Chapter 2: The Role of Economics

Learning Objectives

• In this chapter, you will learn about:

– the role of economics in health care

– the use of economic models to explain phenomena

– the concept of the market and equilibrium

Economics and Policy • Economics can offer a framework to study the

implications of individual decision making and help define the alternative mechanisms available to improve resource allocation

• Sound policy making is based on sound economic principles applied in a sensitive and uniform manner– Lessons can be learned from basic economics

• lessons about human behavior and the way individuals make decisions, respond to incentives, interact with each other—and about the efficient allocation of scarce resources

What is Health Economics?

• Health economists examine a wide range of

issues from the nature and production of health

to the market for health and medical care to the

micro-evaluation of interventions

– The principle activity of economists outside of

the United States is the evaluation of medical

interventions

What is Health Economics?– The primary focus of United States health

economists is the market for health care • Factors affecting the demand for medical

care include: socioeconomic factors of the population, patient demographics, access barriers and the role of providers in determining the services to be provided

• The supply of health care encompasses a broad spectrum of economics on such topics as production theory, input markets, and industrial organization.

• Demand and supply intersect with one another to establish market equilibrium

Why Health Economics is Important

• Understanding the economics of health care is important for a number of reasons– Health is important to us as individuals and as

a society, and health care is one, though not the only, way of modifying the incidence and impact of ill health and disease• Economic analysis offers a unique and

systematic intellectual framework for analyzing important issues in health care and for identifying solutions to common problems

– Healthcare sector is very large

Why Health Economics is Important

– Third, decisions about how health care is funded, provided, and distributed are strongly influenced by the economic environment and economic constraints• One good reason for understanding health

economics is to engage in policy debates as an informed critic

• Health economics is an application of economic theory, models, and empirical techniques to the analysis of decision making by individuals, healthcare providers, and governments with respect to health and health care

Why Health Economics is Important

–Health economics is solidly based in economic theory, but it also comprises a body of theory developed specifically to understand the behavior of patients, doctors, and hospitals, and analytical techniques developed to facilitate resource allocation decisions related to health care

–Health economics has evolved into a highly specialized field, drawing on related disciplines including epidemiology, statistics, psychology, sociology, operations research, and mathematics in its approach

Key Economic Concepts• These terms will serve as unifying themes

throughout the course:– Scarcity addresses the problem of limited

resources and the need to make choices– Opportunity cost recognizes the role of

alternatives– Marginal analysis recognizes that choices are

made at the margin, not on an all-or-nothing basis

– Self-interest is the primary motivator of economic actors

– The Market accomplishes its tasks through a system of prices, or the invisible hand

Key Economic Concepts– Supply and demand serve as the foundation of

economic analysis • Pricing and output decisions are based on forces

underlying these two economic concepts.– Competition forces resource owners to use their

resources to promote the highest possible satisfaction of society: consumers, producers, and investors

– Efficiency measures how well resources are being used to promote social welfare

– Market failure arises when the free market fails to promote efficient use of resources by either producing more or less than the optimal level of output

• Sources of market failure include: natural monopoly, oligopoly, externalities of production or consumption, and public goods

The Use of Economics in Healthcare

• Economic Modeling

– In microeconomics, the assumption of rational

behavior establishes a consistent framework

for individual decision making

• Decision makers, motivated by incentives,

pursue their self-interest

Economic Modeling, continued• The five basic steps in the scientific method are as follows:

– Every analyst begins with a hypothesis based on his or her perception of how the world works

– Analysts then observe the real-world phenomena– A theory is then developed to explain behavior or the phenomena

or predict future behavior• These models are abstractions of reality that capture the

influential features of the observed behavior

– The tests of hypotheses are then performed using gathered facts and data

– Rethinking the model: If the empirical evidence is contrary to the model and its hypothesis, then the analyst may rethink the theory being tested.

