L4 Demand For Health and Health Care 2 PDF

CAS EC 387 Introduction to Health Economics
L4: The Grossman Model
Department of Economics
Spring 2020
Boston University () Demand for Health and Health Care II Spring 2020 1 / 25
The Health Production Function I
Production: a process that turns inputs into output
Let output be an aggregate (composite) measure of the health status,

HS, in the population
Suppose we can quantify inputs that are used to produce health, for
example:
health care (medical care) M
lifestyle factors L
environmental factors E
genetic factors G
other factors that a¤ect health Z
The Health Production Function II
Then we can de…ne a health production function:
HS = f (M, L, E , G , Z )
The function f is the technology - it describes how health producing

inputs are transformed into health
Typically it is assumed that f has the standard properties of any

production function:
nondecreasing
concave
However, some argue that the negative marginal product of medical

care M may be negative for some amounts - too much health care
According to Star…eld, as many as 225, 000 deaths/year may be

caused by iatrogenesis (Star…eld, JAMA July 26, 2000)
Traditional View of Individual Behavior I
Traditional economic agent

Rationality
expected utility maximizers who make decisions based on expected
bene…ts versus costs associated with each choice
unbounded ability to correctly solve very complex optimization
problems
forward-looking
motivated by self-interest
Traditional View of Individual Behavior II
The typical microeconomic agent has well-de…ned and stable

preferences described by a utility function U (c ), where c is a
consumption vector and where U (c ) is increasing and concave
Facing uncertainty about future outcomes, individuals have

well-de…ned beliefs and use Bayes’rule to update beliefs as new
information becomes available
Exponential Discounting I
Traditional assumption about discounting
Consider the preferences of an individual with income w who lives for
two periods:
U (c1 , c2 ) = u (c1 ) + βu (c2 )
where 0 < β < 1 is a parameter that measures the value the
individual places on future utility (discount factor)
The problem is to select a consumption vector c = (c1 , c2 ) that

maximizes U (c ) subject to the budget constraint:
c1 + c 2 w
At the solution, we have:
MU (c1 ) = βMU (c2 )
The future is valued less than the present ( β < 1) , so c1 > c2

The Grossman Model of Health Demand I
Grossman’s model (1972)

Individuals ultimately demand utility - health is an input in the utility
function
People care about their health, but about other things too
They produce healthy days using various inputs
Health is durable – it lasts for many periods and it depreciates
The Grossman Model of Health Demand II
Consumption aspect of health:

Individuals value health for its own sake. Health is a complement to
other goods - utility from consumption is higher when healthy
Investment aspect of health:

Better health increases the number of days spent not sick - possible to
work more and/or enjoy other good (leisure)
The Grossman Model of Health Demand III
A schematic
The Grossman Model of Health Demand IV
An individual is born with a health capital endowment (health stock)
H0
The individual invests in health h using time TH and other

health-promoting goods M (health care, health clubs, etc)
The individual also produces and consumes a "home-good" B, using

time TB and market goods X as inputs
Health capital H evolves according to:
Ht = ht + (1 δ t ) Ht 1
where ht is the health investment made at time t, and where

δt 2 (0, 1) is the depreciation rate
The Grossman Model of Health Demand V
The production functions for h and B can be written:
ht = h(Mt , THt , E , t )
Bt = B (Xt , TBt , E , t )
where E denotes education, which is assumed to impact both health

and home-good production
Time, as well as …nancial resources, is scarce and individuals allocate

their total time T between four uses:
earning income TW
producing/consuming home good TB
investing in health TH
time spent sick TL
The Grossman Model of Health Demand VI
Assume these activities are mutually exclusive
The time budget constraint is:
TW + TB + TH + TL = T
Time available for work or leisure is then:
TB + TW = T TH TL
Income is endogenously determined by TW and indirectly through

choice of health stock
Consider the di¤erence between the investment and the consumption

aspect of holding health capital
The Grossman Model of Health Demand VII
The Formal Grossman Health Investment Model I
The individual’s investment problem
The individual solves the program:
" #
T
max
fB t ,H t g
∑ β u ( Bt , H t )
t
t =0
subject to:
Bt = B (Xt , TBt , E , t )
Ht = ht + (1 δt ) Ht 1
ht = h (Mt , THt , E , t )
Tt = TWt + TBt + THt + TLt
p tM M t +p tX X t w t TW t
∑T
t =0 (1 +r )t
= A0 + ∑T
t =0 h
(1 +r )t t
Here, ptM and ptX are prices, r is the interest rate, wt is labor income
and A0 denotes the individual’s initial assets
The Formal Grossman Health Investment Model II
Solving the problem, we get the condition:

" # !
∂U ( ) (1 + r )t ∂wt ( ) ∂TLt ptM ptM 1
+ = ptM 1 r + δt
∂TLt λt ∂TLt ∂Ht ptM 1
The left hand side is the marginal bene…t of investment in health

capital, and the right hand side is the marginal cost – on the margin
the payo¤ from the investment must cover the foregone interest and
the depreciation
Hence, we have the usual optimality condition MB = MC
Marginal E¢ ciency of Investment I
The MEI curve: diminishing returns to investment – as the health

stock H grows larger, the inputs become less marginally less
productive
The rate of interest on other investments, r , and the health

depreciation rate, δt , are exogenous to the model (although not
necessarily constant)
Shifts and changes in the MEI

