Health Economics 14.

21

Copyright Jeffrey E. Harris 2014

Exam #4

DRAFT ANSWERS TO EXAM #4: MAY 7, 2014!

1. (20 points) Dr. Anands utility is an increasing function of her patients health  H and
her net income  X . Her patients health  H depends exclusively on the quantity  Y of
medical care that Dr. Anand prescribes. The production function  H (Y ) is maximized
at  Y = Y0 . The marginal product of medical care is positive for all  Y < Y0 , and
negative for all  Y > Y0 . Dr. Anand incurs a constant cost  c > 0 for each unit of
medical care.

(a) Suppose that Dr. Anand is paid a fixed salary  K > 0 for all medical care provided to
her patient. Use a properly labeled diagram in the  (Y , X ) plane to show the utilitymaximizing quantity of care  Y1 that Dr. Anand will prescribe. Your diagram should
indicate the relation between  Y0 and  Y1 .

Answer: In the diagram below, Dr. Anands indifference curves are shown in blue, while
the red line shows his net income as a function of Y. The tangency of the red line to an
indifference curve shows the utility-maximizing point, where the quantity of care equals
 Y1 . The diagram correctly shows the relationship  Y1 < Y0 .

(b) Now suppose instead that Dr. Anand is offered an additional volume bonus equal to
 p for each unit of medical care prescribed in excess of  Y2 units of care, where  p > c .
A health economist comments, If  Y2 > Y0 , then the additional volume bonus will
induce Dr. Anand to prescribe more care than she would prescribe if compensated by
salary alone. This is a consequence of the income effect. Provide a critical analysis
of the health economists comments. Support your answer with a properly labeled
diagram in the  (Y , X ) plane.

Answer: The health economists comments are incorrect. The diagram below provides a
counterexample. The joined red line segments show the new relation between Dr.

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Copyright Jeffrey E. Harris 2014

Exam #4: 7-May-2014

Anands income X and the quantity of care Y. The elbow is situated at the quantity
 Y1 > Y0 , yet the utility-maximizing quantity of care remains at  Y1 . Moreover, this
counterexample has nothing to do with the income effect. It could be constructed even if
all of Dr. Anands indifference curves were parallel to each other.

2. (20 points. Beware! Some numbers have changed.) A profit-maximizing monopolist

physician is faced with a private market demand curve  PPrivate = 100 QPrivate , where
 PPrivate is the price charged and  QPrivate is the quantity demanded in patient visits. In
addition to private patients, the physician can also see up to a maximum of 60
Medicaid patient visits at a fixed, government-determined price of  PMedicaid = 20 . The
physicians marginal cost function is  MC = 0.2Q , where  Q = QPrivate + QMedicaid is the
total number of visits provided.

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(a) How many private visits and how many Medicaid visits will the physician supply?

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Answer: The diagram below shows the physicians marginal revenue (MR) and marginal
cost (MC) curves. At the intersection of the black MR curve and the blue MC curve, the
physician will supply a total of 100 visits, including 40 private and 60 Medicaid visits.

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(b) As a result of a Medicaid expansion, the private market demand curve shifts to
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 PPrivate = 100 2QPrivate and the maximum number of Medicaid patient visits increases
to 80. What will happen to the profit-maximizing values of  QPrivate and  QMedicaid ?

Answer: The diagram at the right shows the physicians new marginal revenue (MR) and
marginal cost (MC) curves. At the intersection of the black MR curve and the blue MC
curve, the physician will still supply a total of 100 visits, but the number of private visits
will decrease to 20 while the number of Medicaid visits will increase to 80.

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Copyright Jeffrey E. Harris 2014

Exam #4: 7-May-2014



(c) Comment on the validity of the following proposition: The observed changes in
physician supply behavior predicted by this model are precisely what Garthwaite
observed for pediatricians received less than 5% of revenues from Medicaid before
the introduction of SCHIP.

Answer: The observed changes are indeed consistent with Garthwaites observations. In
particular, as a result of crowd-out, the volume of private patients declined. At the same
time the volume of Medicaid patients increased.

