Health Spending and Medical Innovation: A Theoretical Analysis

The aim of this paper is to explain an empirical fact by economic models. The fact is that there is a tendency for the share of health spending in GDP to rise. This paper asserts that the fact is partly due to medical innovation. The novelty of models is the explicit incorporation of hospital and doctors who treat patients, with the rise in the parameter of the illness treatment function defined as the medical innovation. Under the monopolistic case, the share always rises, while under the competitive case, it declines for the advanced medical society with a high parameter value; it rises for the basic medical society depending on the ratio between healthy and sick workers, and it rises for the backward medical society with a low parameter value. The theoretical ambiguity of assertion is partly removed by the empirical fact of the monopolistic tendency in the US medical sector. As by-products of this formulation, the emergence of moral hazard and adverse selection is discussed theoretically, where medical insurance—discount of sick workers’ medical fee—is procured as a subsidy from healthy workers to them. Moral hazard and adverse selection emerge depending on the parameters of the models.