Basic Concepts of Health Economics

Name: Yihalem Abebe (Assistant Professor, PhD Candidate in Health Economics)

1
Outline

■ What is health and health care?

■ What is Economics?

■ What is Health Economics?

• Why is it important?

• What makes the health care market different from the market
or other goods?

2
What is Health?

• Health – a Priceless Commodity

• Health being the most precious good.

3
 What is Economics?

Limited resources

Unlimited ―wants‖

Scarcity

Choice

4
 Definition of Economics…

• We have limited resources.

• We have unlimited wants.

This leads to scarcity.

• Scarcity exists when there are insufficient resources

to satisfy people‘s wants.
• We have to make choices to choose among the
available alternatives.

5
 What is Economics?

• Economics is a social science that examines how

people choose among the alternatives available to
them.

• It is social because it involves people and their

behavior.

6
 What is Economics?

 Economics is the study of scarcity and choice

 Economics is often described as the ‗science of

scarcity‘ (Witter & Ensor 1997)

 It explains why nations export some goods & import

others & analyze the effect of putting economic
barriers at national frontiers

7
 What is Economics?

• Economics is science that studies how individuals and

organizations in society engage in

– the production

– distribution and

– consumption of goods and services.

• The study of how best to allocate scarce resources

among competing ones
8
 What is Economics?

• As a discipline, it focuses on three general

questions :
– what to produce
– how to produce
– For whom to produce .

9
 What is Health Economics?
 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.

10
 Health Economics…
• It is concerned with allocation of resources within the
various health care strategies,
 quantity and quality of resources used in health care
delivery,
 funding of health care services,
 efficiency in use resources allocated for health care
 and the effects of preventive, curative, and
rehabilitative health services on individuals and the
society.

11
 Why economics in health?
 health resources are finite
 choice must be made about which resources to use.
 to inform health care decision-makers

 most beneficial activities are chosen within the resources

available.
• To inform decision makers so that the choices they make
maximize health benefits to the population

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 Why economics in health?

 Equity, or the fair distribution of resources & benefits

 Decisions about how health care is funded, provided,

and distributed are strongly influenced by the
economic environment and economic constraints

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 Why economics in health?

• Medical decisions involve costs and benefits.

• It is essential that clinicians and policy makers have

knowledge of economic models to provide a
foundation for understanding the issues that affect
medical care and policy.

14
 How is Economics applied in Health?
• The analysis of the economic costs of diseases
• Benefits of programs - returns from investments in
education & training
• Aspects of health problems - type, quality, quantity &
prices of the resources used
• Population problem, the quantity & quality of resources
allocated to the health area
• The medical industry‘s efficiency & losses due to illness,
disability & premature death
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 Classification of Economics

1. Macro Economics
 the study of aggregate economic behavior, of the
economy as a whole.
 Macroeconomics examines national & international
economies.

 It studies how the overall level of economic activity is

determined & how government intervention affects the
economy as a whole

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 Macro Economics
The study of the behavior of the entire economy. for
example,
• national output(GDP)
• income ,
• the overall price level- measured by inflation( increase
in price index) rate
• Unemployment
• foreign trade & so forth.

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 Macroeconomics…
Unemployment

– The state of being available and willing to work but

unable to find acceptable work.

Inflation

– A situation in which the cost of living is rising and

the value of money is shrinking.

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Objectives and instruments of macroeconomic policy

• Four objectives are central to evaluating

macroeconomic performance:
• output,
• employment,
• prices, and
• the foreign sector.

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 Four Objectives
Output: The ultimate yardstick of a country‘s economic success is
its ability to generate a high level of production of economic
goods and services for its population

High employment: Providing good jobs with reasonable payment

for those who want to work is another objective of
macroeconomic policy.

Stable price: This objective contains two parts:

• Price stability denotes that the overall price level does not rise
or fall rapidly

• maintenance of free markets:

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Foreign Sector

Involvement of foreign sector and good trade balance

with foreign trade exchanges.

