ECO560A: HEALTH ECONOMICS & POLICY

PRACTICE PROBLEM SET WITH SOLUTION

I. MULTIPLE CHOICE QUESTIONS

1. In many cases, diabetics require the drug insulin. If they do not get it they will die. From this
information, we would guess that the price elasticity of demand is approximately:
a. – 20.0
b. –1.0
c. –0.5
d. 0.0

2. If the price elasticity of demand is –0.5, a 10 percent increase in price will _____.
a. decrease expenditures by about 5 percent
b. increase expenditures by about 5 percent
c. leave expenditures unchanged
d. The answer cannot be determined

3. Decisions regarding health care differ from decisions regarding auto repair with respect to:
a. the role of insurance.
b. the role of nonprofit providers.
c. the presence and extent of uncertainty.
d. problems of information regarding the appropriateness of the procedure.

4. Uncertainty in the health care economy suggests:

a. providers and their patients may not know whether treatments will be effective.
b. patients may wish to insure against unexpected illnesses or injuries.
c. insurers may make substantial profits.
d. Answers (a), (b), and (c) are correct.

5. Data from the Rand Health Insurance Experiment indicated that:

a. price has no impact on the utilization of health care.
 b. increased price is related to increased use of health care.
c. increased price is related to decreased use of health care.
d. increased price first increases, then decreases use of health care.

6. The term equity refers to:

a. the efficient production of services.
b. equal treatment of all individuals.
c. competition among health providers.
d. government provision of health care.

7. Home health care for the elderly _____ because _____.

a. costs nothing; the caregivers are not working anyhow
b. may be costly; caregivers must spend time providing care that they would have
allocated differently
c. is costly; physicians must monitor the patients
d. is costly; the elderly need to take large amounts of prescription drugs

8. Asymmetry of information may mean that:

a. neither the provider nor the patient has all of the information.
b. the provider has more information than the patient.
c. the patient has more information than the provider.
d. Answers (b) and (c) are correct.

Use the following discussion to consider the next three problems (9-11).
A statistician estimates a demand curve for visits per year to the health club:
Qd = 50 – 10p + 0.5 y,
where p is the price of towels per visit (in dollars) and y is household income (in thousands of
dollars). There are two groups of users. Group A has a mean income of $40 (thousand), and
group B has a mean income of $80 (thousand). Both groups pay $2 per towel.

9. The calculated quantities demanded are:

 a. 70 visits for group A and 50 visits for group B.
b. 50 visits for group A and 70 visits for group B.
c. 50 visits for both groups A and B.
d. 70 visits for both groups A and B.

10. Group A members have a price elasticity of _____ which is _____ than group B.
a. –0.4; more elastic
b. –0.4; less elastic
c. –0.8; more elastic
d. –1.6; less elastic

11. Group B members have an income elasticity of _____ which is _____ than group A.
a. 0; smaller
b. +0.27; smaller
c. +0.57; larger
d. 1.0; larger

II. Indicate whether the statement is true or false, and justify your answer. Be sure to cite
evidence from the chapter and state any additional assumptions you may need.

