Health economics

Health economics is a branch of economics concerned with issues related to efficiency, effectiveness, value and behavior in the production and consumption of health and healthcare. In broad terms, health economists study the functioning of healthcare systems and health-affecting behaviors such as smoking.

How much did the UK spend on healthcare in 2012?

A seminal 1963 article by Kenneth Arrow, often credited with giving rise to health economics as a discipline, drew conceptual distinctions between health and other goods.[1] Factors that distinguish health economics from other areas include extensive government intervention, intractable uncertainty in several dimensions, asymmetric information, barriers to entry, externalities and the presence of a third-party agent.[2] In healthcare, the third-party agent is the physician, who makes purchasing decisions (e.g., whether to order a lab test, prescribe a medication, perform a surgery, etc.) while being insulated from the price of the product or service.

Health economists evaluate multiple types of financial information: costs, charges and expenditures.

Uncertainty is intrinsic to health, both in patient outcomes and financial concerns. The knowledge gap that exists between a physician and a patient creates a situation of distinct advantage for the physician, which is called asymmetric information.

Externalities arise frequently when considering health and health care, notably in the context of infectious disease. For example, making an effort to avoid catching the common cold affects people other than the decision maker.[3][4][5][6]


The scope of health economics is neatly encapsulated by Alan Williams' "plumbing diagram"[7] dividing the discipline into eight distinct topics:

  • What influences health? (other than healthcare)
  • What is health and what is its value?
  • The demand for healthcare
  • The supply of healthcare
  • Micro-economic evaluation at treatment level
  • Market equilibrium
  • Evaluation at whole system level
  • Planning, budgeting and monitoring mechanisms.

Healthcare demand

The demand for healthcare is a derived demand from the demand for health. Healthcare is demanded as a means for consumers to achieve a larger stock of "health capital." The demand for health is unlike most other goods because individuals allocate resources in order to both consume and produce health.

The above description gives three roles of persons in health economics. The World Health Report (p. 52) states that people take four roles in the healthcare:

  1. Contributors
  2. Citizens
  3. Provider
  4. Consumers

Michael Grossman's 1972 model of health production[8] has been extremely influential in this field of study and has several unique elements that make it notable. Grossman's model views each individual as both a producer and a consumer of health. Health is treated as a stock which degrades over time in the absence of "investments" in health, so that health is viewed as a sort of capital. The model acknowledges that health is both a consumption good that yields direct satisfaction and utility, and an investment good, which yields satisfaction to consumers indirectly through fewer sick days. Investment in health is costly as consumers must trade off time and resources devoted to health, such as exercising at a local gym, against other goals. These factors are used to determine the optimal level of health that an individual will demand. The model makes predictions over the effects of changes in prices of healthcare and other goods, labour market outcomes such as employment and wages, and technological changes. These predictions and other predictions from models extending Grossman's 1972 paper form the basis of much of the econometric research conducted by health economists.

In Grossman's model, the optimal level of investment in health occurs where the marginal cost of health capital is equal to the marginal benefit. With the passing of time, health depreciates at some rate . The interest rate faced by the consumer is denoted by . The marginal cost of health capital can be found by adding these variables: . The marginal benefit of health capital is the rate of return from this capital in both market and non-market sectors. In this model, the optimal health stock can be impacted by factors like age, wages and education. As an example, increases with age, so it becomes more and more costly to attain the same level of health capital or health stock as one ages. Age also decreases the marginal benefit of health stock. The optimal health stock will therefore decrease as one ages.

Beyond issues of the fundamental, "real" demand for medical care derived from the desire to have good health (and thus influenced by the production function for health) is the important distinction between the "marginal benefit" of medical care (which is always associated with this "real demand" curve based on derived demand), and a separate "effective demand" curve, which summarizes the amount of medical care demanded at particular market prices. Because most medical care is not purchased from providers directly, but is rather obtained at subsidized prices due to insurance, the out-of-pocket prices faced by consumers are typically much lower than the market price. The consumer sets out of pocket, and so the "effective demand" will have a separate relationship between price and quantity than will the "marginal benefit curve" or real demand relationship. This distinction is often described under the rubric of "ex-post moral hazard" (which is again distinct from ex-ante moral hazard, which is found in any type of market with insurance).