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 2. Micro Economics
 The study of economic behavior of individual
decision making units. such as
– Consumers
– resource owners and
– business firms in a free –enterprise economy.
 It deals with the theory of individual choice

 decisions made by a particular consuming unit

 such as an individual, industries, firms and households

etc .
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 Micro Economics
• E .g. How purchasing decisions of consumers are
influenced by changing prices & income.
Three Big Microeconomic Questions:
• What
• How
• Whom

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 Normative economics
• Refers to economic statements that prescribe how things
should be
 Normative economics involves ethics and value
judgments
 E.g. Should government give money to poor people?
- Should Public sector & private sector provides job opportunity
to the unemployed?
- Should the higher taxes & lower spending reduce the budget
deficit?

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 Positive economics
• Refers to economic statements that describe how things are.

• Positive economics describes the facts and behavior in the

economy.

• E.g. What is the percentage of un employment?

– How many people earn less than 50 birr/day?

– What is the effect of high cigarette taxes on the number of smokers?

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 Key (Basic) Concepts in Economics
1. Scarcity (What is scarcity)?
• Scarcity is the lack of enough resources to satisfy all
desired uses of those resources.
• That is, we can‘t have everything we want because
relative to our wants, Economic Resources are
limited in supply (availability).
• Thus it is the foundation of economics
• It is unavoidable we are to choose among the
competing objectives

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 Basic Concepts…
2. What are Resources?
• Are factors of production that are used to produce
goods and services with which we satisfy our needs.
• Inputs that are needed to produce outputs

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 Basic Concepts…
Four Basic Factors of Production
• Land : refers to all natural resources such as crude
oil, water, air, and minerals.
• Labor : refers to the skills and abilities to produce
goods and services.
• Capital : refers to goods produced for use in the
production of other goods, e.g., equipment,
structures.
• Entrepreneurship: is the assembling of resources to
produce new or improved products and technologies.
(know how, managerial capacity)

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 Basic Concepts…

3. What is the economy?

• Economy refers to the sum of all our individual
production and consumption activities.

• The economy is - the aggregation of all of our supply

and demand decisions.

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 Basic Concepts…
4. Equity:
• Equality of use of health care {for equal need}.

• Equality of access to health care {for equal need}.

• Horizontal equity: the principal of equal treatment

for equal need.

• Vertical equity: provision of unequal treatment for

unequal need.

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 Basic Concepts…
5. Opportunity Costs (―There is no such thing as a free
lunch‖)

• It is what is given up in order to get something else. (The best

alternative forgone)

• The potential benefit that could have been received if the

resources had been used in their next best alternative.

• The value of the next best alternative forgone as a result of the

decision made.

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 Basic Concepts…
6. Production Possibilities Curve (Frontier)—PPC (PPF)
• A graphic representation of production possibilities
• Production possibilities are the maximum alternative
combination of goods and services that could be produced in a
given period of time with all the available resources and
technology.
7. Utility
 Is the benefit consumers get from the purchase of goods and
services.
 It helps to determine how much the consumer is willing to pay.
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 The Production Possibilities Curve
A
5

4 B
OUTPUT OF TRUCKS

3
C

D
2

1
E

F
0 1 2 3 4 5
OUTPUT OF TANKS

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 Opportunity Costs

A Step 1: give up one truck

5

B
OUTPUT OF TRUCKS

4 Step 3: give up another truck

3
Step 2: get two tanks C
Step 4: get one more tank
2
D

1 E

F
0 1 2 3 4 5
OUTPUT OF TANKS

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 A
5
B
OUTPUT OF TRUCKS

4
Y C
3
Unemployment
2

0 1 2 3 4 5
OUTPUT OF TANKS

35
• PPC also shows whether outcomes (of allocation
decision) are Efficient or Inefficient

• Efficiency means getting the maximum output of a good

from the resources used in production

• Every point on a production possibilities curves is

efficient.

