Econ 2CC3 Individual Level Demand and Production of Health PDF

Chapter 5 Individual Level Demand for and Production of Health Econ2CC3/HLTHAG 2C03 Fall 2024 Definitions of Health : Health is defined at the individual level Measures of Health Introduction ► We base our economic analysis of health on the premise that we can gain imp...

Chapter 5 Individual Level Demand for and Production of Health Econ2CC3/HLTHAG 2C03 Fall 2024 Definitions of Health : Health is defined at the individual level Measures of Health Introduction ► We base our economic analysis of health on the premise that we can gain important insights into a wide range of health issues by analyzing health as an economic good ► A good that is subject to many of the same fundamental forces as other goods (but also has distinctive features). ► Increased health provides benefits but just staying in good health may be costly and may conflict with other things we care about: Good health has a price. ► We expect people’s decisions about health to reflect the time, money, costs and benefits of health. The economic analysis of health proceeds from this expectation. Elements of analysis of individual health ► Individuals play an important role in producing their own health. ► This means that we need a unified framework to analyze both the demand for and the production of health at the individual level. ► Time is also important: Health related decisions today in many cases affect future health. ► Health is also determined by social forces: e.g. Education and income distribution may affect behaviour. Individual Factors vs Social Influence Figure 1: Source: Cronin H. 1991. The ant and the peacock The Grossman Health Capital Model ► Focus on individual-level determinants of health in this chapter. ► The Health Capital Model: Health is considered as a stock variable, that changes over time. ► M. Grossman (1972): “On the Concept of Health Capital and the Demand for Health”, JPE Vol.80 ► Theoretical framework for understanding an individual’s demand for and production of health. ► Health is treated as a durable capital stock that produces an output of healthy time in each time period. ► Individuals derive satisfaction from healthy time and from consuming other goods and services. ► Individuals make health investments to increase their stock of health capital, which can yield returns in terms of more healthy time to work, and utility. ► Individuals can invest in their health by engaging in healthy behaviours, such as exercise and proper nutrition, and by consuming medical care. ► The model accounts for the depreciation of health capital over time due to aging, and exogenous changes in other factors such as education and wage Assumptions of the Grossman model ► Each individual is born with some stock of health capital(Health). The person’s decisions (partly) affect what happens to Health over time. ► In Grossman’s model the stock variable ‘Health’ (which is constant during each time period, but changes from one time period to another) produces the flow variable ‘healthy time’. ► healthy time can be used for work or can be combined with market goods (including medical care) to produce health investment or can be combined with market goods used to generate utility from ‘final consumption goods’. ► In general utility can also be obtained from healthy time directly Assumptions- Time and Market Constraints ► Individuals face a number of constraints in deciding the optimal levels of Health Capital and final consumption goods. ► Time Constraint (24hr/day, 365 days/yr) ► Time can be spent: 1. Working (generates income) 2. Producing health investments 3. Producing final consumption goods 4. Illness ► Income Constraint : the total amount of money that they spend on health care and other market goods cannot exceed their income. The Health Production function ► The health production function can be written very generally at the individual level as where H is the level of individual health. ► Difficult to estimate such a full equation in practice ► Hard(or even impossible with current technology) to measure all variables affecting outcome ► Even if we can measure them have to contend with Correlation vs. Causality issues. Some are easy to resolve. E.g. parent and child height. Some are not. ► E. g. Income – Health relationship ► If we don’t account for relationship of education and income then the estimated effect of income on health consists of the effect of income on health and an (unknown) part of the effect of education on health ► Hard to believe income estimate only capturing effect of income. Further Assumptions of the Grossman model ► Health Production Constraint: Health investments can be produced using combinations of health care and time spent producing health investments ► Goods Production Constraint: Final consumption goods and activities can be produced using different combinations of market goods and time devoted to consumption. ► Constant Returns to Scale (CRTS) in production (doubling inputs doubles output) and no joint production (each input helps produce 1 and only 1 output) ► The last piece of Grossman’s model is the depreciation rate of Health Capital: the depreciation rate is the proportion by which Health Capital diminishes each period if an individual does not make health investments. ► Grossman assumes that the depreciation rate of Health Capital increases with age, so that over time it takes larger and larger health investments to maintain a given level of Health Capital. Optimal investment in Health ► The optimal level of Health Capital and investments in health at each time t must satisfy an optimality condition: ► the marginal benefit of an additional unit of Health Capital/health investment just equals the marginal cost of an additional unit of health Capital/health investment. ► Because the benefits of additional health this year accrue over many years into the future, the relevant quantity is the discounted stream of current and future benefits of health Optimal Health Capital trajectory ► Given the preferences and constraints of individuals, the model implies that each person has an optimal level of health capital at each point in life. ► Like the standard problem where a consumer chooses the amounts of x1 and x2 to maximize u(x1 , x2 ) ► except that we are considering a dynamic problem: the optimal consumption amounts are not a point but a trajectory in time (x1* (t ), x2* (t )) where t is every instant in the person’s lifetime. ► and that people can produce final goods and health investments using intermediate goods and time (resources) Grossman’s Consumption and Investment Models ► consumption benefit of increased health: increased healthy time for more final consumption goods. ► Consumption Model : Health affects utility indirectly through an increase in healthy time. Marginal Utility only depends on consumption of final goods. Only reason to work in this model is for more final consumption in this and/or future periods. No direct utility effects of health. ► investment benefit of increased health: Increased healthy time for producing more health. ► Investment Model : Health affects utility indirectly through an increase in healthy time. Marginal utility only depends (positively) on future health which is monotonically related to current medical care. The only reason to live and work in this model is for more health investment! No direct utility effects of health (or health care). Summary of Grossman model predictions Assessment of the Human Capital Model ► Limitations: ► No uncertainty about health (or anything else) Predictions generally remain consistent when uncertainty is introduced Usually leads to higher demand for health Can have strange results with CRTS ► Insights: ► Individuals respond to incentives about the costs and benefits of health production when deciding on health plans ► Time costs play an important role in the demand for health and health care ► Demand for health care seen as a derived demand-a demand derived from the primary demand for health. ► Demand for health and health care are different for individuals with different characteristics Education and Health ► Important questions 1. Causality vs spurious correlation? 2. Direction of causation 3. Mechanism of causation ► The role of time preferences - discount factor Problem: difficult to measure ► Impact of health on education: Health in early life affects educational attainment Poor health in childhood is associated with poor health in adulthood Table 5.2 Education - health gradient, Canada 2005 Source: Canada Community Health Survey- CCHS 3.1 Education - Health gradient, Canada, 2015 Post-secondary Less than High High School certificate, diploma School Diploma % Graduate % or degree % Self Assessed Health Status Excellent 19.0 19.4 24.5 Very Good 32.2 36.2 38.4 Good 29.8 30.5 26.6 Fair 13.7 10 7.8 Poor 5.3 3.9 2.7 Total 100.0 100.0 100.0 Number of Chronic Conditions 0 36.8 33.3 36.3 1 20.0 22.8 24.1 2-3 25.2 28.1 26.6 More than 3 18.0 15.8 13.0 Total 100.0 100.0 100.0 Source: Canadian Community Health Survey PUF, 2015-2016 Impact of education on health ► Many possible channels but difficult to disentangle their relative importance: 1. Income effect 2. Efficiency in production 3. Dynamic preferences 4. Impact on social hierarchy ► Policy implications 1. Income redistribution 2. Informational policies 3. Educational attainment policies may be self-defeating Health-Related Behaviours ► Substantial morbidity and mortality is attributed to obesity, smoking, unsafe sex, use of alcohol and illicit drugs, lack of exercise, and poor diet. ► Problems with modelling such behaviors: Elements of addiction Time preferences and the probabilistic nature of negative consequences Economics of Obesity ► Obesity: Measured using BMI ► Obesity rates on the rise in Canada and the OECD over the last 40 years or so Table 5.3 Percentage