1. Unlike with most types of goods, deriving a demand curve for health care is quite simple
because people rarely skimp on health care.
FALSE. Just as with any good, deriving a demand curve for health care is difficult because it
requires information about how the same population would react to different prices. This requires
either parallel universes or, more realistically, a randomized experiment.
2. The RAND study was especially useful for measuring price elasticities because it randomly
assigned insurance plans to participants (as opposed to letting them choose).
TRUE. Randomization ensured that the groups facing different prices were statistically
equivalent. That meant that any difference in demand between groups was attributable to price,
not some other characteristic.
3. The RAND HIE found that people assigned to the free health plan had the same rate of
hospitalization as people assigned to the cost-sharing plans.
FALSE. The people assigned to the free plan visited the hospital more frequently and were more
likely to visit the ER.
4. In the RAND HIE, the arc elasticity of demand for inpatient care was larger (in absolute
value) than the arc elasticity of demand for outpatient care.
FALSE. That result would imply that people are more price sensitive when it comes to more
urgent health care. Instead, the arc elasticity of demand for impatient care was smaller in
absolute value.
5. Both the RAND and Oregon studies find that demand for health care is approximately unit
elastic, that is, ✏ ⇡ −1.
FALSE. The RAND HIE finds that demand for health care is very inelastic, with arc elasticities
around 0.2.
6. In the RAND HIE, being assigned more generous insurance did not generally improve
participants’ health outcomes, except among certain subgroups.
TRUE. The RAND HIE finds that generous insurance only provided small health improvements
to healthy people. However, high-risk participants (like those who were smokers or had high
blood pressure) did receive substantial health benefits from more generous insurance.
7. To date, no major health insurance experiment has studied the impact of uninsurance, just
different levels of insurance.
FALSE. The Oregon Medicaid Experiment studied the impact of uninsurance.
8. Results from the Oregon Medicaid Experiment suggest that having health insurance has a
positive impact on health status.
TRUE. Lottery winners in the Oregon Medicaid Experiment were not more likely to survive
than lottery losers, but they had better self-reported physical health and mental health.
9. In real life, investments in health can generate long-lasting benefits, but the Grossman Model
neglects this aspect of health.
FALSE. One of the central features of the model is that health is (in part) an investment good. If
someone invests in his health today, it will be higher both today and in the future.
10. In the framework of the Grossman model, one’s level of health is completely controlled by
her actions. Thus, in any given period, an individual is unconstrained in her choice of health
status.
FALSE. Individuals do have a lot of control over their health level, but there may be high levels
of health that they cannot achieve given time and income constraints. If someone invests all her
time and money in improving health, she may still not be as healthy as she would like.
11. In the Grossman model, the marginal efficiency of investment in health care declines as
health improves.
TRUE. Someone who is very unhealthy receives major dividends from even a small
improvement in health, but someone who is already very healthy receives little benefit.
12. Aging shifts the marginal efficiency of investment in health curve inward.
FALSE. As aging occurs, the depreciation rate of health increases. This results in a movement
along the marginal efficiency of investment curve upward, which implies worse optimal health.
13. An hour spent exercising always pays for itself by decreasing the time spent sick by more
than an hour.
FALSE. This is only true in the “free lunch zone.” Once a certain level of health is attained, an
hour spent exercising generates less than an hour of additional productive time.
14. Assume the PPF is as pictured in Figure 3.3. People might choose point E as their optimum
even if they value the home good Z.
FALSE. The only way someone might choose point E is if his indifference curves are vertical.
But a vertical indifference curve means he does not value the home good, Z at all.
15. In the Grossman model, optimal health status declines with age.
TRUE. See Figure 3.13 for an explanation.
16. The fact that older people spend more on health care is evidence against the Grossman
model, which predicts that spending will decline as _ increases.
FALSE. The Grossman model predicts that health optimally declines with age; it does not
predict that health expenditures decline with age. The effect of aging on health expenditures is
ambiguous in the Grossman model. As you age, you need to spend more money and time on
