HEALTH ECONOMICS

Paper instructions:
Listen to the Car Talk clip: Is it a good idea to let people choose anyone they want to be their doctor? Why or why not? How does information play into this choice? Should doctors remain licensed? Does this protect them (giving them market power) or the consumer (protecting the consumer from quacks)? Would you expect the price of physician services to rise or decline if they were not regulated? Why? Would you expect the quality of medical care to increase or decrease? Why?

HSMG 301 HEALTH ECONOMICS
Lecture 2

The topic this week is the theory of demand for healthcare.

Since our country spends over $2 trillion dollars in the health care area, you could certainly conclude that we demand a lot of health care! But what do we mean when we talk about economics and demand for healthcare.

If you look in any elementary economics textbook you would find this same material under a general theory of demand. However, healthcare is different in some ways because consumers don’t really demand health care, what they really are demanding is health. The demand for healthcare is actually called a “derived demand”. What this means is that we demand healthcare, not because healthcare is a “good or service” that we actually desire, but that through its consumption we obtain what we really desire—good health. So we consume healthcare plus other things (healthy food, exercise, etc) in order to achieve good health. If we have good health, we will consume less care (except for preventative care).

As managers, we should be especially aware that the goods we market and produce are for the purpose of improving someone’s overall health. Need for care gets introduced in this context and is an example of how healthcare can be different from others goods and services. When we are sick, we may both need and demand health services. We almost always only demand medical care if we perceive that we need the care.

A key questions in health economics is what does the demand curve for health care look like? For normal economic goods, the basic idea is that there is a downward sloping demand curve. The main idea behind the downward sloping demand curve (usually shown as a straight diagonal line) for a good or service, is as seen below? as price rises we demand less, and as price falls we demand more of a good.

So in the graph above, the demand curve is represented by the line D. At price P1 we are at point X on our demand curve, which is represented as Quantity Q1 on the Quantity axis. We can see as price changes from P1 to P2, the amount demanded will also change, from Q1 to Q2. Take a few minutes and get comfortable with this graph. We are really just showing the tradeoff between money (price) and the good we want to purchase (quantity).

Stop and think for a minute—does this make sense for how you think about your purchases? Have you ever purchased less of something because the price went up for it? Usually the answer is yes, but there are cases where it is not true and we will talk more about those situations next week. But for now, in the usual case, the price almost always affects the amount of something we want to buy. Of course, how much money we have affects this also, so if you are incredibly wealthy, you may not be a sensitive to prices as the rest of us!

So, is health care different? Is the demand curve for health care sloping down? If it doesn’t slope down, but is a straight vertical line….that suggests that the same amount of care is demanded at any price.

Emergency care is an example of care with a steeper demand curve!

Research like the Rand Health Insurance Experiment conducted in the 1970’s made an important contribution in that it showed that people do respond to price of care. And in that sense, health care is not somehow different from other consumer goods (in many other senses it is very different as you noted in your first essay assignment!). As the price for medical care falls, we purchase more care. As the price rises, we purchase less. However, there is the special role that health insurance plays in the demand for health care. Since most of us have health insurance (except for the close to 50 million uninsured!), we do not face the true price of health care when we purchase care. A lot of the current debate about Consumer Directed Health Plans and Health Saving Accounts is directed at getting consumers to face more of the costs of their health care consumption directly. In other words, to get consumers in touch with their own personal demand curves for health care!

The debate about moral hazard addresses this issue that people demand more care because the insurance they have shields them from the true price of health care. People disagree about the impact moral hazard has on healthcare demand. This is the topic of the two extra readings and this week’s essay topic.

Remember, while Health Insurance changes the price of health care that the consumer sees it does not change the true price, only the price paid. If we want to encourage people to consume more of a certain kind of health care, we can lower the price to the consumer. For example, if we encourage people to use preventative care, we may incur lower health care costs in the future. In a real sense, we are substituting prevention for future medical care.

