Demand Cross Elasticities and ‘Offset Effects’
J Glazer, Boston University, Boston, MA, USA, and Tel Aviv University, Tel Aviv, Israel
TG McGuire, Harvard Medical School, Boston, MA, USA
r 2014 Elsevier Inc. All rights reserved.
Glossary
Offset effects When use of one service ‘offsets’ or reduces
use of another.
Introduction
The typical analysis of health insurance and service use con-
siders coverage for a single aggregate commodity, ‘health care.’
It is natural to extend the analysis to more than one service,
raising a number of issues in health insurance design. Fun-
damentally, two covered services can be substitutes or com-
plements. ‘Offset effects,’ a term common in the empirical
literature, refers to the substitute case, when use of one service
‘offsets’ or reduces use of another. The main insight regarding
optimal insurance with multiple services is straightforward:
When one service substitutes for another covered service, the
increase in demand from insurance generates an efficiency
gain from the decreased use of the other covered service. The
reason for this is that the other service is itself insured and
therefore to a degree ‘overused.’ The under appreciated subtlety
in this result is the role of coverage for the ‘other’ service.
Without coverage and overuse, there is no efficiency gain/loss
with a change in demand for the other service. The role of
coverage emerges in the analysis of multiple services, and has
important implications for the way ‘offset effects’ should be
measured and interpreted.
Concern about multiple services and substitutability and
complementarity in insurance design need only be concerned
with relationships with other covered services. Other services,
if these are not part of the insurance plan even if they are
health care services, are irrelevant for questions of optimal
insurance. For example, suppose coverage for a certain pre-
scription drug for pain offsets use of over-the-counter an-
algesics. Because these are not insured, there is no inefficiency
associated with their use, and any ‘offset’ in the use of over-
the-counter drugs is irrelevant for insurance design.
Coverage for the ‘other good’ plays a role in the empirical
literature studying cross effects in demand. A large literature in
health economics and health services research tests for ‘offset
effects.’ The most active area for current research is on the cross
effect of coverage for prescription drugs. Drug coverage is
relatively new and variable. Furthermore, effective drug treat-
ment for many, particularly chronic illnesses, might reason-
ably be expected to prevent/offset the need for other forms
of care.
A related question is insurance coverage for ‘prevention,’
health care that affects the probability of illness. The argument
for coverage for preventive services is similar to the offset ar-
gument, and rests on the presence of coverage of the service
for the illness that would be prevented.
Encyclopedia of Health Economics, Volume 1 doi:10.1016/B978-0-12-375678-7.00803-8
Sufficient statistic In welfare analysis, when a sufficient
statistic is available, no data are informative about a welfare
effect.
The article begins with a brief review of some of the em-
pirical literature on offset effects, and then considers the issue
from the standpoint of welfare economics and insurance
design.
Empirical Literature Cross Elasticities
Much of the empirical research on cross elasticities in health
care has focused on drugs. Ellison et al. (1997) studied
cephalosporins, a class of anti-infectives, using IMS monthly
time series data from 1985 to 1991, and found significant
elasticities between some therapeutic substitutes. More re-
cently, Ridley (2009) investigated cross-price elasticities for
antiulcer drugs and drugs to treat migraines using data for 3
million people from a large pharmacy benefit manager (PBM)
in the early 2000s. He found large effects on demand when
drugs differed in the co-payment from other drugs in
their class.
A particularly interesting case of a cross elasticity has
emerged in statins, used to treat high cholesterol. In June
2006, the second largest-selling statin, Zocor, became available
as generic simvastatin. Statin drugs had very high sales. In
2004, Zocor was the fifth largest selling drug worldwide in
terms of dollar sales, and another statin, Lipitor, was the
worldwide leader among all drugs from any class greater than
$12 billion of sales annually. In response to the availability of
generic simvastatin, managed care plans moved Lipitor to
higher (less favorable) tiers (Aitken et al., 2008 p. W157). One
PBM moved Lipitor to tier 3 in January, 2006 in anticipation
of generic simvastatin, and saw more than 40% of patients
switch from Lipitor to a lower-tier statin (Cox et al., 2007).
