Cost-Benefit Analysis Methods

Chapter 3
Cost and Benefit

Evaluation
Methods
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Cost Identification Analysis
• Cost identification studies

– Measure the total cost of a given medical
condition or type of health behavior on the
overall economy
– Also called cost illness studies
• Three major components
– Direct medical care costs
– Direct nonmedical costs
– Indirect costs
• Direct medical care costs

– All costs incurred by medical care providers,
including:
• Necessary medical tests and examinations
• Administering medical care
• Any follow-up treatments
• Direct nonmedical costs

– All monetary costs imposed on any
nonmedical care personnel, including patients
• Transportation to and from the medical care
provider
• Any other costs borne directly by the patient
• Indirect costs
– Time costs associated with implementation of
the treatment
– Opportunity cost of the patient’s (or anyone
else’s) time that the program affects
Cost-Benefit Analysis
• Resource scarcity
– Forces society to make choices
• Economics - Social science
– Analyzes the process by which society makes
these choices
• People - Rational decision makers

– Rationality: People know how to rank their
preferences from high to low or best to worst
– People never purposely choose to make
themselves worse off
– Make choices based on their self-interests
– Choose those activities they expect will
provide them with the most net satisfaction
• Decision rule
– If expected benefits exceed expected costs
for a given choice, it is in the economic
agent’s best interest to make that choice
• Optimizing rule: NBe(X) = Be(X) – Ce(X)

– X: A particular choice or activity under
consideration
– Be: Expected benefits associated with the
choice
– Ce: Expected costs resulting from the choice
– NBe: Expected net benefits
• If NBe > 0
– Economic agent’s well-being is enhanced by
choosing the activity
• Formal cost-benefit analysis
– Utilizes the same net benefit calculus to
establish the monetary value of all the costs
and benefits associated with a given health
policy decision
• Surgeon general
– Maximize the social utility of the population by
choosing the best aggregate mix of goods
and services to produce and consume
– Allocate land, labor, and capital resources to
any and all uses
– Maximize the total net social benefit (TNSB)
from each and every good and service
produced in the economy
• TNSB = TSB – TSC

– TSB - Total social benefit in consumption
• Money value of the satisfaction generated from
consuming the god or service
– TSC - Total social cost of production
• Money value of all the resources used in producing
the good or service
• TNSB from medical services

TNSB(Q) = TSB(Q) - TSC(Q)
– Q – Quantity of medical services
• Maximize TNSB(Q)
– Choose Q at which the difference between
TSB and TSC reaches its greatest level
Figure 3.1 - Determination of the
Efficient Level of Output
The TSC curve represents the TSC of producing medical care and is upward sloping because total
costs increase as more medical care is produced. The curve bows toward the vertical axis because
the marginal cost of producing medical care increases as more medical care is produced.
Costs TSC
and
benefits
of TSB
The TSB curve represents the monetary value
medical A of the total social benefit generated from
services consuming medical care. The curve is
positively sloped to reflect the added
monetary benefits that come about by
consuming more medical care. The curve
bows downward to capture the fact that
society experiences diminishing marginal
B benefit with regard to medical care.
0 Q0 Quantity of medical services (Q)

TNSB is maximized when the vertical distance between the two curves is greatest and that occurs
at Q0 level of medical services.0
• TSB - Increases at a decreasing rate

– Diminishing marginal benefit
• Successive incremental units of medical services
generate continually lower additions to social
satisfaction
– Slope: MSB(Q) = ΔTSB/ΔQ
• MSB - Marginal social benefit from consuming a unit
of medical services
• MSB decreases with quantity since the slope of the
TSB curve declines due to diminishing marginal
benefit
• TSC - Increases at an increasing rate

– Increasing marginal costs of producing
medical services
– Slope: MSC(Q) = ΔTSC/ΔQ
• MSC - Marginal social cost of producing a unit of
medical services
• MSC increases with output as the slope of the TSC
curve gets steeper due to increasing marginal cost
• Maximize TNSB
– Slope of TSB = slope of TSC
– MSB(Q) = MSC(Q)
– At output level Q0
• Allocative efficiency - Best quantity of medical
services
• MSB curve - Negatively sloped

– Diminishing marginal benefit
• MSC curve - Positively sloped
– Increasing marginal costs
• Efficient amount of medical services: Q0
– where MSB = MSC
Figure 3.2 - Under- and
Overprovision of Medical Services
The MSC curve stands for the marginal social cost of producing medical care and is
Costs and upward sloping because of increasing marginal costs.
benefits of A
medical MSC
services TNSB is maximized at Q0 level of medical
E G care where the two curves intersect. At
that point, the MSB of consuming medical
C care equals the MSC of production.
H The MSB curve stands for the marginal

