads to greater overall health care spending and can lead to iatrogenic illnesses among the patients who receive “too much” or inappropriate health care.

One set of health care providers—physicians—play a central role in the provision of medical care services, and therefore make many of the demand decisions for their patients. They act as agents for their patients. When physicians are able to induce demand for health care, it is called “physician-induced demand.” Whether physicians or other providers can actually induce demand for health care has been an area of research and debate in health care economics.

In the previous section, we discussed how managed care attempts to reduce “moral hazard.” Managed care also attempts to reduce supplier-induced demand. One of the most drastic methods is through capitation, in which providers are paid a fixed amount per patient per year, regardless of how much care the person requires. Providers’ incentives are to keep the utilization of resources down—for example, the number of office visits, or the use of tests and procedures. The use of capitation is currently in decline due to consumer and provider backlash.

Per diem and DRG-based reimbursements to hospitals limit the amount of reimbursement hospitals may receive for each patient’s stay. Under these systems, greater utilization of resources by providers may lead to financial losses. Physicians may be paid bonuses to keep resource utilization down, and pay may be withheld for overutilization. Case management, utilization management, disease management, the use of second opinion, and the use of practice guidelines also are aimed at reducing unnecessary medical care. The research evidence tends to confirm that these managed care methods reduce health care utilization (Yelin, et al., 2004).

The Market for Hospital Services

Hospitals are an important part of the U.S. health care system. They provide emergency care, surgeries, highly technical tests and treatments, and institutional care for those too sick to be cared for at home. Although hospitals in 2007 received 33% of all health care dollars, demand for their services fell during the 1990s, primarily due to managed care influence (AHA, 2009). The number of annual admissions fell 14% from 1980 to 1995, and has not yet returned to its 1980 level (CDC, 2008). Many health care services have moved to the hospital outpatient setting, as indicated by a 163% increase in emergency department, outpatient surgery, and other outpatient care from 1980 to 2006 (CDC, 2008).

Hospitals are classified according to length of stay, type of service, and type of ownership. Short-term hospitals are those with average lengths of stay less than 30 days. Community hospitals are short-stay hospitals that offer general services, and some also provide specialty care and rehabilitation. They may be owned by state or local governments, non-profit voluntary organizations, or for-profit organizations.

Hospital ownership can be private not-for-profit, private for-profit, and governmental. The most prominent form of ownership of hospitals is private not-for-profit (around 60% of all hospitals). However, for-profit ownership grew in the 1980s and 1990s. By 2006, 18% of community hospitals in the U.S. were for-profit (KFF, n.d.).

Some believe that the quality of care in non-profit hospitals must be better because they don’t focus on the “bottom line.” Actually, non-profit hospitals have to be just as conscious of costs and revenues as for-profits. Both for-profit and non-profit hospitals can generate surplus revenue. Where they differ is that for-profits can distribute the surplus in the form of profit to stockholders or owners, whereas non-profits must maintain the surplus within the institution or use it to provide some benefit to the community. The research record on whether non-profit hospitals provide better care is mixed (Eggleston et al., 2006).

Because of the reimbursement and managed care pressures described earlier, hospital organization, finances, services, and employment patterns underwent dramatic change in the past decades. At the beginning of the 1990s, hospitals found themselves negotiating unfavorable contracts with managed care companies because those companies had power on the buyer’s side of the market. In response to this pressure, hospitals merged and formed multihospital systems in the 1990s. Some hospitals merged or expanded vertically by adding non-inpatient types of health care such as home care, nursing home care, rehabilitation, or ambulatory care. Some hospitals closed.

These changes provided integrated hospital systems with greater market power to counter that of managed care, greater economies of scale (efficiencies due to size), and greater economies of scope (efficiencies due to producing many different types of products). It also produced hospital markets that are classically “monopolistic” or “oligopolic” as sellers—that is, one or a handful of hospital systems have carved out the market for hospital care in each geographic area. Managed care plans must negotiate with these few sellers of hospital services. As a result, the cost savings that managed care achieved in the 1980s and early 1990s began to dissipate in the late 1990s as the hospital oligopolies arrived on the scene.

It is thought that hospitals respond to reduced public reimbursement by charging privately-insured patients higher prices. Those who believe that hospitals cost-shift point to the fact that the gap between payment-to-cost ratios of private to public payers widened during the 1980s and early 1990s. With the rise of managed care, the differential declined significantly but began widening again starting in 2000. By 2007, the payment-to-cost ratio of public payers was around 90%, while that of private payers was 130% (Avalere Health, 2009). Internally, in response to lower demand and reduced public and private payments in the 1990s, hospitals downsized and restructured. Both nursing and non-nursing staff were affected. We will discuss the changes and their impact on nursing staff in the next section. In addition, hospitals reorganized care so that patients complete their hospital stays in a shorter amount of time. Average lengths of stay in short-stay hospitals fell from 7.5 days in 1980 to 4.7 days in 2006, a drop of 37% (CDC, 2008). Because hospitals are often paid a fixed or maximum amount per patient stay, length of stay reductions allows them to provide care at costs lower than the fixed reimbursements, and keep the additional revenue.

