Chapter 5: Demand for Medical Services and Medical Spending

Health Economics

Outline
Theoretical derivation of the demand curve for medical services. Economic and noneconomic variables that influence demand. Elasticities. The impact of health insurance on demand.

Medical Care and Utility

Medical

care is an input in producing health

Subject to law of diminishing marginal productivity

Health

yields utility to the consumer

Subject to law of diminishing marginal utility

Medical Care and Utility

Example: Do the following values of Medical Care and Utility imply diminishing marginal utility of care? Medical Care 1 2 3 4 Utility 2 4 6 8 MU

Medical Care and Utility

Graph this relation between medical care and utility.
Utility
8

6
4

2
1 2 3 4

Medical Care

Medical Care and Utility

The previous graph illustrates an example of constant marginal utility Because each additional unit of medical care yields the same increase in utility, the relation can be graphed using a straight line.

Medical Care and Utility

Because this relation is linear, it can also be represented using the following algebraic equation:

Utility = 2*Medical Care

In practice one would never see this relation between utility and medical care, because it violates the assumption of diminishing marginal utility.

Medical Care and Utility

Example: What about these values? Do they satisfy the law of diminishing marginal utility? Medical Care 1 2 3 4 Utility 2 6 9 11 MU

Medical Care and Utility

Graph this relation between medical care and utility.
Utility
10

8
6 4 2 1 2 3 4 Medical Care

Medical Care and Utility

The previous graph illustrates an example of diminishing marginal utility Because each additional unit of medical care yields a smaller increase in utility, the relation cannot be graphed using a straight line.

Medical Care and Utility

We can generally graph the relation between medical care and utility as follows:
Utility

Medical Care

Medical Care and Utility

The graph shows that as the level of medical rises, each additional unit of medical care yields a smaller increase in utility. Given this fact, how does the consumer decide how much health care to purchase?

Consumers Optimal Choice of Health

Define : MU = marginal utility of medical care
P = price q = quantity of medical services z = quantity of all other goods

tradeoffs

Given the consumers income, she chooses q and z to maximize utility. Utility maximization rule :
MUq MUZ

Pq

Pz

Consumers Optimal Choice of Health

Total utility reaches its peak when the marginal utility gained from the last $ spent on each product is equalized.

i.e. The consumer equalizes the bang for the buck across all goods.

Proof

Suppose that instead :

MUq

Pq

>

MUZ

Pz

Last $ spent on medical care generates more U than

last $ spent on other goods Consumer could U by purchasing more medical care (q), and less other goods (z). Then MUq would fall, MUz would rise, until the 2 ratios are equalized.

Deriving a Demand Curve for Physician Visits

Note : Now let q represent physician visits.

Suppose Pq rises. This will lead to :

MUq

Pq
Consumer can

<

MUz

Pz

U by purchasing less q, and more z.

Pq

lower demand for q

Deriving a Demand Curve for Physician Visits

Downward sloping demand curve for physician visits.

Price
P1
P0

q1

q0

Price changes lead to movements along D curve

Demand Curve for Physician Visits

The relation between price and the quantity demanded can be expressed using a demand schedule:

Price per Visit

$100 $75 $50 $25

Quantity of Visits Demanded 1

2 3 4

Economists and Reverse Graph Reading

When we read graphs, we usually ask how a change in the variable on the horizontal axis affects the variable on the y axis.

However, when economists draw demand curves, price is on the vertical axis, and quantity is on the horizontal axis.
The graph is read in reverse of the usual manner: How does a change along the vertical axis affect the variable on the horizontal axis?

Demand Curve for Physician Visits

Graph the previous relation between price and the quantity of physician visits demanded.
Price
$100

$75
$50

$25
1 2 3 4

Physician Visits

Deriving a Demand Curve for Physician Visits (cont.)

Consumers purchase of medical care is a derived demand.

i.e., no direct utility from visiting the doctor
U derived from health resulting from dr. visit: U = U(h,z) h = h(q,)

Deriving a Demand Curve for Physician Visits (cont.)

P

Demand curves are graphed in the form P = a bQ.

Deriving a Demand Curve for Physician Visits (cont.)

Which of the following equations is more likely to be a demand curve for physician visits?

Q = 8 + 2P Q = 8 2P

Practice Question

Can you come up with an algebraic formula for the demand curve for physician visits that we graphed? (e.g. where 1 visit was demanded at a price of $100) Try this at home, and well look at the answer in the next class.

Other Economic Factors Affecting Demand

The demand curve illustrates the effect of changes in the price of the good on quantity demanded holding all other factors (income, prices of other goods) constant. Changes in factors other than the price of the good itself lead to shifts in the demand curve.

Other Economic Factors Affecting Demand

1. Income

If income increases, then at any given price, consumer is willing and able to purchase more q.
Price

DO
P0

D1

q0

q1

Physician Visits

Other Economic Factors Affecting Demand

2. Complements - 2 or more goods which
are consumed together

e.g. left shoes and right shoes. e.g. laser printers and toner cartridges. e.g. alcohol and cigarettes? e.g. contact lenses and optometrist visits.

