ECON 485 SECTION A/ ECON 585 SECTION A

HEALTH ECONOMICS
Professor Georgi Boichev
Winter 2020 – PROBLEM SET 1
Question 1 (60 pts.)

A health economist uses data on enrollment in a health insurance plan, denoted by the binary variable
𝐷𝑖 , and the number of doctor visits, 𝑌𝑖 , to estimate the population regression function (PRF) 𝑌𝑖 = 𝛽1 +
𝛽2 𝐷𝑖 + 𝑢𝑖 by using the following sample:

𝑖 1 2 3
𝐷𝑖 0 1 1
𝑌𝑖 3 3 5

The benchmark group is individuals not enrolled in a health insurance plan.

̂1 , 𝛽
a) (2 pts.) Write down the function 𝑆(𝛽 ̂2 ) that minimizes the sum of squared residuals, where
̂1 is the sample estimator of 𝛽1 and 𝛽
𝛽 ̂2 is the sample estimator of 𝛽2 .

b) (2 pts.) State the dependent, explanatory and exogenous variables from a statistical standpoint.

c) (2 pts.) Briefly describe the nature of the optimization problem of the method of least squares.

̂1 and 𝛽
d) (1 pt.) Briefly explain why 𝛽 ̂2 are treated as constants but 𝐷𝑖 and 𝑌𝑖 are treated as
variables when expanding the summation sign Σ𝑖 (𝑌𝑖 − 𝛽 ̂1 − 𝛽̂2 𝐷𝑖 )2 .

̂1 ,𝛽
𝑑𝑆(𝛽 ̂2 )
e) (3 pts.) Show that ̂1 − 𝛽
= −2(Σ𝑖 𝑌𝑖 − 𝑛𝛽 ̂2 Σ𝑖 𝐷𝑖 ) = 0 by carefully illustrating the chain
𝑑𝛽̂1
rule and all relevant rules of the summation operator. Do NOT skip steps.

f) (2 pts.) Show that your answer in e) implies that Σi 𝑢̂𝑖 = 0, where 𝑢̂𝑖 is the residual of obs. 𝑖.

g) (1 pt.) If the method of least squares implies that Σi 𝑢̂𝑖 = 0, briefly explain why it is
inappropriate to min Σi 𝑢̂𝑖 .

h) (2 pts.) Briefly explain whether Σi 𝑢̂𝑖 = 0 implies that 𝐸(𝑢𝑖 ) = 0

i) ̂1 − 𝛽
(3 pts.) Show that Σ𝑖 (𝑌𝑖 − 𝛽 ̂2 𝐷𝑖 ) = −𝑛(𝑌̅ − 𝛽
̂1 − 𝛽 ̅ ) = −𝑛(𝑌̅̂ − 𝛽
̂2 𝐷 ̂1 − 𝛽
̂2 𝐷
̅ ) by
carefully illustrating all relevant rules of the summation operator used. Do NOT skip steps.

2
j) ̂1 − 𝛽
(2 pts.) Briefly interpret 𝑌̅ = 𝛽 ̅ by making use of the relationship 𝑌̅ = 𝑌̅̂ .
̂2 𝐷

n n
k) (2 pts.) Calculate Σ𝑖=1 𝑌𝑖 , Σ𝑖=1 𝑌𝑖2, Σ𝑖=1
n n
𝐷𝑖 , Σ𝑖=1 𝐷𝑖2 , Σ𝑖=1
n
𝐷𝑖 𝑌𝑖 .

̂1 ,𝛽
𝑑𝑆(𝛽 ̂2 )
l) (4 pts.) Use your results from parts e) and k) as well as ̂1 − 𝛽
= −2Σ𝑖 (𝑌𝑖 − 𝛽 ̂2 𝐷𝑖 )𝐷𝑖 =
𝑑𝛽̂2
̂1 and 𝛽
0 to calculate the estimates of 𝛽 ̂2 .

̂1 and 𝛽
m) (2 pts.) Briefly interpret the estimates of 𝛽 ̂2 .

n) (2 pts.) Briefly explain how the PRF must be modified to estimate the price semi-elasticity of
demand for health insurance, where the change in the number of doctor visits, 𝑌, is measured
as a percentage.

o) (2 pts.) Briefly explain why it is not possible to estimate the price elasticity of demand for health
insurance for this dataset.

p) (4 pts.) Suppose that the true values of the population parameters are 𝛽1 = 3 and 𝛽2 = 2. For
each data point (𝑌𝑖 , 𝐷𝑖 ), calculate the deterministic component 𝐸(𝑌𝑖 |𝐷𝑖 ), the error term 𝑢𝑖 , the
̂𝑖 and the residual 𝑢̂𝑖 .
predicted value 𝑌

q) (2 pts.) Based on your answers in part o), briefly explain if you find evidence of relevant
variables being omitted from the PRF.

r) (4 pts.) In a single graph:

- Draw the sample regression function, the population regression function and all data points,
i.e. (𝐷1 , 𝑌1 ), (𝐷2 , 𝑌2 ) and (𝐷3 , 𝑌3 ).
̂𝑖 and
- For the data point (𝐷𝑖 , 𝑌𝑖 ), illustrate the decomposition of 𝑌𝑖 into its predicted value 𝑌
its residual 𝑢̂𝑖 .

s) (4 pts.) In a single graph:

- Draw the sample regression function, the population regression function and all data points,
i.e. (𝐷1 , 𝑌1 ), (𝐷2 , 𝑌2 ) and (𝐷3 , 𝑌3 ).
- For each data point (𝐷𝑖 , 𝑌𝑖 ), illustrate the decomposition of 𝑌𝑖 into its deterministic
component 𝐸(𝑌𝑖 |𝐷𝑖 ) and its error term 𝑢𝑖 ;

2
t) (4 pts.) Suppose that the sample 𝑣𝑎𝑟(𝛽 ̂2 ) = 6. Test the hypothesis that 𝐷𝑖 has a positive impact
on 𝑌𝑖 . In your answer, you must specify the appropriate hypotheses and statistical test,
demonstrate your calculations and provide a conclusion.

u) (2 pts.) Interpret your result in part t) without using any mathematical notation.

v) (2 pts.) Briefly explain the economic significance of your result in part t).

w) (2 pts.) Briefly explain how the result in part q) casts doubt on your answer in part v).

x) (2 pts.) Briefly explain if your results in part t) are qualitatively similar to those obtained in the
Oregon experiment with respect to the direction of the effect and its statistical significance.

y) (2 pts.) Briefly explain if your results in part t) are qualitatively similar to those obtained in the
RAND experiment with respect to the direction of the effect and its statistical significance.