Review of the Last Lecture
• began our discussion of the demand function for healthcare
• Discussed: derived demand, difference between the demand
function and the demand curce
• specified the demand function for HC:
QD = Q(Y, PHC, PNHC, HS, Z) + 
• discussed the direct and indirect effects of a variable on the
demand for HC
• Were looking at how an increase in the price of a good that is bad
for HS affects the demand for healthcare
317_L10, Jan 29 ,
2008, J. Schaafsma
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An Increase in the Price of a Good
that is Bad for Health
• Some goods are bad for health (tobacco, excessive alcohol
consumption, illegal drugs)
• If the P of a bad  => direct and indirect effects on the Q of HC dem
• the direct effect combines an income effect (P  => real income ,
buy less all goods, HC is a good, Q of HC ) and substitution effect (P
 , substitute other goods that yield utility for the bad, HC such a good,
Q of HC demanded ) Can’t sign the direct effect.
•The indirect effect: smoke less P  (income and substitution effects)
=> HS  => need less HC
• net impact of the direct and indirect effects unknown, likely QD 
317_L10, Jan 29 ,
2008, J. Schaafsma
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Possible Exception to how Q of
HC Demanded Responds to a
Change in the Price of a Bad
• If the person is totally hooked on the bad (P elasticity is 0):
•The direct effect: no substitution effect (no change in smoking
since the P elasticity is 0). There is an income effect. The higher P
extracts more purchasing power from the smoker => less left over
for other goods including HC => Q of HC demanded ).
• The indirect effect: no substitution effect (perfectly price inelastic
demand). However, the higher P lowers purchasing power left over
for other goods => HS  => more HC demanded
• the net impact of the direct and indirect effects could be to
increase the demand for HC as the P of the bad !!
317_L10, Jan 29 ,
2008, J. Schaafsma
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Other Variables in the Demand
Function for HC
• Z denotes a set of other variables in the demand function for HC:
- illness: +ve effect on QHC demanded ~> DC shifts right and
becomes steeper. Why steeper?
- belief about efficacy: e.g. homeopathic products and
services, dietary supplements taken for their expected HS
benefits.
- tastes: (“instant fixes” vs. dietary/lifestyle changes)
•  random error term e.g. (random incidence of illness).///
317_L10, Jan 29 ,
2008, J. Schaafsma
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Own Time Costs and Demand for HC
• for a salaried worker the unit price of HC is PHC
• for an hourly paid worker the effective unit price is PHC + the wages
lost accessing one unit of HC
• thus, ceteris paribus, at each PHC a wage labourer will demand less
care than a salaried person since the effective price is higher for a wage
labourer
• Also, if the demand curve for healthcare is non-linear with respect to
the effective price of HC, the wage labourer’s demand curve with
respect to PHC will be steeper than for the salaried person (see
diagram) => i.e., a drop in PHC will increase Q of HC demanded by
more for a salaried person than for a wage rate labourer.
317_L10, Jan 29 ,
2008, J. Schaafsma
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Insurance and the Demand for
HC: Some Basic Concepts
• will look at two kinds of insurance:
- common kind: insurer pays part or all of the loss
- less common kind: indemnity payment ~> insurer pays a fixed
amount per unit of HC consumed, regardless of actual unit cost.
• both kinds could be subject to a deductible (2 kinds of deductibles):
• annual deductible: insurer only reimburses annual losses in excess of
some annual minimum: e.g., insurer may reimburse 70% of annual HC
costs above $1000 (here must keep track of losses over the year).
• per loss deductible: the insurer only reimburses losses in excess of a
minimum,.e.g., a $500 deductible per loss for theft insurance. If a $600
bike is stolen, insured only gets $100.///
317_L10, Jan 29 ,
2008, J. Schaafsma
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Health Insurance That Pays a
Fraction of the Unit Price
• suppose insurance pays a fraction, ir, of the unit price, e.g., ir = 0.8
• (1 – ir) = cir is the co-insurance rate (fraction paid by the patient)
• Note: two prices: P(1–ir) the effective price paid by the consumer
P the price received by the producer
• thus, if the equation for the demand curve is Q = a - bP without
insurance, it is Q = a - b(1-ir)P with insurance.
• given ir ~> derive new demand curve from the old one (see diagram)
• insurance rotates the demand curve clockwise ~> more price inelastic.
• new demand curve is vertical when ir = 1. ///
317_L10, Jan 29 ,
2008, J. Schaafsma
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Effect of Insurance on P and Q,
and Welfare Loss
• Insurance coverage drives up P and Q and total expenditure on HC
(see diagram)
• Creates a welfare loss: the cost of the additional HC consumed as a
result of insurance exceeds the value placed on the additional benefits
(see diagram)
• Also creates additional producer surplus: a payment to factors of
production in excess of what is needed to have them produce HC (see
diagram) in this case.
• The producer surplus is a transfer from the insured to the providers.
• have ignored the wealth effect of buying insurance, premium reduces
income => demand curves for all goods shift left.///
317_L10, Jan 29 ,
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2008,
J. Schaafsma
The Slope of the Demand and
Supply Curves and the Effect of
Proportional Insurance on P & Q
• the size of the welfare loss depends on the slopes of the
demand and supply curves
• the steeper the demand curve the less the increase in P & Q
from proportional insurance
• if the supply curve is vertical insurance only increases P
• if the supply curve is horizontal insurance only increases Q
317_L10, Jan 29 ,
2008, J. Schaafsma
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A User Fee and the Welfare Loss
• suppose there is 100% insurance coverage ~> P to the consumer = 0
• get the maximum welfare loss (see diagram)
• user fee ~> an amount paid by the patient per unit of HC consumed
• even a modest user fee can reduce the welfare loss substantially (see
diagram) Reason ~> user fee reduces consumption of HC units with
the largest per unit welfare loss, i.e. it eliminates the most wasteful
spending.///
317_L10, Jan 29 ,
2008, J. Schaafsma
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Proportional Insurance and Shifts
in Supply
•As noted earlier: proportional insurance rotates the demand curve
clockwise and increases its slope
• shifts in supply thus have larger P effects and smaller Q effects
(explain the economics with a diagram) the steeper the demand curve
• Implication: with proportional insurance rising costs on the supply
side are easier to pass forward through a higher market P (show). ///
317_L10, Jan 29 ,
2008, J. Schaafsma
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