Health Economics

Lecture 1

Dr. Elena Pizzo

Topics covered in HE

❑ Markets in health

Should health care be privatized?

Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets

How prices are formed?

Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly

The impact of market power on health?

Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly
❑ Externalities

Why should COVID vaccines be provided by the government?

Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly
❑ Externalities
❑ Public Goods

How to finance medical research (e.g. to develop a COVID vaccine)?

Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly
❑ Externalities
❑ Public Goods
❑ Doctor behaviour models

How should we pay doctors in order to improve health outcomes?

Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly
❑ Externalities
❑ Public Goods
❑ Doctor behaviour models
❑ Equity
Who should receive the next donated heart? Or COVID vaccine first?
Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly
❑ Externalities
❑ Public Goods
❑ Doctor behaviour models
❑ Equity and concerns for other people
❑ Asymmetric and imperfect information
Why private health insurance is bad for your health?
Topics covered in HE

❑ Markets and market failures in health

❑ Demand, Supply, and perfect markets
❑ Market failures in health & government intervention
❑ Monopoly
❑ Externalities
❑ Public Goods
❑ Doctor behaviour models
❑ Equity and concerns for other people
❑ Asymmetric and imperfect information
❑ Economic evaluation
Should a cancer drug be provided by the NHS?
Exercise
 Task

• After watching a debate on abc the Department of Health has

established an advisory group to advise on how to organize health care.
You have been asked by the Department of Health to be part of this
advisory board.

• Your task is to advise on whether government should intervene

(financing, provision, regulation) in the health system or if healthcare
should be provided free of government intervention in a private market.

• The video
What is your advise to the Department of Health?

What extra information (if any) do you need?

Brainstorming
Public or Private?
What is Economics?
What is Health Economics?
Economics is about …

❑ Limited resources
❑ Unlimited “wants”

❑ Trade-offs

❑ Choosing
❑ ‘wants’ we can ‘afford’
❑ Resource budget

❑ Efficient resource allocation “You can’t always get what you want”
(Rolling Stones, Let it bleed, 1969)
Economics is about choice

Good B Good A

Budget
Implications of opportunity cost

➢Deciding to do A implies deciding not to do B (i.e. value of

benefits from A>B).

➢Cost can be incurred without financial expenditure.

➢Value not necessarily determined by “the market”

Key economic issues

• Efficiency: maximising benefit for resources used

• Technical efficiency: meeting a given objective at least cost (resources)
– Minimising costs of production
– Maximising output from given inputs

• Allocative efficiency: producing the pattern of output (supply) that matches

the pattern of consumer wants (demand)
– Choice of how much to produce of which goods
– Maximising welfare for given resources

• Equity
– Distribution between individuals and groups
Key economic issues

• Technical efficiency
– Minimising costs of production
– Maximising output from given inputs

• Allocative efficiency
– Choice of how much to produce of which goods
– Maximising welfare for given resources

• Equity
– Distribution between individuals and groups
 Economics is about choice

Technical efficiency
How many beds?

Allocative efficiency
Where do I place the beds, for which
interventions?

Equity
Who is the patient left out?

© Copyright NHS Innovations London 2009

Health economics
What is health economics?

Health economics is the application of economic theory,

models and empirical techniques to the analysis of
decision-making by individuals, health care providers and
governments with respect to health and health care
(K.Arrow 1963)

But is also comprises a body of theory developed

specifically to understand the behavior of patients, doctors
and hospitals and to allocate resources. Often draws from
epidemiology, statistics, psychology, sociology, maths…
What is Health Economics?

Methods
– Application of economic theory
– Systematic analytical framework

Focus
– Decision-making by individuals
Topics in Health Economics

Health Health
and its statistics
value econometrics

Demand
for health Determinants
of health

Human Health Health and

resources the
Economics
economy
Supply of
health Efficiency
and equity
Economic
Medical
insurance evaluation
Public pharma-econ
health HTA
Health
Markets

Source: Wagstaff and Culyer, 2012

 What is health economics and…
why is it important?

• It is important because it offers a unique and systematic

intellectual framework for analysing important issues in
health care

• This is useful because the health care sector consumes a

great deal of resources, and because the organisation and
delivery of health care is strongly influenced by the
economic environment and economic constraints
Why is health economics relevant?

• Read article 1 here

Why is health economics relevant?

