Overview
Health Economics
IHM & MPH 2011-2012
2011-2012
Please note that this document gives only an overview of the main concepts seen during the course.
Its aim is NOT to cover all topics but to give you an overview of the course. By no means are the
concepts excluded less important than the ones in this document. For assessment purposes you
should cover all the material covered during the lectures.
Principles of Economics
o
The fundamental lessons about individual decision making are that people face trade-offs among
alternative goals, that the cost of any action is measured in terms of forgone opportunities, that
rational people make decisions by comparing marginal costs and marginal benefits, and that
people change their behavior in response to the incentives they face.
o
The fundamental lessons about interactions among people are that trade and interdependence
can be mutually beneficial, that markets are usually a good way of coordinating economic activity
among people, and that the government can potentially improve market outcomes by remedying
a market failure or by substituting the market.
Thinking Like an Economist
o
Economists try to address their subject with a scientist's objectivity. Like all scientists, they make
appropriate assumptions and build simplified models to understand the world around them. One
simple economic model is the production possibilities frontier.
o
The field of economics is divided into two subfields: microeconomics and macroeconomics.
Microeconomists study decision making by households and firms and the interaction among
households and firms in the marketplace. Macroeconomists study the forces and trends that
affect the economy as a whole.
o
A positive statement is an assertion about how the world is. A normative statement is an assertion
about how the world ought to be. When economists make normative statements, they are acting
more as policy advisers than as scientists.
o
Economists who advise policymakers offer conflicting advice either because of differences in
scientific judgments or because of differences in values. At other times, economists are united in
the advice they offer, but policymakers may choose to ignore it.
The Theory of Consumer Choice
o
A consumer's budget constraint shows the possible combinations of different goods he can buy
given his income and the prices of the goods. The slope of the budget constraint equals the
relative price of the goods.
o
The consumer's indifference curves represent his preferences. An indifference curve shows the
various bundles of goods that make the consumer equally happy. Points on higher indifference
curves are preferred to points on lower indifference curves. The slope of an indifference curve at
any point is the consumer's marginal rate of substitution–the rate at which the consumer is willing
to trade one good for the other.
o
The consumer optimizes by choosing the point on his budget constraint that lies on the highest
indifference curve. At this point, the slope of the indifference curve (the marginal rate of
substitution between the goods) equals the slope of the budget constraint (the relative price of the
goods).
o
When the price of a good falls, the impact on the consumer's choices can be broken down into an
income effect and a substitution effect. The income effect is the change in consumption that
arises because a lower price makes the consumer better off. The substitution effect is the change
in consumption that arises because a price change encourages greater consumption of the good
that has become relatively cheaper. The income effect is reflected in the movement from a lower
to a higher indifference curve, whereas the substitution effect is reflected by a movement along
an indifference curve to a point with a different slope.
o
The theory of consumer choice can be applied in many situations. It explains why demand curves
can potentially slope upward, why higher wages could either increase or decrease the quantity of
labor supplied, and why higher interest rates could either increase or decrease saving.
The Costs of Production
o
The goal of firms is to maximize profit, which equals total revenue minus total cost.
o
When analyzing a firm's behavior, it is important to include all the opportunity costs of production.
Some of the opportunity costs, such as the wages a firm/organization pays its workers, are
explicit. Other opportunity costs, such as the wages the firm owner gives up by working in the firm
rather than taking another job, are implicit.
o
A firm's costs reflect its production process. A typical firm's production function gets flatter as the
quantity of an input increases, displaying the property of diminishing marginal product. As a
result, a firm's total-cost curve gets steeper as the quantity produced rises.
o
A firm's total costs can be divided between fixed costs and variable costs. Fixed costs are costs
that do not change when the firm alters the quantity of output produced. Variable costs are costs
that change when the firm alters the quantity of output produced.
o
From a firm's total cost, two related measures of cost are derived. Average total cost is total cost
divided by the quantity of output. Marginal cost is the amount by which total cost rises if output
increases by 1 unit.
o
When analyzing firm behavior, it is often useful to graph average total cost and marginal cost. For
a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output
increases and then rises as output increases further. The marginal-cost curve always crosses the
average-total-cost curve at the minimum of average total cost.
o
A firm's costs often depend on the time horizon considered. In particular, many costs are fixed in
the short run but variable in the long run. As a result, when the firm changes its level of
production, average total cost may rise more in the short run than in the long run.