health to maintain a fixed level because of the increasing depreciation rate of health capital.
17. People who drop out of high school are able to produce more health than college graduates
because they have more free time to invest in health production.
FALSE. In the Grossman model, more education shifts out the marginal efficiency of investment
curve. This means that better educated people have a PPF that is shifted upwards relative to
people with fewer years of education. Thus, better educated people spend less time sick and have
more productive time overall. See Figure 3.14.
18. According to the Grossman model, people choose an optimal time to die (barring any
unforeseen accidents).
TRUE. In the Grossman model, death occurs when it no longer makes sense to invest in health
because the depreciation rate of health capital is so high.
19. In the United States, well-educated males can expect to live longer than poorly-educated
males.
TRUE. This is a classic example of a socioeconomic health disparity.
20. Unlike in the U.S., there are no socioeconomic status gradients in health in countries that
provide universal health care coverage to all citizens. That is, in such countries, poorer and richer
citizens have (on average) the same health.
FALSE. Canada and the United Kingdom both provide universal health care, but disparities are
still found there. This chapter covered evidence of disparities between rich and poor children in
Canada, and between high and low-grade civil servants in the United Kingdom.
21. Health status earlier in life is a good predictor of wealth later in life.
TRUE. Smith (1999) found evidence of this from surveys in the United States that tracked
people over a long time period.
22. According to Smith (1999), nearly all of the differences in health outcomes between rich and
poor in America can be attributed to differences in access to medical care.
FALSE. Smith cites evidence that health shocks can actually affect income. In those case, the
rich are rich due to their better health.
23. The thrifty phenotype hypothesis states that early life events after birth have a strong
influence on health status even in adulthood.
TRUE. This hypothesis, sometimes also called the Barker Hypothesis, is supported by evidence
from the Dutch Famine study and other studies of early childhood deprivation. It also
emphasizes the importance of events that happen before birth.
24. People who have a newly-diagnosed chronic disease, such as diabetes, often suffer large
declines in their wealth over time. This decline in wealth is entirely explained by decreased hours
of work.
FALSE. These people do suffer large wealth declines, but only a fraction of these losses are
attributable to decreased income.
25. In the Whitehall study, access to health care was a key variable determining the relative
health outcomes of high and low grade British civil servants.
FALSE. Because all British citizens have access to health care through the National Health
Service, variation in access to care cannot explain the disparity in health outcomes between high-
and low-grade civil servants.
26. One leading theory about why the poor are in worse health than the rich is that the rich enjoy
a greater allostatic load.
FALSE. Allostatic load is the psychological toll or stress of dealing with life’s experiences. The
allostatic load theory argues that less wealthy people are in worse health because of the greater
stresses they face in life. The Whitehall studies present evidence for this hypothesis.
27. In a study of babies born during the Dutch famine toward the end of WorldWar II, those
exposed to the famine in utero were more likely than those not as exposed to be obese as adults.
TRUE. This is considered evidence for the thrifty phenotype hypothesis, which states that
individuals facing starvation conditions in utero and shortly after birth adapt by programming
their bodies to store more fat.
28. In Canada, unlike in the U.S., the gap between rich children and poor children in health status
does not widen as children age.
FALSE. Currie (2003) showed that the gap does widen in Canada after age 10.
29. There is a consensus among health economists that socioeconomic status has a major impact
on health, but health does not have a significant effect on SES.
FALSE. There is a consensus that the relationship is bidirectional: wealth affects health and
health affects wealth.
III. Short Answer Type Questions
Q1. List 3 distinct features that make the market for medical care services different from the
market for a typical good or service.(See from lecture slides 1)
Q2. List 3 insights of the Grossman theory of consumer/patient behavior discussed in class.( See
from Lecture Slides 3)
Q3. Economists argue that health is a type of “human capital.” What does this mean? Define
“Social Capital”?( See from Lecture Slides /class notes)
Q4. In the context of the Grossman theory of consumer/patient behavior, explain why health is
both a consumption good and investment good. (See from Lecture Slides 3)

