What Every Public Finance Economist Needs to Know About Health Economics: Recent Advances and Unresolved Questions

The standard theoretical framework of health economics, as summarized in public finance undergraduate textbooks (e.g., Rosen, 1995, chapter 11), draws attention to four problems. First, illness and accidents are unpredictable but costly events, and therefore health insurance is desirable. Unfortunately, the existence of health insurance means that people are insulated from the true costs of medical care, resulting in too much service use and excessively high medical spending. This moral hazard problem is exacerbated by the tax-subsidy for the purchase of insurance. Second, adverse selection causes low-risk individuals to leave the insurance market, so that a single-pooling equilibrium with one premium for both low- and high-risk is frequently unsustainable and low-risk people are often underinsured. Third, physicians are better informed than patients and the resulting information asymmetries cause market failures. Finally, concerns about equity may lead to redistribution related to health care. This standard theoretical framework provides the underpinnings of most empirical health economics and is a valuable guide for policy analysis. However, it has significant limitations that recent contributions have sought to address. In this paper, we examine these developments and their relation to the important problems confronting health care policy. The next section of the paper first describes the contributions and limitations of the standard theoretical framework, highlighting the significant empirical phenomena that it does not explain. The following four sections examine in turn each of the major areas of health economics: moral hazard, patient-provider informational asymmetries, selection and equity. Each section explains the new developments and discusses