Health technology assessment

Economic evaluation, and in particular cost-effectiveness analysis, has become a fundamental part of technology appraisal processes for agencies in a number of countries. The Institute for Quality and Economy in Health Services (Institut für Qualität und Wirtschaftlichkeit im Gesundheitswesen – IQWiG) in Germany and the National Institute for Health and Care Excellence (NICE) in the United Kingdom, for example, both consider the cost-effectiveness of new pharmaceuticals entering the market.

Some agencies, including NICE, recommend the use of cost–utility analysis (CUA). This approach measures outcomes in a composite metric of both length and quality of life, the Quality-adjusted life year (QALY).

Healthcare markets

The five health markets typically analyzed are:

  • Healthcare financing market
  • Physician and nurses services market
  • Institutional services market
  • Input factors markets
  • Professional education market

Although assumptions of textbook models of economic markets apply reasonably well to healthcare markets, there are important deviations. Many states have created risk pools in which relatively healthy enrollees subsidise the care of the rest. Insurers must cope with adverse selection which occurs when they are unable to fully predict the medical expenses of enrollees; adverse selection can destroy the risk pool. Features of insurance market risk pools, such as group purchases, preferential selection ("cherry-picking"), and preexisting condition exclusions are meant to cope with adverse selection.

Insured patients are naturally less concerned about healthcare costs than they would if they paid the full price of care. The resulting moral hazard drives up costs, as shown by the famous RAND Health Insurance Experiment. Insurers use several techniques to limit the costs of moral hazard, including imposing copayments on patients and limiting physician incentives to provide costly care. Insurers often compete by their choice of service offerings, cost sharing requirements, and limitations on physicians.

Consumers in healthcare markets often suffer from a lack of adequate information about what services they need to buy and which providers offer the best value proposition. Health economists have documented a problem with supplier induced demand, whereby providers base treatment recommendations on economic, rather than medical criteria. Researchers have also documented substantial "practice variations", whereby the treatment also on service availability to rein in inducement and practice variations.

Some economists argue that requiring doctors to have a medical license constrains inputs, inhibits innovation, and increases cost to consumers while largely only benefiting the doctors themselves.[9]

Other issues

Medical economics

Often used synonymously with health economics, medical economics, according to Culyer,[10] is the branch of economics concerned with the application of economic theory to phenomena and problems associated typically with the second and third health market outlined above: physician and institutional service providers. Typically, however, it pertains to cost–benefit analysis of pharmaceutical products and cost-effectiveness of various medical treatments. Medical economics often uses mathematical models to synthesise data from biostatistics and epidemiology for support of medical decision-making, both for individuals and for wider health policy.

Behavioral economics

Peter Orszag has suggested that behavioral economics is an important factor for improving the healthcare system, but that relatively little progress has been made when compared to retirement policy.[11] The relevance of behavioral economics in healthcare is further highlighted in Vuong et al. (2018).[12]

Healthcare systems inherently introduce difficult situations for all parties. Game theory--the branch of economics that studies strategic interaction among small groups of rational decision-makers--can serve as a helpful tool to model and help guide such difficult decisions. Take one instance of the doctor-patient relationship in which a doctor is deciding whether to prescribe opioid pain-killing medication, which is highly addictive, to a new patient who presents with pain. Relieving pain and suffering is one of a doctor’s primary objectives. Moreover, doctors consider patient satisfaction scores when choosing whether and how to treat patients. From the patient's perspective, patients may present to the doctor with real pain, requesting pain-mitigating treatment legitimately, or with fake pain to satisfy an existing addiction or for some other illicit purpose. While physicians may suspect that a patient is not in pain, there is no objective test to prove the patient’s true pain levels. Because patient satisfaction scores impact doctor wages, doctors may over-treat their patients if and when their patients ask for certain treatment in order to receive better satisfaction scores.

This interaction can be modeled in a prisoner's dilemma paradigm as follows:

Prescribe narcotics Do not prescribe narcotics
Patient Real Pain (Patient satisfied; doctor receives high satisfaction score and is professionally rewarded ) (Patient dissatisfied;

doctor receives low satisfaction score and is not professionally rewarded)

Fake Pain (Patient satisfied; doctor receives high satisfaction score and is professionally rewarded) (Patient dissatisfied;

doctor receives low satisfaction score and is not professionally rewarded, even if this response is professionally most ethical)

A standard solution technique utilized in game theory is Nash equilibrium, where the players converge to a common strategy, where no agent can achieve a more favorable outcome by switching actions. Observing where a Nash equilibrium exists in a difficult situation can help inform decisions. This can lead to cooperation and trust, which is vital in a healthcare environment.