The Market Forces of Supply and Demand
o
Economists use the model of supply and demand to analyze competitive markets. In a
competitive market, there are many buyers and sellers, each of whom has little or no influence on
the market price.
o
The demand curve shows how the quantity of a good demanded depends on the price. According
to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the
demand curve slopes downward.
o
In addition to price, other determinants of how much consumers want to buy include income, the
prices of substitutes and complements, tastes, expectations, and the number of buyers. If one of
these factors changes, the demand curve shifts. The determinants of the demand for health care
are: price of health care, prices of substitutes and complements, income, type of insurance, level
of education, age, sex, health status, lifestyle, quality of care, time costs.
o
The supply curve shows how the quantity of a good supplied depends on the price. According to
the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply
curve slopes upward.
o
In addition to price, other determinants of how much producers want to sell include input prices,
technology, expectations, and the number of sellers. If one of these factors changes, the supply
curve shifts.
o
The intersection of the supply and demand curves determines the market equilibrium. At the
equilibrium price, the quantity demanded equals the quantity supplied.
o
The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the
market price is above the equilibrium price, there is a surplus of the good, which causes the
market price to fall. When the market price is below the equilibrium price, there is a shortage,
which causes the market price to rise.
o
To analyze how any event influences a market, we use the supply-and-demand diagram to
examine how the event affects the equilibrium price and quantity. To do this, we follow three
steps. First, we decide whether the event shifts the supply curve or the demand curve (or both).
Second, we decide in which direction the curve shifts. Third, we compare the new equilibrium with
the initial equilibrium.
o
In market economies, prices are the signals that guide economic decisions and thereby allocate
scarce resources. For every good in the economy, the price ensures that supply and demand are
in balance. The equilibrium price then determines how much of the good buyers choose to
consume and how much sellers choose to produce.
Elasticity and Its Application
o
The price elasticity of demand measures how much the quantity demanded responds to changes
in the price. Demand tends to be more elastic if close substitutes are available, if the good is a
luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time
to react to a price change.
o
The price elasticity of demand is calculated as the percentage change in quantity demanded
divided by the percentage change in price. If quantity demanded moves proportionately less than
the price, then the elasticity is less than 1, and demand is said to be inelastic. If quantity
demanded moves proportionately more than the price, then the elasticity is greater than 1, and
demand is said to be elastic.
o
Total revenue, the total amount paid for a good, equals the price of the good times the quantity
sold. For inelastic demand curves, total revenue rises as price rises. For elastic demand curves,
total revenue falls as price rises.
o
The income elasticity of demand measures how much the quantity demanded responds to
changes in consumers' income. The cross-price elasticity of demand measures how much the
quantity demanded of one good responds to changes in the price of another good.
o
The price elasticity of supply measures how much the quantity supplied responds to changes in
the price. This elasticity often depends on the time horizon under consideration. In most markets,
supply is more elastic in the long run than in the short run.
o
The price elasticity of supply is calculated as the percentage change in quantity supplied divided
by the percentage change in price. If quantity supplied moves proportionately less than the price,
then the elasticity is less than 1, and supply is said to be inelastic. If quantity supplied moves
proportionately more than the price, then the elasticity is greater than 1, and supply is said to be
elastic.
o
The tools of supply and demand can be applied in many different kinds of markets such as the
market for wheat, the market for oil, the market for surgery, the market for dentist services, the
market for illegal drugs., etc.