Other Economic Factors Affecting Demand

2. Complements

e.g. contact lenses and optometrist visits. If contact lenses become cheaper, demand for optometrist visits ___.
Price Price of complement falls

D0

D1
Optometrist Visits

Other Economic Factors Affecting Demand

3. Substitutes - other goods which satisfy the
same wants, or provide same characteristics.

e.g. Coke and Pepsi e.g. Physicians and Nurse practitioners? e.g. generic and brand name drugs.

Other Economic Factors Affecting Demand

3. Substitutes - other goods which satisfy the
same wants, or provide same characteristics.

e.g. generic and brand name drugs. If generic drugs in price, D for brand name ___.
Price

Demand for generic drug falls

D1

D0
Brand name drugs

Demand Curve Terminology

Price A B A to B: increase in quantity demanded 10

Quantity

Demand Curve Terminology (cont.)

Price D0 to D1: Increase in demand

D1

D0
Quantity

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Elasticities
Price A relatively flat demand curve implies that a small increase in price leads to a large fall in # visits demanded.

# Visits

Elasticities
Price In this case demand is considered to be relatively elastic with respect to a change in price.

# Visits

Elasticities
Price A relatively steep demand curve implies that a small increase in price leads to a small fall in # visits demanded.

# Visits

Elasticities
Price In this case demand is considered to be relatively inelastic relative to a change in price.

# Visits

Elasticities

We would like a way to quantify the elasticity of a demand curve with respect to price. More generaly, elasticity measures the responsiveness of quantity demanded to a change in an independent factor.

Elasticities measure this responsiveness in terms of proportionality.

Elasticities (cont.)

Own-Price Elasticity of Demand:

ED % QD % change in quantity demanded % P % change in price

Example: If the elasticity of demand for physician visits is -.6, a 10% increase in price leads to a 6% decrease in the number of visits demanded. Elasticities are scale-free
We

can compare the ED for physician visits vs. nursing home days, even though they are consumed in different units.

Elasticities (cont.)

ED is expected to be negative. Thus, ownprice elasticities of demand are often quoted in terms of absolute value. The demand curve is inelastic if 0<|ED|<1

The demand curve is elastic if 1<|ED|<

More price elastic demand leads to a flatter demand curve.

Price

Relatively elastic

Relatively inelastic

# Visits

Elasticities (cont.)

% QD Q Q P P % P P Q P

If you are given a formula for a demand curve, you can compute the elasticity of demand for any combination of price and quantity along that demand curve.

Except in special cases, the ED is different on different points of the demand curve. P
ED = -

4
ED = -1 2 ED = 0 4 Demand curve: Q = 8 2P 8

Elasticities (cont.)

Income elasticity of demand:

EY % QD % change in quantity demanded % Y % change in income

Example: If the elasticity of demand for physician visits is .1, a 10% increase in income leads to a 1% increase in the number of visits demanded. For most types of medical care, EY should be positive.

Elasticities (cont.)

Cross-price elasticity of demand:

% Q X % change in quantity demanded of good X EC % P % change in price of good Y Z

Example: If the elasticity of demand for Tylenol with respect to the price of Advil is 1.5, a 10% increase in the price of Tylenol leads to a 15% increase in the quantity of Advil demanded.
EC

is negative for complements. EC is positive for substitutes.

Elasticities
Own price elasticity of demand critical for determining
a health care managers total revenue. TR = PQ D

Demand theory tells us that

QD

If demand for physician services is inelastic, and the price is raised, then

I %QD I < I %P I

Total revenue will increase if price is raised when demand is inelastic.

Health Care Expenditures

Expenditure=Price x Quantity

Although expenditures are rising, we have seen that health status has also improved. The size of the entire economy has grown, so that the % of GDP spent on health care has held steady.

Health Care Expenditures in the United States, 1960-2001

1960 Nominal health expenditures (billions of dollars) Annual rate of growth (average annual % change from previous period shown) Nominal per capita health expenditures Health expenditures as percentage of GDP $26.9 1970 73.2 1980 247.3 1990 699.4 1995 987.0 1999 1210.7 2001* 1424.2

--

10.6%

12.9

10.9

6.7

5.2

8.4

$143

341

1,052

2,690

3,686

4,358

5,043

5.1%

7.1

8.9

12.2

13.3

13.0

13.4

*Projected Source: Health Care Financing Administration Homepage: http://www.hcfa.gov/stats/stats.htm

Health Care Expenditures 1999 (cont.)

Revenue Source PRIVATE Private health insurance $billions 626.4 375 % of Total 54.7 33.1

Out-of-pocket payments
Other private payments PUBLIC Medicare Medicaid Oth. Govt TOTAL

199.5
51.8 522.7 216.6 170.6 135.5 1149.1

15.4
6.1 45.3 17.6 15.4 12.2 100

Health Care Expenditures (cont.)

The private and public sources of health expenditure are relatively equal. Private health insurance pays for a substantial amount of health care. The Medicare and Medicaid programs account for a majority of public health care expenditures.