HMGT 495 WK 2 DISC 2

Week 2 Discussion: Demand for Healthcare

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YOU MUST USE THE REQUIRED READING NO OUTSIDE SOURCE.

Provide a response to 
TWO of the questions below by Saturday, then provide a response to at least TWO of your peers by Tuesday: 

· Include the two questions that you selected to discuss at the top of your initial posting.

· What exactly is the law of demand? Why does the demand curve generally slope downward?

· Explain the price elasticity of demand?  Why is this important when looking at the demand for health care?

· What does it mean if a good has inelastic demand?  Provide an example of an inelastic good?

· What factors lead to a shift in the demand curve for healthcare?

· What do we mean when we say goods are substitutes? Provide an example related to health care.

· What do we mean when we say goods are complements? Provide an example related to health care.

· What does diminishing marginal utility mean?

· Health care has both a consumption component and investment component? What is the investment component and can you provide an example?

· Economists agree that the healthcare market is characterized by “asymmetric information,” what does this mean exactly? 

APA Requirements -Include Scholarly Evidence: Include at least TWO APA formatted references with correlating in-text citations. 

Supplemental Readings and Resources for Week 2: 

·

Economics Theory through Applications – Supplemental Reading: A Helpful Course Resource

·

PPT- HMGT 435 Week 2 Summary A Helpful Course Resource PPT

·

Institute for Healthcare Improvement (IHI) Website: Measure and Understand Supply and Demand Landing Page

CHAPTER

153

10SUPPLY AND DEMAND ANALYSI

S

Learning Objectives

After reading this chapter, students will be able to

• define demand and supply curves,
• interpret demand and supply curves,
• use demand and supply analysis to make simple forecasts, and
• identify factors that shift demand and supply curves.

Key Concepts

• A supply curve describes how much producers are willing to sell at
different prices.

• A demand curve describes how much consumers are willing to buy at
different prices.

• At the equilibrium price, producers want to sell the amount that
consumers want to buy.

• Markets generally move toward equilibrium outcomes.
• Expansion of insurance usually makes the equilibrium price and

quantity rise.
• Regulation and technology influence the supply of medical goods and

services.
• Demand and supply curves shift when a factor other than the product

price changes.

10.1 Introduction

Markets are in a constant state of flux. Prices rise and fall. Volumes rise and
fall. New products succeed at first and then fall by the wayside. Familiar
products falter and revive. Economics teaches us that, underneath the seem-
ingly random fluctuations of healthcare markets, systematic patterns can be
detected. Understanding these patterns requires an understanding of supply

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Economics for Healthcare Managers154

and demand. Even though healthcare managers need to focus on the details
of day-to-day operations, they also need an appreciation of the overview that
supply and demand analysis can give them.

The basics of supply and demand illustrate the usefulness of econom-
ics. Even with little data, managers can forecast the effects of changes in
policy or demographics using a supply and demand analysis. For example, the
impact of added taxes on hospitals’ prices, the impact of increased insurance
coverage on the output mix of physicians, and the impact of higher electricity
prices on pharmacies’ prices can be analyzed. Supply and demand analysis is
a powerful tool that managers can use to make broad strategic decisions or
detailed pricing decisions.

10.1.1 Supply Curves
Exhibit 10.1 is a basic supply and demand diagram. The vertical axis shows
the price of the good or service. In this simple case, the price sellers receive is
the same price buyers pay. (Insurance and taxes complicate matters, because
the price the buyer pays is different from the price the seller receives.) The
horizontal axis shows the quantity customers bought and producers sold.

The supply curve (labeled S) describes how much producers are will-
ing to sell at different prices. From another perspective, it describes what the
price must be to induce producers to be willing to sell different quantities.
The supply curve in exhibit 10.1 slopes up, as do most supply curves. This
upward slope means that, when the price is higher, producers are willing to
sell more of a good or service or more producers are willing to sell a good or
service. When the price is higher, producers are more willing to add workers,

supply curve
A graph that
describes how
much producers
are willing to sell
at different prices.

120

$0

$50

$100

$150

$200

$250

$300

$350

S

D

Pr
ic
e

Quantity

10080200 40 60

EXHIBIT 10.1
Equilibrium

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Chapter 10: Supply and Demand Analysis 155

equipment, and other resources to sell more. In addition, higher prices allow
firms to enter a market they could not enter at lower prices. When prices are
low, only the most efficient firms can profitably participate in a market. When
prices are higher, firms with higher costs can also earn acceptable profits.

10.1.2 Demand Curves
The demand curve (labeled D) describes how much consumers are willing
to buy at different prices. From another perspective, it describes how much
the marginal consumer (the one who would not make a purchase at a higher
price) is willing to pay at different levels of output. The demand curve in
exhibit 10.1 slopes down, meaning that, for producers to sell more of a
product, its price must be cut. Such a sales increase might be the result of an
increase in the share of the population that buys a good or service, an increase
in consumption per purchaser, or some mix of the two.

10.1.3 Equilibrium
The demand and supply curves intersect at the equilibrium price and quan-
tity. At the equilibrium price, the amount producers want to sell equals the
amount consumers want to buy. In exhibit 10.1, consumers want to buy 60
units and producers want to sell 60 units when the price is $100.

Markets tend to move toward equilibrium points. If the price is above
the equilibrium price, producers will not meet their sales forecasts. Some-
times producers cut prices to sell more. Sometimes producers cut production.
Either strategy tends to equate supply and demand. Alternatively, if the price
is below the equilibrium price, consumers will quickly buy up the available
stock. To meet this shortage, producers may raise prices or produce more.
Either strategy tends to equate supply and demand.

Markets will not always be in equilibrium, especially if conditions
change quickly, but the incentive to move toward equilibrium is strong. Pro-
ducers typically can change prices faster than they can increase or decrease
production. A high price today does not mean a high price tomorrow. Prices
are likely to fall as additional capacity becomes available. Likewise, a low price
today does not mean a low price tomorrow. Prices are likely to rise as capacity
decreases. We will explore this concept in more detail in our examination of
the effects of changes in insurance on the incomes of primary care physicians.

10.1.4 Professional Advice and Imperfect Competition
Healthcare markets are complex. The influence of professional advice on con-
sumer choices is a complication of particular concern. The assumption that
changes in supply will not affect consumers’ choices (i.e., demand) can be
misleading. If changes in factors that ought not to affect consumers’ choices
(e.g., providers’ financial arrangements with insurers) influence providers’

demand curve
A graph that
describes how
much consumers
are willing to buy
at different prices.

equilibrium price
The price at which
the quantity
demanded equals
the quantity
supplied. (There
is no shortage or
surplus.)

shortage
A situation in
which the quantity
demanded at
the prevailing
price exceeds
the quantity
supplied. (The
best indication of
a shortage is that
prices are rising.)

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Economics for Healthcare Managers156

recommendations, a supply and demand analysis that does not take this effect
into account could be equally misleading. Even more important, few health-
care markets fit the model of a competitive market (i.e., a market with many
competitors who perceive they have little influence on the market price). We
must condition any analysis on the judgment that healthcare markets are
competitive enough that conventional supply curves are useful guides. In
markets that are not competitive enough, producers’ responses to changes in
market conditions are likely to be more complex than supply curves suggest.
This text focuses on applications of demand and supply analysis in which
neither providers’ influence on demand nor imperfect competition is likely
to be a problem.

10.2 Demand and Supply Shifts

A movement along a demand curve is called a change in the quantity
demanded. In other words, a movement along a demand curve traces the
link between the price consumers are willing to pay and the quantity they
demand. Demand and supply analysis is most useful to healthcare manag-
ers, however, in understanding how the equilibrium price and quantity will
change in response to shifts in demand or supply. This application helps man-
agers the most. With limited information, a working manager can sketch the
impact of a change in policy on the markets of most concern.

What factors might cause the demand curve to shift to the right
(greater demand at every price or higher prices for every quantity)? We need
detailed empirical work to verify the responses of demand to market condi-
tions, but the list of standard responses is short. Typically, a shift to the right
results from an increase in income, an increase in the price of a substitute (a
good or service used instead of the product in question), a decrease in the
price of a complement (a good or service used along with the product in
question), or a change in tastes.

Economists often use mathematical notation to describe demand. Q
= D(P,Y) is an example of this notation. It says that the quantity demanded
varies with prices (represented by P) and income (represented by Y), which
means that quantity, the relevant prices, and income are systematically
related. A demand curve traces this relationship when income and all prices
other than the price of the product itself do not change.

What factors might cause the supply curve to shift to the right (greater
supply at every price or lower prices at every quantity)? Typically, a shift to
the right results from a reduction in the price of an input, an improvement
in technology, or an easing of regulations. In mathematical notation, we can
describe supply as Q = S(P,W). Here, W represents the prices of inputs (the

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Chapter 10: Supply and Demand Analysis 157

factors such as labor, land, equipment, buildings, and supplies that a business
uses to produce its product). Unless technology or regulations are the focus
of an analysis, we do not make their role explicit.

Worrying About Demand Shifts

More than 12 million Americans rely on long-term
services and supports in home, community, or

institutional settings. This number may more than double by 2050
(Commission on Long-Term Care 2013). Only a small share get services
in nursing homes, and the trend is toward lower rates of nursing home
care.

Several factors may influence how and where Americans get these
services (Spetz et al. 2015). First, Medicaid is a major funder of long-
term services and supports, so any changes in Medicaid policy can
have major effects. Second, rates of disability have been trending
down for a number of years, but there is no guarantee that this trend
will continue. Third, use of long-term services and supports varies
widely among major ethnic groups, so changes in the composition of
the population might have major effects on demand.

Technology represents a wild card in efforts to predict the volume
and nature of long-term services and supports. For example, the devel-
opment of smart homes and devices might well increase the share of
the population getting these services in their homes.

Case 10.1

(continued)

Quantity

Pr
ic
e

Q
1

P
1

S

D

EXHIBIT 10.2
The Demand
and Supply of
Nursing Home
Care

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Economics for Healthcare Managers158

10.2.1 A Shift in

Demand

We begin our demand and supply analyses by looking at a classical problem in
health economics: What will happen to the equilibrium price and quantity of
a product used by consumers if insurance expands? Insurance expands when
the insurance plan agrees to pay a larger share of the bill or the proportion
of the population with insurance increases. This sort of change in insurance
causes a shift in demand (or demand shift). As shown in exhibit 10.3, the
entire demand curve rotates. As a result of this insurance expansion, the

shift in demand
A shift that
occurs when a
factor other than
the price of the
product itself
(e.g., consumer
incomes) changes.

Quantity

Pr
ic
e

Q
1

Q
2

P
2

P
1

D
2

S
D

1

EXHIBIT 10.3
An Expansion of

Insurance

Discussion Questions
• What sorts of policy changes seem likely to

shift the demand for nursing home care?

• How would exhibit 10.2 change given the scenario you outline?

• What sorts of demographic changes seem likely to shift the
demand for nursing home care?

• How would exhibit 10.2 change given the scenario you outline?

• What sorts of technological changes seem likely to shift the
demand for nursing home care?

• How would exhibit 10.2 change given the scenario you outline?

• What sorts of health changes seem likely to shift the demand for
nursing home care?

• How would exhibit 10.2 change given the scenario you outline?

Case 10.1
(continued)

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Chapter 10: Supply and Demand Analysis 159

equilibrium price rises from P1 to P2 and the equilibrium quantity rises from
Q1 to Q2. For example, as coverage for pharmaceuticals has become a part of
more Americans’ insurance, the prices and sales of prescription pharmaceu-
ticals have risen.

10.2.2 A Shift in Supply
Exhibit 10.4 depicts a shift in supply (or supply shift). The supply curve
has contracted from S1 to S2. This shift means that at every price, producers
want to supply a smaller volume. Alternatively, it means that to produce each
volume, producers require a higher price. A change in regulations might
result in a shift like the one from S1 to S2. For example, suppose that state
regulations mandated improved care planning and record keeping for nurs-
ing homes. Some nursing homes might close down, but the majority would
raise prices for private-pay patients to cover the increased cost of care. The
net effect would be an increase in the equilibrium price from P1 to P2 and
a reduction in the equilibrium quantity from Q1 to Q2. A manager should
be able to forecast this effect with no information other than the realization
that the demand for nursing home care is relatively inelastic (meaning that
the slope of the demand curve is steep) and that the regulation would shift
the supply curve inward.

Responses to changing market conditions depend on how much time
passes. A change in technology, such as the development of a new surgical
technique, initially will have little effect on supply. Over time, however, as
more surgeons become familiar with the technique, its impact on supply will
grow. Short-term supply and demand curves generally look different from

shift in supply
A shift that occurs
when a factor
(e.g., an input
price) other than
the price of the
product changes.

Quantity

Pr
ic
e

Q
2

Q
1

P
2

P
1

S
1

S
2

D

EXHIBIT 10.4
A Supply Shift

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Economics for Healthcare Managers160

long-term supply and demand curves. The more time consumers and pro-
ducers have to respond, the more their behavior changes.

10.3 Shortage and Surplus

A shortage exists when the quantity demanded at the prevailing price exceeds
the quantity supplied. In markets that are free to adjust, the price should rise
so that equilibrium is restored. At a higher price, less will be demanded, leav-
ing a greater supply.

In some markets, though, prices cannot adjust, often because a public
or private insurer sets prices too low and consumers demand more than pro-
ducers are willing to supply. Exhibit 10.5 depicts a shortage situation. The
equilibrium price is P* and the equilibrium quantity is Q*, but the insurer
has set a price of P2, so consumers demand QD and producers supply QS.
Because the price cannot adjust, a shortage equal to QD − QS exists.