Firms in Competitive Markets
o
Because a competitive firm is a price taker, its revenue is proportional to the amount of output it
produces. The price of the good equals both the firm's average revenue and its marginal revenue.
o
To maximize profit, a firm chooses a quantity of output such that marginal revenue equals
marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm
chooses quantity so that price equals marginal cost. Thus, the firm's marginal-cost curve is its
supply curve.
o
In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down
temporarily if the price of the good is less than average variable cost. In the long run when the
firm can recover both fixed and variable costs, it will choose to exit if the price is less than
average total cost.
o
In a market with free entry and exit, profits are driven to zero in the long run. In this long-run
equilibrium, all firms produce at the efficient scale, price equals the minimum of average total
cost, and the number of firms adjusts to satisfy the quantity demanded at this price.
o
Changes in demand have different effects over different time horizons. In the short run, an
increase in demand raises prices and leads to profits, and a decrease in demand lowers prices
and leads to losses. But if firms can freely enter and exit the market, then in the long run, the
number of firms adjusts to drive the market back to the zero-profit equilibrium.
Consumers, Producers, and the Efficiency of Markets
o
Consumer surplus equals buyers' willingness to pay for a good minus the amount they actually
pay, and it measures the benefit buyers get from participating in a market. Consumer surplus can
be computed by finding the area below the demand curve and above the price.
o
Producer surplus equals the amount sellers receive for their goods minus their costs of
production, and it measures the benefit sellers get from participating in a market. Producer
surplus can be computed by finding the area below the price and above the supply curve.
o
An allocation of resources that maximizes the sum of consumer and producer surplus is said to
be efficient. Policymakers are often concerned with the efficiency, as well as equity, of economic
outcomes.
o
The equilibrium of supply and demand maximizes the sum of consumer and producer surplus.
That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources
efficiently.
o
Markets do not allocate resources efficiently in the presence of market failures such as market
power or externalities.
o
Conditions for markets to work well are: full and symmetric information, impersonal transactions,
private goods, selfish motivations, many buyers and sellers, free entry and exit in the market,
homogeneous products, no externalities.
o
Efficiency criteria provide strong support for the imposition of competitive markets, assuming that
the conditions under which competitive markets may emerge will be present. However in many
sectors (such as the healthcare sector) many of the necessary conditions do not hold, and hence
competitive markets may not be optimal, or desirable.
Monopoly
o
A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm
owns a key resource, when the government gives a firm the exclusive right to produce a
good, or when a single firm can supply the entire market at a smaller cost than many firms
could.
o
Because a monopoly is the sole producer in its market, it faces a downward-sloping demand
curve for its product. When a monopoly increases production by 1 unit, it causes the price of
its good to fall, which reduces the amount of revenue earned on all units produced. As a
result, a monopoly's marginal revenue is always below the price of its good.
o
Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which
marginal revenue equals marginal cost. The monopoly then chooses the price at which that
quantity is demanded. Unlike a competitive firm, a monopoly firm's price exceeds its marginal
revenue, so its price exceeds marginal cost.
o
A monopolist's profit-maximizing level of output is below the level that maximizes the sum of
consumer and producer surplus. That is, when the monopoly charges a price above marginal
cost, some consumers who value the good more than its cost of production do not buy it. As a
result, monopoly causes deadweight losses similar to the deadweight losses caused by taxes.
o
Policymakers can respond to the inefficiency of monopoly behavior in four ways. They can
use the antitrust laws to try to make the industry more competitive. They can regulate the
prices that the monopoly charges. They can turn the monopolist into a government-run
enterprise. Or if the market failure is deemed small compared to the inevitable imperfections
of policies, they can do nothing at all.
o
Monopoly is generally deemed to be undesirable, not because of the political power of big
corporations, but because monopolists, in maximizing profits, do not produce where marginal
cost equals price. Instead, they produce where marginal cost equals marginal revenue, and
this results in less of the good being produced than other competitive markets
o
The undesirable nature of monopoly has to do with quantities, although the higher prices lead
to a transfer of resources to monopolists.
Externalities
o
When a transaction between a buyer and seller directly affects a third party, the effect is called an
externality. If an activity yields negative externalities, such as smoking, the socially optimal
quantity in a market is less than the equilibrium quantity. If an activity yields positive externalities,
such as technology spillovers, the socially optimal quantity is greater than the equilibrium
quantity.
o
Governments pursue various policies to remedy the inefficiencies caused by externalities.
Sometimes the government prevents socially inefficient activity by regulating behavior. Other
times it internalizes an externality using corrective taxes. Another public policy is to issue permits.