of the Population Obese, Selected OECD countries and Years Percentage of the Population Obese, Selected OECD countries and Years 1989-1992 1998-2001 2006-2009 2013-2016 Australia 16.3 21.3 Canada 14.8 17.2 19.7 Finland 8.3 11.4 14.9 19 France 6.5 8.2 10.5 15.3 Germany 14.7 16.4 Japan 2.5 3.2 3.9 4.2 Netherlands 6.4 9.3 11.8 13.6 New Zealand 12.7 27.8 31.6 Norway 6 10 Sweden 5.5 9.2 10.9 13 Switzerland 5.4 8.1 United Kingdom 14 22.4 23 26.2 United States 22.8 27.7 30.2 Source: OECD (2019) Health Status Data, Non-Medical determinants of Health, Body Weight, What causes obesity? ► What causes obesity? ► If calories ingested exceed calories expended, a person gains weight ► Empirical evidence: the primary explanation is increased caloric intake rather than reduced energy expenditure (Finkelstein et al. 2005) ► What drives then increased caloric consumption? Suggested Causes of Increased Caloric Consumption ► Hypothesis 1: Primal Tastes ► Hypothesis 2: Increased Labour Force Participation by Women ► Evidence suggests this is not a primary cause ► Hypothesis 3: The Role of Changing Prices ► Since 1980 food prices have risen more slowly than general inflation: food became relatively less expensive ► Prices of energy-dense foods have risen more slowly than less energy-dense foods: fall in relative price of a calorie has been even larger than the general decrease in (real) food prices ► Hypothesis 4: The Effects of Technology on Costs ► Reduction in money cost and time cost of preparing a meal Models of Smoking? The Rational Addiction Model (Becker and Murphy 1988) Theoretical Predictions ► Cigarette Consumption depends on current as well as past and future prices ► Empirical evidence: Estimated p.e.d. −0.25 to −0.5 ► Young, less educated, low income, are ► more responsive to price changes than older, more educated, high-income individuals. ► less responsive to negative health information about smoking ► Consistent with empirical evidence ► The model also predicts that the most effective way to quit is to go “cold turkey” Quasi-Rational and Irrational Addiction ► A limitation of the rational addiction model is that it predicts that all smokers are happy with their decisions to begin smoking ► Inconsistent with the evidence ► Led to imperfectly rational models: decisions fail to be fully rational ► Time inconsistent preferences ► Commitment devices Economics 2CC3/HLTHAG 2C03 Fall 2024 Chapter 6 The Determinants of Population Health  Introduction This chapter looks at broader, non-individual determinants of the level and distribution of health in a population such as: – 1) the purity of the air and water – 2) the design of the transportation networks – 3) the safety of workplaces – 4) availability of places to meet and play The unequal exposure to health risks and unequal access to health-enhancing features of the physical and social environment generate systematic inequalities in the distribution of health. Policy (usually) seeks to raise the average level of health and to reduce inequalities.  Broader determinants Observed patterns of ill health derive from a complex interaction of biology, behaviour, and environment. Much of the literature on the broader determinants emphasizes external forces acting on individuals, often without their explicit awareness. The economic policy problem is to identify the nature of the underlying production function and to identify the factors that produce health, how they act alone and in combination to produce the observed level and distribution of health in society. By deliberately manipulating features of the physical and social environments in which people live, policy aspires to give people the resources to respond to the health challenges they confront.  Figure 6.10: A framework for understanding the determinants of health- Evans and Stoddart (1990) Figure 6.1: Life expectancy in England and Wales 1750-2000  Life Expectancy in England and Wales 1750-1850 England and Wales: life expectancy at birth was approximately 35 during the second half of the eighteenth century inching upward in 1800 only to stagnate at 40 during the middle of the nineteenth century, In 1850, simply surviving infancy and young childhood increased the expected age of death by nearly 20 years;  Life Expectancy in England and Wales (and Canada) 1865- Around 1865 there began a steady, steep rise until the present, with the rate of increase moderating in the years following World War II gradual narrowing of the gap between the expected age of death at birth and at ages 10, 45, and 65 implies that much of this gain in life expectancy was from reducing deaths among young children. by 1950, the reduction in infant mortality had closed the life expectancy gap to less than 2 years data for Canada do not extend as far back as for England and Wales, but they suggest a similar pattern: rising life expectancy at birth, with a convergence over time in life expectancy at birth with life expectancy conditional on reaching specified ages  Thomas McKeown’s 2 theses Thomas McKeown (1976; 1979) used detailed death records for England and Wales from 1837 Thesis 1: – Medicine was not primarily responsible for the historical improvements in health in England and Wales - contrary to conventional wisdom at the time. Thesis 2: – Economic growth, rising living standards, and the accompanying improvement in diet were the primary sources of improvements in health.  McKeown-Thesis 1 McKeown presented a series of graphs for death rates from leading causes of death Demonstrated convincingly that clinical medicine could not possibly have been responsible for the historical health improvements: – There were rapidly falling rates of mortality for common diseases, well before effective medical treatments became available Canadian data do not extend as far back as those available to McKeown for England and Wales, but they tell a similar story Figure 6.3:Mortality from Respiratory Tuberculosis in England and Wales 1838-1970  McKeown-Thesis 2 McKeown argued that the major cause was a general improvement in living standards and, particularly, diet associated with economic development. Improved health was an unintended by-product of economic development. McKeown did not provide direct evidence of improved nutrition and its potential impact on health. Rather, he identified and then eliminated other possible explanations such as: – a decline in the virulence of micro-organisms – reduced exposure to potentially harmful organisms – improved treatment leaving improved nutrition as the likely cause.  Robert Fogel on Nutrition Direct empirical support for the effect of improved nutrition was provided by economic historian and Nobel laureate Robert Fogel (1997; 2004). Fogel demonstrated that average caloric intake increased substantially in the middle of the eighteenth century and that this was associated with increased average heights. Based on this evidence, Fogel attributed: – most of the reduction in mortality between the eighteenth and late nineteenth centuries to improved nutrition. – approximately half of the reduction through the twentieth century, to improved nutrition. Some analyses have challenged the thesis that better nutrition caused the fall in mortality rates  Public Health For the period following 1870, subsequent research has argued that the primary driver was not economic growth and nutrition but deliberate social policy in the form of large-scale public health initiatives (Cutler et al. 2006; Szreter 1988). The squalor of the cities of the industrial revolution in England and the greater acceptance of the germ theory to explain the transmission of disease gave birth to the modern public health movement. The movement emphasized three types of action: – 1) Increased regulation to improve housing and workplaces, – 2) public investment in large infrastructure projects such as those required to provide clean water and remove waste, – 3) Investments in public health education to improve health behaviours and practices. Cutler and Miller (2005), for instance, estimate that water purification by large-scale water facilities in American cities (where industrialization was later), contributed up to one-half of the total reduction in mortality between 1900 and 1936.  Samuel Preston’s curves Samuel Preston’s multi-country analysis of the relationship between life expectancy and income provides a second, more general type of evidence suggesting that economic development alone does not account for health gains (Preston 2001). There are four noticeable features: – 1) Life expectancy rises with income per capita – 2) Relationship is highly curvilinear – 3) Upward shift is inconsistent with explanations based on economic growth: if the primary driver of the relationship were economic development, countries would simply move along a single curve – 4) Levels of health achieved by low-income countries are highly variable: some low-income countries can achieve “first-world” life expectancies while others with moderate incomes seem to substantially underachieve. Investments in public health and related social infrastructure (including in recent years, health care systems) are obvious explanations for the shift of the curve over time and the substantial variability at low-income levels.  