When a shortage developed for a decades-old

drug* to prevent hemorrhages in patients
undergoing open-heart surgery, “We essentially
did military-style triage,” said Dr. Brian
Fitzsimons, an anesthesiologist at the Cleveland
Clinic, restricting the limited supply to patients
at the highest risk of bleeding
complications.Credit...T.J. Kirkpatrick for The
New York Times

“It was painful,” said Dr. Yoram Unguru, an

oncologist at the Children’s Hospital at Sinai in
Baltimore and a faculty member at the Berman
• Read article here Institute of Bioethics at Johns Hopkins
University. “We kept coming back to wow,
we’ve got that tragic choice: two kids in front of
you, you only have enough for one. How do you
*aminocaproic acid choose?”
 Is health care economically important?
• Health expenditure in the USA:
– from $1,000,000,000,000 (one trillion) in1997 to $3.6 trillion in 2018 (one
fifth of all US economic activity)
– now accounts for just over 16.8% of USA GDP
– will plausibly reach 33% of GDP by 2050

• Health expenditure in the UK:

– comprises 17% of all Government spending
– is a major consideration in fiscal management of the economy

• In every developed economy:

– health care is a major component of spending, investment and
employment
– the economic performance of the health care system is crucially linked
to the overall economic well-being of a country and its citizens
 International health expenditure, 1995 & 2015
Per person ($US) % Gross Public HE % Public HE %
Data link Domestic Tot HE Public exp
Product
1995 2015 1995 2015 1995 2015 2015
World $ 457 $ 1,300 8.8 9.9 62.1 59.2 15.5

High income $ 2,364 $ 5,280 9.6 12.4 63.5 61.2 18.6

North America $ 3,557 $ 9,040 13.2 16.3 46.3 51.5 22.4
European Union $ 1,664 $ 3,753 8.7 9.9 78.0 79.0 16.4

Low & middle income $ 52 $ 511 5.0 5.4 48.6 52.1 9.1
Latin America & Caribbean $ 243 $ 1,019 6.5 7.4 48.3 48.1 10.3
Europe & Central Asia $ 78 $ 1,024 4.8 5.3 70.4 62.6 9.7
Middle East & North Africa $ 57 $ 724 4.4 5.5 46.9 47.7 9.2
East Asia & Pacific $ 25 $ 646 3.3 6.837 47.4 57.7 10.0
Sub-Saharan Africa $ 32 $ 199 5.8 5.4 39.0 34.7 9.9
Upper middle income $ 90 $ 903 5.3 5.7 51.5 56.9 9.9
Lower middle income $ 21 $ 259 3.8 4.0 36.3 31.6 5.4
Low income $ 10 $ 98 4.1 6.0 38.2 19.6
Source: The World Bank Website, www.data.worldbank.org. Income groups defined by 2018 Gross National Income per person in $US:
Low income, $ 1005 or less; Lower middle income, $ 1006- $3,956.
Upper-middle-income economies are those in which 2016 GNI per capita was between $3,956 and $12,235.
High-income economies are those in which 2016 GNI per capita was $12,235 or more.
 Health expenditure as a share of GDP, 2019-20

38

Source: OECD Health Statistics 2021, WHO Global Health Expenditure Database.
 Health expenditure per capita, 2019

39

Source: OECD Health Statistics 2021, WHO Global Health Expenditure Database.
How much of public spending is for health?

40

https://www.gov.uk/government/statistics/public-spending-statistics-release-may-2022/public-
spending-statistics-may-2022
NHS one of the world’s largest employers

41
Health policy and challenges
Patient demand for health care

Current situation Result

• In most health care systems, • Potential imbalance between

patients’ demands and system’s
interventions are provided at zero or
ability to provide
highly subsidised cost to patient at
point of consumption
• Particularly within context of fixed
budget
• Patients will wish to consume health
care, providing perceived benefit of
intervention exceeds cost to them • Health care is an ‘economic good’
(it is scarce relative to our wants
for it)
Health care as an ‘economic good’
basic economic questions

What combination of health care/non-health care

goods should be produced in the economy?

Which types of health care should be produced?

What resources (inputs) should be used to

produce these health care services?

Who should receive the services?

Is health an economic good?