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• Any point inside the PPC represent inefficient
outcomes…leads to unemployment

• A point outside the production possibilities curve

suggests that we could get more goods than we are
capable of producing->Economic Growth

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with more resources or better technology, production
possibilities curve may shift outward.
Economic Growth

PP2
OUTPUT OF TRUCKS

PP1

0 OUTPUT OF TANKS
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 PPC
 Thus movement along the PPC represent opportunity cost

 How much we give up in the production of one output

to get more of the other output)—tradeoffs

8. Efficiency

 Measures how well resources are being used to promote social

welfare.
- Inefficient output wastes resources while efficient use of scarce
resources promotes social welfare.

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 People Face Trade Offs
Chapters 2, 3, 12
―There is no such thing as a free lunch!‖

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 Demand and Supply
What is DEMAND?

• The amount of a good or service a consumer wants and

willing to buy, and is able to buy per unit time.

• In economics a hungry man who can not pay for

food has no demand for it.

Demand vs. Need?

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 THE ―STANDARD‖ MODEL OF DEMAND

• The DEPENDENT variable is the amount demanded.

• The INDEPENDENT variables are:
– the good‘s own price
– the consumer‘s money income
– the prices of other goods
– preferences (tastes)- Personal feelings toward the
value or desirability of various products.
–Expectation of the future
–Number of consumers/buyers

42
 THE DEMAND CURVE
• The demand curve for any good shows the quantity
demanded at each price, holding constant all other
determinants of demand.

– The DEPENDENT variable is the quantity

demanded.

– The INDEPENDENT variable is the good‘s own

price.

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 THE LAW OF DEMAND
• The Law of Demand says that a decrease in a good‘s
own price will result in an increase in the amount
demanded, holding constant all the other determinants
of demand.

• Demand will increase if the price goes down, holding

other things constant.

• The Law of Demand says that demand curves are

negatively sloped.
44
 A DEMAND CURVE
• A curve illustrating the inverse relationship between
the price of a product and the quantity of it
demanded, other things equal.
• A demand curve must look like this, i.e., be
negatively sloped.
own
price

demand

quantity demanded
Market for Teff
45
 Demand…

• Normal good: When an increase in income causes an

increase in demand

• Inferior good: When an increase in income causes a

decrease in demand

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 Pizza is a normal good

What‘s the effect on the demand

curve for pizza if income rises
own price
to $2,000?

demand @ I = $1000
quantity
Market for pizza

47
 Suppose instead that pizza is an inferior good.

own price What’s the effect on the demand

curve for pizza if income rises
to $2,000?

demand @ I = $1000
quantity
Market for pizza

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 Demand of other goods

• Substitutes: Two goods are substitutes if an increase

in the price of one of them causes an increase in the
demand for the other.
• Thus, an increase in the price of pizza would increase
the demand for spaghetti if the goods were
substitutes.
• Complements: Two goods are complements if an increase in
the price of one of them causes a decrease in the demand for
the other.
• Thus, an increase in the price of pizza would decrease the
demand for beer if the goods were complements
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 Shifts in the Demand Curve
Price of
Ice-Cream
Cone

Increase
in demand

Decrease
in demand
Demand
curve, D 2
Demand
curve, D 1
Demand curve, D 3
0 Quantity of
Ice-Cream Cones 52
 DEMAND SUMMARY

• Demand is a function of own-price, income, prices of other

goods, and tastes.

• The demand curve shows demand as a function of a good's

own price, all else constant.

• Changes in own-price show up as movements along a demand

curve.

• Changes in income, prices of substitutes and complements,

and tastes show up as shifts in the demand curve.

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 Summary
Which of the following do you have a
demand for?

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 SUPPLY
• The amount of a good or service a firm wants to sell, and is able
to sell per unit time.
THE “STANDARD” MODEL OF SUPPLY
• The DEPENDENT variable is the amount supplied.
• The INDEPENDENT variables are:
– the good‘s own price
– the prices of inputs used in its production
– the technology of production
– taxes and subsidies
– Number of sellers in the market

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 Supply…
Supply Curves can also shift in response to the following factors:
– Subsidies and taxes: government subsides encourage
production, while taxes discourage production
– Technology: improvements in production increase ability of
firms to supply
– Other goods: businesses consider the price of goods they could
be producing
– Number of sellers: how many firms are in the market
– Expectations: businesses consider future prices and economic
conditions
– Resource costs: cost to purchase factors of production will
influence business decisions

56
 The Supply Curve
• The supply curve is a line showing the number of units of a good
or service that will be offered for sale at different prices at a given
time

– The DEPENDENT variable is the quantity supplied.