Figure 6.5: Relationship between GDP per capita and Life expectancy, Selected Countries, 1975 and 2005  Rise of Medicine The start of the era of modern medicine is generally dated from the introduction of antibiotics in the 1930’s. The impact of medicine on health has been small in the historical context, it has been substantial since the middle of the twentieth century. Cutler (2004) attempted to quantify the impact of advances in modern medicine on population health since the early 1950’s. He focused on two areas that together account for a large proportion of the increase in life expectancy since the 1950’s: – cardiovascular disease – neonatal mortality  Modern Medicine Between 1960 and 2000, cardiovascular mortality fell by over 50 percent – This reduction accounts for 70 percent of the increase in life expectancy between 1960 and 2000. – Cutler (2004) attributes up to two-thirds of the decrease in cardiovascular mortality to medical progress (the balance is due to a variety of other factors, most importantly reduced smoking). Decreases in infant mortality account for an additional 20 percent of the increase in life expectancy between 1960 and 2000. – Cutler estimates that advances in the treatment of newborns, and especially the treatment of low-birth- weight infants, is responsible for the majority of this decrease in infant mortality.  Summarizing the causes What caused this dramatic, historically unprecedented improvement in life expectancy? Three forces exerted significant influence at different times during the period from 1750: – 1. Economic growth, which raised living standards and improved nutrition, especially relatively early in the period – 2. Public health and related initiatives, especially in the period from about 1870 to 1940 – 3. Modern medicine, especially from 1940 to 2000  Lessons for Improving Population Health Today The modern record establishes that a continual, uninterrupted increase is not automatic. E.g. Figure 6.6: Life expectancy reductions after fall of USSR – The turn from communism beginning in 1989 was marked by small, short-lived dips in life expectancy in Poland and the Czech Republic and steep declines in Russia and Ukraine. – life expectancy continued to rise in western Europe. – Post communism declines are mainly due to alcohol consumption and social and economic disruption Figure 6.7: The “Cuban Health Paradox” is probably due to – 1) Education – 2) Integrated Primary Health Care Working-class white morbidity and mortality in the USA has increased in recent years while the UK has seen reductions in overall life expectancy, mainly due to white working-class reductions.  Implications for Health Policy Today Understanding of the determinants of population health has important implications for health policy today. We must ask hard questions about how best to invest new resources. Some argue, for instance, that medicine is currently at the “flat of the curve” in the production function: additional health care spending may achieve only small gains in health (on average). One of the first government documents to suggest this was the Canadian government’s seminal Lalonde Report (named after the minister of health at the time) (Lalonde 1974). The report articulated a framework that emphasized the broad range of determinants of health. It argued that, at the margin, investments in the physical and social environment may well offer the best investments for improving population health. The Lalonde Report appears to have exerted more influence internationally than it did in Canada (Hancock 1986).  Health inequalities Research on the determinants of health emphasizes both the level and distribution of health in the population. An aspect of the unequal distribution of health that is of great concern, and is still relatively poorly understood, is the social gradient in health. This gradient exists for different measures of socio- economic status(SES) (e.g., income, education), and different measures of health (e.g., self-reported health status, chronic disease, disability). Whatever is responsible for this gradient is not disease specific; it is a more fundamental process that manifests itself through the predominant diseases of an era.  Whitehall study The Whitehall Study has followed the health status of thousands of British civil servants over many years. The study is important because it rules out two commonly hypothesized causes. – 1) Absolute deprivation among those in the lower ranks does not cause the gradient: all of these individuals work in the British civil service earning decent wages. They can afford the necessities of life and they are at least minimally engaged in social interaction. – 2) The gradient extends across the full spectrum of ranks: those in both the administrative and professional/executive classes are highly educated, highly effective individuals earning well-above-average incomes, yet we still observe a difference. Fig 6.8 CHD Mortality in the Whitehall Study  Health Behaviours Differential prevalence of high-risk health behaviours across the ranks does not cause the gradient. Lowest rank has a higher prevalence of common risk factors, but the contribution of such risk factors to the gradient is likely to be relatively small.(see figure 6.9) Education and income correlate with the civil servant ranks, and as we see in Chapter 5, are thought to contribute causally to health status. However, given current evidence regarding the impact of education and income on health, it is unlikely that their differences across the ranks could generate such a large gradient. More likely, education and income are largely proxy measures of social status and class. How do these factors impact health?  Social Determinants of Health Research on the social determinants of health (e.g., Barer et al. 1994; Berkman and Kawachi 2000; Evans 2002) offers some tentative explanations for the social gradient. They draw on research into social hierarchies in primates, the stresses associated with various positions in a social hierarchy, our bodies’ responses to such stresses, and the health consequences associated with these responses: – 1) People in different positions in the hierarchy are exposed to different levels of stress (both in the frequency and the severity of the stress). Exposure to such stresses within the social hierarchy varies inversely with rank. – 2) Psychosocial stress can induce physiological reactions – 3) Physiological responses can manifest in disease. Economics 2CC3/HLTHAG 2C03 Spring 2024 Chapter 3 The Basics of Markets Part 2  Supply and demand A fundamental idea in economics is that supply and demand interact leading observed prices tending towards equilibrium prices in markets Sometimes supply and demand are referred to as “Marshall’s scissors”, after the English economist who developed the theory Alfred Marshall (1842-1924) combined supply side analysis from classical economics with the analysis of the demand side (the marginal revolution). Market Equilibrium Market Equilibrium  Where the scissors meet Equilibrium is where demand & supply curves intersect - where consumers and producers “agree” about the price and volume of production and consumption Below equilibrium price there will be excess demand - purchasers will bid prices up to acquire goods Above equilibrium price there will be excess supply - competition among suppliers will bid prices down & reduce output An example of Price Ceilings: Rent control  Effect of shift in supply curve from S1 to S2 Price 25 S1 S2 20 P1 15 P2 10 5 D Q1 Q2 Quantity 10 20 30 40 50 60 Supply and Demand Analysis of Markets ► The supply and demand framework allows us to trace the impact of any market-affecting event through its influence on supply or demand or both. ► Example: Outbreak of “mad cow” disease ► Impact on Market for Burgers: ) Market Demand Curve shifts Left ) Market Supply curve shifts left ) Why? ► Equilibrium Effects: ) Eqm. Quantity demanded falls ) Eqm. price may fall or rise (intuition?) ► Impact on Market for Pizza: ) Market Demand Curve shifts Right (why?) ) Market Supply Curve is unaffected ► Eqm Effects: Eqm price and quantity increases.  The effect of a reduction in supply on equilibrium price and quantity with demand of varying elasticities Price D1 25 D2 S2 S1 20 D3 15 10 Elastic 5 Less elastic Q3 Inelastic Q 2 Q1 Quantity 10 20 30 40 50 60 Normative Economic Analysis ► Assumptions (Things taken as agreed before normative analysis begins) ► Consumer Sovereignty: ► I n d i v i d u a l w e l l - b ei n g i s a d e q u a t el y r e v e a le d by ch o ice s. ► W e lf a r e of a s o ci e t y s ho u ld o n ly d e pe n d o n t h e s e t of in di v id u a l w e l l - b ei n g s o f m em b e r s o f t h a t s o c i e t y. ► Major Conclusion: Perfect Competition is Sufficient for Pareto Optimality of market processes given consumer sovereignty): ► Large number of consumers and Large number of producers: such that Individuals’ are too small relative to the aggregate for their choices to affect market price: no market power ► No Externalities in consumption or production: Marginal Private Benefits=Marginal Social Benefits (consumption) and Marginal Private Costs=Marginal Social Costs (production) ► Perfect Infomation Consumers’ and Producers’ Surplus Measuring Total Net Social Benefits no externalities In a perfectly competitive market no unit has Market Power ► In a (perfectly) competitive market no single consumer or producer has control over market forces that shape prices - no market power. ► Demand side: No consumer accounts for a large proportion of demand. Each consumer consumes a small (>=0) proportion of the total for every good they consume ► Supply side: Multiple producers producing the same good have access to the same technology and same inputs (at the same price) can freely enter or exit the market Markets With Imperfect Competition 1 Imperfect Competition: Some competition among producers who have some market power. As market becomes more imperfect there needs to be more concern about strategic interaction Such types of market structures are common in the real world e.g: Monopolistic Competition: Many producers each selling a slightly differentiated version of the product: Goods are substitutes but not perfect substitutes Key Factor: Brand-Name Loyalty ► Application: Can provide an explanation for the “Generics Paradox” in the Pharmaceutical industry. ► Generics Paradox: Once the patent of Brand-Name drugs expire lower-priced generic drug producers often enter the market. The data shows that brand-name producers often increase their prices after patents expire. Markets with Imperfect Competition 2 ► Oligopolistic Competition: small number of large producers ► E.g. Competition among brand-name drugs for the same medical condition, petrol providers ► Strategic Interaction: The decisions of one firm affect the profits of the other firm. When firms are deciding how much to produce, their beliefs about what their competitors will do are important in shaping decisions.  