This chapter provides insights from economic theory and empirical methods to determine if production of medical services in a firm is efficient. The concepts of a production function can indicate whether production is technically efficient and estimate the marginal contribution to revenue of each input (labor of different types, capital, etc.). With data on the prices or wages of these inputs, the manager can determine the profit-maximizing rate of use. A cost function can indicate whether there are economies of scale in quantity (somehow defined) and economies or diseconomies in scope. Examples from classic health economics literature are used to show that there was underuse of physician aides and other substitutes in office-based physician practices, that there are constant returns in scale in the production of hospital admissions, and that there are increased returns in emergency rooms. Caution in interpretation of variation in cost per unit output (of the type provided for Medicare in the Dartmouth Atlas) is offered.

This chapter provides economic explanations of the level of total national health expenditures in the US and of population health outcomes. It helps managers explain the role of wage differences with other countries and the impact of income inequality and racism on spending and outcomes. Wages of healthcare workers are much higher in the US than abroad. The healthcare GDP share has stabilized after growing for many years, but beneficial yet costly new technology still matters for cost and health growth. Metrics of relative health spending are distorted by exchange rate mismeasurement. Evidence on the fraction of total spending that is wasteful is very uncertain because no managerial or policy actions as yet have been proven to reduce waste in ways that do more good than harm. Changes in insurance and pricing policy have the highest promise for improvement.

Primary care physicians are supposed to play a central role in care coordination. This chapter finds no strong evidence that they have been able to improve care, a possible reason for relative low incomes for this specialty and small numbers. Evidence does show a need for care coordination, but health system managerial strategies to make gains by use of financial incentives (pay for performance) or organizational changes (patient-centered medical homes) have so far not been demonstrated. Prospects for the use of other sources of coordination (advanced practice providers and hospitalists) are discussed and opportunities outlined. Bundled payment or capitation might help support coordinated services, and competition among health systems to offer different models may eventually lead to success.

This chapter discusses health insurance, including its sources (public and private) in the US and the unique quirks introduced by employer-sponsored insurance. Employer purchasing of health insurance on behalf of employees likely induces a decrease in monetary wages, so employees are paying for much of this out of their own pockets. This is due to the federal tax exclusion of fringe benefits, such that it is cheaper for employers to compensate their employees in health insurance than in monetary salary. The chapter also discusses selection, risk pooling, and coverage options in large group health insurance, as individuals will likely choose jobs with health packages that maximize their own utility, which can lead to adverse selection of which managers should be aware. The chapter concludes by addressing Medicaid and Medicare as the other two arms of insurance in the US, with a final word of caution that our private-centric system may be unstable to future political pressures.

This chapter clarifies the difference between changes in levels of cost versus growth of cost and focuses on the latter. This is because increases in spending may be good if we are getting something for that growth; it all depends whether it is going toward “waste” or if we are obtaining value for that spending in the form of health outcomes – a return on investment. Four targets of cost containment are outlined: administrative costs, competition, state-based spending targets, and value-based payment. It is acknowledged that administrative costs are high in the US in part because consumers have choice over plans, benefits, providers, and networks (as opposed to once centralized system); with this choice comes coordination, information, and standardization costs. Excessive market power due to consolidation may also lead to the extraction of high prices from consumers beyond what would be possible with improved market-level competition. The chapter concludes by addressing the recent flattening in medical spending growth and what might happen in the future.

This concluding chapter summarizes the most pertinent insights from health economics that have been developed in the book. In addition, it includes a section on “debunking” in which economic theory and evidence contradict or heavily qualify views commonly held by experts in health management and policy. The pervasiveness of actionable inefficiency, the emphasis on medical spending rather than health benefits, the value of cost-sharing for nonpoor insureds, and the functioning and tax treatment of employment-based health insurance are all considered.

This chapter addresses the factors outside of medical care that are responsible for health outcomes: social and structural determinants of health (SDOH). It outlines economic stability, education, health access, neighborhood, built environment, and community context (including income inequality and racism) as some of the upstream drivers of the health-income gradient. These SDOH are framed in economic terms as a local public bad. Managers therefore must take SDOH into account if they are aiming to optimize health outcomes and costs for their population, especially if they are in a population-based or capitated payment system. The evidence about what actions to take is still developing, but some interventions are reviewed including Medicare’s direct contracting model, Medicaid’s section 1115 waivers, community health workers, meal delivery programs, and screening and referring to community organizations. Larger actions such as disparate impact monitoring and changing payment incentives and risk adjustment will need to be taken in the future.

Health insurance does not work well when individuals have more information about illness than the insurer. Two problems arise as a consequence of this information gap. Moral hazard, which arises when individuals know more about their current needs than the insurer, generates an overutilization of care services. Adverse selection, caused by insureds having more information about future risk than insurers, leads high-risk individuals to buy high coverage (at a high premium) and low-risk individuals to buy lower coverage than optimal. This chapter covers these market failures and presents some evidence and thoughts about policies that have been used to reduce their negative effect, such as cost-sharing for dealing with moral hazard, and mandates and cross-subsidies for buying high coverage. I end by arguing that dealing with selection should not be a top priority.

