Health economics

• 1. Introduction

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  A single 1963 paper by economist Kenneth Arrow is widely credited with turning health economics into its own academic discipline. Arrow noticed that healthcare markets behave nothing like ordinary ones, and economists have spent six decades since then trying to explain exactly why. What makes a doctor's visit different from buying a loaf of bread, and how do you put a number on something as slippery as a year of healthy life? Answering those questions has occupied researchers from ancient Greece to modern hospital boardrooms, and has shaped everything from nursing budgets to national insurance schemes in India.

• 2. What Makes Health Different

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  Kenneth Arrow's 1963 paper drew a sharp conceptual line between health and other goods, identifying several features that separate healthcare from ordinary markets: heavy government intervention, deep uncertainty along several dimensions, asymmetric information between patients and providers, barriers to entry, externalities, and the presence of a third-party agent, meaning the patient's insurer, who bears the financial responsibility for care the patient consumes. Because of that third-party system, prices and quality are often hidden from the people actually receiving treatment, and the standard tool for comparing treatments, the quality-adjusted life year, is itself notoriously difficult to measure and rests on assumptions that are often unreasonable. Externalities show up constantly in health and healthcare. Avoiding the common cold protects other people as much as the person taking precautions, and finding a sustainable, humane response to the opioid epidemic affects far more than the individuals directly involved. Economist Alan Williams later organized the field's scope into what he called a plumbing diagram spanning eight topics: what influences health beyond healthcare itself, what health is and what it is worth, the demand for healthcare, the supply of healthcare, micro-economic evaluation at the treatment level, market equilibrium, evaluation at the level of the whole system, and the planning, budgeting, and monitoring mechanisms that tie it all together.

• 3. From Aristotle to Arrow

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  In the third century BC, the Greek thinker Aristotle discussed the economic relationship between farmers and doctors in production and exchange, and in the 17th century the British classical economist William Petty argued that money spent on workers' medical and health needs paid off economically. The American Medical Association, founded in 1848 to advance medical science, standardize medical education, and improve public health, did not turn its attention to economics until 1931, when it created the AMA Bureau of Medical Economics to study financial matters affecting the medical profession. After the Second World War, advances in medical technology, an aging population, and a sharp rise in chronic disease drove health spending up sharply. In the United States, health expenditures climbed from 5.0 percent of gross domestic product in 1960 to 17.4 percent in 2013, with nominal national health spending growing at an average annual rate of 9.2 percent against nominal GDP growth of just 6.7 percent over the same period. European health spending followed a similar arc, rising from about 4 percent of GDP in the 1950s to roughly 8 percent by the end of the 1970s, with its share of gross national product climbing by about 1 percent in the 1950s, 1.5 percent in the 1960s, and 2 percent in the 1970s. Selma Muskin published Towards the Definition of Health Economics in 1958 and followed it four years later with Health as an Investment, the first work to treat health spending as an investment with long-term benefits rather than pure consumption. Arrow's 1963 paper, Uncertainty and the Welfare Economics of Medical Care, became probably the single most cited contribution to the field. A second American academic seminar on health economics followed in 1962, a third in 1968, and the World Health Organization held its own first international health economics seminar in Moscow that same year, formally establishing the discipline. In 1979, American health economist Paul Feldstein applied economic principles to the long-term care market, laying groundwork for nursing economics, and the field gained its own publication in 1983 with the founding of Nursing Economic Magazine. In 1993, the University of Iowa Cost Research Center ran a systematic nursing cost study, ultimately identifying 433 cost items across six categories and using computer technology to manage nursing cost assessment and budgeting.

• 4. Modeling the Demand for Health

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  Economist Michael Grossman's 1972 model of health production reshaped how the field thinks about demand. It treats each person as both a producer and a consumer of their own health, viewing health as a stock of capital that degrades over time unless a person invests in it, whether through direct consumption, such as the satisfaction of feeling well, or through investment, such as fewer sick days. Grossman's model predicts how changes in the price of healthcare and other goods, in wages and employment, and in technology affect how much health people choose to hold, and it forms the foundation for much of the field's later econometric research. The World Health Report describes people as taking four distinct roles within a healthcare system: contributor, citizen, provider, and consumer. In the model, a person invests in health until the marginal cost of additional health capital equals the marginal benefit, factoring in the rate at which health depreciates and the prevailing interest rate; age raises the cost of maintaining a given level of health while lowering its marginal benefit, so the optimal stock of health a person holds naturally falls as they get older. A separate distinction matters here too: the real demand for medical care, driven by the desire for good health, differs from the effective demand that shows up at actual market prices, because most patients pay a subsidized, insurance-driven price rather than the full cost of care. Economists describe the resulting overuse as ex-post moral hazard, distinct from the ex-ante moral hazard that shows up in any insurance market.

