An Introduction to Economics of Healthcare

An Introduction to Economics of Healthcare

What does economics study? Economics analyzes the allocation of scarce resources. Resources include anything useful in consumption or production. From a perspective of a manager, resources include the flow of services from supplies or equipment the organization owns and the flow of services from employees, buildings, or other entities the organization hires.

Much of economics is positive. Positive economics uses objective analysis and evidence to answer questions about individuals, organizations, and societies. Positive economics might describe the state of healthcare, for example, in terms of hospital occupancy rates over a certain period.

Normative economics often addresses public policy issues, but not always. The manager of a healthcare organization who can identify additional services or additional features that customers are willing to pay for is demonstrating normative economics.

Why is economics valuable for managers? There are six reasons.

1. Economics helps managers focus on key issues.
2. Economics outlines strategies for realizing goals given the available resources.
3. Economics gives managers ground rules for strategic decision making.
4. Economics gives managers a framework for making sense of costs.
5. Economics gives managers a framework for thinking about value.
6. Most important, economics sensitizes managers to fundamental ideas that affect the operations of every organization.

Over the long-term, factors such as growing demand for healthcare, more formal or virtual integration of services delivery facilitated by health information technology, or substantive legislative reforms affecting the financing and regulation of healthcare could overwhelm the effects of economic cycles.

This article describes some of the Basic Concepts of Economics of Healthcare; such as: Economics as a map for decision making, special challenge for healthcare managers, risk and uncertainty, insurance, information asymmetries, not for profit organizations, description, evaluating and managing risk, describing potential outcome, evaluating outcome, risk references, managing risk, understanding cost, cost perspective, factors that influence cost, variable and fixed costs, the demand for healthcare products, why demand for healthcare is complex, demand with insurance, demand with advice from providers, elasticity, income elasticity, price elasticity of demand, using elasticity, supply and demand analysis, supply curves, demand curves, equilibrium, pricing, the economic model of pricing, price discrimination, pricing and managed care.

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. 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. Like a map, economics highlights some issues and suppresses others. For example, economics tells managers to focus on 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 we want to decide whether setting up an urgent care clinic is financially feasible, economics helps us focus on how our project will change revenues and costs.

Economics also gives managers a framework for understanding rational decision making. By rational decision making, we mean making choices that further one’s goals given 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.

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 decision in healthcare often leaves 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, which makes application of economics 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.

Economics focuses on rational behavior- that is, it focuses on individuals’ efforts to best realize their goals, given their resources. Much of economics is positive. Positive economics uses objective analysis and evidence to answer questions about individuals, organizations, and societies. Positive economics might describe the state of healthcare, for example, in terms of hospital occupancy rates over a certain period. Positive economics also proposes hypotheses and assesses how consistent the evidence is with them. Normative economics often addresses policy issues, but not always. The manager of a healthcare organization who can identify additional services or additional features that customers are willing to pay for is demonstrating normative economics. Likewise, the manager who can identify features or services that customers do not a value is also demonstrating normative economics.

Will be the first to enter a market give our organization an advantage, or will it give our rivals a low-cost way of seeing what works and what does not? Will buying primary care practices bring us increased market share or buyers’ remorse? Knowing economics will not make these choices easy, but it can give managers a plan for sorting through these issues.

Special Challenges for Healthcare Managers

Five issues face healthcare managers more than other managers:

1. The central role 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

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.

Insurance

Because risk and uncertainty are inherent in healthcare, most consumers have medical insurance. As a result, healthcare organizations have to contend with the management problems insurance presents. First, insurance creates confusion about who the customer is. In addition, insurance makes even simple transaction complex. Most transactions involve at least three parties (the patient, the insurer, and the provider), and may involve more.

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.

Not-for-profit Organizations

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. 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. Because of these special circumstances, managers of not-for-profit organizations

can always claim that substandard performance reflects their more complex environment.