Monopoly and Monopsony ► The extreme opposite of perfect competition in supply is Monopoly - a single seller of a particular good ► E.g. Pharmaceutical firm develops a new drug. Patent protection grants monopoly power for a predetermined period of time. ► We have Monopsony when there is only one buyer ► E.g. a one-company town where a single organization is the only employer: has the power to hire workers (“buy labor”) at wages below the competitive level. The Welfare Effects of Monopoly 1 ► Example: Monopoly ► Monopoly Equilibrium: Higher Price (PM) and Lower Quantity (QM) than Competitive Equilibrium at point C, Price PC, Quantity QC) ► At the monopoly output level (QM): ► PM = MPB = MSB > MPC = MSC ► Which implies that MSB > MSC ► Since MPB > MPC why doesn’t the monopolist produce one more unit of output? ► Answer: To sell that extra unit, price would have to decrease - all units sold would be sold at that lower price. The Welfare Effects of Monopoly 2 No Externalities –also see slide 11 ► Whenever the private costs (or benefits) of an activity differ from the social costs (or benefits) of an activity, an externality arises. ► Production Externality: E.g. a firm may generate pollution which may adversely affect the health of individuals that live nearby. If this cost is not paid by the firm then the private cost of the firm is lower than the social cost. ► Consumption Externality: E.g. a consumer may generate positive or negative externalities (e. g vaccinations, second hand smoke.) ► Externalities can lead to inefficiencies in allocation when the market participants base their decisions only on private benefits and costs, ignoring social costs and benefits. The Welfare Effects of Externalities  Information ► Supply side: All producers must have access to information on production methods for the good and on the prices of production inputs ► Demand side: Consumers know the quality of the good, their own valuation of the good (preferences) and the prices charged by producers. ► Of particular concern is the case of asymmetry of information between buyers and sellers.  Information Problems - Example ► Perceived Private Benefits lower than True Private Benefits  Markets and Market Failure In perfectly competitive markets: MSB = MPB = P ∗ = MPC = MSC ► Net Social Benefit from the consumption and production of a good is defined as Total Social Benefit minus Total Social Cost for producing that good. ► Thus a perfectly competitive market also maximizes Net Social Benefit –there are no Potential Pareto improvements. ► Failure of a market or a set of markets to generate a situation where there are no Potential Pareto improvements is called “market failure” ► Market Failure occurs when one or more of the equalities above are violated ► Three possible causes 1. Presence of Market Power 2. Presence of Externalities 3. Presence of Informational Problems 2 Rationales for Government Intervention ► Market Failure Rationale: When one or more of the conditions for perfectly functioning markets is violated ► an unregulated market may fail to generate a Pareto efficient allocation. ► Intervention to “correct” market-failure may be needed. ► Must often choose among second-best alternatives: there are no feasible alternatives that are as efficient as perfectly functioning markets.  Willingness to Pay ► Markets allocate resources on the basis of consumers’ willingness to pay (WTP) ► A person’s WTP depends partly on their preferences and partly on their income or wealth. ► This means that different initial distributions of income will generate (through the market mechanism) different final allocations of goods. ► If markets are well-functioning, e.g perfectly competitive, the final allocation in each case will be Pareto Optimal Final allocation may be deemed equitable if the initial distribution of resources was equitable.  Efficiency vs Equity ► First Fundamental Theorem of Welfare Economics: When markets are competitive, the market mechanism leads to Pareto-efficient allocations. ► Second Fundamental Theorem of Welfare Economics: When markets are competitive, any Pareto efficient allocation can be implemented through the market mechanism with a redistribution of wealth. ► The Second Welfare Theorem tells us that the processes of efficiency and equity are two separate problems: If markets are competitive (i.e. no market failure) but the allocation is not deemed equitable, the (ideal) policy solution is not to intervene in the operation of the market, but to (costlessly) redistribute income so that the market mechanism generates the equitable (and efficient) allocation.  Market Failure Rationale vs Equity Rationale ► Market Failure Rationale: Efficiency-based argument ► Within most areas of economics, efficiency-based arguments (i.e. evidence of market failure) carry more weight. ) Equity is a more contested notion than efficiency. ) While economists tend to agree on the definition of efficiency, there is little consensus on the definition of equity. ► Even though contested, in some sectors equity concerns weigh much more heavily. ► Health and Health care are such sectors. Economics 2CC3/HLTHAG 2C03 Fall 2024 Chapter 3 The Basics of Markets PART 1 The Basics of Markets ► In the last chapter we talked about efficiency in allocating resources within the economy. ► In a well-functioning market, the market mechanism ensures that resources are allocated efficiently. If certain conditions are met Pareto optimality is attained with a market mechanism. ► The competitive market as an allocation mechanism: Forces of competition in supply and demand determine prices Producers and consumers take these prices as given and choose how much to produce (supply) and how much to buy (demand) ► In some cases, especially for health-care markets, we will see that the (sufficient) conditions required for efficiency are not met. Even when markets are not chosen as the primary allocation mechanism, because much economic analysis is based on market analogies, understanding economic analysis requires a solid grasp of the economics of markets. Demand Side - Consumer Behavior ► Two key factors that determine consumer behavior 1. Preferences 2. Budget Constraint ► the choice problem of the consumer: ► Objective is to choose the affordable consumption bundle that gives the highest utility, given preferences, income and prices. Preferences are summarized by a utility function ► e.g: Two good linear utility function u1 (x1 , x2 ) = 2x1 + 3x2 ► For each utility function there are associated marginal utility functions for goods 1 and 2. ► Marginal utility: how much utility changes when we increase one good by a little bit, holding the consumption amount of the other goods constant ► Marginal utility that you get from increasing x1 by a small amount usually depends on how much of x1 and x2 you were consuming in the first place- although it does not for a linear utility function. ► Economists usually assume that the marginal utility functions take positive values: which implies that the consumer always prefers to consume more of a good – satisfaction increases as the consumption amount of a good increases. ► Also often assumed that the additional satisfaction becomes smaller and smaller (although always remains positive) as the consumption amount of the good keeps increasing. This assumption is called diminishing marginal utility. Consumer Behavior - Budget Constraint ► What goods can the consumer afford given their resources (measured in money terms) and market prices? ► Let m denote the consumer’s money (e.g. m = $100) and let p1 and p2 denote the per-unit prices of the two goods. ► Then, a consumption bundle (x1 ,x2 ) is affordable if it is true that p1 x1 + p2 x2 ≤ m ► Total expenditure for the consumption bundle cannot exceed the consumer’s income. Indifference Curves and budget constraint: 1 individual The Demand Function and movements along it ► The demand function (a.k.a. demand curve) for good i summarizes the relationship between the price of a good and its optimal consumption keeping all else constant. ► In particular income and other prices are kept constant. We consider Marshallian(a.k.a. uncompensated/income constant) demands unless otherwise stated. ► This relationship is usually negative: Increases in pi decrease the optimal consumption amount of xi and vice versa ► Can draw this in a graph called the demand curve. ► Demand curves are downward sloping ► Price is normally drawn on the y-axis and Quantity on the x-axis. ► A movement along the demand curve when the price of a good changes is called a movement ‘along the demand curve’. It assesses what happens to quantity demanded of good x when price of x changes all else equal. Shifts in Demand Curves - Substitute Goods ► The demand curve is drawn assuming the prices of other goods remain constant. ► What happens to the demand curve for good i when the prices of other goods change? ► Suppose that the price of good j increases. If goods i and j are substitutes then the consumer will respond by increasing his consumption of good j that is now relatively cheaper ► For any price level of good i, the consumer demands more of good i: The demand curve shifts to the right ► Similarly, if the goods are substitutes but the price of good j decreases, the consumer substitutes away from good i which is now relatively more expensive: the demand curve