This chapter discusses insurance as a central player in the purchasing of health goods and services. It points out the flaws and quirks in the insurance market that lead to an absence of perfect competition and the potential for skewed bargaining power between providers and insurers. Managed care is then outlined as an attempt by insurance companies to curtail health spending through utilization controls and narrow networks. Additional tools such as paying for wellness programs, bundling payments for episodes of care, and cost-effectiveness measures are also discussed as possibilities to improve the efficiency of payouts by insurers. The chapter concludes by reminding us that insurance companies make more money the less they pay out and that making it more difficult for beneficiaries to access care will allow them to accomplish that.

This chapter covers the economic theory and evidence about the impact of provider consolidations (mergers and acquisitions) in healthcare services. As expected, hospital combinations within local markets (horizontal) are associated with higher unit prices but no measurable improvement in metrics of quality or outcomes. Prices increase by about 15%. Currently 30%–40% of the US population lives in big cities with competitive hospital markets. However, an equal fraction lives in smaller cities that could support more competitive hospitals; public policy to encourage competition there would be appropriate. The chapter investigates economic theories of vertical integration across markets; results here are less robust. An example of enhanced market power through bundling is provided, but a health system’s ability to do so is limited by lower administrative cost to employers of dealing with a single insurer that covers sellers in such markets.

This chapter deals with the economics of prescription drugs and of insurance coverage for them. Sellers of drugs have temporary market power because of patents. Drugs are supplied under a cost structure with high fixed costs of research, discovery, and approval followed by low marginal cost of producing additional units; this structure does not permit competitive markets to exist during the period of patient protection. Health systems buy drugs for inpatients in the usual way, but outpatient and pharmacy sold drugs are priced above marginal cost with prices often distorted by insurance coverage. The result can be high prices (though not necessarily increasing ones). A potential solution to the inefficiencies in this market is an agreement between insurers and drug sellers to buy a predetermined volume with the marginal price of additional units low or zero – the so called “Netflix” model. The intent of above-cost pricing for drugs is to encourage the supply of innovative products, but evidence on whether the current patient system in the US achieves an ideal outcome is lacking.

The typical American nonprofit hospital does not fit well with the economic theory of the firm. That theory, as explained by Ronald Coase, imagines that a firm is an organization in which a manager directs the allocation of capital and labor already contracted with the firm. In contrast, US hospital management historically did not employ physicians, supplies of a key input. Physicians were a parallel entity, the medical staff, who billed separately and could issue orders for deployment of other hospital inputs (such as nursing staff). More physicians are not salaried hospital employees, but they still bill separately and have independent control. This chapter outlines a model of the nonprofit hospital in which the objective is maximization of net income of the medical staff and argues that this theory explains much of hospital behavior. Care coordination, tax advantages for nonprofits, and community benefits are also discussed.

This chapter investigates price discrimination among buyers and sellers of healthcare. It is very common for different buyers to pay different prices for the same medical service or drug. Economics does not predict that profit-maximizing sellers will increase the price to other buyers if one buyer reduces price (no cost-shifting), but it does hypothesize that buyers with less price-responsive demands can be charged more than those with more responsive demands by sellers with market power. Likewise, buyers with more buyer market power (e.g., larger insurers) often pay less than smaller insurers or individual uninsured consumers. This chapter explains why price discrimination may improve efficiency compared to simple monopoly by allowing a lower price to be charged to those with lower willingness to pay that is still above marginal cost. The role of pharmacy benefit managers (PBMs) in extracting discounts for drugs is described.

This chapter describes the concept of “value-based” healthcare as an attempt to prioritize value (or quality) over volume (or quantity). However, it points out that the problem with fee-for-service is not that it prioritizes volume per se but that it may prioritize volume of the wrong (low-value) things. This chapter also acknowledges that “value” is difficult to define and quantify – if we are going to pay on it, how do we determine which health services are valuable for which patients? It then outlines an economic model of supplier payment that would lead to maximizing net value and discusses supply curves more in depth. The chapter discusses several forms of value-based payment, including pay-for-performance, bundled episode-based payments, and capitated population-based payments, as well as value-based insurance design. It concludes that the optimal payment mechanism may be a hybrid payment between part capitated (fixed per-patient per-month) and part fee-for-service to carve out high-value services.

This chapter reviews the potential use of cost-effectiveness (CE) analysis in health and health insurance management. The goal is to assure the supply of all medical services with positive benefits greater than cost and none with benefits less than cost. This method is sometimes unpopular in the US because it limits use of care with positive benefits but very high costs; however, the great majority of treatments studied are cost-effective by the usual standards for the dollar value of health improvements. It is shown than cost-sharing can make a service cost-effective. The relevance of the incremental cost-effectiveness ratio (ICER) model for the use of CE analysis by insurers is questioned.