A surplus exists when the quantity supplied at the prevailing price
exceeds the quantity demanded. In markets that are free to adjust, the price
should fall so that equilibrium is restored. In some markets, prices are free to
fall but do so slowly. For example, in the 1990s, many hospitals had unfilled
hospital beds because the combination of managed care and new technology
reduced the demand for inpatient care. Over time, insurance companies used
this excess capacity to secure much lower rates (even though Medicare and
Medicaid rates remained unchanged), and enough hospitals closed or down-
sized to eliminate the excess capacity.

surplus
A situation in
which the quantity
supplied at
the prevailing
price exceeds
the quantity
demanded. (The
best indication of
a surplus is that
prices are falling.)

Quantity

Pr
ic
e

Q
S

Q* Q
D

P
2

P*

SD

EXHIBIT 10.5
A Shortage

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Chapter 10: Supply and Demand Analysis 161

How Large Will the Shortage of
Primary Care Physicians Be?

The Affordable Care Act (ACA) has increased the share of the popu-
lation with health insurance. Most of the newly insured are young
and reasonably healthy. As a result, the ACA will primarily affect the
demand for primary care services, and many anticipate a shortage of
primary care physicians (Porter 2015).

But some other observers suggest that this concern is overblown
(Auerbach et al. 2013). The production of primary care is changing
in ways that shift its supply. One change is the rapid expansion of
patient-centered medical homes, which emphasize a greater role for
technology, nurses, physician assistants, and nurse practitioners.
Another change is the growth of nurse-managed clinics (of which
MinuteClinic, discussed in case 7.1, is an example). Both of these inno-
vations reduce the number of physicians needed to provide primary
care for a population.

Discussion Questions
• If there were a shortage of primary care physicians, what would

happen to their incomes?

• Set up a model of the demand and supply for primary care
physicians. (It should have salary on the vertical axis and number
of primary care physicians on the horizontal axis.) Assuming that
the production of primary care does not change (i.e., the supply
curve does not shift), how do you expect the market equilibrium to
change?

• How have the incomes of primary care physicians changed in the
last few years? Are these changes consistent with your prediction?
(You can get income data from Medscape Physician Compensation
Reports.)

• Do the changes in the incomes of primary care physicians suggest
there is a shortage?

• If retail clinics and patient-centered medical homes continue to
expand, how will they affect the market equilibrium? Which curve
would shift as a result: demand or supply?

Case 10.2

(continued)

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Economics for Healthcare Managers162

10.4 Analyses of Multiple Markets

Demand and supply models can also be helpful in forecasting the effects
of shifts in one market on the equilibrium in another. Such forecasts can
be made only if the markets are related—that is, the products need to be
complements or substitutes.

Parente and colleagues (2017) provide an example of this effect. They
argue that the ACA’s subsidies for health insurance will shift the demand for
registered nurses from D1 to D2 (see exhibit 10.6). As a result, employment
will rise from Q1 to Q2 and wages will rise from W1 to W2.

Quantity

Pr
ic
e

Q
1

Q
2

W
1

W
2

S
2D

2

D
1

EXHIBIT 10.6
Insurance

Subsidies Shift
Demand for
Registered

Nurses

• Deductibles have been rising quickly in recent
years. How would that affect the incomes of
primary care physicians?

• Patient-centered medical homes typically expand the roles of
registered nurses. How would this affect the demand for primary
care physicians?

• The ACA increased some payments for primary care. How would this
affect the demand for primary care physicians?

Case 10.2
(continued)

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Chapter 10: Supply and Demand Analysis 163

10.5 Conclusion

Supply and demand analysis can help managers anticipate the effects of
changes in policy, technology, or prices. Supply and demand analysis is a
valuable tool that managers can use to quickly anticipate the effects of shifts
in demand or supply curves. Short-term shifts in demand are likely to result
from one of two factors: changes in insurance or shifts in the prices or char-
acteristics of substitutes or complements. Short-term shifts in supply are likely
to result from one of three factors: changes in regulations, shifts in the prices
or characteristics of inputs, or changes in technology.

Make sure you understand the basic shapes of demand and supply
curves. Most demand curves slope down, which means that consumers will
buy more if prices are lower. It also means that consumers who are willing
to purchase a product only at a low price do not place a high value on it. In
contrast, most supply curves slope up, which means that higher prices will
motivate producers to sell additional output (or motivate more producers to
sell the same output).

Exercises

10.1 Physicians’ offices supply some urgent care services (i.e., services
patients seek for prompt attention but not for preservation of life or
limb).
a. Name three other providers of urgent care services.
b. What sort of shift in supply or demand would result in a market

equilibrium with higher prices

and sales volume?
c. What might cause such a shift?
d. What sort of shift in supply or demand would result in a market

equilibrium with higher prices but lower sales volume?
e. What might cause such a shift?

10.2 Suppose the market equilibrium price for immunizations is $40 and
the volume is 25,000.
a. Identify three providers of immunization services.
b. What sort of shift in supply or demand would reduce both prices

and sales volume?
c. What might cause such a shift?
d. What sort of shift in supply or demand would result in a market

equilibrium with a price above $40 and a volume below 25,000?
e. What might cause such a shift?

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Economics for Healthcare Managers164

10.3 The table contains data on the number of doses of an antihistamine
sold per month in a small town.

Price Demand Supply

$10 185 208

$9 187 205

$8 188 202

$7 190 199

$6 191 196

$5 193 193

$4 194 190

$3 196 187

$2 197 184

$1 199 181

a. To sell 196 doses to customers, what will the price need to be?
b. For stores to be willing to sell 196 doses, what will the price need

to be?
c. How many doses will customers want to buy if the price is $2?
d. How many doses will suppliers want to sell if the price is $2?
e. Is there excess supply or excess demand at $2?
f. What is the equilibrium price? How can you tell?

10.4 The table contains demand and supply data for eyeglasses in a local
market.

Price Demand Supply

$300 7,400 8,320

$290 7,480 8,200

$280 7,520 8,080

$270 7,600 7,960

$260 7,640 7,840

(continued)

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Chapter 10: Supply and Demand Analysis 165

Price Demand Supply

$250 7,720 7,720

$240 7,760 7,600

$230 7,840 7,480

$220 7,880 7,360

a. At $280, how many pairs will consumers want to buy?
b. How many pairs will consumers want to buy if the price is $290?
c. How many pairs will stores want to sell at $290?
d. Is $290 the equilibrium price?
e. Is there excess supply or excess demand at $290?
f. What is the equilibrium price? How can you tell?

10.5 The graph below shows a basic demand and supply graph for home
care services. Identify the equilibrium price and quantity. Label
them P* and Q*.
a. Retirements drive up the wages of home care workers. How

would the graph change? How would P* and Q* change?
b. Improved technology lets home care workers monitor use of

medications without going to clients’ homes. How would the
graph change? How would P* and Q* change?

c. The number of people needing home care services increases.
How would the graph change? How would P* and Q* change?

d. A change in Medicare rules expands coverage for home care
services. How would the graph change? How would P* and Q*
change?

Quantity

Pr
ic
e Supply

Demand

(continued)

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Economics for Healthcare Managers166

10.6 The demand function is Q = 600 − P, with P being the price paid by
consumers. Put a list of prices ranging from $400 to $0 in a column
labeled P. (Use intervals of $50.)
a. Consumers have insurance with 40 percent coinsurance. For each

price, calculate the amount that consumers pay. (Put this figure in
a column labeled PNet.)

b. Calculate the quantity demanded when there is insurance. (Put
this figure in a column labeled DI.)

c. Plot the demand curve, putting P (not PNet) on the vertical axis.
d. The quantity supplied equals 2 × P. Put these values in a column

labeled S.
e. What is the equilibrium price?
f. How much do consumers spend?
g. How much does the insurer spend?

10.7 The demand function is Q = 1,000 − (0.5 × P). P is the price paid
by consumers. Calculate the quantity demanded when there is no
insurance. (Put these values in column DU of the table.)

P DU PNet DI S

$1,000

$960

$920

$880 560 $176 912 952

$840

$800

$760

$720

$680

$640

$600

$560

The state mandates coverage with 20 percent coinsurance, meaning
that the demand function becomes 1,000 − (0.5 × 0.2 × P).
a. For each price, calculate the amount consumers pay. (Put this

figure in column PNet.)
b. Calculate the quantity demanded when there is insurance. (Put

this figure in column DI.)

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Chapter 10: Supply and Demand Analysis 167

c. Plot the two demand curves, putting P (not PNet) on the vertical
axis.

d. How do DU and DI differ? Which is more elastic?
10.8 The supply function for the product in exercise 10.7 is 160 + (0.9 ×

P). P is the price received by the seller. At the equilibrium price, the
quantity demanded will equal the quantity supplied.
a. What was the equilibrium price before coverage? After?
b. After coverage begins, how much will the product cost insurers?

How much will the product cost patients? How much did
patients pay for the product before coverage started?

10.9 Consumers who can buy health insurance through an employer get
a tax subsidy. Use demand and supply analysis to assess how this
subsidy affects consumers who cannot buy insurance through an
employer.

10.10 Why are price controls unlikely to make consumers better off if a
market is reasonably competitive?

10.11 Make the business case why healthcare providers should advocate for
expansion of insurance coverage for the poor.

References

Auerbach, D. I., P. G. Chen, M. W. Friedberg, R. Reid, C. Lau, P. I. Buerhaus, and
A. Mehrotra. 2013. “Nurse-Managed Health Centers and Patient-Centered
Medical Homes Could Mitigate Expected Primary Care Physician Shortage.”
Health Affairs 32 (11): 1933–41.

Commission on Long-Term Care. 2013. Report to the Congress. Published September
30. www.gpo.gov/fdsys/pkg/GPO-LTCCOMMISSION/pdf/GPO-LTC
COMMISSION .

Parente, S. T., R. Feldman, J. Spetz, B. Dowd, and E. E. Baggett. 2017. “Wage
Growth for the Health Care Workforce: Projecting the Affordable Care Act
Impact.” Health Services Research 52 (2): 741–62.

Porter, S. 2015. “Significant Primary Care, Overall Physician Shortage Predicted by
2025.” American Academy of Family Physicians. Published March 3. www
.aafp.org/news/practice-professional-issues/20150303aamcwkforce.html.

Spetz, J., L. Trupin, T. Bates, and J. M. Coffman. 2015. “Future Demand for Long-
Term Care Workers Will Be Influenced by Demographic and Utilization
Changes.” Health Affairs 34 (6): 936–45.

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CHAPTER

109

7THE DEMAND FOR HEALTHCARE PRODUCTS

Learning Objectives

After reading this chapter, students will be able to

• calculate sales and revenue using simple models,
• discuss the importance of demand in management decision making,
• articulate why consumer demand is an important topic in healthcare,
• apply demand theory to anticipate the effects of a policy change,
• use standard terminology to describe the demand for healthcare

products, and
• discuss the factors that influence demand.

Key Concepts

• The demand for healthcare products is complex.
• When a product’s price rises, the quantity demanded usually falls.
• The amount a consumer pays directly is called the out-of-pocket price

of that good or service.
• Because of insurance, the total price and the out-of-pocket price can

differ markedly.
• Multiple factors can shift demand: changes in consumer income,

insurance coverage, health status, prices of other goods and services,
and tastes.

• Demand forecasts are essential to management.

7.1 Introduction

Demand is one of the central ideas of economics. It underpins many of the
contributions of economics to public and private decision making. Analyses
of demand tell us that human wants are seldom absolute. More often they

demand
The amounts of a
product that will
be purchased at
different prices
when all other
factors are held
constant.

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Economics for Healthcare Managers110

are conditioned by questions: “Is it really worth it?” “Is its value greater than
its cost?” These questions are central to understanding healthcare economics.

Demand forecasts are essential to management. Most managerial deci-
sions are based on revenue projections. Revenue projections in turn depend
on estimates of sales volume, given prices that managers set. A volume esti-
mate is an application of demand theory. Understanding the relationship
between price and quantity must be part of every manager’s tool kit. On
an even more fundamental level, demand forecasts help managers decide
whether to produce a certain product at all and how much to charge. For
example, if you conclude that the direct costs of providing therapeutic mas-
sage are $48 and that you will need to charge at least $75 to have an attrac-
tive profit margin, will you have enough customers to make this service a
sensible addition to your product line? Demand analyses are designed to
answer such questions.

7.1.1 Rationing
On an abstract level, we need to ration goods and services (including medical
goods and services) somehow. Human wants are infinite or nearly so. Our
capacity to satisfy those wants is finite. We must develop a system for deter-
mining which wants will be satisfied and which will not. Market systems use
prices to ration goods and services. A price system costs relatively little to
operate, is usually self-correcting (e.g., prices fall when the quantity supplied
exceeds the quantity demanded, which tends to restore balance), and allows
individuals with different wants to make different choices. These advantages
are important. The problem is that markets work by limiting the choices of
some consumers. As a result, even if the market process is fair, the market
outcome may seem unfair. Wealthy societies typically view exclusion of some
consumers from valuable medical services, perhaps because of low income or
perhaps because of previous catastrophic medical expenses, as unacceptable.

The implications of demand are not limited to market-oriented sys-
tems. Demand theory predicts that if care is not rationed by price, it will be
rationed by other means, such as waiting times, which are often inconvenient
for consumers. In addition, careful analyses of consumer use of services have
convinced most analysts that medical goods and services should not be free.
If care were truly costless for consumers, they would use it until it offered
them no additional value. Today this understanding is reflected in the public
and private insurance plans of most nations.

