Implications of the Interaction Between Insurance Choice and Medical Care Demand

ABSTRACT The gross price elasticity of demand for medical care is decomposed into two separate observable components: the medical care gross price elasticity of insurance choice and the cost-sharing elasticity of medical care. When consumers alter their choice of health-care plans, the price elasticity of medical care is no longer equivalent to the cost-sharing elasticity; using the latter as a proxy for the former may produce misleading results. We present conditions under which the medical care price elasticity is positive, the case of a quasi-Giffen good, and provide a theoretical foundation for extant empirical findings of a positive medical care price elasticity of insurance demand. INTRODUCTION Among the developed, higher-income countries, medical care expenditures have been rising at a pace that is distinctly above overall growth rates. In the United States, for example, total medical cost outlays have increased at an average rate of 8.9 percent since 1980, which is about 2.6 percentage points above the average for the aggregate economy, as measured by gross domestic product (GDP). (1) Similar patterns prevail when one examines medical expenditures in both per capita and budget share terms. As a share of the U.S. economy, medical care has nearly doubled over the 25-year period 1980 to 2005, rising from 9 percent of GDP in 1980 to 16 percent in 2005. (2) Medical care spending per capita has also increased dramatically during this period, increasing to $6,697 from $1,102. (3) Although the United States is by far the medical expenditure leader, similar trends exist in most developed countries. (4) These observations prompt interest in the forces underlying medical care demand and in how individuals respond to its rising costs. In this article, we analyze consumer medical care demand response to a change in the gross price of medical care, paying special attention to the interaction between the consumer's demand for medical care and his demand for health insurance, and the ensuing implications for the measurement of demand elasticities. (5) Private health insurance contracts provide for a price discount at the time the insured purchases medical care; therefore, the more generous an individual's insurance coverage is, the higher might be his demand for medical care. This effect of insurance on medical care demand is known as the moral hazard effect (Arrow, 1963; Pauly, 1968). It refers to the effect of insurance on the net price of medical care (i.e., percentage of cost sharing times the gross price) and to the consequent incentive effects on medical care consumption. In medical care, moral hazard combines with the interdependence between utilization and the insurance contract decision. The choice of type of insurance is influenced by expected utilization of medical care services, whereas utilization itself is affected by the consumer's insurance contract. This interaction complicates the analysis of the consumer's response to changes in medical care prices. (6) We present a principal-agent model of individual consumer medical care demand that highlights this interaction, so that the consumer is allowed to change both his demand for medical care and his selection of insurance contract in response to changes in medical care prices. A change in the gross price of medical care has two effects on demand: a direct effect, for fixed cost sharing, and an indirect effect through a moral hazard response that results from cost-sharing changes associated with price-induced changes in the choice of insurance plan. Much of the extant literature studies the demand for medical care by examining responses to changes in cost sharing, with the gross price held constant and the choice of health insurance contract remaining fixed. However, if one wants to compare medical care demand with the demand for other goods or categories of goods--or if one simply recognizes the fact that most insured consumers choose from among several insurance plans and can alter their intended choice--then the response to a change in gross price is important. …