Health Economics Research paper

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An enormous expansion in the scope and effectiveness of medical care services to diagnose and treat diseases began in the 1930s with the scientific research and development techniques that produced the first antibiotics. Those advances have been followed by continual changes in the organization of the institutions that constitute the supply and demand sides of the medical service industry, continual changes in pricing and payment mechanisms, and continual growth in the amount of nations’ resources that are allocated to medical services.

Theses changes have been universal among countries, even in the presence of substantial heterogeneity in institutional and market structures for health care delivery and financing. The United Kingdom and the United States are examples of nations with very different structures. In 1946 the United Kingdom established universal, government-funded medical insurance, and hospital and medical specialists’ services are produced by the government. In the United States, medical insurance is not universal; government expenditure is substantial, but provides coverage for only selected populations; physician practices are privately owned and organized on a for-profit basis; and most hospitals are privately owned but organized as nonprofit-based corporations. Yet, between 1960 and 2004, total health care expenditure as a share of gross domestic profit doubled in the United Kingdom and tripled in the United States (Organisation for Economic Co-operation and Development 2007).

Health economics applies the tools of microeconomics to individual and societal decisions regarding the allocation and distribution of resources to the production of health and health care services. Kenneth Arrow’s 1963 article “Uncertainty and the Welfare Economics of Medical Care” established health economics as a field by making the case that virtually all of the special features of the medical care industry stem from the prevalence of risk and uncertainty, arguing that “the failure of the market to insure against uncertainties has created many social institutions in which the usual assumptions of the market are to some extent contradicted” (Arrow 1963, p. 946).

Demand- and supply-side analysis is the primary theoretical tool in health economics. On the demand side, health is characterized as a stock of human capital (Schultz 1961; Becker 1962) that produces both direct utility and investment services—capacity to function—over the life cycle. With aging it depreciates naturally and is increasingly subject to shocks from diseases. Replacement health cannot be purchased—it must be produced by combining personal resources such as time and health-affecting behaviors with purchased health or medical care services (Grossman 1972). On the supply side, purchased health care services are regulated by government and produced in hospitals, physicians’ offices, and clinics, and long-term care facilities by physicians, nurses, and other medical care providers using pharmaceutical and other diagnostic and treatment technologies.

The role of third-party payors—predominately employers and governments—constitutes a distinguishing feature of health economics. Given third-party payors, consumers often are not aware of the full range of alternative health care services and do not directly face, or even know, the resource cost—the full price—of their health care. Most consumers are enrolled in managed care type plans that have contracts with providers. Those contracts influence providers’ treatment decisions by specifying which services are covered and what the payment mechanism is between the plan and medical services provider; the consumer does not see the plan-provider contract.

Health economics draws on tools used in several other fields to address this configuration of health and health care institutional characteristics: from public finance, the major government role; from labor economics, the major employer role; from industrial organization, restricted entry and nonprofit organizational form; and from econometrics, quantitative answers to policy-related questions. Variations of cost-effectiveness analysis are more frequently used by health economists in nations such as the United Kingdom, where government-financed third-party coverage is complete.

Much growth in the field of health economics is policy oriented. This can be attributed to the fact that governments are major third-party payors and face the fiscal implications of the costs associated with the expansion in the scope of medical care services. Thus, the research has focused on societal decisions regarding the efficient (costcontaining) allocation of resources to the production of health care services. Research concerning the distributional component of enhancing social welfare (Arrow 1963) has received much less attention in health economics. This has implications for policy because there is substantial evidence of nonrandom heterogeneity in health stock and health outcomes among demographic groups. Racial and ethnic health disparities continue to persist whether health care coverage is universal and provided by government, as in the United Kingdom (Townsend and Davidson 1982), or provided through fragmented systems of imperfect markets that include private and government third parties, as in the United States (U.S. Department of Health and Human Services 2000).

Viewed as human capital, investment in the health of the most vulnerable members of society may be a powerful tool for promoting growth. Public investment in programs that eliminate acquired immunodeficiency syndrome (HIV/AIDS) enhances social welfare and facilitates economic growth in developing African countries. Programs that increase breast-feeding enhance the health of infants and thereby generate positive long-term returns. But John Akin and colleagues reported that in Sri Lanka, highly educated mothers from families in the highest income or asset categories were among the least likely to breast-feed (Akin, Bilsborrow, Guilkey et al. 1981); thus the social rate of return from investment in health may be particularly high for developing countries, but the economic and policy issues are complex. Additional health economics studies can help clarify these issues.


  1. Akin, John, Richard Bilsborrow, David Guilkey, et al. 1981. The Determinants of Breast-Feeding in Sri Lanka. Demography 18 (3): 287–307.
  2. Arrow, Kenneth J. 1963. Uncertainty and the Welfare Economics of Medical Care. American Economic Review 53 (5): 941–973.
  3. Becker, Gary S. 1962. Investment in Human Capital: A Theoretical Analysis. Journal of Political Economy 70 (5, pt. 2): 9–49.
  4. Grossman, Michael. 1972. On the Concept of Health Capital and the Demand for Health. Journal of Political Economy 80 (2): 223–255.
  5. Law, Sylvia A. 1974. Blue Cross What Went Wrong? New Haven, CT: Yale University Press.
  6. Schultz, Theodore W. 1961. Investment in Human Capital. American Economic Review 51 (1): 1–17.
  7. Townsend, Peter, and Nick Davidson, eds. 1982. Inequalities in Health: The Black Report. New York: Penguin Books.
  8. S. Department of Health and Human Services. 2000. Healthy People 2010. 2 vols. 2nd ed. Washington, DC: U.S. Government Printing Office.

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