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CHAPTER 1
WHY HEALTH ECONOMICS?
Learning Objectives
After reading this chapter, students will be able to
• describe the value of economics for managers,
• identify major challenges for healthcare managers,
• find current information about health outcomes, and
• distinguish between positive and normative economics.
Key Concepts
• Economics helps managers focus on key issues.
• Economics helps managers understand goal-oriented decision making.
• Economics helps managers understand strategic decision making.
• Economics gives managers a framework for understanding costs.
• Economics gives managers a framework for understanding market demand.
• Economics gives managers a framework for assessing profitability.
• Economics helps managers understand risk and uncertainty.
• Economics helps managers understand insurance.
• Economics helps managers understand information asymmetries.
• Economics helps managers deal with rapid change.
1.1 Why Health Economics?
Why should working healthcare managers study economics? This simple question is really two questions. Why is economics valuable for managers? What special challenges do healthcare managers face? These questions motivate this book.
Why is economics valuable for managers? There are six reasons. We will briefly touch on each of them to highlight the themes we will develop in later chapters.
1. Economics helps managers focus on key issues. Economics helps managers wade through the deluge of information they confront and identify the data they need.
2. Economics outlines strategies for realizing goals given the available resources. A primary task of economics is to explore carefully the implications of rational decision making.
3. Economics gives managers ground rules for strategic decision making. When rivals are not only competing against them but watching what they do, managers must be prepared to think strategically.
4. Economics gives managers a framework for making sense of costs. Managers need to understand costs because good decisions are unlikely to be made without this understanding.
5. Economics gives managers a framework for thinking about value. The benefits of the goods and services that successful organizations provide to customers exceed the costs of producing those goods and services. Good management decisions require an understanding of how customers perceive value.
6. Most importantly, economics sensitizes managers to fundamental ideas that affect the operations of every organization. Effective management begins with the recognition that consumers are sensitive to price differences, that organizations compete to advance the interests of their stakeholders, and that success comes from providing value to customers.
1.2 Economics as a Map for Decision Making
Economics provides a map for decision making. Maps do two things. They highlight key features and suppress unimportant features. To drive from Des Moines, Iowa, to Dallas, Texas, you need to know how the major highways connect. You do not want to know the name and location of each street in each town you pass through. Of course, what is important and what is unimportant depend on the task at hand. If you want to drive from West 116th Street and Ridgeview Road in Olathe, Kansas, to the Truman homestead in Independence, Missouri, a map that describes only the interstate highway system will be of limited value to you. You need to know which map is the right tool for your situation.
Using a map takes knowledge and skill. You need to know what information you need, or you may choose the wrong map and be swamped in extraneous data or lost without key facts. Having the right map is no guarantee that you can use it, however. You need to practice to be able to use a map quickly and effectively.
Like a map, economics highlights some issues and suppresses others. For example, it tells managers to focus on marginal or incremental costs, which makes understanding and managing costs much simpler, but economics has little to say about the belief systems that motivate consumer behavior. If you are seeking to make therapeutic regimens easier to adhere to by making them more consistent with consumers' belief systems, economics is not a helpful map. If, on the other hand, you want to decide whether setting up an urgent care clinic is financially feasible, economics helps you focus on how your project will change revenues and costs.
Economics also gives managers a framework for understanding rational decision making. Rational decision making involves making choices that further one's goals given the resources available. Whether those goals include maximizing profits, securing the health of the indigent, or other objectives, the framework is much the same. It entails looking at benefits and costs to realize the largest net benefit. (We will explore this question further in section 1.5.)
Managers must understand costs and be able to explain costs to others. Confusion about costs is common, so confusion in decision making is also common. Confusion about benefits is even more widespread than confusion about costs. As a result, management decisions in healthcare often leave much to be desired.
Economists typically speak about economics at a theoretical level, using "perfectly competitive markets" (which are, for the most part, mythical social structures) as a model; as a result, application of economics can be difficult for managers competing in real-world markets. Yet, economics offers concrete guidance about pricing, contracting, and other quandaries that managers face. Economics also offers a framework for evaluating the strategic choices managers must make. Many healthcare organizations have rivals, so good decisions must take into account what the competition is doing. Will being the first to enter a market give your organization an advantage, or will it give your rivals a low-cost way of seeing what works and what does not? Will buying primary care practices bring you increased market share or buyer's remorse? Knowing economics will not make these choices easy, but it can give managers a plan for sorting through the issues.