For example, the government could protect the environment by issuing a limited number of
pollution permits. The result of this policy is largely the same as imposing corrective taxes on
polluters.
Supply, Demand, and Government Policies
o
When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a
tax on a market shrinks the size of the market.
o
A tax on a good places a wedge between the price paid by buyers and the price received by
sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers
receive less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax
(that is, the division of the tax burden) does not depend on whether the tax is levied on buyers or
sellers.
o
The incidence of a tax depends on the price elasticities of supply and demand. Most of the
burden falls on the side of the market that is less elastic because that side of the market can
respond less easily to the tax by changing the quantity bought or sold.
Public Goods and Common Resources
o
Goods differ in whether they are excludable and whether they are rival in consumption. A good is
excludable if it is possible to prevent someone from using it. A good is rival in consumption if one
person's use of the good reduces other people's ability to use the same unit of the good. Markets
work best for private goods, which are both excludable and rival in consumption. Markets do not
work as well for other types of goods.
o
Public goods are neither rival in consumption nor excludable. Examples of public goods include
national defense, eradication of a disease and the creation of fundamental knowledge. Because
people are not charged for their use of the public good, they have an incentive to free ride when
the good is provided privately. Therefore, governments provide public goods, making their
decision about the quantity of each good based on cost–benefit analysis.
o
Common resources are rival in consumption but not excludable. Examples include common
grazing land, clean air, and congested roads. Because people are not charged for their use of
common resources, they tend to use them excessively. Therefore, governments use various
methods to limit the use of common resources.
Asymmetric Information and insurance
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Health care markets tend to be characterized by both imperfect and asymmetric information.
Asymmetric information describes a situation in which those on one side of a transaction have
better information than those on the other side. With asymmetric information the provider that
is better informed acts as an agent, the patient (the principal).
o
Often providers are relatively well-informed (about patient’s illness and treatments). In other
cases buyers are relatively well-informed ( e.g. the purchaser of insurance knows more about
his/her health status and pertinent habits to the insurer)
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One possible consequence of asymmetric information is that the market will not exist. Even if
it exists a general reduction in the quality of goods available might occur (market for lemons).
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The “Lemons” principle is a problem of adverse selection and it is common in health
insurance and health care markets.
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Adverse selection results from asymmetric information, not equally perfect information.
Adverse selection in insurance results in inefficiencies through higher-risk consumers
overinsuring relative to the amounts they would purchase at actuarial fair rates and lower
risks underinsuring.
o
Moral Hazard creates another type of information problem that arises when the insured
individual changes his/her behaviour after obtaining insurance against risk. For example after
buying insurance an insured individual may be less careful about avoiding loss. If the insurer
cannot directly observe the insured’s level of care, the cost of insurance must be higher to
compensate for the greater risk faced by the insurer.
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Moral Hazard can also exist on the provider side. Providers that do not pay for the health care
of their patients and know that their patients are insured might over provide treatment.
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Private markets sometimes deal with asymmetric information with signalling and screening.
Doctor Behaviour Models
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An agency relationships tends to be formed when a party (principal) delegates decision
making to another party (agent). In health care as doctors are normally better informed than
patients the former act as agents to the latter. The problem for the principal is to develop a
relationship to ensure that the agent is acting in the principal’s best interests. Perfect agency
occurs when the agent acts as the principle would do if the latter would be perfectly informed.
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There are 3 theories of doctor behaviour: profit maximization, target income and supplier
induced demand.
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If it is up to the provider to determine how much care the patient needs, there may be an
inducement to provide too much care. This is called supplier-induced demand or SID.
o
Supplier induced demand is an example of an imperfect agency relationship and occurs when
a doctor recommends a course of treatment that a fully informed patient would not choose for
themselves. In practice, supplier induced demand is often associated with excessive
utilisation in response to financial incentives. SID is hard to detect in practice.
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Regulators can use financial incentive to minimize SID.
Efficiency Equity and government intervention
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Economics can provide useful criteria for society’s efficient allocation of resources through the
concept of Pareto optimality. However, Pareto optimality does not imply equity. The allocation in
which one person has all of the resources, and others have none is a Pareto optimal allocation.