Depreciation rate
higher cost of holding health stock H, =) demand for H will decrease
as H worsens, the marginal product of health care increases - hence
investment may increase
Marginal E¢ ciency of Investment II
older people predicted to have worse health state than younger people
and to demand more medical care Mt
optimal time to die
Wages
being healthy is worth more at higher income levels (the return to
healthy days T TL is larger)
observe that producing higher H requires time TH (higher opportunity
cost)
ambiguous e¤ect on health stock and income
note the implication of the pure investment model
Marginal E¢ ciency of Investment III
Education
education improves e¢ ciency in health production, so E shifts MEI
curve outwards – since the marginal products of the inputs (e.g., health
care) increases, the individual demands more health capital – (more
cost-e¢ cient producer of health capital - yields higher rates of return)
predicts positive and causal direction between education and health

(from E to H)
Marginal E¢ ciency of Investment Graph
Extensions to the Original Grossman Model I
Some modi…cations
Health production function with decreasing returns to scale
Depreciation rate depends on health stock
Uncertainty in size of health shock, uncertain time of death
Insurance
Di¤erence between objective and subjective measures of health
Reference points
Socioeconomic Disparities in Health I
The health gradient and SES

Di¤erences in health seem to be systematically linked to
socioeconomic status (SES)
The health gradient or the SES health gradient describes di¤erences

in health status between speci…c populations
Ubiquitous worldwide across ethnic groups, educational attainments,

employment grades, and incomes
Mortality rates for all cancer types for both men and women are
highest among African Americans
Socioeconomic Disparities in Health II
Hispanics report better health status than African Americans,

Caucasians report better health then both Hispanics and African
Americans
Health deteriorates with age across all races, but disparities persist
College graduates are 25% more likely to survive to age 68 than high
school dropouts
High-income individuals self-report a higher health status than those

of lower incomes
For most conditions, the poor exhibit more incidences of disease
Socioeconomic Disparities in Health III
Some exceptions:
Bronchitis – no di¤erence
Hay fever – wealthier children appear to be diagnosed with hay fever
more often
Health disparities persist also in countries with universal health

insurance
Self-reported health status for children of high SES better than

children of low SES in Canada (Currie and Stabile 2003)
Causality is complex - does bad health cause low SES or does low
SES cause bad health?
Socioeconomic Disparities in Health IV
Are there other factors?
E¢ cient producer hypothesis
The direct income hypothesis/access to care
Thrifty phenotype hypothesis
Allostatic load hypothesis
Income inequality hypothesis
Productive time hypothesis - schooling and health
Discounting
Socioeconomic Disparities in Health V
Conclusion
Each theory has supporting evidence and each can explain some
socioeconomic health disparities
Better-educated people generally have better health even with the
same resources
Health events early in life a¤ect health into adulthood
Stress plays an important role in creating health disparities
Equalizing access to care does not eliminate health disparities
There is a two-way relationship between health and SES

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CAS EC 387 Introduction to Health Economics

L4: The Grossman Model

Production: a process that turns inputs into output

Let output be an aggregate (composite) measure of the health status,

The function f is the technology - it describes how health producing

Typically it is assumed that f has the standard properties of any

However, some argue that the negative marginal product of medical

According to Star…eld, as many as 225, 000 deaths/year may be

Traditional economic agent

The typical microeconomic agent has well-de…ned and stable

Facing uncertainty about future outcomes, individuals have

The problem is to select a consumption vector c = (c1 , c2 ) that

At the solution, we have:

MU (c1 ) = βMU (c2 )

The future is valued less than the present ( β < 1) , so c1 > c2

Grossman’s model (1972)

They produce healthy days using various inputs

Health is durable – it lasts for many periods and it depreciates

Consumption aspect of health:

Investment aspect of health:

The individual invests in health h using time TH and other

The individual also produces and consumes a "home-good" B, using

Health capital H evolves according to:

where ht is the health investment made at time t, and where

where E denotes education, which is assumed to impact both health

Time, as well as …nancial resources, is scarce and individuals allocate

Assume these activities are mutually exclusive

The time budget constraint is:

Time available for work or leisure is then:

Income is endogenously determined by TW and indirectly through

Consider the di¤erence between the investment and the consumption

Solving the problem, we get the condition:

The left hand side is the marginal bene…t of investment in health

Hence, we have the usual optimality condition MB = MC

The MEI curve: diminishing returns to investment – as the health

The rate of interest on other investments, r , and the health

Shifts and changes in the MEI

predicts positive and causal direction between education and health

Depreciation rate depends on health stock

Uncertainty in size of health shock, uncertain time of death

Di¤erence between objective and subjective measures of health

The health gradient and SES

The health gradient or the SES health gradient describes di¤erences

Ubiquitous worldwide across ethnic groups, educational attainments,

Hispanics report better health status than African Americans,

High-income individuals self-report a higher health status than those

For most conditions, the poor exhibit more incidences of disease

Health disparities persist also in countries with universal health

Self-reported health status for children of high SES better than

E¢ cient producer hypothesis

The direct income hypothesis/access to care

Thrifty phenotype hypothesis

Allostatic load hypothesis

Income inequality hypothesis

Productive time hypothesis - schooling and health

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