F
social benefit generated from
consuming medical care and is
B downward sloping because of the
MSB notion of diminishing marginal benefit.
QL Q0 QR Quantity of medical services (Q)
If QL amount of medical care is produced, then the MSB exceeds the MSC and society would be better
off if more medical services were produced. If QR amount of medical care is produced, then the MSB is
less than the MSC and too much medical care is produced.
• TNSB
– Area below MSB curve but above MSC curve
• Sum of net marginal social benefits
– Area ABC = Maximum TNSB that society
receives if resources are allocated efficiently
• If QL units of medical services are

produced instead of Q0 units:
– Society fails to receive the part of the TNSB
indicated by area ECF
– Deadweight loss: ECF
• Lost amount of net social benefits
• Cost associated with an underallocation of
resources to medical services
• QR units of medical services are produced

instead of Q0 units:
– Results in deadweight loss GCH
• Indicates net cost to society from producing too
many units of medical services and therefore too
few units of all other goods and services
• NMSB(Q) = MSB(Q) - MSC(Q)

– NMSB - net marginal social benefit the society
derives from consuming a unit of the good
• If NMSB > 0
– Total net social benefit increases if an
additional unit of the good is consumed
• If NMSB < 0
– Society is made worse off if an additional unit
of the good is produced and consumed
Practical Side of Using Cost-Benefit
Analysis - Health Care Decisions
• Benefits, or diverted costs, of a medical
intervention - four broad categories:
1. The medical costs diverted because an
illness is prevented
2. The monetary value of the loss in production
diverted because death is postponed
3. The monetary value of the potential loss in
production saved because good health is
restored
4. The monetary value of the loss in
satisfaction or utility averted due to a
continuation of life or better health or both
Discounting
• A benefit (or a cost) received today

– Has more value than one received at a future
date
• Present value, PV,
– Of a fixed sum of money, F, to be received a
year from now
– r - annual rate of interest (discount rate)
F
PV 
(1  r )
Discounting
• PV of a fixed sum
– Inversely related to the rate at which it is
discounted
• PV of sums of money received over a
number of years, T:
– Ft (t = 1, 2, 3, . . . , T) equals the payment, or
net benefit, received annually for T years
F1 F2 F3 FT
PV  1
 2
 3
 ...  T
(1  r ) (1  r ) (1  r ) (1  r )
Discounting
• Present value in terms of benefits and

costs over time
( Bt  Ct ) T
NB   t
t 1 (1  r )
– NB - the PV of net benefits
Discounting
• Choosing the interest rate

– Too high
• May result in choice of medical interventions that
offer short-term net benefits
– Too low
• May result in choice of medical projects that
provide long-term net benefits
– Should equal the rate at which society
collectively discounts future consumption
Human Capital Approach
• Used to determine the monetary worth of a

life
– Value of a life = the market value of the output
produced by an individual during his or her
expected lifetime
– Involves estimating the discounted value of
future earnings resulting from an improvement
in or an extension of life
Figure 3.3 - Present Value Of Lifetime
Earnings, Males & Females, 2000
• Shortcomings
– Unable to control for labor market
imperfections
• Gender, racial, other forms of discrimination
– Doesn’t take into account
• Value of any pain and suffering averted because of
a medical treatment
• Value an individual receives from the pleasure of
life itself
– A chronically unemployed person
• Has a zero or near-zero value of life
Willingness-to-Pay Approach
• How much money people are willing to pay

