Health Economics

Health Economics: how economics is applied to health and healthcare

The field is also called healthcare economics or health care economics, although health economists distinguish the economics of health from the economics of healthcare. The economics of health covers everything that influences health, from income and education to behaviour, while the economics of healthcare concerns the services that prevent and treat illness. Because every health system has more possible uses for its resources than it can fund, choices have to be made, and health economics supplies the concepts and methods for making them explicitly. Bodies such as NICE use these methods to decide which medicines and devices the NHS in England should fund.

This article explains what health economics studies, why healthcare behaves differently from ordinary markets, and how the discipline is organised into its main branches. It then shows how the central idea of opportunity cost works in practice, the value judgements behind the methods, how health economics informs decisions such as those made by NICE, how much the world spends on health, and how the field developed.

What health economics studies

Early and recent definitions of the field agree closely. In 1958 Selma Mushkin offered a tentative definition that is still quoted: health economics is "a field of inquiry whose subject matter is the optimum use of resources for the care of the sick and the promotion of health." The US National Institutes of Health uses a similar definition that adds a second concern, how care, costs and health are distributed among individuals and groups in society.

Health economics is usually regarded as an applied field of economics. Victor Fuchs described it as drawing mainly on four traditional areas of economics: finance and insurance, industrial organisation, labour economics and public finance. In practice it covers a wide range of questions, including:

• how people value health and how health can be measured, for example with the quality-adjusted life year;
• what determines health, from lifestyle and income to medical care;
• how the demand for health and for healthcare arises, and how care is supplied;
• how healthcare is financed, through health insurance, taxation or direct payment;
• whether particular treatments and programmes are good value, through economic evaluation;
• how fairly health and healthcare are shared, the question of health equity.

Why healthcare is different from other goods

Much of health economics rests on a single observation: healthcare does not behave like an ordinary market good. Kenneth Arrow's 1963 paper "Uncertainty and the welfare economics of medical care" argued that the special economic problems of medical care can be explained as adaptations to uncertainty, both in whether a person will fall ill and in whether treatment will work. Arrow was explicit that his subject was the medical-care industry rather than health itself, since medical care is only one of many causes of health.

Arrow identified several features that set healthcare apart. The patient cannot test the product before using it, so the relationship depends on trust. The doctor usually knows far more than the patient about the likely consequences of treatment, an information asymmetry that gives rise to professional ethics, licensing and delegation of decisions to the doctor. Where markets fail to reach a good outcome, Arrow argued, non-market institutions arise to bridge the gap.

These features explain why market failure is a recurring theme in the field. Arrow also discussed moral hazard, when insurance cover changes how much care people use, and adverse selection, when a plan charging everyone the same premium is left with the higher risks. The doctor's role as the patient's agent raises the possibility of supplier-induced demand. Much of the design of health systems can be read as a response to these problems.

The main branches of health economics

A map of the discipline drawn by Alan Williams in 1987 is reproduced, with some editing, in the Handbook of Health Economics. It is known as the "plumbing diagram", and its arrows show the logical flow from one topic to another. Its four central boxes form the disciplinary engine room, and four further boxes are the main fields of application.

Box	Topic	What it covers
A	What health is and how it is valued	Measuring and valuing health
B	What influences health, other than healthcare	Genetics, occupation, consumption patterns, education, income and family background
C	Demand for healthcare	Why people seek care, a demand derived from the demand for health
D	Supply of healthcare	How hospitals, doctors and other providers produce care
E	Market analysis	How prices, waiting lists and quasi-markets allocate care
F	Microeconomic appraisal	Cost-effectiveness, cost-utility and cost-benefit analysis of alternative ways of delivering care
G	Planning, budgeting, regulation and monitoring	How well the instruments for running a health system work, including budgets, workforce planning, regulation and payment incentives
H	Evaluation at the whole-system level	Equity and allocative efficiency across the system, including comparisons between regions and countries

Box B is where Michael Grossman's 1972 model of the demand for health belongs. The Grossman model treats health as a durable health capital stock that people inherit, that depreciates with age and that can be increased by investment. It separates health, the output people value, from medical care, which is only one input into producing it. Box F is the home of cost-effectiveness analysis and cost-utility analysis, the part of the field most visible in decisions about new medicines.

Scarcity, opportunity cost and efficiency

The economic starting point is scarcity. Staff, time, facilities, equipment and knowledge are limited, so using them for one purpose means they cannot be used for another. The real cost of a programme is therefore its opportunity cost: the value of the benefits that could have been achieved with the same resources in the best alternative use.

Several kinds of efficiency follow from this idea. Technical efficiency means producing a given result with the fewest inputs, for example treating the same number of patients with fewer staff hours or bed days. Allocative efficiency means using resources on the mix of services that produces the most value overall. Health economics also asks whether an efficient allocation is fair, since the option that produces the most health may not share it in a way society considers acceptable.

Worked example: what the same budget could buy

The figures below are illustrative. A health service has £1 million to spend and two possible programmes. Programme A costs £40,000 for each quality-adjusted life year (QALY) it produces, and programme B costs £20,000 per QALY.