Care cannot really be free. Someone must pay, somehow. Modern
healthcare requires the services of highly skilled professionals, complex and
elaborate equipment, and specialized supplies. Even the resources for which
there is no charge represent a cost to someone.

market system
A system that
uses prices to
ration goods and
services.

quantity
demanded
The amount of a
good or service
that will be
purchased at a
specific price when
all other factors
are held constant.

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Chapter 7: The Demand for Healthcare Products 111

7.1.2 Indirect Payments and Insurance
Because the burden of healthcare costs falls primarily on an unfortunate few,
health insurance is common. Insurance creates another use for demand analy-
ses. To design sensible insurance plans, we need to understand the public’s
valuation of services. Insurance plans seek to identify benefits the public is
willing to pay for. The public may pay directly (through out-of-pocket pay-
ments) or indirectly. Indirect payments can take the form of health insur-
ance premiums, taxes, wage reductions, or higher prices for other products.
Understanding the public’s valuation is especially important in the healthcare
sector because indirect payments are so common. When consumers pay
directly, valuation is not important (except for making revenue forecasts).
Right or wrong, a consumer who refuses to buy a $7.50 bottle of aspirin
from an airport vendor because it is “too expensive” is making a clear state-
ment about value. In contrast, a Medicare patient who thinks coronary artery
bypass graft surgery is a good buy at a cost of $1,000 is not providing us with
useful information. The surgery costs more than $30,000, but the patient
and taxpayers pay most of the bill indirectly. Because consumers purchase so
much medical care indirectly, with the assistance of public or private insur-
ance, assessing whether the values of goods and services are as large as their
costs is often difficult.

7.2 Why Demand for Healthcare Is Complex

The demand for medical care is more complex than the demand for many
other goods for four reasons.

1. The price of care often depends on insurance coverage. Insurance has
powerful effects on demand and makes analysis more complex.

2. Healthcare decisions are often challenging. The links between medical
care and health outcomes are often difficult to ascertain at the
population level (where the average impact of care is what matters)
and stunningly complex at the individual level (where what happens to
oneself is what matters). Forced to make hard choices, consumers may
make bad choices.

3. This complexity contributes to consumers’ poor information about
costs and benefits of care. Such “rational ignorance” is natural. Because
most consumers will not have to make most healthcare choices, it
makes no sense for them to be prepared to do so.

4. The net effect of complexity and consumer ignorance is that producers
have significant influence on demand. Consumers naturally turn to

out-of-pocket
payment
Money a consumer
directly pays for a
good or service.

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Economics for Healthcare Managers112

healthcare professionals for advice. Unfortunately, because they are
human, professionals’ choices are likely to reflect their values and
incentives as well as those of their patients.

Demand is complicated by itself. To keep things simple, we will first
examine the demand for medical goods and services in cases where insur-
ance and professional advice play no role. The demand for over-the-counter
pharmaceuticals, such as aspirin, is an example. We will then add insurance
to the mix but keep professional advice out. Finally, we will add the role of
professional advice.

7.3 Demand Without Insurance and Healthcare
Professionals

In principle, a consumer’s decision to buy a particular good or service reflects
a maddening array of considerations. For example, a consumer with a head-
ache who is considering buying a bottle of aspirin must compare its benefits,
as the consumer perceives them, to those of the other available choices.
Those choices might include taking a nap, going for a walk, taking another
nonprescription analgesic, or consulting a physician.

Economic models of demand radically simplify descriptions of con-
sumer choices by stressing three key relationships that affect the amounts
purchased:

1. the impact of changes in the price of a product,
2. the impact of changes in the prices of related products, and
3. the impact of changes in consumer incomes.

This simplification is valuable to firms and policymakers, who cannot change
much besides prices and incomes. This focus can be misleading, however, if
it obscures the potential impact of public information campaigns (including
advertising).

7.3.1 Changes in Price
The fundamental prediction of demand theory is that the quantity demanded
will increase when the price of a good or service falls. The quantity demanded
may increase because some consumers buy more of a product (as might be
the case with analgesics) or because a larger proportion of the population
chooses to buy a product (as might be the case with dental prophylaxis).
Exhibit 7.1 illustrates this sort of relationship. On demand curve D1, a price
reduction from P1 to P2 increases the quantity demanded from Q1 to Q2.

demand curve
A graph that
describes how
much consumers
are willing to buy
at different prices.

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Chapter 7: The Demand for Healthcare Products 113

Exhibit 7.1 also illustrates a shift in demand. At each price, demand curve
D2 indicates a lower quantity demanded than demand curve D1. (Alterna-
tively, at each volume, willingness to pay will be smaller with D2.) This shift
might be due to a drop in income, a drop in the price of a substitute, an
increase in the price of a complement, a change in demographics or con-
sumer information, or other factors.

Demand curves can also be interpreted to mean that prices will have
to be cut to increase the sales volume. Consumers who are not willing to pay
what the product now costs may enter the market at a lower price, or current
consumers may use more of the product at a lower price. Demand curves
are important economic tools. Analysts use statistical techniques to estimate
how much the quantity demanded will change if the price of the product or
other factors change.

Substitution explains why demand curves generally slope down, that
is, why consumption of a product usually falls if its price rises. Substitutes
exist for most goods and services. When the price of a product is higher
than that of its substitute, more people choose the substitute. Substitutes for
aspirin include taking a nap, going for a walk, taking another nonprescrip-
tion analgesic, and consulting a physician. If close substitutes are available,
changes in a product’s price could lead to large changes in consumption. If
none of the alternatives are close substitutes, changes in a product’s price
will lead to smaller changes in consumption. Taking another nonprescription
analgesic is a close substitute for taking aspirin, so we would anticipate that
consumers would be sensitive to changes in the price of aspirin.

Substitution is not the only result of a change in price. When the
price of a good or service falls, the consumer has more money to spend on

shift in demand
A shift that
occurs when a
factor other than
the price of the
product itself
(e.g., consumer
incomes) changes.

substitute
A product used
instead of another
product.

complement
A product used in
conjunction with
another product.

Quantity

Pr
ic
e

Q1 Q2

P1

P2

D1

D2

EXHIBIT 7.1
A Shift in

Demand

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Economics for Healthcare Managers114

all goods and services. Most of the time this income effect reinforces the
substitution effect, so we can predict with confidence that a price reduction
will cause consumers to buy more of that good. In a few cases, things get
murkier. A rise in the wage rate, for example, increases the income you would
forgo by reducing your work week. At first blush, you might expect that a
higher wage rate would reduce your demand for time off. At the same time,
though, a higher wage rate increases your income, which may mean more
money for travel and leisure activities, increasing the amount of time you
want off. In these cases empirical work is necessary to predict the impact of
a change in prices.

Two points about price sensitivity need to be made here. First, a gen-
eral perception that use of most goods and services will fall if prices rise is
a useful notion to keep tucked away. Second, managers need more precise
guidance. How much will sales increase if I reduce prices by 10 percent?
Will my total revenue rise or fall as a result? To answer these questions takes
empirical analysis. Fleshing out general notions about price sensitivity with
estimates is one of the tasks of economic analysis. We also need an agreed-on
terminology to talk about how much the quantity demanded will change in
response to a change in income, the price of the product, or the prices of
other products. Economists describe these relationships in terms of elastici-
ties, which we will talk more about in chapters 8 and 9.

7.3.2 Factors Other Than Price
Changes in factors other than the price of a product shift the entire demand
curve. Changes in beliefs about the productivity of a good or service, pref-
erences, the prices of related goods and services, and income can shift the
demand curve.

Consumers’ beliefs about the health effects of products are obviously
central to discussions of demand. Few people want aspirin for its own sake.
The demand for aspirin, as for most medical goods and services, depends
on consumers’ expectations about its effects on their health. These expecta-
tions have two dimensions. One dimension consists of consumers’ beliefs
about their own health. If they believe they are healthy, they are unlikely to
purchase goods and services to improve their health. The other dimension
consists of their perception of how much a product will improve health. If I
have a headache but do not believe that aspirin will relieve it, I will not be
willing to buy aspirin. Health status and beliefs about the capacity of goods
and services to improve health underpin demand.

Demand is a useful construct only if consumer preferences are stable
enough to allow us to predict responses to price and income changes and
if price and income changes are important determinants of consumption

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Chapter 7: The Demand for Healthcare Products 115

decisions. If on Tuesday 14 percent of the population thinks aspirin is some-
thing to avoid (whether it works or not) and on Friday that percentage has
risen to 24 percent, demand models will be of little use. We would need
to track changes in attitude, not changes in price. Alternatively, if routine
advertising campaigns could easily change consumers’ opinions about aspirin,
tracking data on incomes and prices would be of little use. Preferences are
usually stable enough for demand studies to be useful, so managers can rely
on them in making pricing and marketing decisions.

Changes in income and wealth usually result in shifts in demand. In
principle, an increase in income or wealth could shift the demand curve either
out (more consumption at every price) or in (less consumption at every price).
Overall spending on healthcare clearly increases with income, but spending
on some products falls with income. For example, as income increases, retir-
ees reduce their use of informal home care (Tsai 2015). For the most part,
however, consumers with larger budgets buy more healthcare products.

Changes in the prices of related goods also shift demand curves.
Related goods are substitutes (products used instead of the product in ques-
tion) and complements (products used in conjunction with the product in
question). A substitute need not be a perfect substitute; in some cases it
is simply an alternative. For example, ibuprofen is a substitute for aspirin.
A reduction in the price of a substitute usually shifts the demand curve in
(reduced willingness to pay at every volume). If the price of ibuprofen fell,
some consumers would be tempted to switch from aspirin to ibuprofen, and
the demand for aspirin would shift in. Conversely, an increase in the price
of a substitute usually shifts the demand curve out (increased willingness to
pay at every volume). If the price of ibuprofen rose, some consumers would
be tempted to switch from ibuprofen to aspirin, and the demand for aspirin
would shift out.

7.4 Demand with Insurance

Insurance changes demand by reducing the price of covered goods and ser-
vices. For example, a consumer whose dental insurance plan covers 80 per-
cent of the cost of a routine examination will need to pay only $10 instead
of the full $50. The volume of routine examinations will usually increase
as a result of an increase in insurance coverage, primarily because a higher
proportion of the covered population will seek this form of preventive care.
The response will not typically be large, however. Most consumers will not
change their decisions to seek care because prices have changed. But man-
agers should recognize that some consumers will respond to price changes

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Economics for Healthcare Managers116

caused by insurance. (We will develop tools for describing responses to price
changes and review the evidence on this score in the next chapter.)

Exhibit 7.2 depicts standard responses to increases in insurance. An
increase in insurance (a higher share of the population covered or a higher
share of the bill covered) rotates the demand curve from D1 to D2. As a
result, the quantity demanded may rise, the price may rise, or both may
occur. To predict the outcome more precisely we will need the tools of supply
analysis that we will develop in chapter 10.

For provider organizations, an increase in insurance represents an
opportunity to increase prices and margins. The rotation of D2 has made it
steeper, meaning that demand has become less sensitive to price. As demand
becomes less sensitive to price, profit-maximizing firms will seek higher
margins. (Higher margins mean that the cost of production will represent
a smaller share of what consumers pay for a product.) Higher prices and
increased quantity mean that the expansion of unmanaged insurance will
result in substantial increases in spending.

Demand theory implies that having patients pay a larger share of the
bill (usually termed increased cost sharing) should reduce consumption of
care. Does it? A classic study by the RAND Corporation tells us that it does
(Manning et al. 1987). The RAND Health Insurance Experiment randomly
assigned consumers to different health plans and then tracked their use of
care (see exhibit 7.3). Its fee-for-service sites had coinsurance rates of 0 per-
cent, 25 percent, 50 percent, and 95 percent. The health plans fully covered
expenses above out-of-pocket maximums, which varied from 5 percent to
15 percent of income. Spending was substantially lower for consumers who

cost sharing
The general
term for direct
payments
to providers
by insurance
beneficiaries.
(Deductibles,
copayments, and
coinsurance are
forms of cost
sharing.)

out-of-pocket
maximum
A cap on the
amount a
consumer has to
pay out of pocket.

Quantity

Pr
ic
e

D2

D1

EXHIBIT 7.2
The Impact of
Insurance on

Demand

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Chapter 7: The Demand for Healthcare Products 117

shared in the cost of their care. Increasing the coinsurance rate (the share of
the allowed fee that consumers pay) from 0 percent to 25 percent reduced
total spending by nearly a fifth. This reduction had minimal effects on health.

Costs were lower because consumers had fewer contacts with the
healthcare system. The experiment went on for years, and the suspicion
that reducing use of care would increase spending later was not borne out.
Because of the results of this study, virtually all insurance plans now incorpo-
rate some form of cost sharing for care initiated by patients.

coinsurance
A form of cost
sharing in which
a patient pays a
share of the bill,
not a set fee.

allowed fee
The maximum
amount an insurer
will pay for a
covered service.

Coinsurance
Rate Spending

Any Use
of Care

Hospital
Admission

0% $750 87% 10%

25% $617 79% 8%

50% $573 77% 7%

95% $540 68% 8%

Source: Manning et al. (1987).

EXHIBIT 7.3
Effect of
Coinsurance
Rate

MinuteClinic

Mentioning a nationwide shortage of primary
care providers, millions of patients newly insured

through the Affordable Care Act, and an aging population, Andrew
Sussman, MD, president of CVS’s MinuteClinic division, said, “Minute-
Clinic can help to meet that demand, collaborating with local provider
groups, as part of a larger health care team” (Nesi 2014).

