Stuart Birks

Centre for Public Policy Evaluation

Massey University

Palmerston North

Phone: 06-350-5799 X2660

Fax: 06-350-5660

Email: K.S.Birks@massey.ac.nz

Introduction

The example described in this paper was first used with post-graduate economics and social policy students at Massey University. We have subsequently conducted the exercise in several situations, including in-house training for policy analysts at the Ministry of Health. We found it to be useful for demonstrating several economic phenomena in a way that is not daunting for the non-specialist, while also providing practical applications for economic theorists.

In general, it is useful to consider a problem from the diverse viewpoints of the various participants. The use of an example that is not drawn from the health sector is also useful for those familiar with the sector as it avoids preconceived ideas. It may be that people become locked in to a particular understanding or hold prior assumptions/beliefs/expectations/prejudices with familiar structures. Consideration of an alternative situation is a common lateral thinking tool to give fresh insights. This is what we attempt to do here.

How to do the exercise

This can be run as an interactive group exercise.

1. Call for a couple of volunteers or select two people to run an imaginary restaurant. (The rest will be customers.)
2. Ask the group to suggest a range of items for the restaurant menu, including prices. Children's prices are also allowed. Ensure that there is a range of options over courses and prices. About 10 items would be sufficient. Write the menu on a board.
3. Ask each of the customers whether they represent an individual, a couple, a family, or some other group. Then ask each in turn what they would purchase from the menu. Write their responses on the board.
4. Now tell the restaurateurs that they are going to offer a smorgasbord option whereby, for some set price, customers can have as much as they want of the items from the menu. Customers would still be able to order from the menu if they wish. The problem is to decide a suitable price to charge. There can be different prices for adults and children.
5. Now ask the customers what they would do. If someone represents more that one person, they can have say one person buying from the menu and others taking the smorgasbord. Note down what everyone would take, including the items taken by those choosing a smorgasbord.

What might be observed

Commonly we see all or some of the following behaviours by consumers:

·        "Big eaters" are more likely to choose a smorgasbord.

·        People choosing a smorgasbord are likely to eat more than they would have done otherwise.

·        People choosing a smorgasbord are likely to choose more of the more expensive items on the menu.

The restaurateurs are likely to act as follows:

·        In setting the smorgasbord price, they may start with an average expenditure by diners. They may choose to price somewhere above the average.

·        They may wish to alter the menu by:

o       Removing or restricting consumption of some of the more expensive items;

o       Putting out smaller pieces so that people take less;

o       Including low-cost "filler" items that reduce people's ability to consume other things.

Economic Interpretation:

The Problem

The main point to make is that with a smorgasbord, additional food has a zero price at the point of consumption. Economists realize that in this situation, customers will continue to consume food up until extra portions no longer provide them with additional satisfaction (the marginal utility of the last portion consumed is zero). There are many parallels to this situation in society, but the main goal is to apply the smorgasbord situation to insurance in health care markets. With the smorgasbord option, the major implications are:

·        The customers are likely to consume more food than at an a la carte setting.

·        Customers will concentrate on the more expensive items as the effective price reduction is greater.

Thus in setting the fixed smorgasbord price(s), these factors should be taken into account. Often our restaurateurs, as mentioned above, overlook these economic principles.

Responses by restaurateurs

Once the restaurant owners realize that they are making losses, which often occurs given their original pricing strategy, any number of additional options have been suggested:

·        Deleting more expensive items from the smorgasbord or limiting consumption in other ways.

·        Including low cost ‘filler items’, or changing the size of portions so that people consume/waste less.

·        Changing the smorgasbord price. This might be in terms of a higher entry fee, differentiating price as to age, making some items a la carte, or some other adjustment. A two-part tariff was once suggested where a fixed fee was paid to enter the restaurant after which smorgasbord items could be purchased at less than full cost. There could be extra items which will be consumed although not included in the smorgasbord, such as drinks for which people pay. These could be relatively highly priced.