• Health can be thought as a good:

– is a ‘fundamental commodity’: Becker (1965), Grossman
(1972); main objective of people, for which other goods and
services are created
– is wanted and people are willing to pay for improvements in it
– is scarce relative to peoples wants
– is affected by health care that can be produced and sold
– affects utility and welfare
Wants, demands and needs

• In order to understand the economics of health care it is

important to understand the wants, needs and demand for
health and health care by consumers

• The demand for health and health care can be analysed in

very similar ways to the demand for other goods and services

• However, it is necessary to take account of some special

features of health and health care
Health and health care as special goods

Special characteristics health

– is less tangible than other goods
– cannot be transferred to others
– not tradeable
– improvements cannot be purchased directly

Demand for healthcare derived from demand for health

Special characteristics health care

– is not demanded because it is pleasurable
– is demanded mainly to improve health
Problems with evaluating demand in health and health
care

• Health is not tradeable (it cannot be bought or sold directly)

48
Problems with evaluating demand in health and health
care

• Health care has a ‘derived demand’ from the demand for health

49
Problems with evaluating demand in health and health
care

Not all wants are needs

(C-Section)

But.. With a
complication,
because what
matters is..
Some needs are
not wants (dental
care)

The implications of basing the allocation of resources on needs

rather then demands are profound!
Health Economics is about choices

Cancer treatment Swine Flu jabs

Budget
Opportunity cost
Opportunity cost of using resources to produce a good or service
is the benefits forgone from those resources not being used in
their best alternative

Finite resources
– Medical supplies
– Personnel
– Capital inputs

• Actions taken by patients, health care providers or governments

• use of health care
• forgoing benefits that would have been derived from other uses

• Production and consumption of health care incurs real, human costs and
benefits.
 One IVF course = £2,700
what is the opportunity cost?

11 cataract removals 1 heart bypass

operation

Half a junior school

teaching 150 vaccinations for
assistant for a year Measles,
Mumps and Rubella

1/1000 of a Challenger 2
military tank
2000 school dinners

• Morris et al 2015 Economic analysis in healthcare, Wiley

Choice & Opportunity Cost Allocation of resources

Choices about If we decide to The opportunity cost is

Lower net incomes for consumers.

Higher taxes for firms either
Increase public spending on
lower profits and incentives to
health care by increasing
invest, more incentives to cut
taxes/social insurance
costs, or results in increased
contributions
How much should prices where taxes can be
passed on to consumers.
we spend on
health care as a
country? Increase public spending on
The benefits forgone from lower
health care by spending
education, social welfare or
less on other government
defence spending.
services
Increase public spending on
Economy-wide consequences of
health care by deficit-
public sector debt
spending
What Is a Market?

Market = buyers + sellers + good/service.

• Supply + demand:
• behavior of people
• interact with one another in markets

Buyers determine demand.

Sellers determine supply.
Demand for health and for health care

Health: cannot be purchased directly

Health care: purchased directly
– Demand for health care derived from demand for health

Health value in use but not in exchange

• Health as fundamental commodity
• Want be healthy: can work and enjoy leisure better when healthy

• Good health has intrinsic value in its own right – it brings us utility
• And it has instrumental value – we are able to earn more and are better able
to satisfy our social needs

• Demand for health derived from demand for utility

Utility
Some rules

• Consumers are rational:

– They can express their preferences for different goods or
bundles of goods: complete preference ordering
• Preferences must be transitive:
– If a bundle A is better than B and B is better than C, then A
should be preferred to C
• Consumers are not satiable:
• Increased in consumption of any good will increase utility
Properties

Marginal utility is decreasing

– Each successive unit of medical care generates a smaller
improvement in health
Law of diminishing marginal productivity
– Each increase in health generates a smaller increase in
utility
Law of diminishing marginal utility
The Relationship between Utility and Medical Care

Utility
Utility

Quantity of medical care (q)

Preferences and utility

Utility Function
• Consumption utility

U=U(X1, X2,..., Xn) or

U=U(X, Y)

Indifference Curves (IC)

• Equal satisfaction

(100)=U0=U(nurses visits, doctor visits)

Is a curve that is the combination of 2 goods giving the same level of utility
 Relationship between utility and good consumption and
indifference curve

Utility Utility
Utility
145
60
55 55
50
50
45
40

5 8 10 12 3 5 7 9
Quantity of medical care (GP) Quantity of medical care (Nurse)
Indifference curves

Visits to the • Negative slope: increase in

consumption increases utility,
nurse so an increase in a good
consumption is accompanied
to a decrease in the other
good → to keep the utility at
the same level movement
along the line has different
signs so the curve has a

Y1=7 a negative slope (+,-)

b
Y2=5
d
Y4=3 U1=100

X1=5 X2=8 X4=12

Visits to the GP
Indifference curves

Visits to the • What is c representing?

nurse • C is a higher level of utility
compared to a, b, d because the
combination of goods gives a
higher level of utility