We apply the Nash Equilibrium technique to our opioid prescription decision above: If the patient has real pain, the rational choice for the doctor is to treat the patient. If the patient has fake pain, it is still in the doctor’s best interest to treat the patient so that the doctor elicits a good satisfaction rating. Otherwise, a patient’s low satisfaction score could result in reputation loss and reduced income. Thus, a doctor will prescribe opioids regardless of whether the patient needs them, and the patient addicted to opioids will demand these opioids for short-term satisfaction notwithstanding that their long-term use may eventually harm the patient’s health and society at large. Such an outcome will lead to wasted resources and poor outcomes. The mutual best response, i.e., Nash Equilibrium outcome for this game is for the patient to present with real pain, and for the Doctor to prescribe narcotics, with payoffs in the form (Patient, Doctor) -> (Satisfied, High Satisfaction score & Professionally Rewarded). [13][14]

The situation where the patient has ‘Fake Pain’ and the doctor ‘Prescribes narcotics’ appears the same as the described Nash Equilibrium. however, there are deeper differences that cause this situation to not be a Nash Equilibrium. Doctors are bound to a code of medical ethics and regulatory restrictions, so prescribing addictive drugs to someone not in need can lead to deeper and long term consequences, such as fueling the opioid epidemic. In such a situation, the patient will end up unsatisfied as their health condition worsens because of opioid addiction and the doctor’s reputation could become jeopardized.  

Mental health economics

Mental health economics incorporates a vast array of subject matters, ranging from pharmacoeconomics to labor economics and welfare economics. Mental health can be directly related to economics by the potential of affected individuals to contribute as human capital. In 2009 Currie and Stabile published "Mental Health in Childhood and Human Capital" in which they assessed how common childhood mental health problems may alter the human capital accumulation of affected children.[15] Externalities may include the influence that affected individuals have on surrounding human capital, such as at the workplace or in the home.[16] In turn, the economy also affects the individual, particularly in light of globalization. For example, studies in India, where there is an increasingly high occurrence of western outsourcing, have demonstrated a growing hybrid identity in young professionals who face very different sociocultural expectations at the workplace and in at home.[17]

Mental health economics presents a unique set of challenges to researchers. Individuals with cognitive disabilities may not be able to communicate preferences. These factors represent challenges in terms of placing value on the mental health status of an individual, especially in relation to the individual's potential as human capital. Further, employment statistics are often used in mental health economic studies as a means of evaluating individual productivity; however, these statistics do not capture "presenteeism", when an individual is at work with a lowered productivity level, quantify the loss of non-paid working time, or capture externalities such as having an affected family member. Also, considering the variation in global wage rates or in societal values, statistics used may be contextually, geographically confined, and study results may not be internationally applicable.[16]

Though studies have demonstrated mental healthcare to reduce overall healthcare costs, demonstrate efficacy, and reduce employee absenteeism while improving employee functioning, the availability of comprehensive mental health services is in decline. Petrasek and Rapin (2002) cite the three main reasons for this decline as (1) stigma and privacy concerns, (2) the difficulty of quantifying medical savings and (3) physician incentive to medicate without specialist referral.[18] Evers et al. (2009) have suggested that improvements could be made by promoting more active dissemination of mental health economic analysis, building partnerships through policy-makers and researchers, and employing greater use of knowledge brokers.[16]

