Chapter 4: Economic Efficiency and
Cost Benefit Analysis
1. Economic Efficiency
2. Cost Benefit Analysis
Economic Efficiency
• Economic efficiency requires the maximization of
total welfare, with the optimum quantity reflecting
the sum of consumers’ and producers’ surplus.
1. Consumer surplus (see Figure 4.1)
2. Producer surplus (see Figure 4.2)
• Figure 4.3 shows that the sum of surpluses (total
welfare) is maximized at Q1 where demand
equal supply
• Example: inefficient (monopolist: too fee goods;
polluters: too many goods)
Cost-Benefit Analysis :Background
• US Army Corps of engineers
Congressional subcommittee (1950)
The introduction of Medicare and Medicaid (1965)
All federal regulation (1981)
• Limitation: all shown in monetary term
• Alternatives to CBA
1.Cost-Efficiency Analysis (CEA): a way to quantify
trade-offs between resources used and health outcomes
achievement without having to value health outcomes in
monetary terms
2.Cost-Utility Analysis (CUA)-a special case of CEA with
reflecting individual preference
Cost-Benefit analysis: Basic Principle
• CBA involves evaluation projects without
decisions made in the market place
• Project accepted if B>C
• Best projects: B/C ratio ranked
• Measuring cost-opportunity cost
• Benefit- externality (e.g. flu immunization)
• Is equalizing risks program best?
Viscusi (2000): no.
• Marginal Analysis in CBA (Figure 4-4):
Maximize Society’s net benefit=> Marginal Social benefit
=Marginal social costs
• The cost of saving lives [costs-Resources saving]:
childhood immunization and prenatal care have negative
net costs
• Discounting: multi-periods projects
Present value equation (4.1)
Q1: should those living in the present so disregard future
generation?
Q2: market rate of interest rate=social discount rate?
Q3: Inequalities in discounting rate?
• Risk adjustment: high risk=high interest
rate
Stiglizt (1988): certainty equivalent
(more risk=lower certainty equivalent)
• Distributional Adjustment: stiglizt proposes
more distributional weights to lower
income group
• Inflation: measure in real term
Valuing Human life
• Human capital approach: present value of
future earnings
• (1)Willingness to accept: labor economy of
compensating differentials
(2)Willingness to pay: consumer
purchasing behavior for risk-reducing
devices
Cost-Effectiveness Analysis
• CEA ration (4.2)=C1-C0/E1-E0
where cost as usual in dollar and output in
health status measurement
• Advantage: benefit measurement in nonmonetary term
Cost-utility Analysis
• Quality-Adjusted Life Years (QALY) (4.3)
where quality weight (q) denotes range
from 1 (perfect health ) to 0 (death)
=>individuals’ preference for health
F is the probability of survival;
d is discount rate
The Ageism Critique of QALYs
• Q: Is it fair for the elderly using QALY?
• DALY: human tend to be depend on the
middle age groups
=> a “hump” shaped set of weights
favoring the age groups in the middle