3. (20 points. Beware some questions have changed!) Mrs. Gulko consults Dr.
Vijayalakshmi, worried that her lump might be cancer. She seeks Dr. Vs
recommendation about removing the lump surgically. Mrs. Gs valuations of each
possible outcome (in thousands of dollars) are:

Cancer

No Cancer

Lump Removed Surgically

10

Lump Not Removed

12

Although Mrs. G herself will not pay Dr. V, she knows that her insurance company
will pay him a fee equal to  F > 0 if he performs surgery, but no fee otherwise. Mrs. G
assumes that Dr. V, in making a recommendation about treatment, adds his fee to her
valuation. (For example, Dr. V values the surgical removal of a cancerous lump as
 10 + F .) Both Mrs. G and Dr. V employ the expected value criterion. However, Mrs.
G does not know Dr. Vs assessment of the probability  p of cancer. Once Dr. V
makes his recommendation, Mrs. G has the option of paying herself for an MRI scan,
which is a perfectly informative test.

(a) Let  pG and  pV , respectively, denote Mrs. Gs and Dr. Vs threshold probabilities for
operating. Calculate  pG pV . Your answer should depend on  F .

Health Economics 14.21

Copyright Jeffrey E. Harris 2014

Exam #4: 7-May-2014

Answer: For Dr. V, the benefit of surgery if Ms. G has cancer is  B = (10 + F ) 6 = 4 + F ,
while the cost of surgery if she doesnt have cancer is  C = 12 ( 8 + F ) = 4 F . Hence,
C
4F
Dr. Vs threshold probability is  pV =
=
. For Ms. Gs threshold probability,
B+C
8
1
F
we get  pG = . Hence,  pG pV = .

2
8

(b) Suppose that Dr. V. does not recommend surgery. Derive a formula for the maximum
amount that Mrs. G would be willing to pay for the MRI scan (in thousands of
dollars). Your answer should depend on  F .

Answer: If Dr. V does not recommend surgery, then Ms. G can conclude that Dr. Vs
assessment of the probability  p of cancer satisfies  p < pV . Since  pV < pG , we know that
in the absence of any additional information, Mrs. G. would opt not to have surgery.
However, the perfect information provided by the MRI would still have value. In the
diagram above, the blue lines show, respectively, the expected value of no surgery
Dr V
 ENo Surgery [V ] , the expected value of surgery from Dr. Vs standpoint  ESurgery
[V ] , and the

Ms G
expected value of surgery from Ms. Gs standpoint  ESurgery
[V ] . The line corresponding to
the expected value of surgery from Dr. Vs standpoint is displaced upward from that of
Mrs. G by the quantity  F . The red line shows the expected value after obtaining the MRI
if the test were costless. The maximum value of the information provided by the MRI is

the length of the line segment  KL identified in the diagram. To compute this quantity,
note first that the distance between the red line (the expect value with costless perfect
information) and blue line labeled  ENo Surgery [V ] (Ms. G's expected value without surgery)
is  4 p , where  p is the probability of cancer. Substituting  p = pV gives the result
F
1 F
 4 = 2 .

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2

Health Economics 14.21

Copyright Jeffrey E. Harris 2014

Exam #4: 7-May-2014

(c) Explain whether the following statement is True or False: If Dr. V. does recommend
surgery, the maximum amount that Mrs. Gulko would be willing to pay for an MRI is
larger than the value calculated in part (b), where Dr. V. did not recommend surgery.

Answer: True. If Dr. V. does recommend surgery, then Mrs. Gulko can conclude only that
 p > pV , but she cannot determine whether  p > pG . If she goes along with his
recommendation, the maximum amount that Mrs. Gulko would be willing to pay for an
F
MRI is the length of the segment KM in the diagram above, which equals  2 + . If she
2
decides not to follow his recommendation, the maximum Mrs. Gulko would be willing to
F
pay is  10 6 = 4 . In either case, the maximum exceeds the value  2 calculated in part
2
(b) above.

4. (10 points.) On page 552 of his study, Azoulay comments, A finding that
pharmaceutical sales do not respond to scientific information (holding advertising
intensity constant) would be consistent with the jamming hypothesis. An economist
comments, Such a finding could instead imply that advertising is the principal
vehicle if not the sole vehicle by which scientific findings are communicated to
doctors and patients. Alternatively, it could imply that advertising is endogenous.
Critically evaluate the economists comments.

Answer: The economists first comment has merit. If, for a fixed level of advertising, the
results of clinical trials had no effect on the sales of H2 antagonist drugs, then advertising
could be the principal means by which such findings are communicated to physicians.
This interpretation would not require us to treat advertising as simply noise intended to
block out competitors messages. The economists second comment, however, is
problematic. Lets say that the findings of clinical trials directly caused doctors to change
their prescribing practices and, at the same time, motivated manufacturers to advertise
scientific findings in their favor. In that case, advertising would be endogenous and any
observed relation between advertising and prescription rates would be spurious. But in
this example, pharmaceutical sales could still respond to scientific information, even
holding advertising intensity constant. Suppose that clinical trials uniformly showed
unfavorable effects of a drug, so that manufacturers would not publicize their findings.
Such scientific information would still influence sales, holding advertising constant.