MinuteClinic started in 2000 and as of late 2017 had more than
1,000 locations (CVS 2017). Its clinics are staffed by nurse practitioners
and physician assistants, rather than physicians. The clinics are open
seven days a week and appointments are not needed. The nurse prac-
titioners and physician assistants diagnose, treat, and write prescrip-
tions for a variety of common illnesses. MinuteClinics show customers
the prices of care (typically less than the prices in a physician’s office)
and usually accept insurance. Most clinics are in CVS pharmacies,
although an increasing number are in other sites and some have con-
nections with local health systems.

Case 7.1

(continued)

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Economics for Healthcare Managers118

7.5 Demand with Advice from Providers

Consumers are often rationally ignorant about the healthcare system and the
particular decisions they need to make. They are ignorant because medical
decisions are complex, because they are unfamiliar with their options, because
they lack the skills and information they need to compare their options, and
because they lack time to make a considered judgment. This ignorance is
rational because consumers do not know what choices they will have to make,
because the cost of acquiring skills and information is high, and because the
benefits of acquiring these skills and information are unknown.

Consumers routinely deal with situations in which they are ignorant.
Few consumers really know whether their car needs a new constant velocity
joint, whether their roof should be replaced or repaired, or whether they
should sell their stock in Cerner Corporation. Of course, consumers know
they are ignorant. They often seek an agent, someone who is knowledgeable
and can offer advice that advances the consumer’s interests. Most people with
medical problems choose a physician to be their agent.

agent
A person
who provides
services and
recommendations
to clients (who are
called principals).

In late December 2017, CVS Health announced
an agreement to buy the health insurer Aetna.
Some have suggested that this move could

reshape the healthcare industry by integrating insurance with a pro-
vider organization (Abelson and Thomas 2017).

Discussion Questions
• For what products is MinuteClinic a substitute?

• For what products is it a complement?

• How would continued expansion of MinuteClinics affect revenues of
primary care practices?

• What attributes other than prices would make MinuteClinics
attractive to patients?

• Is the supply of primary care physicians large enough to meet
current levels of demand?

• Would you expect expansion of MinuteClinics to increase or
decrease spending? Why?

• What are the implications of Aetna’s sale to CVS?

• A common criticism is that MinuteClinics locate in well-to-do areas.
Is this a concern?

Case 7.1
(continued)

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Chapter 7: The Demand for Healthcare Products 119

Using an agent reduces, but does not eliminate, the problems associ-
ated with ignorance. Agents sometimes take advantage of principals (in this
case, the ignorant consumers they represent). Taking advantage can range
from out-and-out fraud (e.g., lying to sell a worthless insurance policy) to
simple shirking (e.g., failing to check the accuracy of ads for a property). If
consumers can identify poor agent performance, fairly simple remedies fur-
ther reduce the problems associated with ignorance. In many cases, an agent’s
reputation is of paramount importance, so agents have a strong incentive to
please principals. In other cases, simply delaying payment until a project has
been successfully completed substantially reduces agency problems.

The most difficult problems arise when consumers have difficulty
distinguishing bad outcomes from bad performance on the part of an agent.
This problem is fairly common. Did your house take a long time to sell
because the market weakened unexpectedly or because your agent recom-
mended that you set the price too high? Was your baby born via cesarean
section to preserve the baby’s health or to preserve your physician’s weekend
plans? Most contracts with agents are designed to minimize these problems
by aligning the interests of the principal and the agent. For example, real
estate agents earn a share of a property’s sale price so that both the agent and
the seller profit when the property is sold quickly at a high price. In similar
fashion, earnings of mutual fund managers are commonly based on the total
assets they manage, so managers and investors profit when the value of the
mutual fund increases.

Agency models have several implications for our understanding of
demand. First, what consumers demand may depend on incentives for pro-
viders. Agency models suggest that changes in the amount paid to providers,
the way providers are paid, or providers’ profits may change their recom-
mendations for consumers. For example, consumers may respond to a lower
price for generic drugs only because pharmacists have financial incentives to
recommend them. Second, provider incentives will affect consumption of
some goods and services more than others. Provider recommendations will
not affect patients’ initial decisions to seek care. And where standards of care
are clear and generally accepted, providers are less apt to change their recom-
mendations when their incentives change. When a consensus about standards
of care exists, providers who change their recommendations in response to
financial incentives risk denial of payment, identification as a low-quality
provider, or even malpractice suits. Third, patients with chronic illnesses are
often knowledgeable about the therapies they prefer. When patients have firm
preferences, agency is likely to have less effect on demand. In short, agency
makes the demand for medical care more complex.

Agency is one of the most important factors that makes managed
care necessary. (The other main factor is that insurance plans must protect

principal
The organization
or individual
represented by an
agent.

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Economics for Healthcare Managers120

consumers from virtually all the costs of some expensive procedures, reducing
out-of-pocket costs to near zero.) If all the parties in a healthcare transaction
had the same information, expenditures could be limited simply by changing
consumer out-of-pocket payments. In many cases, though, provider incen-
tives need to be aligned with consumer goals. (Of course, health plans also
have an agency relationship with beneficiaries, and nothing guarantees that
plans will be perfect agents.) Most of the features of managed care address
the agency problem in one way or another. Bundled payments for services
and capitation are designed to give physicians incentives to recommend
no more care than is necessary. Primary care gatekeepers are supposed to
monitor recommendations for specialty services (from which they derive no
financial benefit).

7.6 Conclusion

Demand is one of the central ideas of economics, and managers need to
understand the basics of demand. In most cases, consumption of a product
falls when its price increases, and studies of healthcare products confirm
this generalization. An understanding of this relationship between price and
quantity is part of effective management. Without it, managers cannot pre-
dict sales, revenues, or profits.

To make accurate forecasts, managers also must be aware of the effects
of factors they do not control. Demand for their products will be higher
when the price of complements is lower or the price of substitutes is higher.
In most cases, demand will be higher in areas with higher incomes. We will
explore how to make forecasts in more detail in chapter 8.

The demand for healthcare products is complex. Insurance and profes-
sional advice have significant effects on demand. Insurance means that three
prices exist: the out-of-pocket price the consumer pays, the price the insurer
pays, and the price the provider receives. The quantity demanded will usu-
ally fall when out-of-pocket prices rise but may not change when the other
prices do. Because professional advice is important in consumers’ healthcare
decisions, the incentives professionals face can influence consumption of
some products. How and how much professionals are paid can affect their
recommendations, and recognition of this effect has helped spur the shift to
managed care. To change patterns of consumption, managers may need to
change incentives for patients and providers.

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Chapter 7: The Demand for Healthcare Products 121

Exercises

7.1 Is the idea of demand useful in healthcare, given the important role
of agents?

7.2 Should medical services be free? Justify your answer.
7.3 Why might a consumer be “rationally ignorant” about the proper

therapy for gallstones?
7.4 Why do demand curves slope down (i.e., sales volume usually rises

at lower prices)?
7.5 Why would consumers ever choose insurance plans with large

deductibles?
7.6 During the last five years, average daily occupancy at the Autumn

Acres nursing home has slid from 125 to 95 even though Autumn
Acres has cut its daily rate from $125 to $115. Do these data
suggest that occupancy would have been higher if Autumn Acres
had raised its rates? What changes in nonprice demand factors might
explain this change? (The supply, or the number of nursing home
beds in the area, has not changed during this period.)

7.7 Your hospital is considering opening a satellite urgent care center
about five miles from your main campus. You have been charged
with gathering demographic information that might affect the
demand for the center’s services. What data are likely to be
relevant?

7.8 How would each of the following changes affect the demand curve
for acupuncture?
a. The price of an acupuncture session increases.
b. A reduction in back problems occurs as a result of sessions about

stretching on a popular television show.
c. Medicare reduces the copayment for acupuncture from $20 to

$10.
d. The surgeon general issues a warning that back surgery is

ineffective.
e. Medicare stops covering back surgery.

7.9 Your boss has asked you to describe how the demand for an over-
the-counter sinus medication would change in the following
situations. Assuming the price does not change, forecast whether the
sales volume will go up, remain constant, or go down.
a. The local population increases.
b. A wet spring leads to a bumper crop of ragweed.

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Economics for Healthcare Managers122

c. Factory closings lead to a drop in the area’s average income.
d. A competing product with a different formula is found to be

unsafe.
e. A research study showing that the medication causes severe

dizziness is published.
f. The price of another sinus medication drops.

7.10 A community has four residents. The table shows the number of
dental visits each resident will have. Calculate the total quantity
demanded at each price. Then graph the relationship between price
and total quantity, with total quantity on the horizontal axis.

Price
Abe’s

Quantity
Beth’s

Quantity
Cal’s

Quantity
Don’s

Quantity

$40 0 0 0 1

$30 0 1 0 1

$20 0 1 0 2

$10 1 2 1 2

$0 1 2 1 3

7.11 A clinic focuses on three services: counseling for teens and young
adults, smoking cessation, and counseling for young parents. An
analyst has developed a forecast of the number of visits each group
will make at different prices. Calculate the total quantity demanded
at each price. Then graph the relationship between price and total
quantity, putting total quantity on the horizontal axis.

Price
Teen

Counseling
Smoking
Cessation

Parent
Counseling

$80 10 0 0

$60 15 1 0

$40 20 2 0

$20 40 4 6

$0 50 6 8

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Chapter 7: The Demand for Healthcare Products 123

7.12 The price–quantity relationship has been estimated for a new
prostate cancer blood test: Q = 4,000 − 20 × P. Use a spreadsheet
to calculate the quantity demanded and total spending for prices
ranging from $200 to $0, using $50 increments. For each $50 drop
in price, calculate the change in revenue, the change in volume, and
the additional revenue per unit. (Call the additional revenue per unit
marginal revenue.)

7.13 A physical therapy clinic faces a demand equation of Q = 200 − 1.5
× P, where Q is sessions per month and P is the price per session.
a. The clinic currently charges $80. What is its sales volume and

revenue at this price?
b. If the clinic raised its price to $90, what would happen to volume

and revenue?
c. If the clinic lowered its price to $70, what would happen to

volume and revenue?
7.14 Researchers have concluded that the demand for annual preventive

clinic visits by children with asthma equals 1 + 0.00004 × Y − 0.04
× P. In this equation Y represents family income and P represents
price.
a. Calculate how many visits a child with a family income of

$100,000 will make at prices of $200, $150, $100, $50, and $0.
If you predict that the number of visits will be less than zero,
convert the answer to zero.

b. Now repeat your calculations for a child with a family income of
$35,000.

c. How do your predictions for the two children differ?
d. Assume that the market price of a preventive visit is $100. Does

this system seem fair? What fairness criteria are you using?
e. Would your answer change if the surgeon general recommended

that every child with asthma have at least one preventive visit
each year?

References

Abelson, R., and K. Thomas. 2017. “CVS and Aetna Say Merger Will Improve Your
Health Care. Can They Deliver?” New York Times. Published December 4.
www.nytimes.com/2017/12/04/health/cvs-aetna-merger.html.

CVS. 2017. “MinuteClinic: History.” Accessed January 18, 2018. www.cvs.com/minute
clinic/visit/about-us/history.

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Economics for Healthcare Managers124

Manning, W. G., A. Leibowitz, M. S. Marquis, J. P. Newhouse, N. Duan, and E. B.
Keeler. 1987. “Health Insurance and the Demand for Medical Care: Evi-
dence from a Randomized Experiment.” American Economic Review 77 (3):
251–77.

Nesi, T. 2014. “CVS Aiming to Open MinuteClinics in RI This Year.” WPRI.com.
Published February 19. http://wpri.com/2014/02/19/cvs-aiming-to-open
-minuteclinics-in-ri-this-year/.

Tsai, Y. 2015. “Social Security Income and the Utilization of Home Care: Evidence
from the Social Security Notch.” Journal of Health Economics 43: 45–55.

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CHAPTER

125

8ELASTICITIES

Learning Objectives

After reading this chapter, students will be able to

• describe economic relationships with elasticities,
• use elasticity terms appropriately,
• apply elasticities to make simple forecasts, and
• calculate an elasticity.

Key Concepts

• Elasticities measure the association between the quantity demanded and
related factors.

• Elasticities are ratios of percentage changes, so they are scale free.
• Income, price, and cross-price elasticities are used most often.
• Income elasticities are usually positive but small.
• Price elasticities are usually negative.
• Cross-price elasticities may be positive or negative.
• Managers can use elasticities to forecast sales and revenues.

8.1 Introduction

Elasticities are valuable tools for managers. Armed only with basic marketing
data and reasonable elasticity estimates, managers can make sales, revenue,
and marginal revenue forecasts. In addition, elasticities are ideal for analyz-
ing “what if” questions. What will happen to revenues if we raise prices by
2 percent? What will happen to our sales if the price of a substitute drops by
3 percent?

Elasticities reduce confusion in descriptions. For example, suppose the
price of a 500-tablet bottle of generic ibuprofen rose from $7.50 to $8.00.
Someone seeking to downplay the size of this increase (or someone whose
focus was on the cost per tablet) would say that the price rose from 1.5 cents

Lee.indd 125 1/2/19 3:15 PM

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Economics for Healthcare Managers126

to 1.6 cents per tablet. Describing this change in percentage terms would
eliminate any confusion about price per bottle or price per tablet, but a
potential source of confusion remains.

To avoid confusion in calculating percentages, economists recommend
being explicit about the values used to calculate percentage changes. For
example, one might say that the price increase to $8.00 represents a 6.67
percent increase from the starting value of $7.50.