1.3 Special Challenges for Healthcare Managers
What special challenges do healthcare managers face? Healthcare managers face five issues more than other managers do:
1. The central roles of risk and uncertainty
2. The complexities created by insurance
3. The perils produced by information asymmetries
4. The problems posed by not-for-profit organizations
5. The rapid and confusing course of technical and institutional change
Let us look at each of these challenges in more depth.
1.3.1 Risk and Uncertainty
Risk and uncertainty are defining features of healthcare markets and healthcare organizations. Both the incidence of illness and the effectiveness of medical care should be described in terms of probabilities. For example, the right therapy, provided the right way, usually carries some risk of failure. A proportion of patients will experience harmful side effects, and a proportion of patients will not benefit. As a result, management of costs and quality presents difficult challenges. Has a provider produced bad outcomes because he was unlucky and had to treat an extremely sick panel of patients, or because he encountered a panel of patients for whom standard therapies were ineffective? Did his colleagues let him down? Or was he incompetent, sloppy, or lazy? The reason is not always evident.
1.3.2 Insurance
Because risk and uncertainty are inherent in healthcare, most consumers have health insurance, and healthcare organizations have to contend with the management problems insurance presents. First, insurance creates confusion about who the customer is. Customers use the products, but insurance plans often pay most of the bill. Moreover, most people with private medical insurance receive coverage through their employer (in large part because the tax system makes this arrangement advantageous). Although economists generally agree that employees ultimately pay for insurance via wage reductions, most employees do not know the costs of their insurance alternatives (and unless they are changing jobs, they have limited interest in finding out). As a result of this situation, employees remain unaware of the true costs of care and are not eager to balance cost and value. If insurance is footing the bill, most patients choose the best, most expensive treatment — a choice they might not make if they were paying the full cost.
In addition, insurance makes even simple transactions complex. Most transactions involve at least three parties (the patient, the insurer, and the provider), and many involve more. To add to the confusion, most providers deal with a wide array of insurance plans and face blizzards of disparate claim forms and payment systems. Increasing numbers of insurance plans have negotiated individual payment systems and rates, so many healthcare providers look wistfully at industries that simply bill customers to obtain revenues. The complexity of insurance transactions also increases opportunity for error and fraud. In fact, both are fairly common.
Despite this bewildering array of insurance plans, many providers still rely on a few plans for their revenue (a circumstance most managers seek to avoid). For example, most hospitals receive at least a third of their revenue from Medicare. As a result, changes in Medicare regulations or payment methods can profoundly alter a healthcare organization's prospects. Overnight, changes to reimbursement terms may transform a market that is profitable for everyone to one in which only the strongest, best-led, best-positioned organizations can survive.
1.3.3 Information Asymmetries
Information asymmetries are common in healthcare markets and create a number of problems. An information asymmetry occurs when one party in a transaction has less information than the other party. In this situation, the party with more information has an opportunity to take advantage of the party with less information. Recognizing a disadvantage, the party with less information may become skeptical of the other party's motivation and decline a recommendation that would have been beneficial. For example, physicians and other healthcare providers usually understand patients' medical options better than patients do. Unaware of their choices, patients may accept recommendations for therapies that are not cost-effective or, recognizing their vulnerability to physicians' self-serving advice, may resist recommendations made in their best interest.
From a manager's perspective, asymmetric information means that providers have a great deal of autonomy in recommending therapies. Because providers' recommendations largely define the operations of insurance plans, hospitals, and group practices, managers need to ensure that providers do not have incentives to use their superior information to their advantage. Conversely, in certain situations, patients have the upper hand and are likely to forecast their healthcare use more accurately than insurers. Patients know whether they want to start a family, whether they seek medical attention whenever they feel ill, or whether they have symptoms that indicate a potential condition. As a result, health plans are vulnerable to adverse selection, meaning that high-risk consumers are more likely to seek insurance whereas healthier individuals are more likely to go without.