See also


  1. Arrow, Kenneth (1963). "Uncertainty and the Welfare Economics of Medical Care," The American Economic Review;53(5):941-973
  2. Phelps, Charles E. (2003), Health Economics (3rd ed.), Boston: Addison Wesley, ISBN 978-0-321-06898-9 Description and 2nd ed. preview.
  3. Fuchs, Victor R. (1987). "health economics" The New Palgrave: A Dictionary of Economics, v. 2, pp. 614–19.
  4. Fuchs, Victor R. (1996). "Economics, Values, and Health Care Reform," American Economic Review, 86(1), pp. 1–24 Archived 14 July 2007 at the Wayback Machine (press +).
  5. Fuchs, Victor R. ([1974] 1998). Who Shall Live? Health, Economics, and Social Choice, Expanded edition. Chapter-preview links, pp. vii–xi.
  6. Wolfe, Barbara (2008). "health economics." The New Palgrave Dictionary of Economics', 2nd Edition. Abstract & TOC.
  7. Williams, A. (1987), "Health economics: the cheerful face of a dismal science", in Williams, A. (ed.), Health and Economics, London: Macmillan
  8. Grossman, Michael (1972), "On the Concept of Health Capital and the Demand for Health", Journal of Political Economy, 80 (2): 223–55, CiteSeerX, doi:10.1086/259880
  9. Svorny, Shirley (2004), "Licensing Doctors: Do Economists Agree?", Econ Journal Watch, 1 (2): 279–305
  10. A.J. Culyer (1989) "A Glossary of the more common terms encountered in health economics" in MS Hersh-Cochran and KP Cochran (Eds.) Compendium of English Language Course Syllabi and Textbooks in Health Economics, Copenhagen, WHO, 215–34
  11. Peter Orszag, "Behavioral Economics: Lessons from Retirement Research for Health Care and Beyond," Presentation to the Retirement Research Consortium, August 7, 2008
  12. Vuong, Thu-Trang; Nguyen, Hong-Kong; Ho, Tung-Manh; Vuong, Quan-Hoang (19 June 2018). "Healthcare consumers' sensitivity to costs: a reflection on behavioural economics from an emerging market" (PDF). Palgrave Communications. 4 (1): 70. doi:10.1057/s41599-018-0127-3.
  13. Djulbegovic, Benjamin; Hozo, Iztok; Ioannidis, John P.A. (2015-01). "Modern health care as a game theory problem". European Journal of Clinical Investigation. 45 (1): 1–12. doi:10.1111/eci.12380. Check date values in: |date= (help)
  14. Tarrant, C (1 December 2004). "Models of the medical consultation: opportunities and limitations of a game theory perspective". Quality and Safety in Health Care. 13 (6): 461–466. doi:10.1136/qshc.2003.008417. ISSN 1475-3898.
  15. Currie, Janet and Mark Stabile. "Mental Health in Childhood and Human Capital". The Problems of Disadvantaged Youth: An Economic Perspective ed. J. Gruber. Chicago: University of Chicago Press, 2009.
  16. Evers, S.; Salvador–Carulla, L.; Halsteinli, V.; McDaid, D.; MHEEN Group (April 2007), "Implementing mental health economic evaluation evidence: Building a Bridge between theory and practice", Journal of Mental Health, 16 (2): 223–41, doi:10.1080/09638230701279881
  17. Bhavsar, V.; Bhugra, D. (December 2008), "Globalization: Mental health and social economic factors" (PDF), Global Social Policy, 8 (3): 378–96, doi:10.1177/1468018108095634
  18. Petrasek M, Rapin L; Rapin (2002), "The mental health paradox", Benefits Q, 18 (2): 73–77, PMID 12004583

Further reading

  • Alastair M. Gray, Philip M. Clarke, Jane Wolstenholme, Sarah Wordsworth (2010) Applied Methods of Cost-effectiveness Analysis in Healthcare, Oxford University Press. ISBN 0-19-922728-4
  • Drummond, Michael F. (2005) Methods for the Economic Evaluation of Health Care Programmes, Oxford University Press. ISBN 0-19-852945-7
  • Mahar, Maggie, Money-Driven Medicine: The Real Reason Health Care Costs So Much, Harper/Collins, 2006. ISBN 978-0-06-076533-0
  • Siegel, Joanna E.; Russell, Louise B.; Weinstein, Milton C.; Gold, Marthe R. (1996), Cost-effectiveness in health and medicine, New York [u.a.]: Oxford Univ. Press, ISBN 978-0-19-510824-8
  • Starr, Paul, The Social Transformation of American Medicine, Basic Books, 1982. ISBN 0-465-07934-2
  • Wennberg J, Gittelsohn; Gittelsohn, A. (December 1973), "Small area variations in health care delivery", Science, 182 (4117): 1102–08, Bibcode:1973Sci...182.1102W, doi:10.1126/science.182.4117.1102, PMID 4750608
  • Whittington, Ruth (2008). Introduction to Health Economics: A Beginners Guide Preview. ISBN 978-0-9545494-5-9.
  • Wise, David A. (2009), Developments in the Economics of Aging, University of Chicago Press, ISBN 978-0-226-90335-4
  • A.J. Culyer and J.P. Newhouse, ed. (2000). Handbook of Health Economics, Elsevier. 1A. Description. Elsevier.
  • _____ (2000). Handbook of Health Economics, 1B. Description. Elsevier.


  • Health Economics. Aims & scope and links back-issue titles and abstracts.
  • Journal of Health Economics Aims & scope and links to back-issue titles and abstracts.
  • Review of Economics of the Household
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