Among those with co-payment differences of $21 or more,
80% switched.
It is typical in this literature to measure the ‘offset effect’
by the effect on total spending not just covered or plan
spending on the ‘other service.’ For example, Shang and
Goldman (2007) use Medicare Current Beneficiary Survey
(MCBS) data from 1992 to 2000 to show that extra spending,
measured by plan plus consumer medical costs, on drugs use
induced by Medigap coverage, is more than offset by re-
ductions in total health care spending. Hsu et al. (2006)
compared medical spending for Medicare beneficiaries with a
cap on drug coverage to those without a cap at Kaiser Per-
manente of Northern California before Medicare Part D.
Drug spending was 28% less in the capped group but other
155
156 Demand Cross Elasticities and ‘Offset Effects’
categories of expenditures were higher and total spending for
all care was not significantly different between the groups,
implying a near dollar-for-dollar offset in total costs. Gaynor
et al. (2007) studied the effect of increases in co-payments
charged for drugs among private employees on total (plan
plus consumer) spending. Increases in nondrug spending,
largely in outpatient care, offset $0.35 of each dollar saved in
drug costs. An exception to the singular focus on total
spending is the paper by Chandra et al. (2010), finding that
the savings in costs due to higher co-payments for drugs were
partly offset by higher spending on hospital services among
retired state employees in California. They tracked offsets by
payer because a primary (Medicare) and secondary (em-
ployer-provided supplemental) shared in offsets unequally.
Approximately 20% of the cost savings from higher cost
sharing for physician services and drugs was ‘offset’ by higher
costs of hospitalization overall, with the offset concentrated
among those with a chronic illness. Interestingly, as the
authors point out, in the CalPERS case, this offset largely
takes the form of a negative fiscal externality from the Cal-
PERS supplemental policy (which saves from the elevated co-
payments) to Medicare (which pays most of the costs of
hospitalization).
The implicit logic in offset papers is that if total medical
costs fall due to an increase in coverage, then the change in
coverage is welfare improving (i.e., ‘pays for itself’). This article
argues that change in total medical spending, meaning the
sum of plan and patient out-of-pocket spending, is not the
right measure of the economic value (or cost) of a change in
insurance coverage due to offset effects. Rather, changes in
health plan costs alone measure the economic value of savings
due to reductions in the use of other services. Applying
methods reviewed by Chetty (2009) and Glazer and McGuire
(2012) showed that a ‘sufficient statistic’ for evaluating the
welfare effect of change in coverage for one that is good is the
change in total plan-paid costs less the change in costs trans-
ferred to/from consumers. They derived an elasticity rule for
when the offset effects of an improvement in coverage in-
creases welfare.
A simple argument shows why total costs are not the right
welfare measure of an offset effect. Suppose the plan covers just
one service, ‘health care,’ and an increase in coverage of health
care increases a consumer’s total expenditures on health care.
The consumer budget constraint implies that spending on some
other noncovered services has to fall. This ‘offset’ says nothing
about efficiency because coverage expansions are always exactly
‘offset’ in this trivial sense. What if the other affected spending
were on another form of health care that was minimally cov-
ered in the plan, say for 1% of costs with consumers paying
99%? Logically, token coverage cannot imply that the full
spending change as an offset should be counted.
A Model of Offsets in Health Insurance
Suppose a health plan covers services 1 and 2. Quantity of
each received by a representative individual in the plan is x1
and x2 measured in dollars. Benefits to the individual are
B(x1,x2), where BiZ0, Biio0, i ¼ 1,2, with subscripts indicating
partial derivatives. Letting ci denote the co-payment charged
for each unit of service i, then the individual demands service i
to satisfy:
Bi ðx1 ,x2 Þ ¼ ci i ¼ 1,2 ½1
Let R denote the plan premium paid by the enrollee. As-
suming the plan makes zero profit, the premium is
Rðc1 ,c2 Þ ¼ ð1  c1 Þx1 þ ð1  c2 Þx2 ½2
where (x1,x2) are given by eqn [1].