shifts to the left Shifts in Demand Curves - Complementary Goods ► What if the two goods are complements? ► E.g. burgers and hamburger buns ► A decrease in the price of buns will increase their quantity demanded by the consumer. ► Burgers complement buns so consumers will also demand more burgers. ► Given the price of burgers, the decrease in the price of buns will increase quantity demanded for burgers. ► The demand curve for burgers shifts to the right ► What happens to the demand curve for burgers if the price of buns increases instead? ► A: It would shift to the left Elasticity of Demand ► Applied economic analysis uses Elasticity of Demand to measure the sensitivity of demand with respect to changes in its determinants: 1. Changes in the price/own price: price-elasticity of demand/ own-price-elasticity 2. Changes in income: income-elasticity of demand 3. Changes in prices of other goods: cross-price elasticity of demand ► The elasticity of demand with respect to price, o r some ot he r va ri ab l e, x, is defined as the ratio of the proportionate change in quantity demanded (q) to the proportionate change in price (p), or some other variable x. ∆Q Ep = Q1 A ∆P P1 ► For large changes in prices, elasticity can differ depending on the baseline (whether it is the price before or after the price change) ► Elasticity is often discussed in percentage terms by multiplying top and bottom of the right hand side by 100. The elasticity itself does not change. A demand curve for medicine Price and Quantity of Medicine P Price (£) Medicine 8 (g) 0 6 20 90 0 40 70 60 63 4 80 59 0 2 59 63 70 90 0 Medicine Demanded The price elasticity of demand Measured by price elasticity of demand: % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝑬𝒑 = % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 Sign of the measure is negative (except for “Giffen goods”) but we often talk about the elasticity being greater/demand being more elastic when elasticity is in fact more negative (which is smaller (mathematically)). Need to be precise when we are talking about price elasticities being larger or smaller. -if price rises 10% & demand falls 10% 𝑬𝒑 = − 𝟏 (𝑼𝒏𝒊𝒕𝒂𝒓𝒚) -if price rises 10% & demand falls 15%: 𝑬𝒑 = − 𝟏. 𝟓 (𝑬𝒍𝒂𝒔𝒕𝒊𝒄) -if price rises 10% & demand falls 5% 𝑬𝒑 = − 𝟎. 𝟓 (𝑰𝒏𝒆𝒍𝒂𝒔𝒕𝒊𝒄) Shifts in Demand Curves - Changes in Income ► So far we’ve been looking at shifts in demands under the following assumptions The price of another good (complement or substitute) changed The own-price remained constant Income remained constant ► We’ve also seen that changes in price of a good can be represented as movements along the demand curve holding income constant and the prices of other goods constant ► What if we allow income to vary and assume that all prices remain constant? ► We can trace the effect as a shift in the demand curve ► Whether demand shifts in or out depends on the type of good. Movement along and shift in a Demand Curve Price 25 Shift in the demand curve, for example 20 with higher income 15 10 5 Quantity 10 20 30 40 50 60 demanded Income elasticity of demand % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝑬𝒀 = % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒊𝒏𝒄𝒐𝒎𝒆 𝒀 EY Number Description Graph Inferior good EY -ve QD ↓ as Y ↑ Normal good EY +ve QD ↑ as Y ↑ necessity Less than in 0 < EY < 1 proportion to income increase luxury/superi EY > 1 More than in or proportion to income increase Clarifying some Textbook Errors and Omissions on elasticity of demand table 3.3 From Individual to Market Demand 1 ► So far we’ve been looking at the demand of a single consumer for a single good. ► What about the total demand for a good in an economy with multiple consumers? ► This is called the market demand for good i. ► If we know the demand functions for each consumer we can construct the market demand function by adding the quantity demanded of each consumer for every possible price: ► Market Demand at price p = sum of each consumer’s quantity demanded when the price is p. From Individual to Market Demand 2 ► Note that market demand is affected both by the mean income and the distribution of income.  The production function Health status Health care inputs Shows maximum output for given input level Each additional unit of input produces less additional output Firm Behavior - The Supply Side ► firms or producers seek to maximize profits given their technology or production function. ► Analogous to consumers who seek to maximize satisfaction given their income and market prices, Recall that the production function y = f (x1 ,x2 ) gives us the maximum output y that the firm can produce using different combinations of inputs x1 and x2 given the technology f. ► Diminishing Marginal Product: The concept is similar to diminishing marginal utility - Holding other inputs constant, increasing one of the inputs increases total output but at a decreasing rate. ► This is the fundamental supply side concept which leads to an upward sloping supply curve. Firm Behavior - Average Product ► Marginal product is defined as the change in total output for a unit change in an input. ► Average product is defined as the total output / #units of input ► Interpretation: the average output a unit of input 1 produces, holding the other inputs constant. ► In the next example, the marginal product of the worker initially increases (increasing marginal product) and then falls (diminishing marginal product) Marginal and Average Product of Hamburgers per worker per day. Table 3.4 Marginal Costs of hamburger production. Table 3.5 Marginal Costs of hamburgers ► Account for input prices (see table 3.5) ► E.g. Marginal Cost per Hamburger: The cost of inputs for producing 1 more hamburger. ► When we hire the first worker we produce 50 burgers at the cost of 90 dollars. ► Each of these extra burgers are produced at a marginal cost of 90/50 = 1.80 dollars. ► We hire the second worker and output goes up by 60 burgers while costs go up by 90: The marginal cost of each of these burgers is 90/60 = 1.5 dollars ► We hire the third worker and output goes up by 56 units (and costs by $90). Marginal cost per hamburger 90/56 = 1.607 dollars. ► Eventually marginal costs become very large as the last bit of output is squeezed from the current stock of capital. Marginal Revenues ► What is marginal revenue for a competitive firm? ► Competitive firms take output prices as given ► Each unit of output is sold at the market price p. ► Total revenues go up by p when another unit is sold ► Marginal Revenue = p Profit-Maximizing output ► How many burgers should the firm produce to maximize profits? ► The owner will compare the marginal cost of producing the next burger to marginal revenue ► As long as p is above the marginal cost of producing the next unit of output, the firm should increase output to maximize profits. if p (y)> MC (y ) for some level of output y the firm can increase its profits by increasing y Costs go up by MC(y) and revenues go up by p Profits increase. ► On the other hand if p < MC(y) for some y, the firm can increase profits by decreasing y Firm Supply ► Using the above reasoning we conclude that the producer cannot increase profits any further when marginal costs equal the per-unit price of output. ► So the profit maximizing level of output y * must satisfy MC(y *) = MR(y *) = p (y* ) ► Which implies that the firm will decide to supply according to its marginal cost function ► Since the marginal cost function is, at least after some point, upward sloping, the supply function of the firm is also upward sloping ► Intuition: A higher per-unit price is required to motivate the producer to produce more burgers since the marginal cost of burgers increases as burgers increase. Individual Firm (short-Run) Supply Curve for hamburgers Summarizing the individual supply curve Depicts behaviour of producers as prices change. All else equal, production rises as prices rise and falls as prices fall. So the supply curve is upward sloping. - e.g. butter prices rise, butter producers respond - movement along supply curve Supply curve can also shift, as result of - technological improvement (right) /reduction (left) - input price changes left (input price increase) and right(input price decrease) - Other characteristics of prices of production, e.g. increased safety regulations (left). Movement along and a shift in the supply curve Price 25 20 15 10 Shift in the supply curve, e.g. with positive technological change 5 Quantity 10 20 30 40 50 60 Shifts in the Supply Curve for Hamburgers- Figure 3.8 Market Supply ► Like market demand, we can derive the market supply curve by aggregating over the supply of each individual firm, for each possible price level. ► Example with two firms: Fig 3.9 in textbook. ► Work similarly with multiple firms to derive market supply. Elasticity of Supply ES = proportionate change in quantity supplied/(proportionate change in price) = (percentage change in quantity supplied)/(percentage change in price)  ECON 2CC3/HLTHAGE 2C03 - Health Economics and its Applications to Health Policy Fall 2024 Chapter 2: Essential Economic Concepts Resources and Opportunity Cost – How should society allocate its scarce resources? Raw Materials Physical Capital Human Capital – Opportunity Cost of using resources in a particular way is the highest benefit that would be obtained if we used them in another way – We should never employ resources in a way such that the opportunity cost is higher than the benefit obtained – Production of the highest benefit bundle of goods should be at minimum (opportunity) cost  Money – Resources do not include money. – But money provides a convenient metric to measure the value of resources. – The key link between resources and money is prices. – Prices in a well functioning market system reflect (marginal) benefits and (marginal) opportunity cost. We will see this in chapter 3… – Let’s first turn to optimization using marginal analysis  Marginal Analysis – All concepts of efficiency rest on the concept of optimization – Finding an optimum generally depends on marginal analysis – Marginal analysis identifies the optimal level of something by continually asking the following question: What happens if we do something just a little bit more or a little bit less? – Thinking incrementally or at the margin – The net benefit associated with an activity is maximized when the activity is undertaken to the point at which the marginal benefit is equal to the marginal cost.  