Q5. A consumer’s demand for a medical service is as follows:

Q = 100 − PP
where PP is the out-of-pocket price she actually faces. She is considering four different

insurance options: uninsurance, full insurance, a 50% coinsurance plan, and a copayment plan
with a $25 copay.
(a) Assume this service has a list price of PL = $70. Compute the price for each of the insurance
plans

Uninsurance Full Insurance 50% $25 copay

coinsurance
Price 70 0 35 25
Distortion 0 -70 35 25

(b) Assume this service has a list price of PL = $70. Calculate Q under each insurance plan.
• If the customer is uninsured, PP = PL and Q = 30.
• If the customer is fully insured, PP = 0 and Q = 100.
• If the customer has a 50% coinsurance plan, PP = PL/2 and Q = 65.
• If the customer has the copayment plan, PP = min(PL,$25) and Q = 75.

(c) Draw a big graph (use the entire page) explaining how the demand will look like for each of
these cases.
Note that the D4 should go all the way down to 75

Q6. Using a supply-and-demand graph and assuming competitive markets, show and explain the
effect on equilibrium price and quantity of the following:
(a) A technological change that reduces the cost of producing X-rays on the market for physician
clinic services.
(b) Increased graduations of new doctors on the market for physician services.
(c) The virtual elimination of smoking in the population on the market for hospital services.
(d) A price ceiling placed on physician fees in the market for physician services
Ans:
(a). Increase in supply leads to lower equilibrium price and higher equilibrium quantity.
(b). Same as (a).
(c). Decrease in demand leads to lower equilibrium price and lower equilibrium quantity.
(d). No effect on equilibrium price and quantity, but if the ceiling price is below the equilibrium
price there will be excess demand.

Q7. Consider demand curves for aspirin, estimated for two different sets of consumers:
(a) Q = 20 - 5P + 0.2Y
(b) Q = 30 - 5P + 0.2Y
If Y = $20 and P = $1, calculate the price and income elasticities for group (a) and group (b).
Whose elasticities will be higher? Why?

Ans:

Q8. Given the regression estimate of the demand equation of

Qx = 1000 – 3.3 Px + 0.001Y
where Y is income, what is the change in demand if price rises by $1, holding income constant?
What is the percentage change in demand if price rises by $1 from an initial price of Px = $200
given Y = 10,000? What is the effect on demand of a $1 increase in income, holding price
constant?
Ans:

Q9. Suppose that the market demand for medical care is summarized by the demand function:
Qd = 100 – 2P
and the market supply is summarized by the supply function:
 QS = 20 + 2P
(a) Calculate the equilibrium quantity and price, assuming no health insurance is available.
(b) Suppose that health insurance is made available that provides for a 20 percent coinsurance
rate. Calculate the new equilibrium price and quantity. (Hint: How does the demand curve shift?)
(c) Calculate the deadweight loss due to this insurance.
Ans:

Q.10 .In 1998, Americans smoked 470 billion cigarettes, or 23.5 billion packs of cigarettes. The
average retail price was $2 per pack. Statistical studies have shown that the price elasticity of
demand is –0.4, and the price elasticity of supply is 0.5. Using this information, derive linear
demand and supply curves for the cigarette market.

Answer:
Let the demand curve be of the general form Q=a-bP and the supply curve be of the
general form Q=c + dP, where a, b, c, and d are the constants that you have to find
from the information given above. To begin, recall the formula for the price elasticity
of demand

D P Q
EP  .
Q P
You are given information about the value of the elasticity, P, and Q, which means that
you can solve for the slope, which is b in the above formula for the demand curve.
 2 Q
0.4 
23.5 P
Q 23.5
 0.4  4.7  b.
P  2 
To find the constant a, substitute for Q, P, and b into the above formula so that 23.5=a-
4.7*2 and a=32.9. The equation for demand is therefore Q=32.9-4.7P. To find the
supply curve, recall the formula for the elasticity of supply and follow the same method
as above:

S P Q
EP 
Q P
2 Q
0.5 
23.5 P
Q 23.5
 0.5  5.875  d.
P  2 
To find the constant c, substitute for Q, P, and d into the above formula so that
23.5=c+5.875*2 and c=11.75. The equation for supply is therefore Q=11.75+5.875P.

Interpretation of coefficients

Q .11. The following results are obtained by regressing pack cigarette sales in pack per capita, c
(dependent variable) on state real price of pack of cigarettes p and state per capita disposable
income, y (in US dollars). I have taken care of all the adjustments that are necessary for the
regression and here are the results for the coefficients on y and p.

(a) Interpret the coefficients and interpret the R-squared of the regression.
(b) Compute the price elasticity and income elasticity
(c) Compute the price elasticity and the income elasticity for 1989

Q. 12. Define the following terms: (See from Lecture Slides and handouts supplied)
a. P-value
b. T-test
c. Central limit theorem
d. SE
e. R2
f. Level of significance