for small reductions in the probability of
dying
• Deciding whether to purchase a potentially
life-saving medical service
– Benefit = Reduced probability of dying, π,
times the value of the person’s life, V
– Purchase if benefit just compensates for the
cost, C
• π×V=C
Willingness-to-Pay Approach
• π×V=C
• V=C/π
– Value of the human life lower-bound estimate
• Advantage
– Measures the total value of life and not just
the job market value
Should College Students Be
Vaccinated?
• Increase in number of reported cases of
meningococcal disease
– Prompted a discussion as to whether college
students should be vaccinated for the disease
• Jackson et al. (1995)
– Cost-benefit analysis of this policy
– Benefits - from a decrease in the number of
cases of meningococcal disease
– Cost of implementing a vaccination program
for all college students
Should College Students be
Vaccinated?
• Costs
– Cost of the vaccine ($30) multiplied by the
number of doses needed
• 2.3 million freshmen
• 80% receive the vaccine
– Estimated cost of any side effects
• One severe reaction per 100,000 students
vaccinated ($1,830 per case)
– $56.2 million a year
Vaccinated?
• Benefits include
– Medical costs diverted
• Treatment costs per case = $8,145
• Costs for cases occurring in the 2nd, 3rd, and 4th
years of college - discounted at 4%
• $3.1 million at 15 times the baseline rate
Vaccinated?
– Estimated value of lives saved
• Human capital approach - Used to determine value
of lost earnings
• Each life saved = $1 million
• $8.8 million for 2 times the baseline rate and $60.7
million for 15 times the baseline rate
Table 3.1 - Estimated Benefits and Costs for the
Vaccination of College Students against
Meningococcal Disease (in millions of $)
Baseline times 2 Baseline times 15

Cost of the Vaccination Program $56.2 $56.2
Total Benefits 9.3 63.8
Direct Medical Benefits 0.5 3.1
Indirect Benefits—Value of Lives Saved 8.8 60.7
Net Benefits—(Benefits – Cost) -46.9 7.6
Costs and Benefits of New Medical
Technologies
• Advances in medical technology
– Driving force behind rising medical costs
– Profound effect on health and well-being of
millions of people
• Overall mortality and disability rates in the United
States have fallen consistently since World War II
Costs and Benefits of New Medical
Technologies
• Impact of medical technology on health
– Improves health
• Total product curve - rotates upward
• Each unit of medical care consumed now has a
greater impact on overall health
Cost-Effectiveness Analysis
• Cost-effectiveness analysis (CEA)

– Estimates the costs associated with two or
more medical treatment options or clinical
strategies
– For a given health care objective
– To determine the relative value of one medical
treatment or technology over another
• Incremental cost effectiveness ratio

(ICER)
– Compare a new medical treatment (new) with
an existing treatment (old)
• Cost of new treatment, Cnew
• Cost of existing treatment, Cold
• Medical effectiveness of new treatment, Enew
• Medical effectiveness of existing treatment, Eold
Cnew  Cold
ICER 
Enew  Eold
• New treatment dominate the old

– New treatment is less costly than the old
– New treatment is more effective than the old
– Adopt new treatment
• Old treatment dominate the new
– New treatment is more costly
– New treatment less effective
– Don’t adopt new treatment
• New treatment - More effective & more

costly than the old
– Is the gain in improved health brought about
by the new treatment worth the additional cost
in dollars?
– If the cost of a new medical treatment is less
than $50,000 per additional year of life saved
it is generally viewed favorably
• New treatment - Less effective & less

costly than the old
– Is the decrease in health worth the cost
savings?
– CEA – provide relative cost savings per life-
year
• New medical treatment / technology
– Where none previously existed
Cnew
ICER 
Enew
Figure 3.4 - The Cost-
Effectiveness Plane
Net Cost + The cost-effectiveness plane shows how CEA can be used to determine
(Cnew > Cold) whether a new medical technology or treatment should be adopted.
II I The horizontal axis measures the net impact of a new

medical treatment or technology on health outcomes.
Old Review
treatment relative costs To the right of the origin, the new treatment
Net dominates and benefits Net Effect + enhances health or life expectancy, and to the
Effect - left of the origin it diminishes health when
(Enew > Eold)
(Enew < Eold) III IV compared to the current treatment.
Review New Net costs are measured on the vertical axis with positive
relative costs treatment net costs scored above the origin and negative net costs
and benefits dominates scored below the origin.
Net Cost - Quadrant I depicts the situation in which a new medical option
(Cnew < Cold) is more effective and more costly than the current procedure.
In quadrant II, the new option is less effective and more costly than the current one. In this case, the current medical
option should be retained. Moving counterclockwise, quadrant III shows the case in which the new medical option is
less costly and less effective than the current one. The relevant question is whether the reduction in cost is worth the
loss in health associated with the new medical option. In quadrant IV the new medical option dominates the old one
because it is more effective and less costly.
Cost-Utility Analysis
• Considers number of life-years saved

