Introduction to Health Economics and 
 Methods of Economic Evaluation

HPAd 201: Principles of Health Administration

FERNANDO M. SISON, MD, MPH EMERITO JOSE FARAON, MD, MBA Department of Health Policy and Administration College of Public Health University of the Philippines Manila

1st Semester, SY 2012 - 2013

Session Objectives
At the end of the presentation, participants should be able to: • Give a definition of Economics; • Explain the key concepts / principles of economics as applied to health; and • Understand the various methods of economic evaluation.

Q&A What is Economics?

Why are we interested in this discipline in discussing health issues?

The answer is simple:

Economics is the science associated with the allocation of scarce resources.

► From the Greek words “oikos” (house) and “nomos” (custom or law), hence “rules of the household” ► “Economics is the study of how people and society end up choosing to employ scarce productive resources which have alternative uses – to produce various commodities and distribute [allocate] them for consumption, now and in the future, among persons and groups in society.” (Samuelson)

Macro Economics ► the study of economic phenomena at the level of the entire economy or large aggregates.

Micro Economics ► the study of economic phenomena at the level of small units, the individual, the firm, the market, and the industry.

► A situation wherein the amount of good or service demanded exceeds the amount available. ► Problem of limited resources and unlimited wants/desires ► Challenge: allocating resources among competing objectives/alternatives.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

resources are scarce

cannot have everything that we desire (unlimited)

forced to make trade-offs

• Studies how society allocates the limited resources of the Earth to the insatiable appetites of humans. • Law of Supply and Demand


What are trade-offs? What does tradeoff imply?

Have you ever been faced with tradeoffs? What are these?

Trade-off or Production Possibility Frontier

Production Possibility Frontier – a curve or schedule which depicts the ‘trade-off” between two goods which shows the frontier of all various production possibilities for these two goods

The Inevitability of Trade-Offs
► Choose from among medical interventions ► Which drugs to include in the formulary ► Choose from among experimental procedures ► Which new technology to invest in

In assessing a trade-off, we have to consider the costs and the benefits.

Opportunity Cost
► The cost of deciding among alternatives based on the value of foregone opportunity. ► Time and resources used to satisfy one set of desires cannot be used to satisfy another set.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

Marginal Analysis
►The economic way of thinking about the optimal allocation of resources. ► Choices are seldom made on an “all-ornothing basis” but rather are made “at the margin” (incremental benefit and incremental costs).


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

The Concepts of Average Values and Marginal Values

Month January February March April May June

No. of Admissions 20 22 23 27 31 33

What are the average and marginal values in the above Table?

Fig. 2.3 Average & Marginal Benefits from Alternative Health Programs

Production Function for Health Summarizes the relationship between health status and the various factors that maybe used to produce good health

Health Status





Medical Care Spending

Health Status




Medical Care Spending

► A behavioral assumption that individuals are motivated to promote their own interests. ► People respond to incentives and practice economizing behavior only when they individually benefit from such behavior.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

Markets and Pricing
► Market has proven to be the most efficient way to allocate scarce resources. ► It accomplishes its tasks through a system of prices. ► Price mechanism becomes a way to attain equilibrium.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

Supply and Demand
► Serves as the foundation for all economic analysis ► Pricing and output decisions are based on the underlying forces of supply and demand


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

The Concept of Demand and Supply – there
are two forces which interact and determine the state of the economic system.


Supply Curve

Equilibrium point

Demand Curve Q

The Law of Demand
► “There is an inverse relationship between the amount of a commodity that a person will purchase and the sacrifice that must be made to obtain it”

► Q&A: When price of a commodity / service changes, what is the effect on quantity demanded?

Demand for Health Care Services
Factors affecting the patient’s demand for medical care:
► Actual or perceived illness or desire for preventive medicine ► Marital status ► Type of people desiring the commodity ► Income ► Education ► Availability of substitutes ► The price of related commodities ► Time costs

Price Elasticity of Demand
► Technical concept used to answer the question: “When prices changes, how much does quantity demanded change?”

