Chap 2 Microeconomic Tools
for Health Economics
Scarcity and the Production
Possibilities Frontier
• The PPF is a curve drawn in a graph to
illustrate the trade-offs between two
categories of goods=> no free lunch
• Increasing opportunity cost (see Table 2-1)
The slope of the PPF=opportunity cost
Bowed-out shape of the PPF
*An interior point in PPF means that it is
inefficient.
Practice with Supply and demand
• The demand curve and demand shifters
1. As long as people buy less at higher prices=>
the demand curve is downward-sloping
2. implicit assumption: all other things are held
constant
= Demand shifter
(1) Income: normal good
(2) Other price: the price of other substitutable
good
(3) Insurance: health insurance
(4) Tastes
• Supply shifters
1. Technological changes
2. Input prices
3. Prices of Production-Related Goods: orange or juice
4. Size of the industry: Immigration
5. weather
• Equilibrium : demand=supply (static equilibrium in Figure
2-3)
• Comparative statistics
1. Coffee were a freeze in Brazil (Figure 2-4 A)
2. The market for tea when the price of sugar rises
(Figure 2-4 B)
Functions and curves
• Linear Functions: Y=a+bx
where y=dependent variable
x= independent variable
a= intercept
b= slope
• Demand functions: Qd=a-bP
• The demand for spaghetti: Qd=f(Ps,Po,Y,Z)
where Ps: price of spaghetti
Po: the prices of substitute
Y:income
Z: taste factor
Qd=500-10*Ps+5*Po+20Y+40Z
It is download sloping in its own price, shifting rightward (leftward) with
higher price of substitutes (complements), shifting rightward (leftward)
with income increases for normal (inferior) goods, and shifting
rightward with a positive shift in tastes
Derived demand: Demanded by consumers for a final foods or service
may stimulate the providers of that service in turn to demand factors of
production.
E.g. health-> exercise equipment, health foods, and visits to a physician
Consumer Theory: Ideas Behind the demand curve
• Utility
1.Marginal Utility (=slope of utility)
2. The slope is fatter=decreasing marginal utility
• Indifference Curves
1. convex to the origin.
2. The rate at which agent want to trade off the two
goods is represented by the slope of the indifference
curve
• Budget Constraint
Changes in budget constraints due to changes in price
or income (Figure 2.8)
• Consumer equilibrium: To maximize satisfaction given a
budget constraint, the consumer will want to be on the
highest attainable indifference curve.
• Individual and market demand: Market demand is the
horizontal sum of individual demands
Elasticities
• Elasticity is defined as the percent change in the
dependent variable resulting from a 1 percent change in
dependent variable
• Price elasticity:
Ep=(percent change in quantity demanded)/(percent
change in price)
Ep is always negative
• Income elasticity:
Ey=(percent change in quantity demanded)/(percent
change in income)
Ey may be positive (if a normal good) or negative (if an
inferior good)
• Example (Figure 2-12)
1. Demand is perfectly inelastic (D1)=> tax revenue will be
at a maximum but with no effect on smoking
2. Increasing elastic demand (D2 and D3) creates bigger
reductions in smoking but at the cost of decreasing tax
revenue
Production and Market Supply
• The product function shows that the maximum
sustainable output that can be obtained from all
of the various combinations of inputs with
existing technology.
• The law of diminishing returns represents the
idea that the marginal product of an input will
eventually tend to fall as more is added. (See
Figure 2-3)
• Q=f(X1,X2,…,Xn)
• e.g. Cobb-Douglas
MP and AP are shown in Table 2-4
t
• Isoquant curves:
1.combinations of inputs producing equal output lie on isoquant.
2. The negative slope to an isoquant indicates the possibilities of
substituting inputs in the production process and of the positive
marginal product of the input.
3. E.g. Empirical estimates reveal substantial substitution
possibilities between physicians’ assistants and physicians.
*Isocost curves:
TC=wL+rK
*Cost Minimization or Output Maximization determines efficient
combination of labor and capital (Fig 2-15)
E.g. Hospitals may achieve cost minimization in applying hospital
inputs, and home health care service may achieve cost minimization
in applying home health care resources. But, for society as a whole
to minimize its costs of care, we need to know which of these types
of care is the most cost efficient for particular patients even the
comparing quality of care.
Marginal and Average cost curves
• Economics of scale: Total and average
costs are related to the scale of activity. If
the higher level of production leads to
improved ability to take advantage of
specialization proving a better division of
labor; it may be possible to reduce
average costs.
• The long-run marginal cost curve shows
the cost of producing an incremental unit
when all inputs can be varied. It will go
through the minimum point of the LRAC.
The firm curve under perfect competition
• Assumptions:
1. A sufficient number of buyers and sellers of the good exist so that
no single actor has any power over the price.
2. The good is homogeneous; that is, all producers produce the
exact same good so that the market cannot be segmented on the
basis of differences of goods.
3. Information is perfect.
4. no barriers to entry or exit are presented.
• The above assumption ensures that the short-run market equilibrium
can be represented by the price and the quantity at which demand
(D=MR=P)and supply curves (p=MC) intersect. (see Figure 2-17,
MR>MC at Q1 ; MR=MC at Q*)
* positive economic profit will be attractive to potential entrants. With
perfect information and no barrier to entry, other suppliers will enter
the market until the prices have fallen enough to eliminate economic
profit. In the long run, equilibrium profit will be zero, and price will be
at the lowest point on each firm’s long-run average cost curve
Monopoly and other market structure
• Firms in other market structures, unlike perfect
competition, have market power, which is the ability to
affect market price such as the pure monopoly,
monopolistic competition, the several forms of oligopoly.
E.g. In health sectors, pharmaceutical firms that control
patens for certain drugs are pure monopoly.
• Equilibrium for the monopolist is illustrated in Figure 2-18.
To maximize profit, the monopolist produces where
MR=MC at Q0. The corresponding price is P0 and the
total profit is the rectangle P0ACB.
• Welfare loss: The total net gain to society from
increasing output from Qm to Qc (see Figure 2-19) is
triangular area labeled ABC. Thus, a welfare loss,
represented by an area under the demand curve and
above the marginal cost curve, is an opportunity for
mutual gains that is being foregone by the market.