David M.

Cutler Spring 2019

Lecture 2: Health Capital

Key points:
• Health as a consumption and investment good
• Value of survival is linear in flow utility (not marginal utility)
• Health improvements are worth a lot

I. Introduction

Health is valuable in two ways:

• As a consumption item (we enjoy being healthier)
• As an investment item (we earn more when we are healthier)
• U = U(Y(H), H)

We can influence health, but it also moves exogenously.

Health is multidimensional, but people usually compress into one or two (length and
quality of life) dimensions.

There is a basic fact which underlies much of this literature: better educated people are
healthier. We’ll come back to the reason for that. But for now take it as given and use that as a
motivation.

Questions:
• How do we understand individual choices about health?
• Why does health differ systematically across groups?

II. The Human Capital Model (Grossman)

Preferences: Max 𝑈 = ∑𝑇𝑡=0(1 + 𝜌)−𝑡 𝑣(𝑐𝑡 , 𝐻𝑡 )

ct is consumption and Ht is health. T is the maximum extent of life.

Evolution: 𝐻𝑡+1 = 𝜃𝑚𝑡 + (1 − 𝛿𝑡 )𝐻𝑡

of health
where θ is an efficiency parameter and depreciation (δ) varies by age. Death
occurs when Ht ≤ H.

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 𝑐𝑡 𝑝 𝑚 𝑦 (𝐻 )
Lifetime budget: ∑𝑇𝑡=0 + ∑𝑇𝑡=0 (1+𝑟)
𝑚 𝑡
= 𝐴0 + ∑𝑇𝑡=0 (1+𝑟)
𝑡 𝑡
(1+𝑟)𝑡 𝑡 𝑡

constraint

Pm is the cost of health improvement. yt(Ht) reflects the productivity effect

of health.

How does education enter into the model?

• Grossman: Productive efficiency: Education increases θ. That is, education makes

one more efficient at combining the same inputs (e.g., better educated people
remember to take their meds more regularly)

• Kenkel: Allocative efficiency: Better educated people know how to choose inputs that
better improve health (e.g., make smarter smoking decisions)

• Muurinen: Depreciation: Education works to reduce the rate of depreciation (e.g.,

don’t have to work as hard on the job)

• Becker/Mulligan: Time preference: Education leads people to have lower discount

rates.

Combining the budget constraint and the evolution of the health stock and taking first
order conditions yields (you should have gotten this!):
1+𝜌 𝑣𝐻𝑡 𝑝
𝑣𝑐𝑡 = 𝜇( 1+𝑟 )𝑡 = [ 𝜃𝑚 (𝑟 + 𝛿𝑡 ) − 𝑦𝐻𝑡 ]
𝑣𝑐𝑡
1+𝜌 𝑝
𝑣𝐻𝑡 = 𝜇( 1+𝑟 )𝑡 [ 𝜃𝑚 (𝑟 + 𝛿𝑡 ) − 𝑦𝐻𝑡 ]

The expression in the box says that the marginal rate of substitution is equal to the
relative price, where the relative price depends on the dollar cost (adjusted for
efficiency), the discount rate (because the health investment has payoffs down the road)
and the growth rate of income. Note that this is the functional equivalent to the standard
first order condition for the growth of consumption in a dynamic consumption equation.

Implications
1. Standard comparative statics: Health stock is higher with lower pm, lower δ, lower
ρ, and higher θ. Health stock increases with higher income or initial assets.

2. Effect of depreciation is important. Think about different types of jobs (manual,

white collar) or some other trait so that 𝛿𝑡 = 𝛿𝑡 (𝑧). Then, optimal health will be
lower for a trait that increases health depreciation (show this!).

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3. The yt(Ht) function is really
important. Income potential is
not just a function of current
health. It reflects past health
too. For example, health as a
child may influence educational
attainment or cognitive ability,
which could have lifelong
economic returns (Heckman).

θ is a capability vector,
encompassing cognition, mental
health, and physical health.

[Aside: there are a few

common profiles of health]

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III. The Value of a Life and Lifeyear

The health capital model enables us to learn about the value of a life (Murphy and Topel).

Utility at age a is

𝑣(𝑡)𝑆(𝑡,𝑎) 𝑢(𝐻,𝑐,𝑙) 𝐻𝑢(𝑐,𝑙)

𝑈(𝑎) = ∑∞
𝑡=𝑎 (1+𝑟)𝑡−𝑎 ; 𝑣(𝑡) = = .
𝑢𝑐 𝑢𝑐

where v(t) is the flow utility in year t, which depends on health, consumption, and leisure.
The latter equality is for convenience. S(t,a) is the survival function t years in the future
from age a. Dividing by the marginal utility of income expresses utility in dollars.