εP = percentage change in Q

percentage change in P
▲Perfectly Elastic ▲Elastic ▲Unit Elastic ▲Inelastic ▲Perfectly Inelastic |ε|= ∞ 1<|ε|<∞ |ε|= 1 0<|ε|<1 |ε|= 0

► Nature:

The Law of Supply
►“There is a direct relationship between the amount of a commodity that a producer will make available and the income that will be received”

The Law of Supply
Factors affecting the availability of goods and services in a market: ► nature and character of the production function:
o Capital (land, building, equipment / technology) o Labor (number of manpower / firms supplying the commodity)

► The prices of resources used to produce the commodity ► Producers’ expectations about future prices of the commodity / service

►Forces resource owners to use their resources to promote highest possible satisfaction of society. ►Promotes more efficient methods of production


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

► Measures how well resources are being used to promote social welfare. ► Consumers: better off by allocating limited budgets. ►Producers: seek maximum profit by using cost-minimizing methods.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

Comparative Advantage
►Explains how people benefit from voluntary exchange when production decisions are based on opportunity cost. ►Everyone specializes in the activity that they do best: the one with the lowest opportunity cost.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

Market Failure
►A situation in which a market fails to produce the socially optimal level of output.


James W. Henderson. Health Economics & Policy. 3rd Edition. 2006.

Market Failure in Health Care
When does it exist? ► mismatch between what the market supplies and what fully informed, rational consumers of health care would demand.

What will be the health consequence? ► unreasonably high prices for services which are beyond the reach of many consumers.

Why does market failure occur?
► Information asymmetry ► Public goods ► Externalities in production and consumption ► Presence of monopoly and monopsony

Market Failure in Health Care

►Even if not necessary, a healthcare provider will provide the service Ex. In Quezon City, most government hospitals are located here & networking is crucial; 1 CT scan / MRI / linear accelerator Problem of where to invest, what equipment ►Asymmetric information such that patients don’t know what they need (MDs know it all) so need for CPGs

Public Goods
►Non-rival: one’s consumption does not reduce the amount available for others. ►Non-excludable: if they are made available to everyone, they are made available to all.


Public Goods
Ex. flood control projects; sanitation; police protection; national defense

► the economic effect of production or consumption that is felt by parties beyond the immediate producer or consumer.


Externality – Positive or Negative?
The increased number of water pumps in a community affects the water table and makes water most costly to extract for all. People have to dig deeper pumps just to get the same amount of water as before.

Externality – Positive or Negative?
The increased number of motor vehicles increases the amount of carbon monoxide and other gas emissions in the atmosphere and therefore leads to smog in the city and to pollution.

Externality – Positive or Negative?
The indiscriminate disposal of garbage leads to the increase of communicable diseases, unsightly surroundings, and the perception that health hazards pose a great risk to foreign visitors.

Externality – Positive or Negative?
The presence of small and medium scale industries helps to promote the growth of the middle class and encourages greater income equality in the population. This in turn helps to improve social and political stability by encouraging the prosperity and growth of members of the population who are less radical in outlook and more work-oriented.

Types of Government Intervention

inform; regulate; mandate; finance; provide or deliver.

“The issue of resource allocation cannot be separated from the role of participatory politics and the reach of informed public discussions”.. - Amartya Sen

Methods of Economic Evaluation

Importance of Economic Evaluation
► Scarcity of resources and we do not have the ability to satisfy the desires of all the people all the time. ► Reality of opportunity cost ► Useful alternatives compete for same funds / resources ► Making choices is sometimes unpleasant

It is important that we approach resource allocation decisions in health care in a clear and systematic way.

What is Economic Evaluation?
► A comparative analysis ► Evaluating alternative courses of action ► Examining both costs and consequences ► Tasks required: to IDENTIFY, MEASURE, PUT A VALUE, and COMPARE all relevant costs and consequences.
(Drummond, M., et. al. “Methods of Economic Evaluation of Health Care Programmes”







The Diagram illustrates how a comparison of costs and consequences of two alternative programs provides a basis for a decision.

Types of Economic Evaluation

►Cost-of-Illness Studies* ►Cost-Benefit Analysis* ►Cost-Effectiveness Analysis* ►Cost-Utility Analysis

*(Garber, Alan M. “Recent Developments in CBA/CEA” in Handbook of Health Economics. 2001)

Cost-of-Illness Studies


COSTS (Direct, Indirect, Intangible)

Cost-of-Illness Studies 

(in some literature, a.k.a. Cost Minimization Analysis)

► Merely look at the question, “what is the cost?”, No “outcome” measure. ► ? whether it is an economic evaluation ► Provides important information to policy makers and health economists on the burden of a disease. ► CIS maybe a first important step in cost identification leading to an economic evaluation.