In addition to health insurance, physicians also influence our demand for health care. In many areas we have a situation where we rely on experts to help us decide how much of something we want to purchase. For example, when we seek the advice of a financial planner or a lawyer, we are seeking expert help. We call the expert the “Agent” and we are the “Principal”. We seek advice from these agents, but we also need to decide for ourselves if we believe them! There are cases where the agent has an economic interest in providing certain recommendations which can distort the classic Principal-Agent relationship. Historically, we have place a lot of trust in medical doctors because of their education and professionalism. But our financing systems have always created conflicts of interest between patients and doctors. In a fee-for-service system, doctors get rewarded financially by recommending more care for us. Given that we have insurance and don’t experience the full cost of the advice, we may be inclined to demand for care than we would otherwise and the doctors may be inclined to recommend more care than they would otherwise. Since both the doctors’ incentives and the patients incentives are toward more care, the trend has been toward greater levels of consumption. Other methods of paying doctors have changed this incentive—for example; the capitation method gives doctors a fixed amount of money per patient. In this case, the doctor has an incentive to provide less care. Research has shown that doctors do respond in the predicted ways to these financial incentives. Similar research has shown that when hospitals were paid on a per diem (a fixed amount per day), they provided many more days of care than when the payment method shifted to a per case method (DRG-diagnostic related group).

The bottom line is that financial incentives matter…..to patients and to medical providers. If we want to change behavior, we need to change the incentives! But beware of unintended consequences…..For example, we may think that we want to encourage people to consume less health care and reduce overall expenses, but there are forms of health care that we do not want people to consume too little of. We want to encourage prevention and early detection and treatment. And not always because it will cost less, since a healthy person can contribute to society better than a sick person can, we do want to spend money on health care to keep people healthy—even if it costs more to do it than not providing the care!

Demand for a good is strongly influenced by the availability of other goods in the market. Some goods are substitutes for one another, while others are complements. Substitutes are goods that can be used interchangeably, so as the cost of one of them increases (Good A), we would purchase more of the other (Good B). An example of substitutes in health care is seeing a physician or a nurse practitioner. For some illnesses, a physician and a nurse practitioner are excellent substitutes for one another. For some more complex illnesses, they may not be as easily substituted one for the other.

Complements are things that get consumed together. So if you consume more of Good A, if they are complements you will also consume more of Good B. Left and Right shoes are complementary goods for most of us with 2 feet! In fact, these go together so frequently, they are always sold in pairs. Pizza and beer, bread and butter, and many other goods are complements. In medical care, we would say anesthesiologists and surgeons are complements, in that their services tend to be consumed together. Personally speaking, I don’t want to undergo surgery without anesthesia!

For extra credit, email me some interesting examples of complements and substitutes in medical care that you have observed!

HSMG 301 Health Economics
Lecture 3:
Lecture Notes: Price Elasticity of Demand
Economists (and most professionals) have to add their own special jargon to concepts which can make it confusing for students trying to understand the concept for the first time. Elasticity is one of the concepts that tends to confuse most people when they first hear of it, but is really very simple if you take it step by step. In its simplest form “elasticity” is just a measure of how one “thing” changes when some other “thing” else changes. The “thing” can be the quantity supplied (then it would be called the “price elasticity of supply”) or it can be the quantity demanded (also known as the “price elasticity of demand”). In other words, the elasticity is just another word for the consumer’s responsiveness to price.

Think about these scenarios….
Would you go to the movies less if the price doubled? Tripled?
Would you go to the movies more if the price dropped by half?
Would you eat more lobster or steak if the price fell?
Would you be more likely to go to a restaurant if you had a coupon for half off an entrée?
Would you change the number of visits to your dentist if the price increased 5%?
Would you send your kids to private school if it were free?

Your answer to these questions tells us about your price responsiveness or your “price elasticity of demand.”

Economists have a formula (of course!) to measure the exact level of the consumer’s price responsiveness.
(Change in Q) / (level of Q)
E = ——————————-
(Change in P) / (level of P)

Because a price increase will almost always lead to drop in demand, and a price fall will almost always lead to an increase in demand, the actual value of E will be negative. However, by convention we will just drop the negative sign from the results and use the absolute values. So, when E > 1, then the good is said to be “elastic.” When E < 1, then the good is said to be “inelastic.” When E = 1, then the good is said to be “unit elastic.”
In other words, we say that something is:
Elastic — if the quantity demanded changes a lot with change in price
Inelastic — if the quantity demanded changes very little to not at all with change in price
Unitary Elastic — if the percent change of the amount demanded equals the percent change in the price

This table is taken from an economics textbook and shows the elasticities for some common goods and services.