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Although Pareto optimal conditions provides a menu of possible allocations of goods, the decision
as to which allocation is preferable for society is a political one that must be provided by a political
process.
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On which basis can we justify Government intervention in the economy, in our case, in defining
and shaping health policies? Welfare economics states that the State intervenes in the economy
to correct market failures, and hence to reintroduce efficiency in the use of resources.
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We have encountered several examples of market failures in this module: from adverse selection
and moral hazard in the insurance market, to the supplier induced demand problem. Further, we
have seen the different policies that the government, or a general third party payer, can adopt to
solve those problems.
o
However, even when resources are used efficiently, a social decision maker, such as the
Government, can still intervene in shaping health policies on the ground of moral or equity
principles, to guarantee a fair health system for all, for example. In the latter case, the
fundamental question that can be addressed is: what type of preferences does society and/or the
regulator have? How do such preferences shape the social planner decisions regarding the
redistribution of resources in the society?’
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Different principles of justice lead to different preferences and consequently different allocation of
resources. Preferences are depicted by the shape of the social welfare function. The social
welfare function is the combination individual utilities. Different preferences will give different
weights to different groups of individuals.
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Each person utility will count more or less depending on society preferences. Social welfare
functions involve value judgments about interpersonal utility
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Utilitarian, rawlsian, egalitarian and weighted utilitarian are some of the possible types of welfare
functions
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Horizontal equity is concerned with equal treatment of individuals who are equal in relevant
respects. So, for example, equity in the financing of health care may imply that those with equal
incomes should pay the same amount. Horizontal equity in the delivery of health care may imply
that those in equal need should receive the same amount of health care.
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Vertical equity is concerned with unequal treatment of individuals who are unequal in relevant
respects. So, for example, those who own more may be expected to pay more towards health
care. Those in greater need may be expected to receive more health care.
Economic Evaluation
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The ultimate aim of economic evaluation is to assist health care decision makers in the allocation
of scarce health care resources.
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There are four main types of economic evaluation:
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cost- minimisation analysis, where only the costs of interventions are compared. The
cheapest technology is chosen.
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cost benefit analysis (CBA), where outcomes (and costs) are measured in money terms.
When net benefits are positive then technology is cost effective.
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cost-effectiveness analysis (CEA) compares a single outcome with costs
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cost-utility analysis (CUA) compares costs with a generic measure of health status, the
most well-known of which are the Quality Adjusted Life Year (QALY) and Disability
Adjusted Life Years (DALY).
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Cost analysis or cost-minimisation analysis is the simplest form of economic evaluation: only
costs are compared across alternative interventions. These approaches only have relevance if the
outcomes are similar for the interventions being compared.
o
In cost-benefit analysis outcomes are valued in money terms. This has the advantage that the
question of whether the benefits of therapy justify the costs can be answered directly, without
reference to other interventions or an external benchmark. Whilst cost savings and productivity
changes can be more readily expressed in dollars or pounds sterling, the main difficulty in
undertaking CBAs has been in valuing the health outcomes in money terms. However, a growing
number of studies have estimated the money value of improved health by assessing individuals’
willingness-to-pay for improved health.
o
By contrast, the result of a cost-effectiveness or cost-utility study can only be interpreted in
relation to some notion of an ‘acceptable’ amount to pay for an additional life-year or QALY.
Indeed, in cost-effectiveness or cost-utility analysis an implicit value is being placed on (say) a
life-year or a QALY when a decision is made whether or not to provide a given treatment.
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In cost-effectiveness analysis, a single outcome (e.g. life-years gained, or increase in symptomfree days) is chosen and compared with costs.
o
This form of analysis is most suitable in situations where there is widespread agreement on the
primacy of outcome of interest (e.g. to extend life or to relieve symptoms). The incremental costeffectiveness ratio (ICER) is calculated thus: ICER =(CA – CB)/(EA – EB)
o
In cost-utility analysis, a generic measure of health status is chosen and compared with costs.
The most well known measure is the quality adjusted life-year (QALY).
o
Cost-utility analysis can be viewed as a special form of cost-effectiveness analysis, where the
measure of effectiveness is the QALY. In constructing the outcome measure in cost-utility
analysis, valuation procedures are applied. That is, various elements of the outcome of therapy
(e.g. extension of life, improved quality of life) are being valued relative to one another.