8.2 Elasticities

An elasticity measures the association between the quantity demanded and
related factors. For example, Chen, Okunade, and Lubiani (2014) used statis-
tical techniques to estimate that the income elasticity for adjusted inpatient
days was 0.04. The base for this estimate is average income, so an income 1
percent above the average is associated with an average level of physician visits
that is 0.04 percent above average. As we shall see, these apparently esoteric
estimates can be valuable to managers.

First we need to learn a little more about elasticities. Economists rou-
tinely calculate three demand elasticities:

1. income elasticities, which quantify the association between the quantity
demanded and consumer income;

2. price elasticities, which quantify the association between the quantity
demanded and the product’s price; and

3. cross-price elasticities, which quantify the association between the
quantity demanded and the prices of a substitute or complement.

Elasticities are ratios of percentage changes. For example, the income
elasticity of demand for visits would equal the ratio of the percentage change
in visits (dQ/Q) associated with a given percentage change in income (dY/Y).
(The mathematical terms dQ and dY identify small changes in consumption
and income.) So, the formula for an income elasticity would be (dQ/Q)/
(dY/Y). The formula for a price elasticity would be (dQ/Q)/(dP/P), and
the formula for cross-price elasticity would be (dQ/Q)/(dR/R). (A cross-
price elasticity measures the response of demand to changes in the price of a
substitute or complement, so R is the price of a related product. Substitutes
have positive cross-price elasticities. Complements have negative cross-price
elasticities.)

Now recall that Chen, Okunade, and Lubiani (2014) estimated that
the income elasticity for physician visits is 0.04. This implies that 0.04 =
(dQ/Q)/(dY/Y). Suppose we want to know how much higher than average

income elasticity
The percentage
change in
the quantity
demanded divided
by the percentage
change in income.
For example, if
visits are 0.04
percent higher for
consumers with
incomes that are 1
percent higher, the
income elasticity
is 0.0004/0.010,
which equals 0.04.

substitute
A product used
instead of another
product.

complement
A product used in
conjunction with
another product.

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Chapter 8: Elast ic i t ies 127

the number of visits per person would be in an area where the average income
is 2 percent higher than the national average. Because we are considering a
case in which dY/Y = 0.02, we multiply both sides of the equation by 0.02
and find that visits should be 0.0008 (0.08%) higher in an area with income
2 percent above the national average. From the perspective of a working
manager, what matters is the conclusion that visits will be only slightly higher
in the wealthier area.

8.3 Income Elasticities

Consumption of most healthcare products increases with income, but only
slightly. As exhibit 8.1 shows, consumption of healthcare products appears to
increase more slowly than income. As a result, healthcare spending will rep-
resent a smaller proportion of income among high-income consumers than
among low-income consumers.

8.4 Price Elasticities

of Demand

The price elasticity of demand is even more useful, because prices depend
on choices managers make. Estimates of the price elasticity of demand will
guide pricing and contracting decisions, as chapter 9 explores in more detail.

Managers need to be careful in using the price elasticity of demand
for three reasons. First, because the price elasticity of demand is almost
always negative, we need a special vocabulary to describe the responsiveness
of demand to price. For example, −3.00 is a smaller number than −1.00,
but −3.00 implies that demand is more responsive to changes in prices (a
1 percent rise in prices results in a 3 percent drop in sales rather than a 1
percent drop in sales). Second, changes in prices affect revenues directly and
indirectly, via changes in quantity. Managers need to keep this fact in mind
when using the price elasticity of demand. Third, managers need to think
about two different price elasticities of demand: the overall price elasticity of
demand and the price elasticity of demand for the firm’s products.

price elasticity of
demand
The ratio of the
percentage change
in sales volume
associated with a
percentage change
in a product’s
price. For example,
if prices rose
by 2.5 percent
and the quantity
demanded fell by
7.5 percent, the
price elasticity
would be
−0.075/0.025,
which equals
−3.00.

Source Variable Estimate

Chen, Okunade, and Lubiani (2014) Adjusted inpatient days 0.04

Newhouse and Phelps (1976) Hospital admissions 0.02 to 0.04

Newhouse and Phelps (1976) Physician visits 0.01 to 0.04

EXHIBIT 8.1
Selected
Estimates of
the Income
Elasticity of
Demand

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Economics for Healthcare Managers128

Economists usually speak of price elasticities of demand (but not other
elasticities) as being elastic or inelastic. When a change in price results in
a larger percentage change in the quantity demanded, the price elasticity of
demand will be less than −1.00, and demand is said to be elastic. When price
change results in a smaller percentage change in the quantity demanded, the
price elasticity of demand will be between 0.00 and −1.00, and demand is
said to be inelastic. For example, a price elasticity of −4.55 would indicate
elastic demand. A price elasticity of −0.55 would indicate inelastic demand.

Inelastic demand does not mean that consumption will be unaffected
by price changes. Suppose that, in forecasting the demand response to a 3.5
percent price cut, we use an elasticity of −0.20. Predicting that sales will rise
by 0.7 percent (0.007 = −0.035 × −0.2), this elasticity implies that demand
is inelastic but not unresponsive. Recall that a price elasticity of demand
equals the ratio of the percentage change in quantity that is associated with
a percentage change in price, or (dQ/Q)/(dP/P). Using this formula and
our elasticity estimate gives us −0.20 = (dQ/Q)/(−0.03). After solving for
the percentage change in quantity, we forecast that a 3 percent price cut will
increase consumption by 0.006 (or 0.6%), which is equal to −0.20 × −0.03.
Exhibit 8.2 shows that the demand for medical care is usually inelastic.

elastic
A term used to
describe demand
when the quantity
demanded
changes by a
larger percentage
than the price.
(This term is
usually applied
only to price
elasticities of
demand.)

inelastic
A term used to
describe demand
when the quantity
demanded changes
by a smaller
percentage than
the price. (This
term is usually
applied only to
price elasticities of
demand.)

Source Variable Estimate

Ellis, Martins, and Zhu (2017) Total spending −0.44

Dunn (2016) Total spending −0.22

Ellis, Martins, and Zhu (2017) Inpatient −0.30

Ellis, Martins, and Zhu (2017) Outpatient −0.29

Ellis, Martins, and Zhu (2017) Emergency department −0.04

EXHIBIT 8.2
Selected

Estimates of the
Price Elasticity

of Demand

The Curious Case of Daraprim

In August 2015 Turing Pharmaceuticals raised the
price of Daraprim from $13.50 a tablet to $750,

an increase of 5,456 percent (Over and Silverman 2015). Daraprim is
the only available treatment for toxoplasmosis, a rare infection that
can become deadly for patients with weakened immune systems. This

Case 8.1

(continued)

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Chapter 8: Elast ic i t ies 129

price increase means that an individual’s treat-
ment could cost up to $634,000. Daraprim’s patent
expired in 1953, and it can be compounded for less

than a dollar per tablet (Langreth 2015).
Two contradictory trends are evident. Generic drug prices have

been declining in the United States since at least 2010, yet multiple
generic drugs have risen in price (Ornstein and Thomas 2017). The
price increases generate far more attention than the price decreases,
yet the structure of the market has not changed.

In the United States, pharmaceutical prices (indeed most medical
prices) are based on negotiations between private insurers and suppli-
ers. The US market has two features that are uncommon in other coun-
tries. First, pharmacy benefit managers often act as an intermediary
between insurers and suppliers. Second, the federal government plays
a limited role in negotiating prices. Although the Department of Vet-
erans Affairs negotiates drug prices for its beneficiaries, private firms
negotiate for Medicare.

Discussion Questions
• Would you expect demand for Daraprim to be elastic or inelastic? Why?

• What change in the market would make demand for Daraprim more
elastic? Less?

• What would the out-of-pocket cost for Daraprim be for a patient on
Medicare? Medicaid?

• What would the price elasticity be after a patient exceeded the out-
of-pocket maximum?

• Why did other companies not start making versions of Daraprim?

• Did Turing Pharmaceuticals violate any laws or regulations when it
raised the price?

• Could a company have raised the price of a drug like this in
Canada? France? Australia?

• Companies have also raised prices for other off-patent drugs. Can
you explain why?

• Can you offer examples of large price increases for off-patent drugs?

• What should the United States do about cases like that of Daraprim?

• Should the federal government negotiate pharmaceutical prices?
Why? Why not?

• Should someone else negotiate pharmaceutical prices? Who? Why?
Why not?

Case 8.1
(continued)

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Economics for Healthcare Managers130

8.5 Other Elasticities

The cross-price elasticity of demand describes how the quantity demanded
changes when the price of a related product changes. This might sound eso-
teric, but it has practical implications. For example, how does use of hospital
services change when the price of primary care changes? Alternatively, how
does the demand for outpatient or emergency care change if drug copay-
ments change? These questions are important for the design of health insur-
ance plans. Unfortunately, the evidence is contradictory.

For example, among their other effects, insurance expansions reduce
the out-of-pocket price for primary care. In some instances, this scenario has
led to an increase in emergency department use, suggesting that primary care
is a complement for emergency department care. In other cases, it has led to
a reduction in emergency department use, suggesting that primary care is a
substitute (Sommers and Simon 2017).

8.6 Using Elasticities

Elasticities are useful forecasting tools. With an estimate of the price elasticity
of demand, a manager can quickly estimate the impact of a price cut on sales
and revenues. As noted previously, managers need to use the correct elastic-
ity. Most estimates of the overall price elasticity of demand fall between −0.10
and −0.40. For the market as a whole, the demand for healthcare products is
typically inelastic. For individual firms, in contrast, demand is usually elastic.
The reason is simple. Most healthcare products have few close substitutes,
but the products of one healthcare organization represent close substitutes
for the products of another.

The price elasticity of demand that individual firms face typically
depends on the overall price elasticity and the firm’s market share. So, if the
price elasticity of demand for hospital admissions is −0.17 and a hospital
has a 12 percent share of the market, the hospital needs to anticipate that
it faces a price elasticity of −0.17/0.12, or −1.42. This rule of thumb need
not hold exactly, but good evidence indicates that individual firms confront
elastic demand. Indeed, as we will show in chapter 9, profit-maximizing firms
should set prices high enough that demand for their products is elastic.

Armed with a reasonable estimate of the price elasticity of demand, we
will now predict the impact of a 5 percent price cut on volume. If the price
elasticity faced by a physician firm were −2.80, a 5 percent price cut should
increase the number of visits by 14 percent, which is the product of −0.05
and −2.80. (Prudent managers will recognize that their best guess about
the price elasticity will not be exactly right and will repeat the calculations

cross-price
elasticity of
demand
The ratio of the
percentage change
in sales volume
associated with
a percentage
change in another
product’s price.
For example, if
prices of the other
product rose
by 2.0 percent
and the quantity
demanded fell by
5.0 percent, the
cross-price price
elasticity would be
−0.05/0.02, which
equals −2.50.

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Chapter 8: Elast ic i t ies 131

with other values. For example, if the price elasticity is really −1.40, volume
will increase by 7 percent. If the price elasticity is really −4.20, volume will
increase by 21 percent.)

How much will revenues change if we cut prices by 5 percent and the
price elasticity is −2.80? Obviously, because prices are reduced, revenues will
rise to a lesser extent than volume does. A rough, easily calculated estimate of
the change in revenues is the percentage change in prices plus the percentage
change in volume. Prices will fall by 5 percent and quantity will rise by 7 to
21 percent, so revenues should rise by approximately 2 to 16 percent. Our
baseline estimate is that revenues will rise by 9 percent. If costs rise by less
than this percentage, profits will rise.

Should Sodas Be Taxed?

One in five adults is obese in wealthy countries
around the world. Unfortunately, in the United

States, the rate is about two in five (Organisation for Economic Co-
operation and Development [OECD] 2017). Major causes appear to be
sweet drinks and added sugars in other products. According to the
Centers for Disease Control and Prevention (2017), frequent consump-
tion of sweetened beverages is associated with obesity, heart disease,
kidney diseases, cavities, and other diseases.

Oddly, despite the obesity epidemic, subsidies for crops that can
be refined into sugar—corn, wheat, rice, sorghum, and others—con-
tinue. The subsidies reduce the prices of products containing sugars.
These products include sodas, sweetened teas, and other products.

A number of local governments have enacted taxes on sweetened
beverages, but no taxes have passed at the state or federal level.
(France and Mexico have passed national taxes.) Paarlberg, Mozaffar-
ian, and Micha (2017) argue that a 17 percent tax on sweetened bever-
ages would reduce consumption by 15 percent.

Discussion Questions
• What price elasticity does the estimate by Paarlberg, Mozaffarian,

and Micha (2017) imply?

• Can you find another estimate of the price elasticity of demand for
sweetened drinks?

• Is the demand for sweetened drinks elastic or inelastic?

Case 8.2

(continued)

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Economics for Healthcare Managers132

8.7 Conclusion

An elasticity is the percentage change in one variable that is associated with
a 1  percent change in another variable. Elasticities are simple, valuable
tools that managers can use to forecast sales and revenues. Elasticities allow
managers to apply the results of sophisticated economic studies to their
organizations.

Three elasticities are common: income elasticities, price elasticities,
and cross-price elasticities. Income elasticities measure how much demand
varies with income, price elasticities measure how much demand varies with
the price of the product itself, and cross-price elasticities measure how much
demand varies with the prices of complements and substitutes. Of these,
price elasticity is the most important because it guides pricing and contract-
ing decisions.