The individual’s total utility from the plan is thus
U ðc1 ,c2 Þ ¼ Bðx1 ,x2 Þ2c1 x1 2c2 x2 2Rðc1 ,c2 Þ ½3a
where (x1,x2) are from eqn [1] and R is from eqn [2].
Substituting for R to recognize that the individual pays for
services by a combination of the cost sharing and the
premium:
U ðc1 ,c2 Þ ¼ Bðx1 ,x2 Þ2x1 2x2 ½3b
Consider now what happens to utility (welfare) eqn [3b] if
the plan were to change the co-payment for service 2:
q Uðc1 ,c2 Þ q x1 q x2
¼ ðB1  1Þ þ ðB2  1Þ
q c2 q c2 q c2
q x1 q x2
¼ ðc1  1Þ þ ðc2  1Þ ½4
q c2 q c2
The second equality follows from eqn [1].
Suppose co-payment for service 2 is reduced. If
q x1 =q c2 40, there is an offset effect and consumption of x1
falls with this change. What happens to welfare? Equation [4]
tells us how to value the offset. Reversing the sign of eqn [4] to
get an expression in terms of plan shares, when co-payment
for service 2 goes up (down), utility of the individual goes up
(down) if and only if eqn [5] holds:
2 3
6 q x1 q x2 7
4ð1  c1 Þ þ ð1  c2 Þ 5o0 ½5
q c2 q c2
Offset effect Own-price effect
The intuition for this result is the following: The second
term on the left-hand side of the inequality captures the
inefficiency in consumption induced by the reduction in co-
payment for service 2. With health insurance, the marginal
benefit of health care is less than the marginal cost
(B2 ¼ c2o1), and the extra consumption of x2 due to the
reduction in co-pay creates additional welfare loss. In the
conventional analysis of optimal health insurance, this
welfare loss is weighted against the risk spreading gain to
find the optimal co-payment, c2. The first term on the left-
hand side in eqn [5] is the offset effect due to the change in
consumption (in this case reduction) of x1. Just as with the
own-price effect, benefits and costs both matter in valuing
welfare of any offset effect. The 1ðq x1 =q c2 Þ part is the re-
duction in total cost from the change in x1 and, because
B1 ¼ c1, the c1 ðq x1 =q c2 Þ part is the loss in benefits. Thus,
the net welfare measure of offset effects is plan’s savings:
ð1  c1 Þq x1 =q c2 :
Changes in (consumer’s) welfare to changes in plan costs
can now be related. From eqn [2] it is known that when co-
payment for service 2 changes, the change in the plan costs is

given by
q Rðc1 ,c2 Þ q x1 q x2
¼ ð1  c1 Þ þ ð1  c2 Þ  x2 ½6
q c2 q c2 q c2
Equation [4] for changes in welfare, and eqn [6] for
changes in plan costs, are the same except for the presence of
x2, the cost shifting effect of a change in c2, a transfer ultim-
ately paid by the consumer in any case. Using eqns [4] and [6]
a rule for a welfare change, in terms of changes in plan-paid
costs, can be stated.
Rule for Welfare Effects
The welfare effect of a change in coverage is equal to minus the
change in plan costs net of the cost-shifting effect of the cov-
erage change.
Proof. From eqns [4] and [6] the result is
q Uðc1 ,c2 Þ q Rðc1 ,c2 Þ
¼   x2 ½7
q c2 q c2
This rule for welfare effects constitutes, in Chetty’s (2009)
term, a ‘sufficient statistic’ for welfare evaluation of health
insurance changes. The measure, change in plan costs less cost
shifting, is equal to the welfare change, and thus yields an ‘if
and only if rule’: Welfare goes up if and only if plan costs less
transfers go down.