Marginal Analysis 1 – Consider the problem of deciding how many beds we should put in a hospital. – Let 𝑥 denote the number of beds. We can write the net benefit of having 𝑥 beds as a function of 𝑥 – 𝑁𝐵(𝑥) = 𝑇𝐵(𝑥) − 𝑇𝐶(𝑥) – where 𝑇𝐵(𝑥) is the total benefit and 𝑇𝐶(𝑥) the total cost associated with 𝑥 beds. – What is the optimal value of 𝑥? – When 𝑥 = 0 𝑁𝐵 = 𝑇𝐵 = 𝑇𝐶 = 0. Consider adding the first bed. What happens to 𝑁𝐵? – If the 𝑁𝐵 is positive we should add the first bed.  Marginal Analysis 2 – Therefore, we should add the first bed if – 𝛥𝑇𝐵 − 𝛥𝑇𝐶 > 0 – or equivalently MB>MC – Now note that 𝛥𝑇𝐵 from adding the first bed is the definition of the marginal benefit from adding the first bed. – Similarly, 𝛥𝑇𝐶 is the marginal cost of adding the first bed. – Therefore we should add the first bed if the marginal benefit of the first bed exceeds its marginal cost. – Continuing in the same way we should keep adding the second, third, fourth, etc., beds if the associated marginal benefit exceeds the marginal cost.  Marginal Analysis 3 – When should we stop adding more beds? – Suppose that we have 1000 beds in a hospital and we are considering adding one more. – From our previous analysis we know that if 𝛥𝑇𝐵 < 𝛥𝑇𝐶 then 𝛥𝑁𝐵 < 0 so we should not add the extra bed. – Suppose that we are considering removing one bed, i.e. decreasing 𝑥 by 1 unit. – We should remove the bed if our Net Benefits will increase as a result of the change in 𝑥. – The key difference to the case where we were considering an increase in 𝑥 is that now 𝛥𝑇𝐵 < 0 and 𝛥𝑇𝐶 < 0  Marginal Analysis 4 – So we know what conditions must be satisfied to add or remove a bed. – For any value of 𝑥, if 𝑀B(𝑥) > 𝑀𝐶(𝑥) we should increase 𝑥. – For any value of 𝑥, if 𝑀B(𝑥) < 𝑀𝐶(𝑥) we should decrease 𝑥. – We should stop when we reach a value for x, say 𝑥 ⋆ such that – 𝑀B(𝑥 ⋆ ) = 𝑀𝐶(𝑥 ⋆ ) – The last condition implies that at 𝑥 ⋆ we cannot increase the net benefit of beds by adding or removing beds.  Marginal Analysis Example – Colon cancer is asymptomatic in its early stages but early detection can dramatically improve outcomes. – Guaiac Test: can detect colon cancer in its pre- symptomatic stage but the test is not perfect: Possibility of false negative Possibility of false positive – In the early 70’s the American Cancer Society recommended that doctors should carry out six Guaiac tests on a person. – Is this a good recommendation? Is six the optimal number of tests? Marginal Analysis and Screening for Colon Cancer 1 Marginal Analysis and Screening for Colon cancer 2 – Neuhauser and Lewicki (1975) simulated the effects of screening 10,000 individuals, 72 of whom had the disease. – The test has 91.67 percent chance to correctly identify each case. – We would expect to detect 65.9 of the 72 cases. The cost of the test in the first round is $77,511. – Second round of tests: cases detected increase to 71.4, total costs rise to $107,690 – Six rounds of tests will detect effectively all cases (71.94) at an average cost of $2451. – The analysis, however, is based on the average cost per case, not the marginal cost. – The marginal cost per case detected with the 6th test was over 47 million dollars (in 1975!). – Surely there would have been more beneficial uses of that 47 million dollars than a 6th stool test to the person diagnosed ( and certainly to society as a whole)  Production. Technology and the Production Function – Production transforms inputs into outputs. – The level of output that we can produce with a given set of inputs depends on the available technology. – The technology is summarized by a production function – We usually write the production function as 𝑦 = 𝑓(𝑥1 , 𝑥2 ,.. 𝑥𝑛 ) 𝑦 = (Maximum) output produced for different values of inputs 𝑓: the technology that converts resources to output 𝑥𝑖 :level of resource 𝑖 used in production. As we change the values of x variables we change the value of y for a given f – Example: 𝑦: number of immunizations 𝑥1 :work hours of doctors; 𝑥2 : work hours of nurses Other inputs: 𝑥3 = number of Disposable needles, 𝑥4 = quantity of vaccine available etc. 𝑓: the technology that converts the above inputs to vaccinations. There are usually many different ways to produce a given output. Which (not) to choose? – Generally there are many different ways to produce a given level of output. – E.g we can produce 100 vaccinations (given 100 needles and 100 doses of vaccine) in a particular time period using 1 full time doctor or 1 full time nurse or a ½ time doctor and a ½ time nurse. – Suppose that the following programs are equally effective in treating 100 individuals with depression. (i.e they result in the same value of y) – Which of the programs should we use? Table 2.2  Technical Efficiency 1 – Which of the above (imaginary) programs should we use to treat those 100 depressed individuals? – Firstly, is there a program that we should definitely not use given the above information? Yes: Program C. Why? Program C is not technically efficient and therefore can be excluded from our list of candidate programs to treat depression. – Technical Efficiency: No resources are wasted in production. – Here the production technology is such that 1500 hours of therapy and 250 drug doses produces the same output as 1500 hours of therapy and 300 drug doses. – If we only cared about quantity produced we would be indifferent between programs A, B and D.  Technical Efficiency 2 – A combination of input levels (𝑥1 ′, 𝑥2 ′) for producing a given level of output (e.g. 𝑦 = 100) is not technically efficient if one or both of the following is true: 1. Can produce more output (e.g. 𝑦 > 100) given (𝑥1 ′, 𝑥2 ′) 2. There exists a different combination of inputs (𝑥1 ″, 𝑥2 ″) that can produce the same level of output (e.g. 𝑦 = 100) and it is true that 𝑥1 ″ ≤ 𝑥1 ′ and 𝑥2 ″ ≤ 𝑥2 ′ with at least one inequality being strict. – In our last example, Program C is not technically efficient because there exists another combination of inputs that uses the same number of hours of behavioral therapy but strictly less daily doses of drug therapy (Program C) to produce the same output (relieving 100 cases of depression). – Given the information in the last table, we cannot say that A, B or D are technically inefficient.  Productive Efficiency – So which of the (not) Technically (in) Efficient methods of production should we use to treat 100 cases of depression? – If we want to minimize the cost of production (as we should if we are rational as we can then use the saved money to buy other inputs/ resources to produce other things),the answer depends on the per-unit price (cost) of each input. – Productive efficiency/Cost-effectiveness: Among all the technically efficient methods of production we should use the one with the lowest cost. The productively efficient methods of production are a subset of the Technically-Efficient methods of production. If a production method is not technically efficient it is also not productively efficient/cost-effective Introducing (hypothetical) prices in our previous example: Table 2.3  Productively efficient method is unique – Program D is the unique productively efficient method to treat 100 cases of depression. – In general the productively efficient method is unique. – See isocost and isoquant approach to determining an optimum and appendix fig 2A.2 for an example of producing houses using labour and capital. Fig 2A.2(ii) The Production Possibilities Frontier – Consider an economy that produces two kinds of output: Houses and Food. – Given the resources (labour and capital) in the economy, the combinations of Food and Houses that can be produced can be illustrated with a Production Possibilities Frontier(PPF). – The PPF for housing and food is built up in Appendix 2. p50-53 Fig 2A.5 Characterising points on, below and above the PPF – All points on the PPF (Points C, D, E, F, G) are Technically efficient and productively efficient – All points below the PPF (points A and B) represent technically inefficient production or productively inefficient production. – Points above the PPF are not feasible with current resources and technology.  Pareto/Allocative Efficiency 1 – An allocation of resources is Pareto Optimal/Allocatively Efficient if it is impossible to find a different allocation that satisfies the following conditions 1.it is preferred by at least one individual, and 2.no individual is made worse-off. – If an allocation fails to meet the above criteria, (ie we can move to a new allocation that satisfies the above conditions), we say that the original point is not Allocatively (or Pareto) Efficient, equivalently we say that it is Pareto inefficient. – Pareto Efficient Allocations are a subset of productively efficient Allocations.  Pareto/Allocative Efficiency 2 – Allocative Efficiency requires that society produce and distribute goods and services in accord with the value that individuals place on those goods and services. – To identify allocatively efficient resource distributions we need to know how consumers value goods and services. – I.e. we need to know consumers’ preferences over goods and services. – An individual’s preferences are summarized by a utility function  Utility Functions – We write 𝑢𝑖 (𝑐1 , 𝑐2 ,.. , 𝑐𝑛 ) to express an individual’s preferences over 𝑛 goods. 