• 5. Health, Utility, and Lifestyle

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  Economists generally assume people act to maximize their lifetime satisfaction, or utility, within the limits of their resources, and health economists model health itself as a source of that satisfaction, treating it as a durable good much like a house or a car. In the standard formulation, utility equals a function of a bundle of other goods and a person's stock of health, written as U(X, H); as with most goods, more health means more utility. Like other durable goods, a person's stock of health wears down over time through aging, and public health efforts and individual medical care exist to slow that depreciation. Charted across a lifetime, an individual's health typically rises through childhood, then gradually declines with age, punctuated by sudden drops from injury or illness. Lifestyle choices heavily influence both the pace of that decline and the severity of its drops; the consumption of alcohol, tobacco, and drugs, along with diet and exercise habits, can be sorted into good types, such as moderate exercise, bad types, such as a high-cholesterol diet, and neutral types, such as books or concerts, that show no clear effect on health. Agencies including the United Kingdom's National Institute for Health and Care Excellence recommend cost-utility analysis, comparing a treatment's incremental cost-effectiveness ratio against its quality-adjusted life year value, to make these tradeoffs explicit; a 2019 study found the cost-effectiveness threshold countries use for this purpose ranged from 0.14 times GDP per capita in Ethiopia to 1.47 times GDP per capita in the United States.

• 6. Medical and Mental Health Economics

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  Medical economics, often used as a synonym for the broader field, focuses more narrowly on physicians and institutional care providers, typically applying cost-benefit analysis to pharmaceutical products and cost-effectiveness analysis to specific treatments, drawing on biostatistics and epidemiology to support medical decisions. Mental health economics carries its own set of challenges, since individuals with cognitive disabilities may struggle to communicate their preferences, making it hard to place an economic value on their mental health status. In 2009, researchers Currie and Stabile published Mental Health in Childhood and Human Capital, examining how common childhood mental health problems affect children's later accumulation of human capital, an effect that can ripple outward to family and coworkers. Studies of globalization's effects have also found, for example, that young professionals in India's outsourcing industry develop a hybrid cultural identity shaped by competing expectations at work and at home. Employment statistics used to study mental health economics often fail to capture presenteeism, when a worker shows up but performs at reduced capacity, or the unpaid burden carried by family members. Despite evidence that mental healthcare reduces overall costs and improves productivity, comprehensive services remain in decline; researchers Petrasek and Rapin, in 2002, attributed this to stigma and privacy concerns, the difficulty of quantifying medical savings, and physicians' financial incentive to medicate patients rather than refer them to specialists. A 2009 study by Evers and colleagues suggested that more active dissemination of mental health economic research and stronger partnerships between policymakers and researchers could help reverse the decline.

• 7. Markets, Insurance, and Failure

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  Health economists typically analyze five distinct markets: healthcare financing, physician and nurse services, institutional services, input factors, and professional education. Insurance markets depend on risk pools in which healthier enrollees subsidize sicker ones, but insurers struggle with adverse selection when they cannot fully predict an enrollee's future medical costs, a problem that group purchasing, preferential enrollment, and preexisting-condition exclusions were all designed to manage. Because insured patients bear less of the cost of their own care, they tend to consume more of it, a pattern known as moral hazard and documented by the RAND Health Insurance Experiment; insurers try to limit it through copayments and by restricting the incentives available to physicians. Patients themselves often lack the information to judge which services or providers offer the best value, opening the door to what economists call supplier-induced demand, where providers base treatment recommendations on financial rather than medical grounds, along with wide practice variations in how similar patients get treated. Some economists argue that requiring a medical license restricts supply and raises prices without benefiting patients. Insurance markets can fail outright when treating a disease is extremely expensive, as with cancer, HIV/AIDS, or a sudden new disease; private insurers may charge prohibitively high premiums or decline to cover certain patients at all, leaving a gap that governments typically step in to fill. That is exactly what happened worldwide during the COVID-19 pandemic, when no private insurer had priced in the risk of such an outbreak and state intervention became necessary. In 2018, India launched Ayushman Bharat, the largest health insurance scheme in the world, to extend coverage to citizens who could not otherwise afford it. Markets can also fail through monopoly power, since hospitals, patent-protected drugs, and some insurance markets are prone to concentrated control and above-market profits, which is why limits on physician-owned hospitals are sometimes proposed to preserve competition. Underlying much of the field's long-run cost growth is the Baumol effect, in which sluggish productivity growth in labor-intensive sectors like healthcare pushes costs upward over time.