Virtually all price elasticities of demand for healthcare products
are negative, reflecting that higher prices generally reduce the quantity
demanded. Overall, demand is generally inelastic, meaning that a price
increase will result in a smaller percentage reduction in sales. In most cases,
though, the demand for an individual organization’s products will be elastic,
meaning that a price increase will result in a larger percentage reduction in
sales. This difference is based on ease of substitution. Few good substitutes
are available for broadly defined healthcare products, so demand is inelastic.
In contrast, the products of other healthcare providers are usually good sub-
stitutes for the products of a particular provider, so demand is elastic. When
making decisions, managers must consider that their organization’s products
face elastic demands.

• If the price of sodas rose by 5 percent, how
much would sales drop?

• What are substitutes for sweetened drinks?

• Can you find an estimate of the cross-price elasticity of demand for
sweetened drinks?

• Is water a substitute or complement for soda?

• In light of your answer to the previous question, should the cross-
price elasticity be positive?

• Do you favor a tax on sweetened drinks? Why? Why not?

• Do you favor a tax on added sugars? Why? Why not?

• How could a health system reduce sugar consumption? Should it
try?

Case 8.2
(continued)

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Chapter 8: Elast ic i t ies 133

Exercises

8.1 Why are elasticities useful for managers?
8.2 Why are price elasticities of demand called “elastic” or “inelastic”

when other elasticities are not?
8.3 Why is the demand for healthcare products usually inelastic?
8.4 Why is the demand for an individual firm’s healthcare products

usually elastic?
8.5 Per capita income in the county was $40,000, and physician visits

averaged 4.00 per person per year. Per capita income has risen to
$42,000, and physician visits have risen to 4.02 per person per year.
What is the percentage change in visits? What is the percentage
change in income? What is the income elasticity of demand for
visits?

8.6 Average visits per week equal 640 when the copayment is $40 and
360 when the copayment rises to $60. Calculate the percentage
change in visits, percentage change in price, and price elasticity of
demand.

8.7 Sales were 4,000 at a price of $200 but fell to 3,800 when the price
was increased to $220. Calculate the percentage change in sales, the
percentage change in price, and the price elasticity of demand.

8.8 Per capita income in the county was $45,000, and physician visits
averaged 5.0 per person per year. Per capita income has risen to
$49,500. The income elasticity of demand for visits is 0.4. By what
percent will visits rise? What will the average number of visits be?

8.9 The price elasticity of demand is −1.2. Is demand elastic or
inelastic?

8.10 The price elasticity of demand is −0.12. Is demand elastic or
inelastic?

8.11 If the income elasticity of demand is 0.2, how would the volume of
services change if income rose by 10 percent?

8.12 You are a manager for a regional health system. Using an estimate
of the price elasticity of demand of −0.25, calculate how much
ambulatory visits will change if you raise prices by 5 percent.

8.13 If the cross-price elasticity of clinic visits with respect to
pharmaceutical prices is −0.18, how much will ambulatory visits
change if pharmacy prices rise by 5 percent? Are pharmaceuticals
substitutes for or complements to clinic visits?

8.14 If the cross-price elasticity of clinic visits with respect to emergency
department prices is 0.21, how much will ambulatory visits change

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Economics for Healthcare Managers134

if emergency department prices rise by 5 percent? Are emergency
department visits substitutes for or complements to clinic visits?

8.15 If the income elasticity of demand is 0.03, how much will
ambulatory visits change if incomes rise by 4 percent?

8.16 A study estimates that the price elasticity of demand for Lipitor is
−1.05, but the price elasticity of demand for statins as a whole is
−0.13.
a. Why is demand for Lipitor more elastic than for statins as a

whole?
b. What would happen to revenues if the makers of Lipitor raised

prices by 10 percent?
c. What would happen to industry revenues if all manufacturers

raised prices by 10 percent?
d. Why are the answers so different? Does this difference make

sense?
8.17 The price elasticity of demand for the services of Kim Jones, MD, is

−4.0. The price elasticity of demand for physicians’ services overall is
−0.1.
a. Why is demand so much more elastic for the services of Dr. Jones

than for the services of physicians in general?
b. If Dr. Jones reduced prices by 10 percent, how much would

volume and revenue change?
c. Suppose that all the physicians in the area reduced prices by 10

percent. How much would the total number of visits and revenue
change?

d. Why does it make sense that your answers to questions b and c
are so different?

References

Centers for Disease Control and Prevention. 2017. “Get the Facts: Sugar-Sweetened
Beverages and Consumption.” Updated April 7. www.cdc.gov/nutrition/data
-statistics/sugar-sweetened-beverages-intake.html.

Chen, W., A. Okunade, and G. G. Lubiani. 2014. “Quality–Quantity Decomposition
of Income Elasticity of U.S. Hospital Care Expenditure Using State-Level
Panel Data.” Health Economics 23 (11): 1340–52.

Dunn, A. 2016. “Health Insurance and the Demand for Medical Care: Instrumental
Variable Estimates Using Health Insurer Claims Data.” Journal of Health
Economics 48: 74–88.

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Chapter 8: Elast ic i t ies 135

Ellis, R. P., B. Martins, and W. Zhu. 2017. “Health Care Demand Elasticities by Type
of Service.” Journal of Health Economics 55: 232–43.

Langreth, R. 2015. “Express Scripts Covers $1 Alternative to $750 Pill Daraprim.”
Bloomberg. Published November 30. www.bloomberg.com/news/articles
/2015-12-01/express-scripts-to-cover-1-alternative-to-750-pill-daraprim.

Newhouse, J. P., and C. E. Phelps. 1976. “New Estimates of Price and Income
Elasticities of Medical Care Services.” In The Role of Health Insurance in the
Health Services Sector, edited by R. Rosett, 261–320. New York: Neal Watson.

Organisation for Economic Co-operation and Development (OECD). 2017.
“OECD Health Statistics 2017.” Accessed August 16, 2018. www.oecd.org
/els/health-systems/health-statistics.htm.

Ornstein, C., and K. Thomas. 2017. “Generic Drug Prices Are Falling, but Are
Consumers Benefiting?” New York Times. Published August 8. www.nytimes.
com/2017/08/08/health/generic-drugs-prices-falling.html.

Over, M., and R. Silverman. 2015. “The 5000% Price Increase and the Economic
Case for Pharma Price Regulation.” Global Health Policy Blog. Published Sep-
tember 23. www.cgdev.org/blog/5000-price-increase-and-economic-case
-pharma-price-regulation.

Paarlberg, R., D. Mozaffarian, and R. Micha. 2017. “Viewpoint: Can U.S. Local
Soda Taxes Continue to Spread?” Food Policy 71: 1–7.

Sommers, B. D., and K. Simon. 2017. “Health Insurance and Emergency Depart-
ment Use—A Complex Relationship.” New England Journal of Medicine 376
(18): 1708–11.

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CHAPTER

199

13ASYMMETRIC INFORMATION AND
INCENTIVES

Learning Objectives

After reading this chapter, students will be able to

• define asymmetric information and opportunism,
• describe two strategies for aligning incentives,
• explain why opportunism is a special management challenge in

healthcare, and
• discuss challenges in limiting opportunism.

Key Concepts

• Asymmetric information is information known to one party in a
transaction but not another.

• Asymmetric information allows the better informed party to act
opportunistically.

• Asymmetric information is a common problem for managers.
• Aligning incentives helps reduce the problems associated with

asymmetric information.
• Concerns about risk, complexity, measurement, strategic responses, and

team production limit the extent of incentive-based payments.
• Incentive-based contracts have become more common in healthcare.

13.1 Asymmetric Information

Asymmetric information confronts healthcare managers in most of their
professional roles. Vendors typically know more about the strengths and
weaknesses of their products than do purchasers. Employees typically know
more about their health problems than do human resource or health plan
managers. Subordinates typically know more about the effort they have put

asymmetric
information
Information known
to one party in a
transaction but not
another.

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Economics for Healthcare Managers200

into their assignments than do their superiors. Providers typically know more
about treatment options than do their patients. In all these examples, one
party, commonly called an agent, has better information than another party,
commonly called a principal. Unless the principal is careful, the agent may
take advantage of this information asymmetry—in other words, engage in
opportunism.

Asymmetric information can result in two types of problems. One
is that mutually beneficial transactions may not take place if concern about
asymmetric information is too great. The other is that resources may be
wasted because of agents’ opportunism or principals’ costly precautions. For
example, an insurer cannot easily discern whether a treatment is really needed
(Arrow 1963). In response, an insurer may not cover services thought
likely to be abused, may require substantial consumer payments to restrain
demand, or may require prior authorization before providing coverage. As
a result, consumers may not use helpful services because the services cost
too much. Alternatively, the plan, providers, and consumers may experience
increased costs due to the requirement for prior authorization. (The insurer
must staff the authorization office, the provider must spend time and money
getting authorizations, and the consumer is likely to experience delays and
repeat visits.) Asymmetric information also affects managers directly. Man-
agers are often poorly informed about the quality, efficiency, and customer
satisfaction issues that their subordinates face. But managers are also often
poorly informed about whether costs are padded, whether quality problems
are avoidable, or whether staffing is adequate. Fearing that subordinates
will take advantage of them, managers may require reviews or audits. Both
increase costs without directly adding to the output of the organization.

Asymmetric information is a concern when

• the interests of the parties diverge in a meaningful way,
• the parties have an important reason to strike a deal, and
• determining whether the explicit or implicit terms of the deal have

been followed is difficult.

These circumstances are far from rare. Unfortunately, they are an invitation
to act opportunistically.

13.2 Opportunism

Opportunism can take many forms. Crime is one. For example, deliberately
billing a health plan for services that were not actually rendered is a form of
opportunism more commonly known as fraud. The forms of opportunism

agent
A person
who provides
services and
recommendations
to clients (who are
called principals).

principal
The organization
or individual
represented by an
agent.

opportunism
Taking advantage
of a situation
without regard for
the interests of
others.

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Chapter 13: Asymmetr ic Information and Incentives 201

that managers deal with are not usually so stark. Cruising the Internet rather
than making collection calls, using the supplies budget to refurbish your
office, scheduling a physical therapy visit of questionable value to meet vol-
ume targets, and referring a patient to a specialist for a problem you could
easily handle are also examples of opportunism.

From experience, we know that some individuals are opportunistic
some of the time. Some individuals seldom act opportunistically, whereas
others often do. As a first step, we try to avoid dealing with those who are the
most opportunistic. We then try to set up systems to restrain those who may
be tempted. These systems will be imperfect because our ability to anticipate
what may happen and how individuals may react is imperfect.

13.2.1 Remedies for Asymmetric Information
Remedies for asymmetric information focus on aligning the interests of the
parties or monitoring the behavior of the agent. Changes in incentives are
usually part of the preferred strategy because monitoring is usually expensive
and nonproductive. For example, healthcare plans are commonly subject to
utilization review designed to control use of services. Utilization review rarely
changes recommended therapies, however, despite its cost and annoyance.
Health plans would love to eliminate utilization review. Without it, a plan
would rapidly gain market share because it could increase consumer satisfac-
tion, increase provider satisfaction, and reduce premiums. In addition to
being costly, monitoring may be difficult. For example, a product that a ven-
dor honestly recommended may fail or may not meet your needs, or it may
work but have features you do not need and cost more than a more suitable
product. Monitoring is likely to be only part of the remedy for asymmetric
information.

13.2.2 The Special Challenges for Healthcare
The challenges posed by asymmetric information are not unique to health-
care, although their extent poses special problems for healthcare managers.
Three features make asymmetric information especially troublesome in the
healthcare sector:

1. By paying the bills of healthcare providers, insurance creates a
principal–agent relationship not found in most fields.

2. Insurance reduces the patient’s incentive to monitor the performance
of healthcare providers because it limits the patient’s exposure to
financial opportunism.

3. Asymmetric information is intrinsic to most provider–patient
relationships. Patients typically seek providers’ services because they
want information, so opportunism is always possible.

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Economics for Healthcare Managers202

Opportunism is such an obvious risk that strategies have developed to
limit it (Arrow 1963). One of the most obvious is our preference for dealing
with those who have proven themselves. For example, primary care physicians
tend to refer patients to physicians who have served them and their patients
well. For fear of losing this business, specialists who might be tempted to pro-
vide unnecessary services will be reluctant to do so. These sorts of ongoing
relationships—between buyer and seller, patient and provider, and supervisor
and subordinate—tend to deter observable opportunism. Much of the regu-
lation of the healthcare sector also serves to deter opportunism. The problem
is that these mechanisms work only when opportunism is detectable. In many
cases, it is not.

13.2.3 Signaling
When differences in quality or other attributes of care are hard to observe,
agents may use signaling to reassure principals. Signals should tell prospec-
tive clients about the agent, should be hard to counterfeit, and should be
relatively inexpensive. Brand names are classic signals. Including a Pfizer
label on a new drug costs little and reassures consumers that the drug meets
stringent quality standards because substandard quality would hurt Pfizer’s
sales. The challenge is to prevent others from counterfeiting the labels. Sur-
prisingly, branding in the healthcare market, especially branding of healthcare
services, is not common. Quality certification is another strategy for dealing
with asymmetric information. For example, hospital accreditation by The
Joint Commission is a signal of quality that is difficult to counterfeit. Unfor-
tunately, the process is so expensive that many smaller hospitals do not seek
accreditation.

Other signals may be useful but are likely to be less credible. For
example, high prices and high levels of advertising also serve as quality sig-
nals because low-cost, low-quality providers could not afford to advertise
frequently or raise prices (Gneezy, Gneezy, and Lauga 2013). In markets with
standardized products, poorly informed agents can buy information (e.g., by
subscribing to Consumer Reports) or copy well-informed agents. The more
individualized products are, the less this strategy works, so its value in the
healthcare market is unclear. Although we can identify healthcare cases in
which signaling reduces the problems associated with asymmetric informa-
tion, it is far from a comprehensive solution.