Y3=9 c • SHIFT of THE UTILITY CURVE

Y1=7 a
b U2 =200
Y2=5
d U1=100
Y4=3

X1=5 X2=8 X3=10 X4=12

Visits to the GP
Marginal rate of substitution

• The change in utility for each good can be expressed in terms of

their marginal utility by rearranging the equation:
• MUx=ΔU/ΔX in ΔU=MUxΔX
• So to keep ΔU the same → MUXΔX = MUYΔY →
• ΔX/ΔY = MUY /Mux
• Marginal rate of substitution of good X, Y = MRSX,Y
• The slope for the curve with negative sign
 Indifference curves- shape

Visits to the
nurse
MRSGP,N= 2 = |-2 |= 2
-1

Y1=7 b
Plus 2 a
Y2=5

U1=100

X1=5 X2=6 Visits to the GP

Minus 1
Indifference curves- diminishing marginal utility

Visits to
the
nurse

Minus 1 Y1=6 a
Y2=5 b
Minus 1
Y4=4 U1=100

X1=5 X2=8 X4=12

Visits to the GP
Plus 3 Plus 4
 Budget constraints and maximisation

How do we decide?
• Decisions constrained: limited resources and the prices

Max U s.t. (subject to)

Income=Py *Y+ Px* X

Px = Price of X
Py = Price of Y
 Budget Constraint – how to draw the line

Visits to I= Py*Y+ Px*X

the nurse Py=25; Px=50
I=1000
[Good Y]
40
1000=25Y+50X
Y=1000/25 – (50/25)X
Y= 40 – 2X
Y1=30
d If I spend all in Y=40
If I spend all in X=20

Y=I/Py-(Px/Py)X

X1=5 20 40
0 Visits to the GP
Px = Price of X (GP)
Py = Price of Y (nurses)
[Good X]
 Budget Constraint – what about f?

Visits to I= Py*Y+ Px*X

the nurse Py=25; Px=50
[Good Y] I=1000
40 f
For point f
40*25 + 7*50= 1000+350= 1350
Y1=30
d Cannot afford it!

X1=5 X2=7 20
0 Visits to the GP
Px = Price of X (GP)
Py = Price of Y (nurses)
[Good X]
 Budget Constraint - what about g?

Visits to I= Py*Y+ Px*X

the nurse Py=25; Px=50
[Good Y] I=1000
40
For point g
We are not using all available
Y1=30
d income!

X1=5 20
0 Visits to the GP
Px = Price of X (GP)
Py = Price of Y (nurses)
[Good X]
 Budget Constraint - what if the price of a good decreases?

Visits to I= Py*Y+ Px*X

the nurse Px=25 (instead of 50)
[Good Y] 1000=25Y+25X
40
Y=1000/25 – (25/25)X
Y= 40 – X

Y1=30
d e
Y=I/Py-(Px/Py)X
Y2=22

1000=25Y+25X

X1=5 X3=18 20 40
0 Visits to the GP
Px = Price of X (GP)
Py = Price of Y (nurses)
[Good X]
 Budget Constraint – slope

Visits to How is the slope of the BC?

the nurse
How much is the slope?
[Good Y]
40
What does it represent?

Y1=30
d It is the ratio of the two prices!
Px/PY=-2

X1=5 20 40
0 Visits to the GP
Px = Price of X (GP)
Py = Price of Y (nurses)
[Good X]
Exercise for home

• Starting from I= 1000; PX= 50; PY= 25

a)Try to double the price of good X

b) Try to double the price of good Y
c) Try to double both prices simultaneously
d) Try to double your income
e) Try to double the prices and income simultaneously
 Maximising utility s.t. BC

I= Py*Y+ Px*X
Visits to the
Py=25; Px=50
nurse
I=1000
[Good Y]

40 Y=I/Py-(Px/Py)X

Y1 d
e
Y2
U3=300
YA a
U2=200
U1=100

0 X1 XA X2 20 40

Px = Price of X (GP) Visits to the GP

Py = Price of Y (nurses)
[Good X]
 Maximising utility s.t. BC if the price of a good decreases

I= Py*Y+ Px*X
Visits to the
Py=25; Px=25
nurse
I=1000
[Good Y]

40 Y=I/Py-(Px/Py)X

Y1 d
e 1000=25Y+25X
Y2
U3=300
U2=200
U1=100

0 X1 X2 20 40

Px = Price of X (GP) Visits to the GP

Py = Price of Y (nurses)
[Good X]
Exercise for home

• Using U2=200 and starting from I= 1000; PX= 50; PY= 25

a)Try to double the price of good X

b) Try to double the price of good Y
c) Try to double both prices simultaneously
d) Try to double your income
e) Try to double the prices and income simultaneously
and see if you are maximizing utility
The Utility Maximizing Rule

Utility-maximizing rule

– Marginal utility gained from the last £ spent on each product is equal across
all goods and services purchased
MUn/Pn = MUgp/Pgp