►used to compare alternative interventions for the same disease or condition where it can be proved that the alternatives have identical outcomes. ►the technique requires a test of equivalence of outcomes rather than just the assumption that outcomes are equivalent. ►to test for equivalence, it is necessary to define an outcome indicator.


Analysis whether surgery (method 1) or injection (method 2) is an effective treatment for varicose veins

Outcome indicator: proportion of patients who had required no further treatment in 3 years. Once the outcomes of alternatives are shown to be identical, cost minimization employs the same technique as cost analysis.

Cost minimization chooses the cheapest alternative.


Results are interesting BUT.. do not answer questions related to the most effective options for treating the disorders.

Cost-Benefit Analysis

Cost Benefit Analysis



Cost-Benefit Analysis
► CBA requires that benefits and costs both be measured in terms of money. ► An analytical technique comparing all the costs and all the benefits arising from a program/project. ► Aim: Maximize profits/net gain from the project

CBA for company buying a new software to improve its business

the price of the software (including interest and taxes) cost of hardware additional staff (IT personnel) space requirement for hardware and IT personnel the cost of the consultants to install and implement the software the cost of training for the users of the software insurance premiums

improved business processes (leading to an annual cost decrease) better available information being able to take better decisions (leading to additional cash-flows) increased staff morale from using the state of the art tools for running the business (increased productivity) reduced manpower requirement due to computerization.



Challenges of Cost-Benefit Analysis
► Valuing Benefits ▲Human Capital Approach – measures the resource savings which result from the intervention because people are healthier (direct benefits); benefits of reduced mortality and morbidity are valued in terms of increased production because people work longer and more effectively; Issue: How do you place a value on a human life?

▲Willingness-to-Pay Approach
When applied to health, willingness-to-pay depends on:
►wealth ►life expectancy ►current health status ►possibility of substituting current consumption for future consumption

►Choosing a discount rate

Cost-Effectiveness Analysis

Cost Effectiveness Analysis



Cost-Benefit Analysis

Cost Benefit Analysis



Cost-Effectiveness Analysis
► CEA measures the benefits of a health intervention in terms of physical units (i.e., #
of lives saved by the intervention)

► Measures health benefit in terms of either the intermediate or the final health outcome, not the peso / dollar value of life

Example of Cost Effectiveness of a Program
Program: Children immunization Intermediate output indicators: Proportion of correct diagnosis Number of immunizations Number of new acceptors in a family planning program Final output indicator (measurement of success): The number of lives saved by the intervention The number of years of life (called “life- years”) saved by an intervention

Cost – Effectiveness Analysis
The C-E ratio is obtained by dividing the total cost of a program by the indicator of effectiveness.

It represents the cost per unit of effectiveness – for example, cost per life saved, cost per life-year gained, cost per correct diagnosis.

In general, the lower this ratio, the more efficient the program is.

CEA can be used to: (1) Compare alternative designs of the same project (e.g., different methods of treating dehydration); (2) compare unrelated programs if they have the same objective.

CEA is used as a means of choosing between competing programs.

Measuring Costs

▲ Direct – associated with the use of resources ► Medical – the cost associated with the use of medical resources (hospitalization, outpatient visits) ► Non-medical – cost typically borne by the patients/families (transportation expenses, home service) ▲ Indirect – related to lost productivity ► Sick leave; reduced productivity at work; productivity losses due to early retirement or premature death ▲ Intangible – associated with pain and suffering, grief, anxiety, and disfigurement

► Availability of quality data ► Gold standard – clinical trials ▲Shortcoming – too short to capture longterm costs and consequences ▲Solution – modeling of epidemiological history of disease and treatment

Cost Utility Analysis
Rationale: ►Health interventions: save/extend lives BUT reduce the quality of life. ►Determine appropriateness in measuring benefits by the extension in the quantity of life in these situations. ►The need to combine quantity (reduced mortality) and quality (reduced morbidity).

Cost Utility Analysis (CUA) seeks to do this.

► Cost utility analysis is based on cost effectiveness analysis. ► The first step is to estimate the number of life-years gained by an intervention. The extra years of life are then adjusted to account for changes in the quality of life. ► The CUA indicator of benefit is called a Quality-Adjusted Life Year (QALY).

What are DALYs?
► DALYs = Disability Adjusted Life Years ► It is a tool which expresses years of life lost (YLLs) due to premature death and concurrently factors in years of healthy life lost because of years lived with a disability (YLDs) ► DALY = YLL + YLD (one DALY is equivalent to one lost year of healthy life)



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