Consider some factor α that can improve health (both length and quality of life). The
dollar value of improvements in health is given by:

𝑈𝛼′ (𝑎) 𝑣(𝑡)𝑆𝛼 (𝑡,𝑎) 𝐻𝛼 (𝑡) 𝑢(𝑐,𝑙)𝑆(𝑡,𝑎)

𝑉𝛼 (𝑎) = = ∑∞
𝑡=𝑎 + ∑∞
𝑡=𝑎 .
𝜇 (1+𝑟)𝑡−𝑎 𝐻(𝑡) 𝑈𝑐 (1+𝑟)𝑡−𝑎

The first term is the value of increased survival and the second is the improved quality of
life. The social value is the sum of this over everyone alive and all future births. Clearly,
this can get to be a big number!

Note that health investments are complementary. The value of one investment increases
in the number of other investments made. (e.g., it’s more valuable to cure Alzheimer’s
disease once infant mortality has been reduced.)

IV. Empirical Analysis of the Value of Life

Hedonic analysis is typically used to value life. This involves relating income forgone to
health risk. Suppose i denotes people and j denotes jobs.

Wij = Xiβ + γ*riskj + εij

Viscusi and Aldy (RESTAT, 2008): Value of life is about $5 mn for a typical middle-
aged person (range = $3-$10 mn). With discounting, this is about $200,000 / year

Most common value used: $100,000 for a year in good health.

Note that this is the marginal value for the marginal person. Often, we want the average
value in the population.

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Implication I: Huge improvements in
welfare from better health over time
Life expectancy has increased greatly over
time. Thus, welfare is increasing by much
more than just income. Nordhaus shows
that the value of improvements in health
rivals value of increased consumption.
Murphy and Topel (JPE) show that
‘modest’ reductions in mortality would
have enormous benefits – worth many
trillions of dollars.

Implication II: Medical care is worth it on average

This is what a lot of my work has been about. As medical care has changed
technologically over time, what has happened to the value of output? Conceptually, I
look at ΔCost / ΔLife years due to medical care and compare to the value of a life. The
shortest version is Cutler, Rosen, Vijan (NEJM, 2006).

Start with the denominator. The change in Increase in Life Expectancy by Cause, 1960-2000
life expectancy can be decomposed by
cause. [Note: assumes independence]. Cancer 0.2
Cardiovascular disease and infant mortality Pneumonia/Influenza 0.3
were the major contributors to reduced External Causes 0.4
mortality over time. There are a variety of Infancy 1.4
studies that estimate how much of each Cardiovascular 4.9
cause was a result of medical care versus
Total 7.0
other factors. An overall total for medical
care is about 50-60%. The paper uses 50%. 0 5 10
But note that this is a debated issue. Years of Life

For the numerator, use data on spending by age and year to forecast the expected change
in the present value of medical spending over time.

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The division shows a generally favorable
return, with declining values over time.
Care might not be worth it for the elderly
in recent decades.

This type of finding has been replicated in

a few settings. Frank Lichtenberg shows
that conditions where there have been the
most new drugs have seen the greatest
increase in life expectancy over time.
Newhouse argues that there is no obvious
welfare loss from medical spending
increasing over time, because the gains
from care increases may be worth it.

Implication III: We should spend more on medical care as income rises.

Hall and Jones: As income grows, the marginal utility of consumption approaches zero
but the value of another year does not (because that depends on the level of
consumption). Thus, optimal medical spending to extend life increases.

A social planner will maximize expected utility subject to the budget constraint:

𝑚𝑎𝑥𝑐,ℎ 𝑓(ℎ)𝑢(𝑐) 𝑠. 𝑡. 𝑐 + ℎ = 𝑦

where f(h) is the survival probability. Let s = h/y. It is straightforward to show (prove
it!) that
𝑠∗ 𝜂ℎ
=
1−𝑠∗ 𝜂𝑐

ℎ 𝑐
where 𝜂ℎ = 𝑓 ′ (ℎ) 𝑓 and 𝜂𝑐 = 𝑢′ (𝑐) 𝑢,
the elasticities of survival and utility
with respect to their arguments.

Empirical evidence:

- Costa, Kahn (Journal of Risk

and Uncertainty, 2004).
Income elasticity of value of
life is about 1.6.

- Hall and Jones: for reasonable

values of curvature of the utility
function (γ≈2), health spending
should rise to 30%+ of GDP.

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V. Troubling Features of Grossman Model

1. Death may or may not occur. Suppose r = ρ and δ is constant over the lifecycle.
Then, H will be constant over the life cycle. People will choose an infinite
lifetime.

2. The dynamics of δ are key. If δt increases with age, there is an optimal time of
death. But just before that
time, people should get no
medical care (false!).

3. Medical care should be

inversely related to health.
Because health
deterioration is
proportional to its stock,
the amount of health
decline is greater with
higher initial health.
Thus, more new
investment (false!).