𝑐𝑚 is the consumption amount of the m’th good – In modern consumer theory the value of 𝑢𝑖 for a given consumption bundle need not be inherently meaningful nor interpersonally comparable- there are no units of measurement for personal satisfaction. – A utility function need only be ordinal: it serves the purpose of ranking alternative consumption bundles. I.e. it orders consumption bundles from least preferred to most preferred according to the consumer’s underlying preferences. – Analytical Problem: The underlying rankings or preferences are not directly observed. Let’s ignore this problem for now and assume that consumers’ utility functions are objectively known. Indifference Curves and budget constraint: 1 individual Exchange efficiency 1  2 or more individuals How can we determine the allocatively efficient combinations of food and housing to produce, and the associated distributions of the two goods among members of society? First consider exchange efficiency. Choose a given point on the PPF (e.g point F= 300 food 1100 housing)and divide it among 2 agents alpha and beta. In Figure 2A.7 , the horizontal axis represents the total amount of housing available, and the vertical axis represents the total amount of food available. Into this box, we can draw indifference curves. (note the numbers are incorrect in that total housing allocated to alpha and beta does not equal 1100 (the sum is 825) and the total food does not equal 300(the sum is 240) Is point X allocatively efficient? Not according to the Pareto Criterion. Starting at point X, it is possible to reallocate housing and food to reach point Y, thereby increasing Beta’s utility without decreasing Alpha’s.  Exchange efficiency 2 Once point Y is reached, it is impossible to reallocate housing and food in a way that increases one person’s utility without decreasing the other’s. Hence, point Y is exchange efficient by the Pareto Criterion. Notice that all points of tangency (e.g Y, W, Z) between Alpha’s and Beta’s indifference curves represent Pareto-efficient allocations for given total production F i.e We cannot move along the contract curve without decreasing the utility of one individual. All points on the ‘contract curve’ are pareto optimal given production of F. Note we do not need cardinality of the utility function nor interpersonal comparability of levels of utility to identify exchange efficiency. We just need there to be an allocation where alpha and beta are willing to trade off food for housing at the same rate irrespective of the levels of utility. UPF for point F  UPF 1 If we can measure the levels of utility then: The set of all allocations on the contract curve can be converted into the utility-possibilities frontier (UPF) associated with the amounts of food and housing produced at point F on the production possibilities frontier ( Figure 2A.8(i) ).  UPF 2 Given the resources of society, cost effective production of F and the level of utility of one person, the UPF tells us the maximum level of utility the other person can attain Is there any reason to prefer one point on the UPF over another? To choose one of these points given the total production of food and housing we must be able to trade off one person’s utility for another E.g Total utility is maximized when the UPF is tangent to a line of slope -1. But this goes beyond the Pareto principle as all points on the UPF are Pareto optimal given F However we decide to distribute F we can still ask the question: would society be better off by producing some other mix of goods other than F? Maybe by producing another set of goods we can increase utility for both alpha and beta relative to any allocation of F?  UPF and GUPF 1 We can repeat the previous exercise for every point on the production possibilities frontier—in each case, there is a resulting UPF. Then trace out the most outward points on all the UPFs-the envelope. Call this the grand utility possibilities frontier (GUPF) The GUPF tells us the maximal combinations of utility that can be attained among all possible combinations of food and housing that society can produce and among all the possible ways the goods can be divided among members of society All points on the GUPF are Pareto-efficient. Can we choose from among these points? To answer this, we need to know something about the views of members of society regarding distributional equity, since the different points on the GUPF distribute well-being differently among members of society. E.g Total utility is maximized at H. Point I is the point of equal utility. UPF and GUPF 2 (Figure 2.2)  UPF and GUPF 3 there is one point on the UPF for F at which the slope of the tangency between the individuals’ indifference curves equals the slope of the PPF at point F equality of these two slopes means that the rate at which the individuals want to trade off food and housing, given their preferences, exactly equals the rate at which society can trade off production of the two goods, given the available technology We have efficiency in production, in exchange, and harmony between the two elements of the economy(production and exchange). This is called the top-level condition. There is no way we could reallocate resources from this position without making one person worse off even if we could change the output mix. So this allocation must lie on the GUPF. For any other allocations on the contract curve we could change the output mix and increase utility for one or more individuals. Therefore all other points on the UPF associated with F could not be on the GUPF. So to build up the Grand Utility Possibility frontier we only have to plot one point in utility space of alpha and beta for each point on the PPF rather than the whole UPF for each point on the PPF. All points on the GUPF satisfy the top-level condition.  Potential Pareto Criterion – Pareto criterion receives wide acceptance-almost everyone agrees we should be on the GUPF(at least for ‘socially acceptable’ preferences.) – And (without using information about the level of utility to which allow us to draw UPF’s and the GUPF in utility space) Pareto criterion does not require cardinality nor interpersonal comparability of utility. – BUT The Pareto Criterion does not identify a unique allocation.. –.. and it has nothing to do with the concept of fairness – Also, almost no public policies that reallocate resources pass the Pareto test. They usually hurt one group while benefiting another – The potential Pareto Criterion: if the gains to the winners under a reallocation are sufficiently large that the winners could compensate the losers and still be better off, even if no compensation is actually paid, the policy is deemed allocatively efficient. – Generally the potential Pareto Criterion leads to maximization of the net benefit to society: Net Benefits = Total Benefits - Production Costs  Equity – The second key criterion economists use to judge the desirability of alternative allocations of resources is equity. – Equity concerns fairness. – One could argue that allocations where one of the agents gets all of the goods in the economy cannot be fair. – we might be tempted to think that equal division of goods is fair, we should first also consider the characteristics of individuals when we consider equity.e.g health care needs – there can be reasons for desiring an unequal distribution of goods(incentives+rewards, needs e.g due to disabilities ,deserts) – Equity- an ethical characteristic, is not, in general the same concept as equality- which is a mathematical or distributional feature  Distributional Equity Require 3 types of information: 1) agreement regarding the thing (or “good”) whose distribution is of equity concern; 2) the characteristic of individuals (e.g., income, health status) judged relevant to assessing a fair distribution of the good; 3) a definition of how the distribution of that characteristic among individuals corresponds to a fair distribution of the good among individuals (who should get more and who less?). Things of concern for distributional equity in the health care sector might be: health care itself, access to health care, health, or the burden of paying for health care Under the equity principle of “allocation according to need,” for example, the relevant individual characteristic for assessing distributional equity in health care utilization would be a person’s need for care. Under the equity principle of “payment according to ability to pay,” the individual characteristic relevant for assessing distributional equity in health care finance would be a person’s income or wealth.  Procedural Equity In some situations, we cannot accurately observe one or both of – a) the good finally consumed – b) the equity-relevant characteristics of individuals, making it impossible to compare how the equitable distribution compares to the actual distribution Procedural equity concerns the process of distribution – Especially useful for indivisible goods – Ensure that whatever mechanism we used to distribute resources in a society, the process treats everyone fairly. – This is the concept of procedural equity.  