– The INDEPENDENT variable is the good‘s own price

• The Law of Supply says that an increase in a good‘s own price

will result in an increase in the amount supplied, holding constant
all the other determinants of supply.

• The Law of Supply says that supply curves are positively sloped.
57
 Supply schedule and supply curve
Price of
Ice-Cream
Cones Supply curve
$3.00
Price of Quantity of 2.50 1. An increase
Ice-cream cone Cones supplied in price . . .
$0.00 0 cones 2.00
0.50 0 1.50
1.00 1 2. . . . increases quantity
1.50 2 1.00 of cones supplied.
2.00 3
2.50 4 0.50
3.00 5
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

58
 A SUPPLY CURVE

A supply curve must look like this, i.e., be positively sloped.

own supply
price

quantity supplied
Teff Market
59
 Shifts in the Supply Curve: What causes them?
Price of
Ice-Cream Supply curve, S 3
Supply
Cone
curve, S 1
Supply
Decrease curve, S 2
in supply

Increase
in supply

0 Quantity of
Ice-Cream Cones 60
 Shifts in the Supply Curve…
• … are caused by changes in
– Input prices
– Technology
– Number of sellers (short run)

• The market supply will shift right if

– Raw materials or labor becomes cheaper
– The technology becomes more efficient
– Number of sellers increases

61
 Cost to Produce Amount of Supply Supply Curve Shifts

Cost of Resources Falls

Cost of Resources
Rises

Productivity Decreases

Productivity Increases

New Technology

Higher Taxes

Lower Taxes

Government Pays
Subsidy
62
 Supply summary

• Supply is a function of own price, input prices, and

technology.

• The supply curve shows supply as a function of own

price, all else constant.

• Changes in a good‘s own price show up as

movements along a supply curve.

• Changes in input prices, technology, or taxes show up

as shifts in the supply curve.
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 Demand and Supply in Health Care

• Every individual has a need or a potential need for

health care in the form of health promotion,
prevention, cure or rehabilitation.
• This need is not always translated into a demand for
health care particularly in developing countries for
various reasons
• Health need is transformed into a health care demand
for example when a patient seeks a medical care.
64
Reasons Why Need For Health Care Far
Exceeds The Effective Demand For It

• Affordability
• Geographical accessibility
• Availability
• Acceptability
• Cost of time off from work and costs of waiting.
The demand for health care is generally inelastic.
• meaning that any increase in user fees will result in a less than
proportionate drop in demand

65
 EQUILIBRIUM PRICE DEFINED
The equilibrium price of a good is:
–a price at which quantity supplied equals quantity
demanded.
–a price at which excess demand equals zero.

At the equilibrium price there is no net tendency

for price to change.

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 EQUILIBRIUM PRICE

• Excess demand exists when, at the current price, the

quantity demanded is greater than quantity supplied.

• Excess supply exists when, at the current price, the

quantity supplied is greater than the quantity
demanded.

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 Markets Not in Equilibrium

(a) Excess Supply

Price of
Ice-Cream Supply
Cone Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
68
 Markets Not in Equilibrium

(b) Excess Demand

Price of
Ice-Cream Supply
Cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
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 EQUILIBRIUM PRICE

• When there is EXCESS DEMAND for a good, price will tend

to rise.
• When there is EXCESS SUPPLY of a good, price will tend to
fall.
• When excess demand equals zero, price must be the
equilibrium price, and we say the market is in equilibrium.
If you want to find out the price at which a market is in
equilibrium, then look for the price where the excess demand is
zero.

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 SUPPLY/DEMAND SUMMARY

• Market price serves as the adjustment mechanism to

move markets to equilibrium.

• Price changes in response to the existence of excess

demand or excess supply.

