DEMAND FOR MEDICAL CARE: Evidence of the impact of ‘reference health’

How much medical care people choose to consume is influenced not just by their current health but also by the level of health to which they become accustomed – their ‘reference health’. That is the conclusion of research on Americans’ demand for healthcare by Matt Harris of the University of Tennessee and Jennifer Kohn of Drew University.

Their study, published in the November 2018 issue of the Economic Journal, finds that the level of health to which individuals are accustomed is roughly half as important as their current health in explaining why they consume medical care. In other words, while poor health matters, the path to poor health matters too.

Perhaps more importantly from a policy perspective, programmes such as healthy ageing initiatives that slow the trajectory of health decline, are significantly undervalued if we ignore the effect of reference health. These programmes can provide value to society not just by keeping people healthy for longer, but helping people avoid large sharp drops in their health.

The researchers note that the United States spends more than $3 trillion per year on medical care, but expenses are not evenly distributed over the population. A mere 5% of people incur about half of all medical care spending. Obviously people in poor health tend to consume more medical care than healthy people, but high spenders are not all old and sick.

In fact, fewer than 20% of high spenders report poor health, and of those with poor health the top 5% still account for 40% of spending. Why? It turns out that determining who the heavy consumers of healthcare are is not that simple.

The central tenet of economics is that individuals try to make themselves as happy, or well off, as they can, subject to the limitations they face. In understanding why individuals consume more or less healthcare, economists care not just about individuals’ health, but how people feel about their health.

Harris and Kohn’s work is the first in economics to consider that habituation to a certain level of health may affect the way people feel about their health today, and therefore affect the decisions they make – including how much healthcare to consume.

The idea of habituation or ‘reference dependence’ has been studied in finance, but this is the first time that the concept has been applied to health. For a financial example of why habituation may affect choices, suppose a person wakes up with a net worth of €2 million. Most people would be exuberant, and may open up their wallets a bit. But the Warren Buffetts or Richard Bransons of the world would feel very differently about this state of affairs and would be likely to tighten their belts while looking to recover.

Therefore, for a given current level of wealth, persons with different reference points for wealth will feel – and act – very differently. An analogous example for health might involve a person currently walking with a limp. That person might feel very differently about this state of affairs if she was previously an elite athlete versus if she was previously bed-ridden.

The new findings indicate that helping people age gradually will generate cost savings by making people less likely to be among the 5% at the deep end of the pool of medical care consumption. Cost-benefit analyses that do not take the role of reference health into consideration may understate the benefits of programmes like healthy ageing initiatives by as much as half, thereby leading to underinvestment.

The new study also has implications for how, and how much, households and society at large save for lifetime healthcare expenses.

Reference Health and the Demand for Medical Care’ by Matt Harris and Jennifer Kohn is published in the November 2018 issue of the Economic Journal.