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The choice of perspective determines both the range of relevant costs to be included and how, at
least in principle, they should be valued.
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The quality-adjusted life-year (QALY) values health states over a period of time on an interval
scale where 1 equals perfect health and 0 equals dead.
o
The quality-adjusted life-year (or QALY) is the most common outcome measure used in costutility analysis. The calculation of the QALYs gained requires valuations of states of health on an
interval scale where 1 equals perfect health and 0 equals dead. In principle, a health state can
also have a negative value if it is considered worse than death, (e.g. extreme pain in end-stage
disease). An interval scale is one where the same change (e.g. an improvement of 0.1) means
the same no matter what part of the scale is being considered.
o
In the literature, a number of methods have been used to obtain values for health states:
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Professional judgement. With this method a judgement is made either by the analyst or a
relevant group of experts (e.g. physicians or nurses) on the value for a particular health
state. This method offers no real advantage over and above convenience.
o
Visual analogue scale. With this method individuals are asked to place various health
states on a scale, in order of their desirability, with the spaces reflecting the extent to
which one state is more desirable than another. The states could either be the health
state that the individual is currently experiencing, or a state that may be described to him
or her. Therefore, perfect health would be assessed by most individuals to be ‘most
desirable’ and death ‘least desirable’. Most other states (e.g. suffering from rheumatoid
arthritis) will be somewhere in between.
o
Time trade-off. With this method individuals are asked to make a choice between living
the rest of their life (t) in a given health state (i) (e.g. on dialysis) and a shorter period of
time (x) living in perfect health. Time x is varied until the individual is indifferent between
the two alternatives, at which point the required preference value for state i is x/t. The
logic is that the higher the value the individual places on state i, the greater he or she
would require time x to be. Although the choice presented is hypothetical, it is not so
different from the choice faced by individuals when ill. For example with cancer, patients
sometimes have to bear several months of side effects from cytotoxic therapy in order to
gain a few extra months of survival.
o
Standard gamble. With this method individuals are asked to make a choice between the
certainty of remaining in a given health state i and an alternative with two possible
outcomes: perfect health and death. The probability of the outcome ‘perfect health’ p is
then varied until the respondent is indifferent between the gamble and the certainty. At
the point of indifference the required preference value for state i is simply p. The logic
here is that the higher the value the respondent places on state i, the higher the
probability of a successful outcome from the gamble (he or she would require). As with
the time trade-off method, the choice posed is hypothetical, but is similar to the choice
faced by someone requiring a surgical operation. Namely, a patient would not
contemplate an operation with a substantial risk unless his or her current health condition
was serious.
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Economists prefer the methods that introduce the notion of choice, and the standard gamble has
the most well-developed theoretical arguments to support it.
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DALYs is an alternative to QALYs and measures disability adjusted of life years. Disability is
normally given by burden of disease. The disability scores associated with DALYs are given by
professional judgement.
o
The timing of costs and consequences is an important factor to account for in economic
evaluations. A positive rate of time preference indicates a preference for benefits today rather
than in the future. Discounting calculations use the rate of time preference or the interest rate to
calculate the present value of a cost or consequence occurring at a future point in time.
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The discounting of costs is relatively uncontroversial, although there is considerable debate about
the choice of discount rate. On the other hand, economists disagree about whether health
benefits should be discounted at all, or at a different rate from costs.
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There are a number of different perspectives from which to conduct an economic evaluation. The
broadest perspective is that of society as a whole. Other possibilities include that of:
o
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The public sector
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The health care system
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A given institution (such as a hospital)
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The patient and family
The perspective of the study will have an impact on the costs, benefits to take into consideration
in the analysis as well as how they are valued and consequently will have an impact on the ICER
or net benefit of the technology/treatment under consideration.
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When taking decisions on whether to fund a drug, policy makers look at ICERs but also on the
impact on the budget.
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Economic evaluation can be used to manage demand, to obtain value for money (efficiency) and
to avoid postcode lotteries.