• Changes in demand and changes in supply lead to

changes in equilibrium prices and quantities.

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 ELASTICITY

• Elasticity is the concept economists use to describe

the steepness or flatness of curves or functions.

• In general, elasticity measures the responsiveness of

one variable to changes in another variable.

• In economics elasticity refers to the ratio of the

relative change in a dependent to the relative change
in an independent variable

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 ELASTICITY…

The main measures of elasticity are:

–Price elasticity of demand

– Income elasticity of demand

–Cross elasticity of demand

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 PRICE ELASTICITY OF DEMAND

• Measures the responsiveness of quantity demanded to

changes in a good‘s own price.

• The price elasticity of demand is the percent change

in quantity demanded divided by the percent change
in price that caused the change in quantity demanded.

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 Using the Midpoint Formula

% change in Q
Elasticity =
% change in P
% change in p = change in P times 100.
average P
P
)  100
% change in p =
(
PMEAN

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What’s the percent increase in price here because of the shift
in supply?

S'
price S

pE = $2.50
pE = $2

D
QE Q
DRUG MARKET
76
What’s the percent change in Q due to the shift in
supply?

S'
price S

pE‘ = $2.50
pE = $2.00

D
QE‘ = 7 QE = 10 Q (millions)
DRUG MARKET
77
 NOW COMPUTE ELASTICITY

• % change in p = 22.22 percent

• % change in Q = -35.3 percent

• E = -35.3 / 22.22 = -1.6 (approx.)

78
 TERMS TO LEARN
• Demand is ELASTIC when the numerical value of
elasticity is greater than 1.
• Demand is INELASTIC when the numerical value
of elasticity is less than 1.
• Demand is UNIT ELASTIC when the numerical
value of elasticity equals 1.

• NOTE: Numerical value here means ―absolute

value.‖

79
 ELASTICITY…

• If demand is elastic, total expenditures will change in

the opposite direction from a change in price.

• If demand is inelastic, total expenditures on a

commodity will change in the same direction as a
change in price

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 Cross Elasticity of Demand
• Cross elasticity (Exy) tells us the relationship between
two products.
• It measures the sensitivity of quantity demand change of
product X to a change in the price of product Y.

• Formula: Exy = percentage change in Quantity demanded

of X / percentage change in Price of Y.

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 Income Elasticity of Demand
• Income elasticity of demand (EI, here I stands for
income) tells us the relationship a product's quantity
demanded and income.
• It measures the sensitivity of quantity demand change
of product X to a change in income.

• Income elasticity formula: EI = percentage change in

Quantity demanded / percentage change in Income
• Income elasticity of demand will be positive for
normal goods, negative for inferior ones.

82
 Determinants of price elasticity of demand

• # of Substitutes: If a product can be easily substituted, its

demand is elastic. If a product cannot be substituted easily,
its demand is inelastic, like Insulin.
• Luxury Vs Necessity: Necessity's demand is usually
inelastic because there are usually very few substitutes for
necessities.
• Luxury product, such as leisure sail boats, are not needed in
a daily bases. There are usually many substitutes for these
products. So their demand is more elastic.
83
 Determinants…

• Price/Income Ratio: The larger the percentage of

income spent on a good, the more elastic is its
demand. A change in these products' price will be
highly noticeable as they affect consumers' budget
with a bigger magnitude

• the smaller the percentage of income spent on a good,

the less elastic is its demand.

84
 Determinants…

• Time since price change

– short time
no time to adjust,
demand is inelastic
– long time
time to adjust,
demand is elastic

85
 Elasticity of Supply

• If the amount put on the market is highly responsive to

price changes, the supply is elastic.

• Except that the amount supplied and the price ordinarily

move in the same rather than the opposite directions, the
concepts of demand and supply elasticity are similar.