Estimated Price Elasticities of Demand for Various Goods and Services
Goods Estimated Elasticity of Demand
Inelastic
Elasticity<1
Salt 0.1
Matches 0.1
Toothpicks 0.1
Airline travel, short-run 0.1
Gasoline, short-run 0.2
Gasoline, long-run 0.7
Residential natural gas, short-run 0.1
Residential natural gas, long-run 0.5
Coffee 0.25
Fish (cod) consumed at home 0.5
Tobacco products, short-run 0.45
Legal services, short-run 0.4
Physician services 0.6
Taxi, short-run 0.6
Automobiles, long-run 0.2
Approximately Unitary Elasticity
Elasticity ~ =1
Movies 0.9
Housing, owner occupied, long-run 1.2
Shellfish, consumed at home 0.9
Oysters, consumed at home 1.1
Private education 1.1
Tires, short-run 0.9
Tires, long-run 1.2
Radio and television receivers 1.2
Elastic
Elasticity>1
Restaurant meals 2.3
Foreign travel, long-run 4.0
Airline travel, long-run 2.4
Fresh green peas 2.8
Automobiles, short-run 1.2 – 1.5
Chevrolet automobiles 4.0
Fresh tomatoes 4.6

Source: Economics: Private and Public Choice, James D. Gwartney and Richard L. Stroup, eighth edition 1997, seventh edition 1995; primary sources: Hendrick S. Houthakker and Lester D. Taylor, Consumer Demand in the United States, 1929-1970 (Cambridge: Harvard University Press, 1966,1970); Douglas R. Bohi, Analyzing Demand Behavior (Baltimore: Johns Hopkins University Press, 1981); Hsaing-tai Cheng and Oral Capps, Jr., “Demand for Fish” American Journal of Agricultural Economics, August 1988; and U.S. Department of Agriculture.
One of the major factors that affect the price elasticity of demand is the availability of substitutes for the good. For example, notice the high price elasticity for peas in the table above. This is because there are a lot of vegetable substitutes for peas.
There are other types of elasticity also. We can measure the change in the amount we demand of goods and services when our income rises or falls (Income Elasticity). We can also measure the amount our demand for a good changes when another good experiences a price change (Cross-price Elasticity). These elasticities may be positive or negative, so for these calculations we do need to include the sign of the result.
The fact that our relative demand for a good might change with a change in our income makes sense if we remember that the higher our income, the more we may spend on luxury items or other non-essentials. Health care is consumed in greater amounts when we have a higher income.
Cross-price elasticity can tell us if two goods are substitutes or complements for each other. If the increase in a price of one good leads to a fall in the consumption of another good, then the two goods are complements (for example, surgeons and anesthesiologists; radiologists and MRI machines). When the increase in the price of a good leads to an increase in the demand for the other good or service, then these goods/services are substitutes (for example, Home care and inpatient post-operative recuperative time, inpatient and outpatient surgery).

Here is a summary of the main types of elasticity:

English Economics
Price Elasticity How does my demand for a good or service change when the price of that same good changes? (Change in Q) / (Q)
E = ——————————-
(Change in P) / (P)

Income Elasticity How does my demand for a good change when my income changes? (Change in Q) / (Q)
E = ——————————————–
(Change in Income) / (Income)

Cross-price Elasticity How does my demand for a good change when the price of a different good changes? (Change in Q) / (Q)
E = ———————————————-
(Change in Price of Y) / (Price of Y)

Price Elasticity of Supply How does the supply of a good change when the price for that good changes? (Change in Q supplied) / (Q)
E = ———————————————-
(Change in Price of Q) / (Price of Q)

The above equations for elasticity assume that the change in the price will be 1% or “small.” However, if the change in Q is not small, it’s customary to calculate the “arc elasticity,” or “mid-point” elasticity. Here’s the definition of arc elasticity:
(Change in Q) / (average of Qs)
Arc Elasticity = ————————————
(Change in P) / (average of Ps)
To get the average of the Qs, add them and divide by 2. The same goes for the average of the Ps.
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