– MUn – marginal utility - from the last unit of nurses services purchased
– Pn – price of nurse
– MUgp – marginal utility derived from the last unit visits to the gp
– Pgp – price of visit to the GP
Initial
– Optimal mix of physician services and all other goods
MUn/Pn = MUgp/Pgp

If price of nurses services increases

MUn/Pn < MUgp/Pgp

– More satisfaction per dollar from going to the GP

– Buy fewer units of nurses services and more units GP services:
MUn/Pn increases, MUgp/Pgp decreases until

MUn/Pn = MUgp/Pgp (MUgp/MUn= Pgp /Pn )

 Consumer Max U=U (X,Y)

MUx=ΔU/ΔX MUY=ΔU/ΔY

ΔY

Indifference curve

ΔX

Subject to Budget Constraint

I= Py*Y+ Px*X

Budget Constraint
Catherine’s Demand Schedule

Price of Physician Services Quantity of Physician

Services Demanded
$0 12
5 10
10 8
15 6
20 4
25 2
30 0
Catherine’s Demand Schedule Price of Physician
Services
Quantity of Physician
Services Demanded

and Demand Curve $0 12

5 10
Price 10 8
$30 15 6

Decrease in price 25 20 4
25 2
20 30 0

15
10
5
0 2 4 6 8 10 12 Quantity of
Increase in quantity demanded Physician Services
 The Market Demand Curve

When the price is $20, Catherine will When the price is $20, Nicholas will
demand 4 physician services. demand 3 physician services.

Catherine’s Demand + Nicholas’s Demand = Market Demand

Price Price Price of Physician

Services

20 20 20

10 10 10

3 5 4+3=7 13
4 8
Quantity Physician Services Quantity Physician Services Quantity Physician Services

When the price is $10, When the price is $10, The market demand at
Catherine will demand 8 Nicholas will demand 5 $10, will be 13 physician
services
• You fix the price and then you add the quantities!!
Imperial College Business School Imperial means Intelligent Business 84
Determinants of Demand
Demand for health care

Demand for health care is a function of:

– Price of health care
– Prices of substitutes and complements
– Lifestyle (smoking, exercise, diet)
– Income
– Type of insurance
– Level of education
– Age
– Sex
– Health status
– Quality of care
– Time costs
Change in the Quantity and Demand Curve

• Change in Quantity Demanded (along the curve)

• Change in Demand Curve
Changes in Quantity Demanded
Price of
Physician A tax on physicians raises
Services the price of services and
B
$20 results in a movement
along the demand curve.

10 A

D
0 4 8 Quantity of Physician
Services
Consumer Income Normal and Inferior Goods

Price An increase in
income...
£30

25
Normal Good
Increase
20

15
Inferior Good
10 Decrease

5
D2
D3 D1
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Demand functions: determinants of demand

• Elasticity measures the responsiveness of changes in one

variable, for example the quantity demanded, to changes in
another variable, for example price
• PED= (dQ/dP) (P/Q)
• P price Q quantity demanded and dQ/dP is the slope

• Evidence suggests that the demand for health care is price

inelastic, that is, demand is not particularly responsive to
changes in the price of health care

• Income elasticity of demand IED=(dQ/dI) (I/Q)

Movements along and shifts in the demand curve

e.g. if the price of the

Price good increased, there is a
movement along the
curve D

P2 e.g. if the size of the

consumer population
grows, D shifts

P1

D2

D1

Q2 Q1 Q3 Quantity demanded
Asymmetry of information and imperfect agency

• Health care is characterised by asymmetry of information. In particular,

doctors are usually better informed about health and health care than
patients

• A principal-agent relationship usually develops in which the doctor – the

agent – makes available their specialist knowledge to the patient – the
principal

• If doctors acted as perfect agents they

would maximise the utility of the principal
 Asymmetry of information and imperfect agency – Supplier
Induced Demand (SID)

• The hypothesis of supplier induced demand is that doctors act as imperfect

agents who maximise their own utility

• Supplier induced demand is difficult to detect, since empirical findings may

be consistent with non-inducement
Supplier induced demand by Irish GPs

• GPs can treat both public patients (paid by the state) and private patients
(pay for themselves higher fees).
• 23.5% of GP visits led to the GP rearranging a return visit to private
patients

94
The problem of identifying supplier-induced demand

e.g. influx of
doctors from
overseas;
Price doctors
D1 D2 D4
S1 recommend more
treatments
S2

P4
P1
P2
D3: no
P3 inducement

Q 1 Q3 Q2 Q4 Quantity demanded
Questions?