Another steak or another year of life? Consumption choices and the rise in health spending

Americans currently spend about 15 percent of gross domestic product (GDP) on health care, but new research is projecting that by 2050, we'll be spending more than 30 percent of our income on health. "It's true that the Congressional Budget Office's long-range forecast shows the deficit exploding due to health spending that's increasing faster than GDP," said economist Charles Jones of the University of California, Berkeley. "But before we think about what the solution is, understanding why health shares are rising is a critical ingredient."

Americans currently spend about 15 percent of gross domestic product (GDP) on health care. By 2050, it is projected that we'll spend more than 30 percent of our income on health — and that may be a good thing. That was the message delivered by University of California, Berkeley Economics Professor Charles Jones in a recent presentation at the 18th Annual Health Economics Conference, hosted by the School of Health Management and Policy at the W. P. Carey School of Business.

According to Jones, the United States devoted 5.2 percent of GDP to health care in 1950, 9.4 percent in 1975, and 15.4 percent in 2000. At the same time, life expectancy has increased; life expectancy at birth was 68.2 years in 1950, 72.6 years in 1975, and 76.9 years in 2000. "A lot of people think we spend too much on health care," Jones admitted.

But in the research paper he presented, "The Value of Life and the Rise in Health Spending," published in February, 2007 in The Quarterly Journal of Economics, Jones and his co-author, Stanford Economics Professor Robert Hall, offer a different view. "The big lesson, which is counter to the way a lot of people think about it, is that we ought to appreciate the fact that life is incredibly valuable and we may want to spend 30 percent of GDP in another 50 years on health care — that may be the right thing to do," Jones said.

How to pay for that increased spending on health care, Jones suggested, is a question better asked after we understand why spending on health care is increasing. "It's true that the Congressional Budget Office's long-range forecast shows the deficit exploding due to health spending that s increasing faster than GDP," Jones said. "But before we think about what the solution is, understanding why health shares are rising is a critical ingredient." (Health share is the portion of our income that we spend on health care.)

One more steak or another year of life?

"Over the past half century, Americans spent a rising share of total economic resources on health and enjoyed substantially longer lives as a result. Debate on health policy often focuses on limiting the growth of health spending. We investigate an issue central to this debate: Is the growth of health spending a rational response to changing economic conditions — notably the growth of income per person?" write Jones and Hall.

To investigate whether the growth in health spending is a rational response to growing incomes, Jones and Hall look at the choices we make between spending on health and spending on all other forms of consumption together — houses, education, cars, TVs, and food, for example.

"In the model, the key decision is the division of total resources between health care and non-health consumption. Utility depends on quantity of life — life expectancy — and quality of life — consumption. People value health spending because it allows them to live longer and to enjoy better lives," write Jones and Hall. (In economics, utility is the satisfaction a consumer receives from a given level and form of consumption.)

One factor that affects the choice between health spending and spending on other types of consumption is an economic principle called diminishing marginal returns. When a type of consumption is subject to diminishing marginal returns, the utility we receive from consuming more of the good declines with each additional unit of good that we consume. (Marginal returns — compared to total returns — are those benefits generated by one additional unit.)

Both health spending and consumption are subject to diminishing marginal returns, Jones said. "There's a race between declining marginal returns on consumption and declining marginal returns on heath spending." The key, he said, is how rapidly each declines. If the marginal benefits to consumption decline more quickly than the marginal benefits to health spending, then we see a rising share of our income spent on health care rather than other types of consumption.

The marginal benefits to consumption do decline relatively quickly, Jones said. "As we get richer we can eat one steak dinner a day, and then as we get even richer we can eat steak for lunch and dinner, then steak for breakfast, lunch, and dinner. But as we get richer and richer our consumption of steak dinners experiences diminishing returns — we can only eat so many steak dinners in one day. The way we increase our utility is by adding more days onto our lives on which we can eat steak dinners." And we add more days onto our lives by spending money on health care.

The marginal benefits of health spending decline, too, as we spend more and more on health. The first $100,000 we spend, for example, to cure cancer, benefits us greatly, but the next $100,000 we spend, perhaps to cure less dangerous ailments, doesn t benefit us quite as much, and the next $100,000 even less than that, and so on until we re spending $100,000 for very minor gains in health status.

Jones finds empirical evidence that the benefits of consumption decline more rapidly than the benefits of health spending. The richer we get the greater percentage of our income we devote to health care spending relative to other types of consumption because the value of an additional month of life is greater than the value of an additional unit of consumption — and that's because the benefits of health spending diminish more slowly than the benefits of consumption.

The crux of the argument, write Jones and Hall, is that the marginal benefits to consumption fall relative to the marginal benefits of health spending as income rises — and that causes us to spend a greater share of our income on health. "The basic intuition for a rising health share emerges clearly," the authors write. "The health share rises over time as income grows if the marginal utility of consumption falls sufficiently rapidly relative to the joy of living an extra year and the ability of health spending to generate that extra year."

Technological change as a driver of increasing health spending

But some economists argue that rising shares of income devoted to health spending can be explained by increasingly expensive medical technology. "When we started our work, we found from the existing literature that the conventional wisdom was that the increasing health share was due to technological change," Jones said.

His explanation — that health shares rise because marginal benefits of consumption decline more quickly than the marginal benefits of health spending — is complementary to the technological change explanation, but sheds additional light in a number of ways, Jones said. "We need to ask ourselves why we need to use these new technologies, and why we invent them in the first place."

Some economists suggest that health insurance distorts the true cost of technologies, so we invent and use more expensive technologies than we would without health insurance. But, Jones said, there are lots of countries that are more disciplined about what kinds of medical technologies people can buy, and health shares are rising there, too. "If life is increasingly valuable, we want to invent and use new technologies that will help us live longer." That, Jones said, explains why the share of our income dedicated to health spending is rising.

The path of health spending over time

Plotting their model estimates of optimal health share against actual health care spending as a share of GDP, Jones and Hall find not only that optimal health share increases — as actual health share does — but also that optimal health shares are substantially higher than actual health shares.

In 2000, for example, the actual health share was just over 15 percent. The modeled optimal share ranged from a low of about 20 percent to a high of about 25 percent (the range accounts for a number of different parameters the authors consider). By 2050, modeled optimal health share ranges from 23 percent to 45 percent. "Viewed from every angle, our results support the proposition that both historical and future increases in the heath spending share are desirable," the authors write.

How to accommodate rising health shares

Jones suggested that his work may have important policy implications in the future. Increased health spending, he said, "requires very different institutions and very different ways of financing than we have today — and that's going to be an important problem in the future."

"We believe it likely that maximizing social welfare in the United States will require the development of institutions that are consistent with spending 30 percent or more of GDP on health by the middle of the century," write Jones and Hall. After all, we can only eat so much steak, but our desire for longer, healthier lives is as timeless as our search for the Fountain of Youth.

Bottom line

• Americans currently spend about 15 percent of gross domestic product (GDP) on health care. By 2050, it is projected that we ll spend more than 30 percent of our income on health.
• Health spending is a rational response to the growth of per-capita income.
• As we become richer, an additional year of life is more valuable than an additional unit of material consumption.
• Technological change is not the cause of rising health shares, but a result of the increasing value of life.
• Increased spending on health care will require the development of different institutions and ways of financing health care.