HEALTH ECONOMICS

ECN 369
Dr Georgios Kavetsos
Textbook: Folland, Goodman, Stano The Economics of
Health and Health Care, 7th edition, Pearson.

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Structure of the Course

2 hours Lectures per week:

Mondays at 11:00-13:00
1 hour Class per week
Coursework (presentations): 25% of final mark
Final exam: 75% of final mark
Well apply fundamentals of micro in the context of health.
I assume you know basic econometric tools.
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Plan of the Course

Lecture 1: Introduction + Basic Tools for Health
Lecture 2/6: Demand and Supply of Health:
Lecture 2: Determinants of Health
Lecture 3: Demand for Health Capital
Lecture 4: Health and Economic Outcomes
Lecture 5: Demand of Health Care
Lecture 6: Supply of Health Care

Lecture 7/8: Health Care Labour Markets (Key Players in

the Health Care Sector)
Lecture 9: Market Failure
Lecture 10: Economic Evaluation
Lecture 11: Health Economics of Bads
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Todays plan
Introduction:
Health Economics? The Relevance of Health Economics
Economic Methods and Examples of Analysis
Does Economics Apply to Health and Health Care?
Is Health Care Different?
Microeconomic Tools for Health Economics
Econometrics you need to know for the course
Paper from the economic literature

Reading:
FGS: Chapters 1 and 2
Paper: Fuchs, 2000
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Health Economics?
Health, and health care costs dominate the economic and political

landscape in many countries.

Health economics studies the allocation of resources to and within the

health economy.

Given its relevance (size of the sector in the economy and share of GDP) it

emerged as a distinct specialty within economics.

Kenneth Arrow (1963): conceptual distinctions between health and other
goods.
Health: a key determinant of objective lists of well-being.
What distinguishes health economics from other disciplines?

Eg extensive government intervention, intractable uncertainty in

several dimensions, asymmetric information, barriers to entry,
externalities and the presence of a third party agent.
Who is the third party agent? The physician, who makes purchasing
decisions (eg whether to order a lab test, prescribe a medication, perform a
surgery,)
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The relevance of Health Economics

U.S. Health Expenditure Shares (%GDP), 1960 2020

Source: Centers for Medicare and Medicaid Services: http://www.cms.gov/NationalHealthExpendData/25_NHE_Fact_Sheet.asp,

accessed August 8, 2011.

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The relevance
of Health
Economics
Health
Expenditures as
% of GDP in
Selected OECD
Countries

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The
relevance
of Health
Economics
Total
Consumption
Expenditures in
$ Billions, by
Type, 2009

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The relevance of Health Economics

People Employed at Health Services Sites: 2009

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The relevance of Health Economics

Active Health Personnel and Number per 100,000 Population (in Parentheses)

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Size of health workforce, 2008

(WHO Health Statistics, 2010)

European
Region
Physicians
Nursing &
midwifery
Dentists

Total number Density per

10,000
population
2,877,344
33
6,020,074

68

428,343

5
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The relevance of Health Economics

National Health Expenditures and Other Data for Selected Years

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Household out of pocket expenditures on health, 2008

(OECD Health Data, 2010)

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What affects health and health care?

Decisions about how health care is funded, provided and

distributed are strongly influenced by the economic

environment and economic constraints
Global, national and local policy responses to health

issues are increasingly being informed by economic

models

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Economic methods
Scarcity of societal resources
Assumption of rational decision making
Concept of marginal analysis
Use of economic models

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Modelling in economics
In economics, a model is a theoretical construct that

represents economic processes by a set of variables and a

set of logical and/or quantitative relationships between
them.

Useful because:
Expression of concepts in formal language promotes clarity
Implicit assumptions easier to detect
Derive all implications of explicit assumptions
Promotes logical coherence
Gravelle, H. Connecting health and economics. Centre for Health Economics, York, 2011.
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DOES ECONOMICS APPLY TO HEALTH

CARE? Does Price Matter?

The curve is similar to a

usual demand curve:

Demand Response of Ambulatory

Mental Health and Medical Care in
the RAND Health Insurance
Experiment

It shows people
consuming more care (Q)
as the care becomes less
costly (P) in terms of
dollars paid out-ofpocket.
Importantly, those facing
higher prices demand less
care.
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Is Health Care Different?

Presence and Extent of Uncertainty
Prominence of Insurance in the US
Personal Health Care Spending, Selected Years (in $ Billions)

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Is Health Care Different? (cont.)

Problems of Information
Restrictions on Competition
Role of Equity and Need
Government Subsidies and Public Provision

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Summing up
The greatest strengths of economics and economists are a
framework of systematic theory,
an array of concepts and questions that are particularly relevant to the

choices facing policy makers, and skill in drawing inferences from

imperfect data. . . .

Economists framework of systematic theory facilitates the

transfer of knowledge drawn from other fields of study to the
health field.
But need to be aware of the peculiarities of the health care!
Health economists have also inherited from economics a set of concepts
and questions that have proven to be particularly relevant to the policy
problems that have emerged in health during the past three decades.
Scarcity, substitution, incentives, marginal analysis, and the like were
just what the doctor ordered, although in many cases the patient
found the medicine bitter and failed to follow the prescribed advice.
(Fuchs, 2000, p. 148)
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Microeconomic Tools for Health Economics

Scarcity and the Production Possibilities Frontier
Practice with Supply and Demand
Functions and Curves
Consumer Theory:Ideas Behind the Demand Curve
Individual and Market Demands
Elasticities
Production and Market Supply
The Firm Supply Curve Under Perfect Competition
Monopoly and Other Market Structures
Conclusions
Lets briefly look at these
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Scarcity and the Production

Possibilities Frontier (PPF)
Society s Trade-Off Between Guns and Butter

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Demand/Supply Curve and

Demand/Suppy Shifters

Income
Prices of Other Goods
Insurance
Tastes
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Technological Change
Input Prices
Prices of Production-Related Goods
Size of Industry
Weather

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Market Effects of Supply and

Demand Shifts

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Health Economics Examples

A national health insurance proposal is passed that provides
comprehensive health insurance to everyone
demand curve shifts to the right resulting in an increase in the
equilibrium price and quantity.
A new law requires that hospitals hire only nurses with B.A.
degrees
cost of hospital care rises shifting supply curve to the left resulting
in an increase in the equilibrium price and a reduction in the
equilibrium quantity of care

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FUNCTIONS AND CURVES

Linear Functions
y = a + bx

y is dependent variable and x is

independent variable
a is the y-intercept, the value of y
when x is 0
b is the slope of the function, the
amount that the variable y changes
when x changes

Demand Functions
Qd = a bP

where, Qd is quantity demanded

and P is price
when graphing demand functions,
economists customarily put the
independent variable, P, on the
vertical axis and the dependent
variable, Qd on the horizontal axis

Qd = f (Ps, Po, Y, Z )

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for example, the quantity of

spaghetti demanded is a function
of the price of spaghetti (Ps), the
price of related goods (Po), the
individual s income (Y) and tastes
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and preferences (Z)

Ideas behind the Demand Curve:

Consumer Theory
Utility (a measure of an individual s satisfaction with

various combinations of consumer goods).

Marginal utility is the extra utility achieved by consuming
one more unit of a good.
Indifference curves summarize a person s preferences
with regards to two goods. They are downward sloping and
convex to the origin.
The budget constraint indicates the set of bundles the
consumer can afford with a given income.
Consumer equilibrium: to maximize satisfaction given a
budget constraint, the consumer will seek the highest
attainable indifference curve

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Market Demand
Derivation of a market Demand Curve

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Price Elasticity
Elasticity is defined as

the responsiveness of a
dependent variable to
changes in an
independent variable.
Price elasticity: the
responsiveness of
quantity demanded to
changes in price

E.g.Policy makers may impose a

tax on the sale of cigarettes both
to raise revenue and curb smoking.
The concept of elasticity helps us
to see these as contradictory goals.

Ep = (% change in Qd)

(% change in P)
or (Q/Q) (P/P)
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Production Function
PF shows the maximum output that can be
obtained from various combinations of inputs,
with existing technology.
Q = f(X1, X2, X3, ), where X1, X2 and X3
represent inputs
Ex X-ray services:
A commonly applied
functional form:
Cobb-Douglas:
Q = L0.8 + K 0.2
L will increase
output by 0.8%
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a 1% increase in

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Isoquants and Isocost Curves

Isoquant Q* represents

all the combinations of

capital and labour that
could be used to
produce 10 units of
output.

Cost Minimization (or Output

Maximization) - Determining
Efficient Combinations of Labor
and Capital

Isocost TC = 686

represents all
combinations of capital
and labor that cost
$686.
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Summing up
Production possibility frontier
Demand-and-supply analysis
Utility and indifference curve analysis
Production and cost curves of a typical
firm

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Fuchs, The future of health economics (2000)

Structure:
Future of health economics depends on how well health economists do 2 things:
contribute to the understanding of economic behaviour
provide input into health policy and health services research.

This role expanded, but there are still pockets of strong resistance to the application of economics to

health problems. Why?

How can health economists provide input to health policy and health services research?
How can we do these 2 things better?
Tremendous expansion of the field in the past 35 years:
Fuchs illustrates this using data on publications and citations (of journals and economists).
What explains this growth?
Intellectual advances, greater availability of data, ever-increasing health care expenditure (which we

discussed earlier today)

Strengths and weaknesses of economics.

Potential for interdisciplinary research.
Reasons why demand for health economists will continue.

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Fuchs, The future of health economics (2000)

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Fuchs, The future of health economics (2000)

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Fuchs, The future of health economics (2000)

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Fuchs, The future of health economics (2000)

How can health economists provide input to health policy and
health services research?
- Strengths of economics

- Weaknesses of economics
- Interdisciplinary and multidisciplinary research

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Fuchs, The future of health economics (2000)

Will the bull market in health economics continue?
Factors fuelling the demand for health economics:
- Growing gap between what medicine can do, and what it is
economically feasible to do.
- Aging population will put more pressure on health care
resources.
- Data are getting better.
- Anti-egalitarian trend?

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For next week

Read Paper:

Hitiris T., J. Posnett, The Determinants and Effects of

Health Expenditure in Developed Countries, Journal
of Health Economics, 11 (1992), 173-181.
To be presented by?

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Statistical Tools for Health

Economics
Hypothesis Testing
Difference of Means
Regression Analysis
Multiple Regression Analysis
Endogeneity

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Endogeneity
The problem of endogeneity occurs when the
independent variable is correlated with the error term in
a regression model.
This implies that the regression coefficient in an
Ordinary Least Squares (OLS) regression is biased
The endogeneity can come from:
- an uncontrolled confounding variable.
- measurement error
- simultaneity in simultaneous equations models

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Omitted variables
A variable is both correlated with an independent variable
in the model and with the error term.
Assume that the "true" model to be estimated is
but we omit Zi (perhaps because we don't have a measure
for it) when we run our regression Zi will get absorbed by
the error term and we will actually estimate:

If the correlation of X and Z is not 0 and Z separately

affects Y, then X is correlated with the error term.

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Measurement Error
Suppose that we do not get a perfect measure of one of our
independent variables.
Imagine that instead of observing Xi we observe
Where is the measurement "noise".
When we try to estimate the following univariate regression
we actually end up estimating

Since both

and

depend on

they are correlated.

NB Measurement error in the dependent variable, however, does not cause

endogeneity (though it does increase the variance of the error term).
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Endogeneity
There are many methods of overcoming this:
- Fixed Effects Models
- Instrumental Variables

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Fixed Effects
Fixed effects models come primarily out of longitudinal data designs

in which we have repeated observations on an individual over time.

We can take advantage of the longitudinal design to eliminate some

of the unobserved heterogeneity.

First, let's define a set of dummy terms, Di, which will be one if the
observation comes from individual i and zero otherwise

These dummy variables allow us to fit a term for every individual.

Because we have multiple observations per individual, doing this will

not saturate the model. Essentially, we are trying to explain variation
within individuals. The i terms are our "fixed effects."

The FEs can account for both observed and unobserved time-

constant variables. Thus we can be certain that our new estimate are
not the result of lurking variables that are constant across time.
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Instrumental Variables
In some cases we may not be able to rule out that x is partially

endogenous but we may have another variable z which we can

be fairly certain has an effect on x but not on y.
The best situation is when we know that z has been completely
randomized.
This situation is rare. The more common situation is a natural
experiment in which for some historical reason we observe a
shock to a system which can reasonably be treated as random.
The most famous example here is the use of birthdates in the question

of whether military service affected subsequent labor market

experience. Because the draft was assigned on the basis of birthdates,
it is highly correlated with military service, but unlikely to be correlated
with labor market experience.

If this relationship holds, then we can treat z as an instrument

for inducement into the "treatment" of x.

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Instrumental Variables
The most common method for doing the actual estimation: two-

stage least squares (2SLS)

As a first step, predict the value of from xi from zi.
(If you plan on including other terms in your final model for y, say wi, it is
typical to include them at this stage as well):

Now use the predicted value of x rather than its real value in an

OLS regression predicting y

Because you are using the predicted value of x you are
essentially leaving behind the residuals from the first equation.
Since z is an exogenous shock on x, those residuals are the
part of x which are potentially endogenous with y. You have
stripped them away.
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