Economic Modeling, continued

• Model Building– One of the main goals of economics is to

understand, explain, and predict the actions of economic actors

– Microeconomic models examine the behavior of individual decision makers—individual households and firms and government agents—or specific markets

• Economic Optimization – When more than one alternative is available, the

optimal choice produces an outcome that is most consistent with the decision maker’s stated objectives

Economic Modeling, continued

– Optimization is nothing more than determining the best action given the decision maker’s goals and objectives• Constrained optimization takes into

account scarcity of resources• Choices in the health economy are made at two

levels: – Individual actors must decide the best course

of treatment or services to consume– Policy makers must decide on the best course

of action for the entire community 

Economic Modeling, continued• The framework of this analysis is the neoclassical model

with its assumptions of rational behavior on the part of decision makers– Firms maximize profits given technology and the costs

of the resources; and consumers maximize utility or satisfaction from consuming various amounts of goods and services given limited income and the prices of goods and services considered

• The optimal consumption of goods and services is where the marginal benefit (MB) from consumption (i.e., the additional benefit received from consuming the next unit of the good or service) equals the marginal cost (MC) of consumption (i.e., the additional cost of consuming the next unit of a good or service)

Summary• Central tenets of economics can be summarized

below:– Resources are relatively scarce related to wants

• To strike a balance between scarce resources and unlimited wants involves making choices

• Medical decisions involve costs and benefits• It is important to strike a balance between

incremental benefits and costs.

Chapter 5:

Health Economics

in a

Health Policy Context

Chapter Overview

• Chapter 5 provides a basic overview of economics and why it is important for health policymakers to be familiar with basic economic concepts.

• Chapter 5 focuses on:– How economists make decisions– Supply– Demand– Markets

Economic Decision-making

• Economists believe that people are rational actors who will never purposely choose to make themselves worse off– People seek to maximize utility

• Given the scarcity of resources, decisions need to be made about the production, distribution, and consumption of health care resources– Consider individual preference and efficiency

Demand

• Demand: the quantity of goods and services that a consumer is willing and able to purchase over a specified time

• Common demand shifters– Price

• Of the original good• Of a substitute good• Of a complementary good

– Income– Quality (actual or perceived)

Demand

• Demand elasticity: the percentage change in the quantity demanded resulting from a 1% change in price or income.

• If a product is elastic, a change in price/income will result in an equivalent or greater change in demand

• If a product is inelastic, demand for the good is not sensitive to a change in price/income

Health Insurance and Demand

• Health insurance acts as a buffer between the consumer and cost of health care goods and services– Goods and services cost the consumer less than the

charged price because of the presence of health insurance

• Moral Hazard– Because a consumer does not pay the full cost of a

good, the consumer may purchase more than goods than he would otherwise purchase without insurance

Supply

• Supply: the amount of goods and services that producers are able and willing to sell at a given price over a given period of time

• Common supply shifters– Input costs– Sale price– Number of sellers– Change in technology

Supply

• Supply elasticity: the percentage change in quantity supplied resulting from a 1% increase in the price (or other variables, such as inputs) of buying the good.

• If a product is elastic, a change in price (or other variables) will result in an equivalent or greater change in supply

• If a product is inelastic, supply of the good is not sensitive to a change in price (or other variables)

Supply

• Suppliers are driven to maximize profit

• In a competitive market, profit is maximized at the level of output where marginal cost equals price

• Equilibrium exists in the market when there is a balance between the quantity supplied and the quantity demanded

Health Insurance and Supply

• The presence of health insurance may impact a provider’s willingness to supply goods and services

• Competing concerns– Providers act as patient’s agent and act in patient’s best interest– Providers may have a financial incentive to act or refrain from

acting in a certain way due to insurance arrangements or the lack of insurance

• Supplier-induced demand is the provider version of moral hazard– Providers create a demand beyond the amount the well-

informed consumer would have chosen– It is debated whether supplier-induced demand actually occurs

Markets

• Market structures– Perfectly competitive market

• efficiently allocate resources

– Monopolies• Single seller controls market

– Oligopolies• Few dominant firms, substantial barriers to entry

– Monopsonies• Few consumers who control price paid to sellers

• Health care is a monopolistically competitive market– Few dominant firms with significant market power and many

smaller firms without market power

Health Insurance and Markets

• A typical market transaction involves two parties– Consumer and supplier

• Health care transaction with an insured patient involves three parties– Consumer (patient)– Supplier (provider)– Insurers

• Presence of third party (insurers) changes consumer and supplier analysis of costs and benefits of each transaction

Market Failure

• A market failure means that resources are not produced or allocated efficiently– Traditionally, inequitable distribution of

resources does not equal a market failure

• Common reasons for market failures– Imperfect information– Concentration of market power– Consumption of public goods– Presence of externalities

Market Failure

• Ways to address market failure– Do nothing– Gov’t finances or directly provides public

goods– Gov’t increases taxes, tax deductions,

subsidies– Gov’t issues regulatory mandates– Gov’t prohibitions– Redistribution of income