• Quality of life
• Adjusts the number of life-years gained by
some type of index that reflects health
status, or quality of life
• Rating scales
– Quality-adjusted life-years (QALYs)
• Life expectancy ˣ Health-utility index
– Health-utility index = Measure of the quality of
remaining life-years
• Scale: 1 to 0
• 1 = one year of full health
• 0 = death
Survey Techniques
• Rating scale
– Individuals rate various health outcomes
– Scale 0 to 1
• Standard gamble
– Two hypothetical health alternatives
– Choose π that generates an indifferent
response between the two alternatives
– Health-utility index = π
• Time trade-off
– Hypothetical choice
• Live for x years in perfect health followed by death
• Live for y years with a particular chronic condition
• y>x
• Vary x until the person is indifferent between the
two outcomes
– Health-utility index = x/y
• Cost-utility ratio from a new medical

treatment or technology
– QALYs – quality adjusted life-years
Cos tne w - Cos t old

No. of QALYs ne w - No. of QALYs old
• Critics
– Accuracy of survey techniques
– Discrimination
– Does not tell us whether the overall well-being
of society is increased
– Just whether one medical treatment or
technology is more cost effective than another
• Digital vs. film mammography

– Digital - Superior in its ability to detect cancer
for certain subpopulations
• Far more expensive
– Tosteson et al. (2008)
• Replacement of all-film mammography screening
with all-digital = cost $331,000 per QALY gained
• Targeted-digital mammography screening
– Women 50 and younger - $26,500 per QALY
– Women 50 and younger plus women older than 50 with
dense breasts - $84,500 per QALY
Table 3.2 - An Example of Cost
Effectiveness and Cost-Utility Analysis
Treatment option Cost Life-years gained Health-utility index QALY

Current procedure $20,000 2 years 0.7 1.4
New procedure $110,000 8 years 0.4 3.2
Autologous Blood Donations – Are
They Cost Effective?
• Autologous blood donation
– Donor and recipient are the same person
• Allogeneic blood donation
– Donor and recipient are different people
• Autologous blood donation
– Safer
– More costly
• More administrative and collection expenses
• Higher discarding costs
Table 3.3 - Estimated Cost Effectiveness
of Autologous Blood Donations
Total Hip Coronary- Abdominal Transurethral

Replaceme artery Hysterectom Prostatectom
nt Bypass grafting y y
Additional cost
per unit of $68 $107 $594 $4,783
autologous
blood transfused
QALY per unit 0.00029 0.00022 0.00044 0.00020

transfused
Cost effectiveness $235,000 $494,000 $1,358,000 $23,643,000

(row one/row two)
Patient Protection and Affordable Care
Act (PPACA) of 2010
• Patient-Centered Outcomes Research
Institute
– To provide people with the knowledge needed
to make educated decisions regarding
medical care
• The development and dissemination of
comparative effectiveness research
(CER)
Patient Protection and Affordable Care
Act (PPACA) of 2010
– CER - “simply knowing what works and what
doesn’t will improve productive efficiency by
shedding” medical practices that are less
efficient and possibly even harmful
• CER can be considered a public good
– the information it provides can be consumed
simultaneously by more than one individual
– it is costly to exclude nonpayers from using
the information

Cost-Benefit Analysis Methods

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Chapter 3

Cost and Benefit

• Cost identification studies

• Direct medical care costs

• Direct nonmedical costs

• People - Rational decision makers

• Optimizing rule: NBe(X) = Be(X) – Ce(X)

• TNSB = TSB – TSC

• TNSB from medical services

0 Q0 Quantity of medical services (Q)

• TSB - Increases at a decreasing rate

• TSC - Increases at an increasing rate

• MSB curve - Negatively sloped

H The MSB curve stands for the marginal

QL Q0 QR Quantity of medical services (Q)

• If QL units of medical services are

• QR units of medical services are produced

• NMSB(Q) = MSB(Q) - MSC(Q)

• A benefit (or a cost) received today

• Present value in terms of benefits and

– NB - the PV of net benefits

• Choosing the interest rate

• Used to determine the monetary worth of a

• How much money people are willing to pay

Baseline times 2 Baseline times 15

Net Benefits—(Benefits – Cost) -46.9 7.6

• Cost-effectiveness analysis (CEA)

• Incremental cost effectiveness ratio

• New treatment dominate the old

• New treatment - More effective & more

• New treatment - Less effective & less

II I The horizontal axis measures the net impact of a new

• Considers number of life-years saved

• Cost-utility ratio from a new medical

Cos tne w - Cos t old

• Digital vs. film mammography

Treatment option Cost Life-years gained Health-utility index QALY

New procedure $110,000 8 years 0.4 3.2

Total Hip Coronary- Abdominal Transurethral

QALY per unit 0.00029 0.00022 0.00044 0.00020

Cost effectiveness $235,000 $494,000 $1,358,000 $23,643,000

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