The Market for Nurses

The term nurse means different things to different people. By “nurse” we refer to both licensed nurses, such as RNs and licensed practical nurses (LPNs), and unlicensed nurses, such as nursing assistants. We focus primarily on the market for RNs.

Because most nurses are employees of health care institutions, the demand for their employment is derived from their employers, who employ nurses based on the demand and prices for their services, and the productivity and prices (wages, salaries, and benefits) of the nurses being hired. As reimbursement changed to prospective systems, and as managed care practices grew, the growth in demand for inpatient care slowed and the prices paid for care were constrained. As a consequence, hospital demand for licensed nurses fell in the 1990s, as reflected in lower staffing ratios (RNs or licensed nurses per acuity-adjusted patient day) and lower skill mix (RNs or licensed nurses as a proportion of total nurses) (Unruh & Fottler, 2006).

On the other hand, the demand for nurses in other areas such as ambulatory surgery centers and home care has grown. This growth slowed in home care after 1997, when the Balanced Budget Act (BBA) introduced a Prospective Payment System (PPS) for home care. With that, the demand for home care nurses plunged. In other areas, such as nursing homes and physicians’ offices, demand has been more stable.

After reports of surpluses of nurses (demand lower than supply) in hospitals in the mid-1990s, a shortage of RNs in hospitals reemerged in the late 1990s. At that time, public reimbursement improved and managed care pressures lessened. Admissions increased, and length of stay stabilized. In addition, the typical hospitalized patient was acutely ill. Suddenly, demand for nurses, particularly RNs, rose. Hospital vacancy rates peaked at 12% to 15% in 2001 (AHA, 2002). In 2007, hospital vacancy rates still stood at 8.1% (AHA, 2007).

The RN shortage that began in the late 1990s is considered to be structural rather than temporary. It is expected that the gap between RN supply and demand will grow: by 2020 the gap between supply and demand is projected to climb to 16% (Buerhaus et al., 2008). This structural shortage has several causes. On the demand side, population growth and an aging population exerts growing health care consumption pressure. Other factors affecting demand include levels of access afforded by public and private insurance, and the efficiency of health care delivery. On the supply side, factors include a large population of older RNs who are expected to retire soon; educational bottlenecks that restrict the growth of nursing supply; and difficult work environments that discourage entry into, and encourage withdrawal from, the profession.

In 2008, the RN shortage took an unexpected turn. A general economic crisis in the U.S., with high unemployment levels and reduced hospital utilization, is thought to have contributed to an increase in RN supply and a drop in hospital demand for RNs. Given the fact that supply increased and demand fell, the gap between supply and demand in hospitals may have narrowed considerably. It is generally agreed, however, that this adjustment is temporary and that the overall forces leading to a severe shortage within 10 years have not changed.

It was mentioned earlier that in a competitive market shortages would not occur. Why do we see shortages in the market for nurses? One economic theory is that the primary employers of nurses—hospitals—enjoy a monopsony over the hiring of nursing labor; they have market power in the buying of nursing labor, which they use to keep wages, benefits, and working conditions at lower-than-equilibrium levels. Even though employers would like to employ more nurses, the wages, benefits, and working conditions they offer do not attract people to their jobs. Raising wages alone may not be the answer to this problem, however, as long as working conditions remain difficult (Di Tommaso et al., 2009; Spetz & Given, 2003).

It may be that wages, benefits, and working conditions for nurses are at suboptimal levels because nursing care is not appropriately valued and priced. At the societal level, market economies have tended to downplay the value of “caring” services, as well as “women’s work,” both of which are the cultural and historical legacy of nursing (Nelson & Folbre, 2006). At the payer level, specific nursing services have generally not been included in reimbursement systems. Studies of the DRG payment system have shown that DRG values are not strongly associated with the intensity of nursing care for that category (Welton & Halloran, 2005). At the organizational level, health care facilities typically treat nursing care only as “expense” items in their budget, not as revenue-generating items. The price of nursing is wrapped into the room rate.

To receive adequate wages, benefits, and working conditions, these societal, financial, and organizational impediments to properly valuing and pricing nursing services need to be overcome. Ways to accomplish this include conducting and disseminating research on the following: