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FRBSF Economic Letter
2005-10; May 27, 2005
More Life vs. More Goods: Explaining Rising
Health Expenditures
 Debates about health care have been a central feature
of U.S. public policy discussions for at least the
last 20 years. One trigger of these debates is the
statistical evidence on the rising cost of health care.
For example, according to a survey conducted by the
Kaiser Family Foundation (2004), health insurance premiums
for employer sponsored plans increased by 11.2% between
the spring of 2003 and the spring of 2004, the fourth
consecutive year of double-digit increases. A related
set of statistics is just as striking: In 1960, the
share of U.S. GDP spent on health care costs was only
5%, but by 2002, it had climbed to more than 14% (see
Figure 1). In the public policy discussion, much attention
has focused on waste and fraud in the health care system,
which clearly are harmful to the economy.
But are health expenditures rising for reasons other
than waste or fraud? If so, do these reasons portend
a continuation of this rapid pace of increase? Is there
an end in sight? This Economic Letter draws on recent
economic research (Hall and Jones 2004) to explore
some possible answers to these questions. One of the
perhaps surprising conclusions from this research is
that the rising health share may reflect the natural
course of economic growth: as we get richer and richer,
one of the most valuable and productive opportunities
for our spending is to purchase better health and longer
lives.
 One reason for rising
health expenditures: costly new technologies
Figure 2 plots the share of GDP spent on health
care from 1960 to 2002 in four industrialized countries:
Germany, France, Japan, and the United Kingdom. As
the figure clearly shows, the U.S. is not the only
country that has been expending an increasing share
of its GDP on health care. Indeed, this pattern holds
true for virtually all industrialized nations.
The commonality of this trend is important, because
it suggests that the rise in the U.S. health share
is not driven solely by factors specific to this country,
such as changes in U.S. government policy or particular
features of U.S. health insurance. Instead, the fact
that health shares are rising in many countries suggests
that something more fundamental is going on.
Newhouse (1992) surveyed a number of possible causes
for rising health care expenditures; these included
the aging of the population, the rising cost of health
insurance, and anecdotes associated with doctors who
induced patients to spend more on medical care than
they really would prefer. Newhouse's analysis found
these explanations wanting, and, as a result, he concluded
that the rise in the health share of spending was due
to the discovery and use of new, expensive medical
technologies. The invention of MRIs, CAT scans, new
drugs, and new medical procedures allows people to
spend more on health care over time as the new technologies
become available.
Another reason: people's
preferences
By itself, however, Newhouse's story is incomplete.
People do not have to purchase the new medical technologies
if they don't want to, and, in fact, people do not
have to invent them in the first place if they are
not valuable. Given that, it must be the case, at some
level, that the increasing share of GDP expended on
health care reflects people's preferences.
To begin to think about this, it is helpful to consider
some facts. Over the 20th century, U.S. life expectancy
at birth increased from about 50 years in 1900 to about
77 years by 2000. Exactly how much of this increase
is due to increased health spending is unclear, but
the large gains in life expectancy clearly represent
one of the major accomplishments of the 20th century.
Over this same period, the consumption of goods other
than health care in the United States increased from
about $4,000 per person in 1900 to about $20,000 per
person in 2000. Nordhaus (2003) noted these relative
trends in life expectancy and consumption and considered
the following simple question: If you could have either
the nonhealth consumption in 2000 with the medical
technologies of 1900 or the nonhealth consumption in
1900 with the medical technologies of 2000, which would
you choose? Nordhaus found that the people he surveyed
were split roughly evenly on this question. He went
on to confirm that the standard models in economics
have the same prediction: the increase in life expectancy
over the 20th century had roughly the same impact on
economic welfare as the increase in nonhealth consumption
over the same period.
The fact that gains in life expectancy are approximately
as valuable as the gains in all other forms of consumption
starts to suggest an answer to why health spending
has grown so rapidly: because it is very valuable.
In some recent research, Hall and Jones (2004) have
considered this question in more detail. The authors
develop a model of optimal health spending, where individuals
face a tradeoff: they can spend their income on the
consumption of nonhealth goods, or they can spend their
income on health. By spending on consumption, people
increase the flow of utility they receive at a point
in time. By spending on health, people increase their
life expectancy, that is, the number of periods they
expect to live. Put simply, people face a choice between
adding additional months of life versus adding additional
consumption during a current month.
Now consider what happens when income grows over time,
as it has in the U.S. and other industrialized countries.
Consumption in every month increases along with income,
and health spending rises as well. But the key question
is: Does health spending rise faster than consumption?
It turns out that standard models predict that it should.
And the prediction is rooted in a central theme in
economics called the Law of Diminishing Returns. According
to this principle, the first $10,000 of consumption
is incredibly valuable, the next $10,000 less valuable,
and so on. The additional utility one gets by increasing
consumption falls as consumption rises. As people in
the United States and elsewhere get richer over time,
consumption rises, and the return to increasing consumption
falls.
Now consider the return to adding months of life.
Standard models in economics compute utility by simply
adding up the flows of utility over a lifetime. Adding
additional months does not run into the same diminishing
returns that increasing consumption within a month
encounters. As we get richer and richer, which is more
valuable: a third car, yet another television, more
clothing—or an extra year of life? The standard model,
then, predicts that while both consumption and health
spending should rise as income increases, health spending
should rise by more. The welfare maximizing share of
income going to health rises as income grows.
By estimating and simulating this model, the authors
produced possible paths for the health share over the
next 50 years. The simulations suggest that, while
the United States spends about 15% of its GDP on health
today, the utility maximizing health share may rise
to between 25% and 35% of GDP by 2050.
Conclusion
There are many facets to the public policy
debate on health care in the United States, and the
results of the research reported on in this Economic
Letter have implications for at least two of them.
One facet involves the concern about the possibility
of waste and fraud in the U.S. health care system and
the search for ways to deliver higher quality health
for each dollar that we spend. This is an admirable
goal, and it is important to note that nothing said
above is inconsistent with the search to reduce waste.
However, the analysis reviewed in this Economic Letter
also suggests that we should not necessarily be surprised
if health spending continues to grow even after we
eliminate inefficiencies in spending. As we get richer
and richer, one of the most valuable uses of our income
is to increase the quality and quantity of our remaining
lives. The other facet involves the looming issue of
funding Medicare and Medicaid (for more details, see
Jones 2003). As the analytical results make clear,
increased health spending is not likely to go away,
and, on the contrary, is more likely to become increasingly
important over time. New thinking—both by researchers
and by business people—will be needed in the coming
years as we seek to discover the best ways to finance
a rising health share.
Charles I. Jones
Professor of Economics, U.C. Berkeley, and Visiting
Scholar, FRBSF
References
Hall, Robert E., and Charles I. Jones. 2004. "The
Value of Life and the Rise in Health Spending." U.C.
Berkeley Working Paper (November).
Jones, Charles I. 2003. "The
Fiscal Problem of the 21st Century." FRBSF
Economic Letter 2003-27 (September 19).
Kaiser Family Foundation and Health Research and Educational
Trust. 2004. Employer
Health Benefits: 2004 Summary of Findings. Menlo
Park, California.
Newhouse, Joseph P. 1992. "Medical Care Costs:
How Much Welfare Loss?" Journal of Economic
Perspectives 6(3) (Summer) pp. 3-21.
Nordhaus, William D. 2003. "The Health of Nations:
The Contribution of Improved Health to Living Standards." In Measuring
the Gains from Medical Research: An Economic Approach,
eds. Kevin Murphy and Robert Topel. Chicago: University
of Chicago Press.
Suggested supplemental
reading
Cutler, David. 2004. Your Money or Your Life: Strong
Medicine for America's Health Care System NY:
Oxford University Press.
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