5. (10 points.) On page 710 of their study, Iizuka and Zhe Jin express concern that their
key variable SUMDCTA is endogenous. However, they go on to observe, We argue
that DTCA across classes is correlated within the same company, either because the
company pursues a particular marketing strategy for all products or because different
drugs are subject to a common constraint in the advertising budget. How is the
second observation relevant to their proposed solution to the endogeneity problem?

Answer: The authors express concern that both the rate of office visits and the cumulative
amount of direct-to-consumer television advertising (SUMDCTA) may depend on other

Health Economics 14.21

Copyright Jeffrey E. Harris 2014

Exam #4: 7-May-2014

factors. For example, the aging of the population may have resulted in an increased
demand for arthritis medications, which could have led pharmaceutical companies to
advertise these medications on TV. To address the endogeneity problem, the authors
looked for an instrumental variable (or simply, an instrument) that would be a
determinant of DCTA but not office visits for prescriptions. They argued that a companys
global budget for DCTA would be such an instrument. Their contention was that the
global budget for DCTA would determine the level of DCTA for a specific therapeutic
class, such as arthritis drugs, but would be independent of the number of office visits for
arthritis drugs.

6. (10 points.) A health economist comments, Madden and colleagues use of private
patients as a control group has been criticized, inasmuch as the 1989 change in
compensation of Irish GPs from FFS to capitation could also have had an income
effect on the volume of private patients. However, the fact that the volume of private
patient visits declined after the 1989 regulation shows that this criticism is of minimal
importance. Critically evaluate the economists comment.

Answer: The first sentence of the economists comment has merit. The 1989 change in
compensation from FFS to capitation could have increased or decreased GPs income,
depending on the amount of capitation paid. Lecture #17, Slide 36, illustrates the positive
income effect of a sufficiently large capitation payment on the quantity of care prescribed
for private patients. As a consequence of this income effect, GPs private patients cannot
be considered an adequate control group, as the intervention (that is, the change in
payment for Medical Card patients) influenced the volume of private patient visits as
well. However, the second statement by the economist is not justified. If the income
effect of the switch to capitation is sufficiently large, the volume of private patient visits
could indeed decline, just as shown in Lecture #17, Slide 36. The economist was
implicitly but unjustifiably assuming that the switch from FFS to capitation resulted
in a loss of income from Medical Card patients. If so, then the resulting income effect
would have increased the volume of private patient visits.

7. (10 points) How did Francis and Mialon explain their finding of an inverse relation
between the extent of gay tolerance and the incidence of HIV? Provide two possible
criticisms of the authors explanation. Each criticism should be based on the possible
endogeneity of gay tolerance. Explain how the authors attempted to counter each
criticism.

Answer: Francis and Mialon posited that the HIV incidence rate was directly related to
the extent of high-risk sexual activity among gay men, particularly anonymous sex with
multiple partners. They posited that increased tolerance permitted gay men to form stable,
low-risk monogamous relationships, thus reducing high-risk sexual activity. In their
article (p. 260), the authors responded to several criticisms involving the presumed
endogeneity of gay tolerance. These include: (i) the HIV rate could affect tolerance; (ii)
changes in behavioral norms in the gay community could affect tolerance in the general
population; and (iii) public information campaigns about AIDS might affect gay
tolerance. See Lecture #20, Slides 1517, for their detailed responses.

Health Economics 14.21

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Copyright Jeffrey E. Harris 2014

Exam #4: 7-May-2014

Health Economics 14.21

Copyright Jeffrey E. Harris 2014

Exam #4

6. (XX points) A health economist comments, Francis and Mialon may indeed have
underestimated the duration of the incubation period of HIV infection and thus
incorrectly located the peak of the HIV epidemic in the late 1980s. However, the real
problem with their analysis is their specification of a time trend rather than fixed effects
for each year. Their underlying model was  yit = + ri + t + dit + Xit + it , where
 ri = 1 for state  i , where  dit measures the tolerance level and  Xit measures other
covariates in state  i in year  t , and where  t is a linear in  t . If instead they had
specified the fixed effect model  yit = + ri + t + dit + Xit + it , where  t = 1 for
year  t , they would have obtained very different results. Provide a critical analysis of
the health economists comments.

END OF EXAM