Consumer reaction

The consumers may modify their behaviour once the restaurateurs have addressed their strategy:

·        Some may choose not to purchase the smorgasbord (entry fee outweighs the expected benefit).

·        However those who consume the most (the big eaters) are still likely to choose the smorgasbord option.

This latter is the problem of adverse selection, where there is an imbalance of information between buyer and seller. Only the buyers know how much they will eat, and although the restaurateur might have suspicions about the type of customer that would be attracted, there is still uncertainty as who might be willing to pay a higher price.

Parallels with the Provision of Health Care:

Moral hazard

The purpose of the interactive exercise with the smorgasbord has been to bring out the problem of moral hazard, insurance and health care in our courses in Health Economics. In the USA, it is argued that moral hazard has played a major role in cost inflation in the health area. The idea is that if health care is left to market forces, and insurance is present, the result will be excess consumption of health care. As in the smorgasbord case, comprehensive health care insurance cover (with no co-payments) lowers the price at point of service to zero. Since demand depends at least partially on price, more will be consumed than if there were no charge. The patient might stay in hospital an extra day or two to be on the safe side. The same might apply to GP visits or the use of prescription drugs.

Medical insurance itself changes the economic incentives that individuals face. The individual may recognize that overuse will increase insurance premiums, but the insured individual has little incentive to limit use. The individual's behaviour affects only a fraction of total insurance cost, and if the individual curtails use, cost savings are spread mainly to other policy holders. Yet benefits of additional use to the individual are great. This is similar to the smorgasbord example.

Once insurance companies see what is happening, their dilemma is much like the one that confronted our restaurateurs. Additional options, which include new pricing strategies, are needed to keep insurance companies from losing money in the health care area.

New strategies

Most discussions on moral hazard consider that the problem of excess consumption can be reduced through either coinsurance or deductibles. Coinsurance means that each insured patient must pay a certain fraction of each dollar of health costs (say 25%). Thus the consumer faces a positive price less than the market price, and the higher the fraction, the less health care that is consumed. This would equate with the two-part tariff example suggested in the smorgasbord.

A deductible is the exclusion of a certain amount of the expense from the insurance cover. This might mean that the first  $100 of any insurance charge is paid by the consumer.  Insurance companies practice other options, including not providing cover for certain ailments. This is similar to leaving out certain dishes, especially the expensive ones, from the smorgasbord.

This analysis can be applied to New Zealand. In the case of New Zealand’s earlier public hospitals (pre-reform), we simply replace insurance companies with the State. The care then is provided by the State at zero cost, funded out of tax receipts. Under that system individuals might have been seen as consuming excess health care and thus contributing to escalating health costs in New Zealand. This is an argument put forward to justify co-payments.

We could speculate further be considering how restaurant behaviour may differ if there are several competing restaurants. Under these circumstances restaurants may include specialist dishes so as to distinguish themselves from their competitors. Similarly, competing health insurance companies may offer specialist treatments. This can raise costs overall.

We may also observe non-price allocation methods in both restaurants and health care. Hence someone may be cutting and serving the meat in a restaurant, and there may be an approval mechanism for hospital treatment. High cost items may not be offered and a limited range of choices may be made available. One restaurant option can be expensive add-ons, such as drinks which are charged for in addition to the basic price of the meal. There may be parallels in health care, such as additional room service in private hospitals.

We should be careful not to stretch the restaurant-healthcare analogy too far. There may be some differences between the restaurant example and the case of health care.

People go into a restaurant knowing that they want to eat. They do not purchase health insurance knowing that they will need treatment, or how extensive the treatment might have to be. There are equity issues with health care which would not apply to restaurants. This ties in also with the issue of public versus private provision.

Lessons learned

We hope that this example has demonstrated that economics is not such a mystery. Using a familiar situation and basic economic principles we have been able to indicate some of the problems involved in designing an appropriate health care delivery system. We must be careful not to stretch an analogy too far, but certainly in this instance there are many useful similarities.