1.3.4 Not-for-Profit Organizations
Most not-for-profit organizations have worthy goals that their managers take seriously, but these organizations can create problems for healthcare managers as well. For example, not-for-profit organizations usually have multiple stakeholders. Multiple stakeholders mean multiple goals, so organizations become much harder to manage, and managers' performance becomes harder to assess. The potential for managers to put their own needs before their stakeholders' needs exists in all organizations but is more difficult to detect in not-for-profit organizations because they do not have a simple bottom line. In addition, not-for-profit organizations may be harder to run well. They operate amid a web of regulations designed to prevent them from being used as tax avoidance schemes. These regulations make setting up incentive-based compensation systems for managers, employees, and contractors (the most important of whom are physicians) more difficult. Further, when a project is not successful, not-for-profit organizations have greater difficulty putting the resources invested in the failed idea to other uses. For example, the trustees of a not-for-profit organization may have to get approval from a court to sell or repurpose its assets. Because of these special circumstances, managers of not-for-profit organizations can always claim that substandard performance reflects their more complex environment.
1.3.5 Technological and Institutional Change
This fifth challenge makes the others pale in comparison. The healthcare system is in a state of flux. Virtually every part of the healthcare sector is reinventing itself, and no one seems to know where the healthcare system is headed. Leadership is difficult to provide if you do not know where you are going. Because change presents a pervasive test for healthcare managers, we will examine it in greater detail.
1.4 Turmoil in the Healthcare System
Why is the healthcare system of the United States in such turmoil? One explanation is common to the entire developed world: rapid technical change. The pace of medical research and development is breathtaking, and the public's desire for better therapies is manifest. These demands challenge healthcare managers to regularly lead their organizations into unmapped territory. To make matters worse, changes in technology or changes in insurance can quickly affect healthcare markets. In healthcare, as in every other sector of the economy, new technologies can create winners and losers. For example, between 2000 and 2007, Medicare payments to ambulatory surgery centers more than doubled. Medicare changed its policy, and growth slowed down (Medicare Payment Advisory Commission 2018). What appears profitable today may not be profitable tomorrow if technology, competition, rates, or regulations change significantly.
The Affordable Care Act (ACA) has resulted in a wave of innovations by providers, insurers, employers, and governments. (See chapter 6 for more detail.) Which of these innovations will succeed is not clear. In addition, some healthcare organizations will thrive in the environment of the ACA, and some will fail. The passage of the ACA appears to have been transformative, but its repeal might not undo the changes it led to.
1.4.1 The Pressure to Reduce Costs
The economics of high healthcare costs is far simpler than the politics of high healthcare costs. To reduce costs, managers must reallocate resources from low-productivity uses to high-productivity uses, increase productivity wherever feasible, and reduce prices paid to suppliers and sectors that have excess supply. They also must recognize that cost cutting is politically difficult. Reallocating resources and increasing productivity will cost some people their jobs. Reducing prices will lower some people's incomes. These steps are difficult for any government to take, and many of those who will be affected (physicians, nurses, and hospital employees) are politically well organized.
Case 1.1
Why Is the Pressure to Reduce Healthcare Costs So Strong?
The United States spends far more than other wealthy industrial countries but has poorer outcomes. Spending per person is more than double the spending per person in Canada, France, and the United Kingdom (see exhibit 1.1). Differences this large should be reflected in the outcomes of care.
However, of the six countries listed in exhibit 1.2, the United States has the shortest life expectancy at birth. In part, this difference is because the United States invests relatively little in improving the social determinants of health and reducing inequality. Adler, Glymour, and Fielding (2016) note that the life expectancy of 40-year-old men at the bottom of the income distribution is 14.6 years shorter than for men in the top of the income distribution. Greater spending should not produce these results.
Discussion Questions
• Why is spending so much more than other countries a problem?
• What can Americans not buy because of high spending on healthcare?
• What factors other than healthcare affect population health?
• Does this evidence suggest that the American healthcare system is not efficient?
• What are the most important social determinants of health?
(Continues…)
Excerpted from "Economics for Healthcare Managers"
by .
Copyright © 2019 Foundation of the American College of Healthcare Executives.
Excerpted by permission of Health Administration Press.
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