13.3 Incentive Design for Providers

Recognition that the insurance system of the United States created multiple
incentives for inefficiency triggered the growth of managed care. Providers

signaling
Sending messages
that reveal
information
another party does
not observe.

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Chapter 13: Asymmetr ic Information and Incentives 203

were faced with strong incentives to deliver care as long as the benefits
exceeded their patients’ costs, and costly care was often free for insured
patients. Neither party had a compelling reason for taking the true cost of
care into account. We have already discussed redesign of consumer payments,
so let us consider how incentives relate to provider payments.

Incentives are implicit in the four most common methods of paying
providers: volume-based payments, salaries, capitation, and case-based pay-
ment. Each of these methods has some advantages and disadvantages.

Exhibit 13.1 contrasts the incentives created by different payment sys-
tems. Note that volume-based and salary compensation systems incorporate
opposite incentives. The incentive structures of capitation and case-based
payment systems are similar and fall between these opposite cases. Volume-
based, case-based, and capitation payment systems immediately reward pro-
viders who have large numbers of clients. Having more clients means higher
revenues in all these systems. In contrast, unless other incentive systems are
in place (e.g., review by superiors or the possibility of promotion), salary and
budget payment systems do not reward providers according to the number
of clients they serve.

The only form of payment that rewards providers who provide a large
volume of services per client is volume-based payment. In case-based and
capitation systems, the disincentive for high volumes of service per client
is tempered by the rewards for attracting additional clients. Just as they do
not reward for large numbers of clients, salary and budget systems also deter
providers from delivering high volumes of service per client.

All the payment systems except volume-based payment encour-
age providers to avoid clients with complicated, expensive problems (or at
least encourage them to prefer clients with simple, inexpensive problems).

capitation
Payment per
person. (The
payment does not
depend on the
amount or type of
services provided.)

case-based
payment
A single payment
for an episode of
care, regardless
of the number of
services.

Volume-
Based

Case-
Based Capitation

Salary or
Budget

Number of clients + + + –

Services per client + – – –

Client acuitya + – – –

Unbillable servicesb – + + +

Note: A “+” indicates that the compensation system rewards producing more of an output
or using more of an input. A “–” indicates that the compensation system rewards producing
less of an output or using less of an input.
a In this context, client acuity refers to the amount of services that a client is likely to need.
Higher acuity means that a client is likely to need more services.
b Unbillable services include both services for which the provider cannot bill because of the
provisions of the insurance plan and services provided by others.

EXHIBIT 13.1
Financial
Incentives of
Alternative
Compensation
Systems

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Economics for Healthcare Managers204

Expensive clients, when combined with fixed payments per case or per
period, are financially unrewarding for providers. Likewise, all the payment
systems except volume-based payment motivate providers to refer patients to
external services (e.g., church-sponsored organizations or services provided
by friends), as long as they are cost-effective from the provider’s perspective.
From society’s perspective, patients should be referred elsewhere as long as
the marginal benefit of doing so exceeds the marginal cost. Providers who
are paid on the basis of cases, capitation, or salary may refer patients too
often, especially if the provider does not bear the full cost of the services of
community organizations or other external services. In contrast, only billable
services can be profitable in volume-based systems. Volume-based payment
creates an incentive not to use external resources (or at least not to use the
organization’s resources to improve clients’ access to them). Volume-based
payment typically rewards providers who refer patients too infrequently, from
society’s perspective.

None of these payment systems solves the asymmetric information
problem. Providers still usually know more about appropriate treatment
options than do patients or insurers. Volume-based providers inclined toward
opportunism are still able to recommend additional billable services, case-
based providers are still able to avoid unprofitable cases, capitated providers
are still able to recommend limited treatment plans, and salaried providers are
still able to limit how much they do.

This discussion should not be construed as an assertion that only
financial incentives matter. Such an assertion would be inconsistent with basic
economic theory, which postulates that principals and agents balance alterna-
tive objectives. Only some of these goals will be financial. For example, some
physicians may offer extensive patient education programs because of their
commitment to the health of their patients or because the programs are an
effective marketing tool, even if the volume-based payment system does not
treat these programs as a billable service. Nonetheless, economics anticipates
an aggregate response to financial incentives and predicts that physicians will
offer more of such services if the volume-based payment system offers com-
pensation for them or if they are profitable under case-based or capitation
arrangements.

Suppose that a physician schedules four patients per hour for 30 hours
per week and works 48 weeks per year (see exhibit 13.2). Under plan A, the
physician earns $20 per patient and has a total income of $115,200. (This
example bases compensation on visits to simplify the discussion, not to define
an attractive volume-based compensation plan. More sensible volume-based
payment systems base compensation on billings, relative value units, and so
forth.) Plan B provides a base salary of $80,000 plus $20 per patient for visits
in excess of 4,000. At the margin, plans A and B have the same incentives,

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Chapter 13: Asymmetr ic Information and Incentives 205

even though plan B combines salary- and volume-based payments. Each plan
pays $20 per patient and provides the same total income. This example illus-
trates that blended compensation systems can give agents similar incentives
with less risk than pure compensation systems.

The incentives of plan C are subtly different from the incentives of
plans A and B. Plan C offers a $100,000 base salary plus $20 per patient for
visits in excess of 4,000. Although plan C pays $20 per visit at the margin, as
plans A and B do, the physician’s income will be higher under plan C than it
would be with the same number of patients under plan A or B. Consequently,
the physician may feel less need to add an additional patient at the end of the
day or double book to squeeze in an acutely ill patient. In this case, income
effects are the effects incentive systems have on physicians’ decisions about
the number of patients they will treat (Kalb et al. 2017).

Plan D offers a base salary of $57,600 plus $10 for each patient visit.
Even though the physician’s income will be the same with 5,760 patients per
year under plans A, B, and D, the physician may choose to see fewer patients
under plan D because the marginal reward is smaller.

13.4 Insurance and Incentives

How much have compensation systems changed since 2010, given the
importance of how providers are paid? Less than you might suspect, but
change is taking place. For example, even in areas in which managed care is
pervasive, most physicians continue to be paid on the basis of their productiv-
ity (typically measured by billings, visits, or net revenue), just as they were at
the turn of the century (Landon and Roberts 2013). A number of organiza-
tions are changing their compensation models, but they are headed in differ-
ent directions. Some are moving to salaries without quality or productivity
bonuses. Some are moving to a mix of quality-based and productivity-based
compensation (Barkholz 2017).

In 2015 Congress passed legislation called the Medicare Access and
CHIP Reauthorization Act, commonly called MACRA. While still basing

income effect
The effect of
income shifts
on amounts
demanded or
supplied. (Shifts
may be due to
changes in income
or due to changes
in purchasing
power caused by
price changes.)

Plan Base Salary
Marginal

Compensation
Volume

Payments Total Income

A $0 $20 $115,200 $115,200

B $80,000 $20 $35,200 $115,200

C $100,000 $20 $35,200 $135,200

D $57,600 $10 $57,600 $115,200

EXHIBIT 13.2
An Illustrative
Model of
Incentives

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Economics for Healthcare Managers206

most Medicare payments on volume, MACRA adds significant incentives for
quality. Physicians with high quality scores can get bonuses that start at 4
percent in 2019 and increase to 9 percent in 2022. Physicians with low qual-
ity scores can get penalties of the same size (Mire and Desai 2017). There
are two ways of earning bonuses. Physicians can report their performance
using the Merit-based Incentive Payment System, or they can work in an
organization that uses an alternative payment model (typically an ACO) and
get a 5 percent bonus each year because their performance is monitored by
the ACO. Currently, the incentives are modest, and the effects are likely to
be modest as well. But, as case 13.1 suggests, both the incentives and the
effects may grow substantially.

Incentives in Accountable Care
Organizations

An accountable care organization (ACO) represents a consortium of
doctors, hospitals, and other providers who contract to take financial
responsibility for the quality of care. As such, it faces a complex incen-
tive problem, needing to identify contracts that allow it to meet its
quality and cost targets. An ACO also needs to establish contracts with
providers that incentivize them to provide efficient, high-quality care.
In addition, the ACO must do this as the providers are simultaneously
being paid using traditional volume-based methods, bundled pay-
ments, and a variety of alternative payment models. Whitman (2017)
quotes Micky Tripathi, founder and CEO of the Massachusetts eHealth
Collaborative, as saying, “What makes a successful ACO? As an indus-
try, we don’t know.”

A consortium that decides to form an ACO contracts with Medicare
for three years. Medicare sets a benchmark that is a weighted average
of spending by beneficiaries that are attributed to the ACO. One impli-
cation is that consortia with high levels of spending in the past find it
easier to meet cost goals. In contrast, commercial ACO contracts are
based on a negotiated rate and a negotiated degree of risk.

For example, UnityPoint Health, a $4 billion system with 43 hospi-
tals across Iowa, Illinois, Wisconsin, and Missouri, has a physician-led
ACO that in 2016 covered 70,672 Medicare beneficiaries in the Medi-
care Next Generation ACO model. Through its self-insured health plan

Case 13.1

(continued)

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Chapter 13: Asymmetr ic Information and Incentives 207

and its ACO contracts with private payers, includ-
ing UnitedHealthcare, Wellmark, and Blue Cross
and Blue Shield of Illinois, it covered another

255,379 individuals, with 102,125 of those in full-risk contracts (Uni-
tyPoint Accountable Care 2017). UnityPoint did not reduce costs in its
first attempts at a Medicare ACO but ultimately developed a system for
reducing costs. The system tracks high-risk patients, standardizes care
pathways, uses analytics to understand the population it serves (and
the care being provided), and emphasizes incorporating behavioral
health into primary care.

UnityPoint Clinic, which has 500 physicians across Iowa and Illi-
nois, now bases 86 percent of compensation on productivity. By 2020
it plans to have 33 percent of physician compensation based on pro-
ductivity, 33 percent based on salary, and 33 percent based on cost,
quality, and satisfaction measures (Barkholz 2017). The logic is that
provider payments need to be aligned with payments for care.

Discussion Questions
• Why is creating a successful ACO difficult?

• How many Medicare ACOs are there? How are they structured?

• How many commercial ACOs are there? How are they structured?

• How many Medicaid ACOs are there? How are they structured?

• Is the number of ACOs increasing or decreasing?

• What outcomes represent success for an ACO? What predicts
success?

• Do ACOs that accept more risk get more shared savings? Why?

• Do some ACOs improve clinical quality? How do they do it?

• Do some ACOs improve patient satisfaction? How do they do it?

• How does being paid in varied ways complicate ACO design?

• How does being paid in varied ways affect provider incentives?

• What sort of incentives does pure volume-based payment create for
providers?

• What sort of incentives does a mixed payment model create for
providers?

• What sort of incentives does pure salary create for providers?

• How does MACRA affect incentives to create a Medicare HMO?

• What incentives does the Medicare benchmark create?

Case 13.1
(continued)

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Economics for Healthcare Managers208

13.5 Limits on Incentive-Based Payments

A number of factors limit how complete incentive-based payments can be.
Concerns about risk, complexity, and team production make agents reluctant
to enter into incentive-based compensation arrangements. Likewise, concerns
about opportunism make principals reluctant because a high-powered incen-
tive system may leave them worse off if agents respond in unanticipated ways.

13.5.1 Risk
Capitation, utilization withholding, and case-based payment systems are often
referred to as risk-sharing systems. This term is somewhat misleading. The goal
of these systems is incentive alignment; risk sharing is a side effect. For exam-
ple, capitation gives physicians incentives to use resources wisely, so capitation
succeeds if physicians do not run unnecessary tests or if they avoid hospital-
izing patients when better community treatment options are available. Full-
risk capitation, in which physicians are responsible for all their patients’ costs,
gives physicians incentives to take such steps. Unfortunately, the financial risks
associated with full-risk capitation can be substantial. One patient with a rare,
expensive illness can bankrupt a solo practice; an unexpected jump in pharma-
ceutical prices can bankrupt a small provider-owned HMO. These risks are one
reason the growth of capitation has stalled and many organizations avoid full-
risk capitation (Mechanic and Zinner 2016). Organizations that accept full-risk
capitation are organized differently from those that do not. They are generally
larger, more likely to have salaried physicians, more likely to have sophisticated
information management, and more likely to have programs to reduce treat-
ment variation and manage high-risk patients (Mechanic and Zinner 2016).

13.5.2 Complexity
Providers and employees are more likely to respond to simple, comprehensi-
ble systems than to complex, confusing systems. Simple systems limit the use
of incentives and the problems they create. If you want the payment system
to reward physicians for keeping customer satisfaction high, MMR (measles,
mumps, and rubella) vaccination rates high, out-of-formulary drug use low,
hospitalization rates low, hospital lengths of stay short, after-hours response
times prompt, record updates prompt, and asthma follow-up appointments
timely, the system is likely to be unwieldy. Moreover, the reward associated
with each component of the system is likely to be small.

13.5.3 Opportunistic Responses
Managers must anticipate opportunistic responses to incentive systems. An
agent with better information can harm the principal. In many cases, whether

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Chapter 13: Asymmetr ic Information and Incentives 209

an agent has lived up to contract requirements is difficult to ascertain. In
other cases, the agent may act in ways the principal did not anticipate. Some
responses will necessitate system redesign; some will have to be tolerated
to prevent the system from becoming excessively complex. For example,
one response to the price reductions introduced by PPOs was to unbundle
services. Physicians and other providers began to bill separately for services
once included in the standard office visit. While insurers attempted to limit
unbundling in a variety of ways, the fundamental problem remained that
the incentives of physicians and insurers were misaligned (Golden, Edgman-
Levitan, and Callahan 2017). Physicians’ profits would be higher when they
billed for more services, but insurers’ profits would be higher when physi-
cians billed for fewer services.