Equity and Efficiency – Equity and Efficiency do not need to conflict: The two problems can be separated and examined apart from each other. All points on GUPF are Pareto efficient An efficient allocation exists that is consistent with just about any conceivable criterion of distributional equity between the two individuals potential Pareto Criterion is an efficiency criterion which dictates that the single efficient allocation is the one that maximizes total net benefits even under the potential Pareto Criterion such a conflict is not inherent in that moving towards equity may lead to greater net benefits. Must be done on a case-by-case basis Evidence shows that people are willing to trade off greater amounts of a good against a fairer distribution of the good. The extent to which individuals are willing to make this trade-off depends on the nature of the good being distributed; but in health care, people seem to place considerable weight on equity willing to tolerate quite substantial reductions in total health produced to generate a more equal distribution of health  SWF Conceptually the social welfare function can be used to identify the most preferred allocation on the grand utility possibilities frontier It is tremendously challenging to estimate social welfare functions empirically. They therefore do not play a prominent role in empirical economic research. They are, however, a vitally important conceptual tool when analyzing policy choices SWF utilitarian (figure 2A.10(i) SWF –inequality averse (figure 2A.10(iii)  Markets – So far we have said nothing about markets – we could just divide the endowments in the economy equally, and let the consumers trade with each-other in a market. – Would the market outcome be efficient and equitable? – It would be efficient under the assumption that the market is well-functioning… – We will take a closer look at the assumptions that lead market outcomes being efficient in the next chapter.  ECON 2CC3/HLTHAGE 2C03 - Health Economics and its Applications to Health Policy Fall 2024 Chapter 1 Health and Health Care systems 1  What is economics? From the Greek oikonomia: ‘household management’; Scarcity of resources: - economics can be considered the (art) and science of scarcity - economics is the study of how scarce resources are or should be allocated among competing uses. - it studies (rational) choice within constraints. Three fundamental economic questions: - 1) what to produce; - 2) how to produce it; - 3) how to distribute what is produced. 2  – A growing field of (mainly) applied microeconomics. – Studies the determinants of health and allocation of resources within the health system. What is – Some questions health economists ask: Health How is health valued? How should it be valued? What economic factors influence health, besides health care? What influences the supply and demand for health care? Economics? How do we pay doctors? How should we pay doctors? How do we finance healthcare? How should we finance it? More specific questions may be: Should a new drug be listed on the public formulary? Should hospital administrators purchase a new MRI? Should we substitute inpatient care from medical doctors to physician assistants? 3  – The Health Care system encompasses goods, The Health services and activities only intended to improve or maintain health and Health- – The Health Care system is part of the more general health system: Care e.g. transportation is part of the health system but not part of the health-care Systems system – Some contributions to the health system/ health care system have little additional(aka marginal) benefit. – Some have very high marginal cost. 4 Circular Flow of the Health Care (and Health) systems 5  Gross Domestic Product (GDP), Gross National Product (GNP), Gross National Income (GNI) GDP refers to the total market value of all officially recorded final goods and services produced in a country in a given time period. GNP is the market value produced by enterprises owned by a country's citizens in a given time period, and includes all the value created by its citizens both at home and abroad, and excludes the value created by foreign citizens who reside in the country. GNI refers to total income obtained by citizens of a country in a given period (such as a year), including its citizens’ domestic income and net primary income from abroad. - Generally, GNP = GNI = GDP + net income from the rest of the world. GDP counts the value of production with reference to location, while GNP and GNI value production according to ownership with reference to citizenship. 6  Inflation and Purchasing Power Parity Inflation A persistent rise in the price of goods, services and factors of production over an extended period of time, as measured by a price index such as the "consumer price index". Inflation reduces the purchasing power of a unit of money, and tends to redistribute income from those with savings(creditors) and those on fixed incomes to those who owe money(debtors) and those who have sufficient bargaining power in the economy to raise their prices, wages, or professional fees above the rate of inflation. Purchasing Power Parity’s (PPP’s) PPP's are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs are the ratios of the prices in national currencies of the same good or service in different countries. Source: The Canadian dictionary of business and economics / David Crane; OECD 7 How much will Canada spend on Health in 2022?  – Total Health Care Expenditure = Public Expenditure + Private Expenditure – Private Expenditure = Out-of-pocket + Insurance Payments Total health spending in Canada is expected to reach $331 billion or $8,563 per Canadian in 2022(we have final numbers up to 2021 to date May 5 2024),. Health Care Total health expenditure in Canada is expected to rise by 0.8% in 2022, following Expenditure/Costs high growth of 13.2% in 2020 and 7.6% in 2021. Prior to the pandemic, from 2015 to 2019, growth in health spending averaged 4% per year. Hospitals (24.34%), Physicians (13.60%) and Drugs (13.58%) continue to account for the largest shares of health dollars (more than half of total health spending) in 2022. 9  – It is anticipated that health expenditure will represent 12.2% of Canada’s gross domestic product (GDP) in 2022, following a high of 12.9% in 2020 down to 12.3% in 2021. – 7% in 1975 – In the meantime GDP has been rising (on average) – Implies that health care costs have been Health-Care rising at a faster rate than income. – Is this bad? Costs/Expenditure Not necessarily.. Costs are only half of the equation.. Must also consider benefits – Some new technologies offer genuine new improvements in health outcomes – But many others offer small benefits, at best, over existing technologies at a substantially higher cost 10  11 Share of total health expenditure by spending category CAN2022 forecast  12 Total health expenditure and GDP, annual growth rates, CAN 2002-2026 Five distinct periods of growth in total health spending per capita: Canada since 1975 13 14 How do the provinces and territories compare? Expenditure and growth rates per capita 2022 forecast 2020 Health Spending CAD per capita  2021 Health Spending CAD per capita How does Canada’s health spending compare? Dollars per person($CA), 2021 United States Germany Netherlands Canada $8,046 Sweden Australia France United Kingdom New Zealand OECD average $6,044 $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 Notes OECD: Organisation for Economic Co-operation and Development. Total current expenditure (capital excluded). Expenditure data is based on the OECD’s A system of Health Accounts 2011. Source Organisation for Economic Co-operation and Development. OECD Health Statistics 2023. 2023. 16 2020 Health Spending as % of GDP  2021 Health Spending as % of GDP How does Canada’s health spending compare? Percentage of GDP, 2021 United States Germany United Kingdom Canada 12.3% France Netherlands Sweden Australia New Zealand OECD average 9.7% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Notes GDP: Gross domestic product. OECD: Organisation for Economic Co-operation and Development. Total current expenditure (capital excluded). Expenditure data is based on the OECD’s A system of Health Accounts 2011. Source 18 Organisation for Economic Co-operation and Development. OECD Health Statistics 2023. 2023. 2020 public/private split  2021 public/private split How does Canada’s health spending compare? Public- and Private-sector shares, 2021 Public share (%) Germany France New Zealand Australia United States* 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Notes * For the United States, the public-sector share of total health spending excludes compulsory private insurance expenditures. OECD: Organisation for Economic Co-operation and Development. The public-sector share of total health spending is the sum of expenditures for government schemes and compulsory health insurance. Total current expenditure (capital excluded). Expenditure data is based on the OECD’s A system of Health Accounts 2011. Source 20 Organisation for Economic Co-operation and Development. OECD Health Statistics 2023. 2023. Canada-Life Expectancy at birth and Infant (< 1year)Mortality per 1000 live births  Life expectancy at birth, by sex in 2020 Source: OECD Health Statistics 2022: Health status  Infant mortality rates in 2020 Source: OECD Health Statistics 2022: Health status 23 Life expectancy at age 30 by sex and educational level 24  Canada’s health spending as share of GDP and life expectancy higher than OECD average Total health spending as percentage of GDP, 38 OECD countries, 2021 Life expectancy at birth, 2021 United States Germany United Kingdom Canada 81.6 years France Austria Switzerland Netherlands Japan Sweden Portugal Belgium Denmark Spain Australia Finland New Zealand Norway Iceland Czech Republic --- OECD average: 9.7% Slovenia --- OECD average: 80.3 years Italy Korea Chile Greece Latvia Colombia Israel Lithuania Slovak Republic Costa Rica Estonia Hungary Ireland Poland Mexico Luxembourg Türkiye 70 75 80 85 90 20% 15% 10% 5% 0% © Canadian Institute for Health Information, 2023 Notes Life expectancy at b irth: The mos t recent available data is for 2021. Total health spending as a percentage of gross domes tic prod uct (GDP): 2021 provision al or estimated value. Total curren t expenditure (capital excluded except for Israel an d Mexico). Source 25 Organisation for Economic Co-operation and Development. OECD Health Statis tics 2023. 2023.  Some OECD countries spend less on health and have higher life expectancy than Canada Total health spending per person, $CA PPP, 38 OECD countries, 2021 Life expectancy at birth, 2021