The rule brought out in this article can be used to interpret
the existing logic of the offset literature which focuses on total
costs, plan paid plus patient paid, and concludes that an im-
provement in coverage for good 2 is worthwhile if it ‘pays for
itself’ in savings on good 1. Consider a reduction in c2 that
decreases use of covered good x1 (an offset effect). Suppose the
improvement in coverage for x2 ‘pays for itself’ in the sense
that the reduction in the total cost of x1 exceeds the increase in
plan costs for x2. This rule tells us that this condition is neither
necessary nor sufficient for an increase in welfare. It is not
necessary because the cost-shifting effect of the change in c2 is
disregarded for welfare. It is not sufficient because it is not
total costs that measure the value of the offset, but plan-paid
costs. Instead of looking for a coverage improvement to ‘pay
for itself,’ the following simple rule, expressed in terms of
demand elasticities for when an improvement in coverage
improves welfare via an offset effect, is proposed.
A Simple Rule for When Offsets Increase Welfare
Welfare goes up with a decrease in c2 (improvement in cov-
erage) when the partial derivative in eqn [4] is negative, or
alternatively
q x1 q x2
ð1  c1 Þ 4  ð1  c2 Þ ½8
q c2 q c2
Putting this in elasticity form and dividing through by – e22
(a positive number), the criterion for a welfare improvement
with a decrease in c2 becomes
e12 ð1  c2 Þx2
 4 ½9
e22 ð1  c1 Þx1
Demand Cross Elasticities and ‘Offset Effects’ 157
In eqn [9], e12 is the cross and e22 is the own-price elasticity
with respect to c2. The RHS of eqn [9] is positive and equal to
the ratio of plan paid costs for service 2 to service 1. The
following rule can now be stated: For a decrease in c2 to im-
prove welfare, the goods must be substitutes (e1240); and the
ratio of the absolute values of the cross to the own-price
elasticity must exceed the ratio of the plan paid costs for the
two services.
The offset rule for welfare is simple to apply. Suppose it is
known that the own-price elasticity of drugs is  1.0 and the
cross-price elasticity for hospital services is þ 0.2. If the
plan paid drug costs are less than 20% of the plan-paid hos-
pital costs, an improvement in coverage for drugs improves
welfare.
Attention to plan rather than total cost can change the
tenor of the policy implications of offset effects, particularly
for drug coverage where plan shares are relatively small.
Turning to some results in significant recent offset papers il-
lustrates the quantitative importance of the plan-cost per-
spective. Comparing the change in total costs for drugs and
hospitals, Chandra et al. (2010, p. 208) found that a decrease
in coverage for drugs reduced total drug costs by $23.06 per
member per month, but increased total hospital costs by only
$7.23 – the offset amounted to only a 1:3 ratio of hospital cost
increases to drug cost savings, and in the authors’ judgment
was ‘unlikely to be enough’ to reverse the perceived value of
the co-payment increase. However, taking the plan rather than
total cost perspective it can be said that because drugs are
covered at roughly 50% and hospital cost at 100%, the offset
ratio doubles, to approximately 2 to 3. It should be noted here
that the California change studied in Chandra et al. (2010)
also involved increases to outpatient co-pays, which are ig-
nored in this illustrative example. These increases also saved
money, making the offset ratio 1:5. By ignoring this other
benefit change in this discussion, it is, in effect, assumed that it
is the drug coverage change that causes the offset.