86
 Market Structure
Market - a set of arrangements which allow buyers &
sellers to communicate & exchange goods, services or
resources
• It is the sum of all individual firms.
Market structure refers to how an industry (broadly called
market) is operating in structured or organized way.
• The key ingredients of any market structure are:
– Number of firms in the market/industry
– Extent of barriers to entry
– Nature of product
– Degree of control over price.
87
 Market Structure

• Four broad market structures have been identified

by economists:

– Perfect competition

– Monopolistic competition

– Oligopoly

– Monopoly

88
Market Structure

89
 Determinants of market structure

• Freedom of entry & exit

• Nature of the product – homogenous (identical),
differentiated?
• Control over supply/output
• Control over price
• Barriers to entry

90
 Perfect Competition
• The main assumptions of perfect competition are:

– Many buyers and sellers

– No barriers to entry and exit

– Dealing with homogeneous products with no differentiation

– Perfect information/knowledge

– The price is fixed by the market

91
 Perfect Competition…

• Advantages of Perfect Competition:

• High degree of competition helps allocate resources to
most efficient use
• Normal profit made in the long run
• Firms operate at maximum efficiency
• Consumers benefit

92
 Market Structures
2. Monopoly
• Monopoly defines the other pole or extreme of the

market structure spectrum

– Only one seller

• Usually refers to a situation where there is a single

producer in the market

93
 Summary of Monopoly
– High barriers to entry
– Firm controls price OR output/supply
– Unique products
– Firms are price maker
– Abnormal profits in long run
– Possibility of price discrimination
– Consumer choice limited
– Prices in excess of MC

94
 3. Monopolistic Competition

• Monopolistic competition is also characterized by a large

number of buyers and sellers and

• Absence of entry barriers

• In these two respects it is like perfect competition

95
 Monopolistic Competition

• Firms are price-takers but not in the extreme

sense of perfect competition

• Products are differentiated and in this respect,

it is different from perfect competition

• Slightly different, perhaps branded

96
 Monopolistic Competition
Characteristics:
– Many buyers and sellers

– Products differentiated

– Relatively free entry and exit

– Each firm may have a tiny ‗monopoly‘ because of

the differentiation of their product

– Firm has some control over price

– Examples –building firms, Private schools

97
 4. Oligopoly
Characteristics;
– Industry dominated by small number of large firms
– Non–price competition
– Many firms may make up the industry
– High barriers to entry
– Products could be highly differentiated – branding or
homogenous
– Abnormal profits
– High degree of interdependence between firms
– E.G Supermarkets, Banking industry, Oil, Medicinal drugs,
Broadcasting
98
 Oligopoly…

• Because there are only a few dominant sellers, actions of

any one firm can change the overall market price.
• Similarity of Oligopoly with other Market Structures:
– It is similar to perfect competition in the sense that
firms compete with each other which may result in
prices very similar to those that would obtain under
perfect competition.
– It is similar to monopolistic competition since there is a
possibility of having differentiated products.
99
Government’s Role & the Politics of Health Care

• What are the roles of government in health care?

• Why do government set involved in health care?
• What are the economic justifications for market
failure?

100
Government‘ Role & the Politics of Health Care

• Government roles
– Financing
– Delivery
– Regulation
– Licensure,
– Guide line setting

101
 What is Market Failure?

• Market failure occurs when freely functioning

markets, operating without government intervention,
fail to deliver an efficient or optimal allocation of
resources.

• Market failure exists when the competitive outcome

of markets is not efficient from the point of view of
the economy as a whole.

102
 Market Failure…
Economic Justifications For Market Failure
• Nature of goods (public goods)
• Externalities (Positive and negative)
• Imperfect competition
• Uncertainty and imperfect information
• Asymmetry of information
• Health care as free market

103
 Public good
• In economics, a public good is a good that is both
non-excludable and non-rivalrous

• For such goods, users cannot be barred from

accessing or using them for failing to pay for them

• Also, use by one person neither prevents access of

other people nor does it reduce availability to others

104
 Unique Characteristics of Health Care Market
• The unpredictable & irregular nature of demand for health
care
• Product uncertainty
• Health care commodity is a non-homogeneous product
• Asymmetry of information: supplier induced demand
• Absence of perfect competition
• The presence of externalities
• Some health care services have the characteristics of ‗Public
goods‘
105
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