13.5.4 Team Production
Team production also limits the use of incentives. Production of health-
care products usually involves a number of people, and the shortcomings
of one person can undermine the efforts of the entire team. For example,
rudeness by one disaffected team member can negate the efforts of oth-
ers to provide exemplary customer service. This interdependency can also
weaken the effects of individual incentives. Workers who try hard to do a
good job or physicians who are conscientious about reducing length of stay
are likely to feel that their efforts are not appreciated if the shortcomings
of others deny them bonuses. Building and maintaining effective teams
are important tasks for managers. Unless carefully structured, financial
incentives tend to reward individualistic behavior, which usually weakens
teams. Equally problematic, team financial incentives (i.e., every member
of the team receives a bonus when the team reaches its goals) often fail to
motivate workers.

13.6 Incentive Design for Managers

Incentives for managers can be financial or nonfinancial. If both types are
used, the two incentive systems should operate in tandem. Otherwise, they
may worsen the problems created by asymmetric information (Lagarde and
Blaauw 2017).

Incentive pay for managers is a partial response to the asymmetric
information problem. It usually takes the form of bonus payments, profit
sharing, or stock options. In most cases, it is a modest part of total com-
pensation and is only loosely tied to managers’ performance. Four concepts
underlie incentive pay for managers:

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Economics for Healthcare Managers210

1. Financial incentives can strongly motivate people to perform in ways
the organization desires, yet organizations seldom want managers
to focus only on duties that will increase their pay. (Volume-based
compensation presents the same problem.)

2. Managers’ goals are often not fully defined. Managers need to respond
creatively to problems or, better yet, position the organization to
respond to problems that are not yet evident. Performance assessment
based on intangibles would be difficult, if not impossible.

3. Most managers’ performance is hard to measure. As a result,
compensation based on individual productivity ceases to make sense.

4. What is measurable and what is desired are unlikely to coincide.
Compensation based on measurable outputs is likely to increase
opportunism as managers react to what is rewarded rather than to what
is sought.

For these reasons, incentive pay for managers generally needs to reflect the
success of the overall organization. The dilution of incentives that results from
using profit sharing or gainsharing is a reasonable price to pay for promoting
team-oriented behavior. Gainsharing is like profit sharing, but bonuses can be
based on a broader array of outcomes. (Chapter 6 discussed gainsharing in
not-for-profit hospitals, where profit sharing is not permitted.) Members of a
group can earn bonuses for hitting production, customer satisfaction, profit,
quality, or cost targets. As individual contributions become less discernible,
group incentives are likely to become more effective. Members of the group
will be able to monitor each other more easily, alignment of the group’s and
the organization’s incentives will become more important, and the group will
more easily alter how it does its work. For example, hospital care is produced
by teams, but pay for many physicians depends on their personal billings. To
encourage physicians to participate in hospital performance improvement
activities, implementing payments to physicians that are based on the perfor-
mance of the hospital is often helpful.

Incentive pay is only part of an effective incentive system. Economic
theory does not imply that individuals will not respond to opportunities
to do challenging work, public celebrations of their accomplishments, or a
positive review by a trusted mentor. An effective manager will consider these
tools as well. Successful organizations require cooperation in management
and production, so a nonfinancial system that rewards cooperation is a sen-
sible option for aligning incentives. Promotions typically combine financial
and nonfinancial rewards.

gainsharing
A general strategy
of rewarding those
who contribute to
an organization’s
success. (Profit
sharing is one form
of gainsharing.
Rewards can be
based on other
criteria as well.)

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Chapter 13: Asymmetr ic Information and Incentives 211

The Total Care and Cost Improvement
Program

In 2011 CareFirst BlueCross BlueShield, a plan offering coverage in
Maryland, the District of Columbia, and northern Virginia, implemented
a patient-centered medical home (PCMH) program that included
enhanced payments for primary care practices, financial incentives
for primary care physicians to reduce spending, and care coordina-
tion tools to support improved care. The model, called the Total Care
and Cost Improvement Program, changed payments to primary care
physicians, increasing fees by 12 percent to compensate for extra care
coordination and population management activities. The program also
established a one-sided system of shared savings, increasing fees
for the following year if spending was below the target. For example,
savings realized in 2012 would increase fees in 2013. The increases
depended on the savings achieved by the panel, a quality score, panel
size, and savings consistency over time. The increases were substan-
tial, an average of 45 percent by 2013 (Afendulis et al. 2017).

How well did the program work? That is not clear. Afendulis and
colleagues (2017) conclude that savings were small and that many
physicians were not fully engaged with the program. Cuellar and col-
leagues (2016) report savings of nearly 3 percent in 2013, largely
driven by reductions in emergency department and hospital use. They
conclude that “a PCMH model that does not require practices to make
infrastructure investments and that rewards cost savings can reduce
spending and utilization” (Cuellar et al. 2016, 1382). The differences
appear to be driven by analytic decisions about whether to analyze use
of services by patients who switched to PCMH practices during the first
three years (Afendulis et al. 2017).

The differing interpretations may not matter. In September 2017
CareFirst issued a press release hailing “an historic slowing of overall
medical cost growth” (CareFirst BlueCross BlueShield 2017). In 2016
CareFirst members seeing PCMH providers had hospital admission
rates that were 10.4 percent lower and readmission rates that were
34.7 percent lower than those of patients receiving care from other
providers. What changed? First, PCMHs had become a much more
common approach to primary care by 2016. Second, in 2014 CareFirst
got a grant from Medicare to extend the program to cover Medicare
beneficiaries. This change increased its clinical and financial effects.

Case 13.2

(continued)

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Economics for Healthcare Managers212

The grant also allowed CareFirst to train staff in
the PCMH practices and to hire care coordinators,
nurse case managers, consultants, pharmacy man-

agers, clinical pathway specialists, and analysts. Third, organizational
change takes time, and three more years had elapsed.

Bleser and colleagues (2014) argue that becoming an effective
PCMH requires three things:

1. strong desire for change and a belief in the need for change,

2. capacity to carry out performance improvements, and

3. detailed understanding of current and best-practice clinical
protocols.

It is not clear that these elements were present during the early years
of the Total Care and Cost Improvement Program. Afendulis and col-
leagues (2017) report that physicians in the program were receptive to
making quality improvements but were less interested in cost reduc-
tions. In addition, most were not familiar with or interested in the
shared savings incentives.

Discussion Questions
• Why would physicians not be interested in cost reductions?

• How should the program have been framed to align the goals of
CareFirst and physicians?

• How did including Medicare beneficiaries change incentives?

• The Medicare grant added infrastructure to the program. Was that
important?

• Have other PCMH programs become more effective as they matured?

• What should have been done to improve physicians’ knowledge of
current clinical protocols?

• How could one improve physicians’ knowledge of best-practice
clinical protocols?

• Why were most physicians unwilling to change their practices to
claim incentives?

• Most PCMH programs pay care coordination fees per patient per
month for patients with chronic illnesses. How do the incentives
differ from those of the CareFirst program?

• Would care coordination fees have been a better strategy than
higher visit fees?

• Many of the practices were small. Do you expect that they could
carry out performance improvement projects?

Case 13.2
(continued)

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Chapter 13: Asymmetr ic Information and Incentives 213

13.7 Conclusion

Incentive restructuring is an imperfect response to the problem of asymmet-
ric information, as are all responses to this problem. The rewards of incentive
systems are usually based on results, not on what agents actually do, and
agents can respond opportunistically to virtually any incentive system. The
challenge is to align the incentives of all the individuals in a system with the
interests of its stakeholders. Because good incentive systems must balance
competing objectives, no magic formula exists. In addition, managers must
anticipate that incentives may have multiple effects and that designing incen-
tive systems and keeping them up to date will be expensive.

Major changes in payment systems are underway. Both public and
private insurers are moving aggressively away from pure volume-based pay-
ments. Most of the new systems incorporate quality measures in some way,
but quality is multidimensional and hard to measure. In addition, measuring
quality uses resources. O’Shea (2017) estimates that quality reporting costs
more than $40,000 per physician per year, and many are concerned about
the burdens imposed on providers. MACRA creates significant incentives
for physicians to participate in advanced alternative payment models, which
could reduce the reporting burden and allow revenues to rise. The problems
that asymmetric information creates have not gone away, but the new pay-
ment systems have created pressure for change.

Exercises

13.1 Describe some healthcare situations in which an agent has taken
advantage of a principal. Then describe some healthcare transactions
that have not taken place because of fears about asymmetric
information.

13.2 Identify some ways that nursing homes can signal high quality to
consumers. Which of these signals are most apt to be reliable?

13.3 Provide an example of costly monitoring in the healthcare
workplace. Can you think of an employment contract that would
allow a reduction in monitoring without a reduction in quality?

13.4 What are some strategies for reducing adverse selection in insurance
markets? What sorts of problems do these solutions cause?

13.5 One physical therapist is paid $20 per session. Another is paid $400
per week plus $20 per session in excess of 20 sessions per week.
A third is paid $400 per week, plus $200 per week for having all
paperwork complete and filed within 48 hours, plus $20 per session
in excess of 30 sessions per week. How do the therapists’ incentives

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Economics for Healthcare Managers214

to produce sessions compare? How do their incentives to complete
paperwork differ?

13.6 One physician is paid $100 per visit. Another is paid $2,500 per
week plus $100 per session in excess of 20 sessions per week. A
third is paid $2,000 per week plus $100 per session in excess of 20
sessions per week. The third physician is also paid a weekly bonus
of $500 for being in the top quartile for management of common
chronic diseases, appropriate antibiotic use, preventive counseling,
screening tests, and appropriate prescribing in elderly patients. How
do the physicians’ incentives compare?

13.7 The Federal Trade Commission requires that firms advertise
truthfully. Why does this requirement promote competition? Would
firms be better or worse off if the Federal Trade Commission
adopted a “let the buyer beware” policy?

13.8 Your firm sells backup generators to hospitals and clinics. The
generators are guaranteed to operate on demand for two years. Your
data show that the generators run an average of 42 hours per year.
Your firm offers an extended warranty that covers the next three
years. Your data show that repairs are needed for 2 percent of units
during this three-year period. When repairs are needed, the average
cost is $4,000. You charge $400 for the extended warranty, and
about 20 percent of your clients buy it.
a. The extended warranty has been a consistent money loser. Claims

average $1,000 per customer. How could this situation happen,
given the data presented here?

b. Would raising the premium to $1,000 solve this problem?
c. What would you recommend that your company do to solve this

problem?
13.9 For the population as a whole, average healthcare spending is

$1,190 per year. Those with a family history of cancer (5 percent
of the population) spend $20,000 on average, and those with no
family history (95 percent of the population) spend $200. An
insurer is offering first-dollar coverage for $1,200.
a. You are not risk averse and have no family history of cancer. Do

you buy coverage?
b. You are not risk averse and have a family history of cancer. Do

you buy coverage?
c. If you were risk averse, how would your answers to the last two

questions change?
d. What could an insurer do to prevent this sort of adverse

selection?

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Chapter 13: Asymmetr ic Information and Incentives 215

e. What would be wrong with having everyone undergo a physical
exam to qualify for coverage?

13.10 You want to hire a new laboratory technician. Excellent technicians
generate $1,000 in value added each week. Adequate technicians
generate $500 in value added each week. Half the graduates are
excellent, and half are adequate.
a. You cannot tell who is highly capable and who is adequate. You

are prepared to pay each technician the value added. What salary
do you offer?

b. Who will accept this offer?
c. Is there any way that excellent technicians could communicate

their productivity?
d. Propose a compensation system that will attract both types of

technicians and pay no technicians more than their value added.
13.11 A new test identifies individuals with a genetic predisposition to

develop heart disease before age 70. People who are predisposed to
heart disease cost twice as much to insure as those who are not.
a. Can you make a case that a law prohibiting this test would be a

good idea?
b. The test is not expensive. Would you prefer to skip the test and

buy insurance at a premium that covers everyone or take the test
and buy insurance at a premium that covers your group?

13.12 Your hospital wants to buy practices to expand its primary care
networks. You are aware that physicians who want to sell their
practices differ. Some love to practice medicine and love seeing
patients. They want to sell their practices to focus on patient care
50 hours per week. Some physicians love to play golf and want to
provide patient care no more than 35 hours per week. Propose a
compensation plan that will allow you to hire only physicians who
love to practice.

13.13 Having access to the books and understanding local markets
better than new owners, the owners of medical practices generally
understand their finances better than prospective buyers do. What
sorts of transactions tend to take place as a result of this information
asymmetry? What sorts of transactions tend not to take place? What
can buyers and sellers do to offset this information asymmetry?

13.14 You are considering acquiring a firm rumored to have developed an
effective gene therapy for diabetes. The value of the firm depends
on this therapy. If the therapy is effective, the firm is worth $100
per share; otherwise, the firm is worth no more than $20 per share.
Your company’s management and marketing strengths should

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Economics for Healthcare Managers216

increase the share price by at least 50 percent in either case. You
must make an offer for the firm now, before the results of clinical
trials are in. The current owner of the firm will sell for the right
price. Make an offer for the firm. Explain why you think your offer
makes sense.

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