Final Comments
In applied policy research, offset effects played an important
role in the discussion about the design of optimal health in-
surance for mental health treatment, and more recently they
do so in the case of coverage for drugs. Most public and private
plans cover drugs, but the coverage is partial in the sense that a
drug formulary typically excludes many drugs, and for those
drugs that are covered, the percent paid by the plan is much
less than for other health care services. Interestingly, the co-
payment for generic drugs is often so high that it exceeds
the acquisition cost to the health plan. The ideas in this article
about valuing offset effects have the most current direct ap-
plication to the question of coverage for drugs. If health
insurance markets worked perfectly, competition would maxi-
mize welfare of the representative consumer, implying the
efficiency issues discussed here would be taken care of in
competitive equilibrium. Health insurance markets are fraught
with sources of market failure, however, such as moral hazard,
adverse selection, imperfect competition, externalities due to
the participation of multiple insurers, as well as concerns
about equity. In many cases there can be little assurance that
158 Demand Cross Elasticities and ‘Offset Effects’
market forces alone will lead to optimal coverage, leaving a
role for calculations of the type illustrated here.
The major limitation of this rule for offsets and model
setup generally, stems from the assumption that quantity is
determined by the equality of marginal benefit to the con-
sumer/patient and patient co-payment. Although the standard
demand model is widely applied in theoretical and empirical
health care research, it is also seriously questioned as a basis
for describing the outcome of patient–provider interactions.
Effective physician agency on behalf of the patient would be
consistent with this approach, but it is acknowledged that the
marginal benefit–marginal cost equality is still a strong as-
sumption. Relatedly, health economists doubt whether con-
sumer demand should be interpreted as marginal benefit
when assessing the efficiency of changing coverage. Per-
spectives from ‘value-based insurance design’ and behavioral
economics both question the conventional welfare framework
for assessing the efficiency cost of added coverage for a service.
See also: Efficiency in Health Care, Concepts of. Evaluating
Efficiency of a Health Care System in the Developed World. Resource
Allocation Funding Formulae, Efficiency of. Value-Based Insurance
Design
References
Aitken, M., Berndt, E. and Cutler, D. (2008). Prescription drug spending trends in
the United States: Looking beyond the turning point. Health Affairs 28(1),
W151–W160.
Chandra, A., Gruber, J. and McKnight, R. (2010). Patient cost-sharing,
hospitalization offsets in the elderly. American Economic Review 100(1),
193–213.
Chetty, R. (2009). Sufficient statistics for welfare analysis: A bridge between
structural and reduced-form methods. Annual Review of Economics 1, 451–487.
Cox, E., Klukarni, A. and Henderson, R. (2007). Impact of patient and plan design
factors on switching to preferred statin therapy. The Annals of Pharmacotherapy
41, 1946–1953.
Ellison, S., Cockburn, I., Grilichres, Z. and Hausman, J. (1997). Characteristics of
demand for pharmaceutical products: An examination of four cephalosporins.
RAND Journal of Economics 28(3), 426–446.
Gaynor, M., Li, J. and Vogt, W. B. (2007). Substitution, spending offsets, and
prescription drug benefit design. Forum for Health Economics and Policy 10(2),
1–31.
Glazer, J. and McGuire, T. G. (2012). A welfare measure of ‘offset effects’ in health
insurance. Journal of Public Economics 96, 520–523.
Hsu, J., Price, M., Huang, J., et al. (2006). Unintended consequences of caps on
Medicare drug benefits. New England Journal of Medicine 354(22), 2349–2359.
Ridley, D. (2009). Payments, promotion and the purple pill. Fuqua School of
Business, Duke University, unpublished.
Shang, B. and Goldman, D. P. (2007). Prescription drug coverage and elderly
medicare spending, NBER working paper 13358. Available at: http://
www.nber.org/papers/w13358 (accessed 26.07.13).
Further Reading
Duggan, M. (2005). Do new prescriptions pay for themselves? The case of second-
generation antipsychotics. Journal of Health Economics 24(1), 1–31.
Gibson, T. B., Mark, T. L., Axelsen, K., et al. (2006). Impact of statin copayments
on adherence and medical care utilization and expenditures. American Journal of
Managed Care 12, SP11–SP19.
Goldman, D. P., Joyce, G. F. and Karaca-Mandic, P. (2006). Varying pharmacy
benefits with clinical status: The case of cholesterol-lowering therapy. American
Journal of Managed Care 12(1), 21–28.