Stimulating cost overruns or stimulating innovation? – Health Economist

Based on a study done Frankovich & Kuhn (2022), the answer is both. However, the value of expanding innovation, as measured by increased life expectancy, more than offsets inefficiencies due to cost overruns. In particular, the authors use a model of overlapping generations, in which people can purchase health insurance, and medical progress depends on the return on investment in the health sector. The authors calibrate their model using life expectancy data from the Human Mortality Database from 19650 to 2005, income data from the Current Population Survey (CPS), and health care expenditure data from the National Center for Health Statistics (NCHS). This time frame matters because 1965 was the year Medicare was introduced in the US.

Using this methodology, the authors conclude that:

… broader health insurance accounts for a large share of US health care spending growth, but also contributes to accelerating the pace of medical progress. Welfare analysis shows that although subsidizing health care through health insurance leads to excessive health care costs, the increase in life expectancy caused by medical progress more than offsets this.

In general, higher levels of health insurance lower consumption as more money is spent on health care. At the same time, capital, especially capital invested in research and development, is increasing as health insurance increases return on investment as more sick patients can afford treatment. The authors note that:

One explanation for why the benefits of medical progress increasingly outweigh the costs of moral hazard is that incomes continue to rise: as per capita consumption increases over time, people tend to value life more and more (Hall & Jones, 2007, Chen et al., 2021). This argument extends to moral hazard assessment, where people are willing to tolerate increasing distortion from health insurance in exchange for longer life expectancy if it only slows but does not reverse consumption growth.

The authors also note that health care prices increase over time due to Baumol’s cost sickness; in particular, the combined effect of productivity growth in the final goods sectors and progress in medicine itself leads to higher prices.

Courtesy Journal of Health Economics.

You can read the full article here.