Programme	Cost per QALY	QALYs from £1 million
A	£40,000	1,000,000 ÷ 40,000 = 25
B	£20,000	1,000,000 ÷ 20,000 = 50

Spending the budget on programme A produces 25 QALYs, but the opportunity cost is the 50 QALYs that programme B would have produced, so choosing A means 25 fewer QALYs overall. This is the logic behind cost-effectiveness thresholds: a new treatment that costs more per QALY than the services it displaces reduces total health, even if it benefits the patients who receive it. Real decisions also weigh uncertainty, equity and other factors that this simple comparison leaves out.

The value judgements behind the methods

Health economic methods rest on choices about what counts as a benefit and whose costs count. The traditional welfarist approach judges options solely by the utility of the individuals affected, as judged by their own preferences, often measured through willingness to pay, which underlies cost-benefit analysis. The extra-welfarist approach, associated with Anthony Culyer and building on the work of Amartya Sen, treats health itself as the main outcome of a health system, which underlies cost-utility analysis using QALYs, the approach NICE uses in its reference case.

Other choices follow. The perspective of an analysis, whether a health system's budget or society as a whole, decides which costs are included, and a decision-maker may give extra weight to health gains for some groups, as NICE does for severe illness through its severity modifier. These are value judgements, and good practice is to state them openly.

How health economics informs decisions

Health economics is most visible in health technology assessment, where bodies decide whether a health service should fund a new technology. In England, NICE has a statutory duty to have regard to the broad balance between the benefits and costs of health and social care services, and under its methods manual (PMG36) committees assess clinical and cost effectiveness. The manual states that decisions must consider the implications for healthcare programmes for other patient groups that may be displaced by adopting the new technology, which is the opportunity cost described above.

The results are usually expressed as an incremental cost-effectiveness ratio, the extra cost per extra QALY gained compared with current care. Following the update to its manual on 31 March 2026, NICE normally bases its decision on the cost-effectiveness estimate when the most plausible ratio is below £25,000 per QALY gained. Between £25,000 and £35,000 per QALY gained, the committee's decisions refer explicitly to further factors such as uncertainty, uncaptured benefits and health inequalities, and above £35,000 it needs an increasingly strong case to recommend the technology. Other tools support different decisions: budget impact analysis addresses affordability, and value of information analysis asks whether further research is worth its cost.

How much the world spends on health

Health is one of the largest parts of most economies, which is why the efficient use of health resources matters. The World Health Organization reports that global spending on health was US$9.8 trillion in 2022, or 9.9 per cent of global GDP, the first fall in real terms since 2000. Spending is concentrated: high-income countries accounted for 79 per cent of the global total in 2022, and the United States alone for 43 per cent.

Among OECD countries, health spending was estimated at around 9.3 per cent of GDP on average in 2024, with the United States spending the most, at 17.2 per cent of its GDP. Large differences in spending between countries are themselves a subject of health economics, which asks what the extra spending buys in health.

A short history of the field

Health economics emerged as a distinct field in the second half of the twentieth century. Mushkin's 1958 paper set out its scope, and the editors of the Handbook of Health Economics describe Arrow's 1963 article as the classic starting point from which the modern field can be dated. Grossman's 1972 model of the demand for health gave the field its own theory of how people invest in their health.

The field then built its own institutions. The Health Economists' Study Group was founded in the United Kingdom in 1972 and describes itself as the oldest organisation of its type in health economics. The Journal of Health Economics published its first issue in 1982 and the journal Health Economics in 1992. The International Health Economics Association was formally founded in 1994. The Handbook's editors note that the field has contributed to mainstream economics in areas including the theory of human capital, outcome measurement and valuation, and the methods of cost-effectiveness analysis.

Health economics, health policy and public health

Health economics overlaps with several neighbouring fields. Health policy is concerned with the decisions governments and organisations make about health systems, and health economics supplies much of the evidence and reasoning behind those decisions, from how to pay hospitals to which treatments to fund. Victor Fuchs observed that policy-oriented research plays a major role in the field, and that many important policy-relevant articles appear in journals read by doctors and others directly involved in health.

Public health and health services research are close partners. Some major areas of research, such as cost-effectiveness studies and the determinants of population health, are multidisciplinary by nature and have led to integrated research teams with health economists at their centre. What health economics adds is a particular way of thinking: every choice has an opportunity cost, and the aim is the best use of limited resources across all patients.

Common misunderstandings

A common misunderstanding is that health economics is mainly about cutting costs. Its concern is value, getting the most health from the resources available. A health economic analysis can show that a more expensive treatment is worth funding, and a cheaper option is preferred only when the extra benefit of the dearer one is not worth its extra cost.

Another is that valuing health in money terms is a hidden or improper step. Cost-effectiveness thresholds, and in cost-benefit analysis the value of a statistical life, do attach money values to health gains. Doing so openly makes explicit the trade-offs that a fixed budget forces in any case, and decisions still weigh other considerations, including fairness and the needs of particular groups.

Sources

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