#### Transcript 3 Basic Steps in Economic Evaluation

Demand for Medical Services
Part 1
Health Economics
Professor Vivian Ho
Fall 2007
Outline
Theoretical derivation of the demand
curve for medical services
 Economic and noneconomic variables
that influence demand
 Elasticities
 The impact of health insurance on
demand

Medical Care and Utility
• Medical care is an input in producing health
 Subject to law of diminishing marginal productivity
• Health yields utility to the consumer
 Subject to law of diminishing marginal utility
Medical Care and Utility
We can generally graph the relation between
medical care and utility as follows:
Utility
Medical Care
Medical Care and Utility

The graph shows that as the level of
medical care rises, each additional unit
of medical care yields a smaller
increase in utility

Given this fact, how does the consumer
decide how much health care to
purchase?
Consumer’s Optimal Choice of
Health
Define : MU = marginal utility of medical care
P = price
q = quantity of medical services
z = quantity of all other goods


Given the consumer’s income, she chooses q
and z to maximize utility.
Utility maximization rule :
MUq
MUZ
Pq
Pz
Consumer’s Optimal Choice of
Health

Total utility reaches its peak when the
marginal utility gained from the last \$ spent
on each product is equalized
i.e. The consumer equalizes “the bang for the
buck” across all goods
Proof

MUq
Pq
>
MUZ
Pz
 Last \$ spent on medical care generates more U than
last \$ spent on other goods
 Consumer could U by purchasing more medical care
(q), and less other goods (z)
 Then MUq would fall, MUz would rise, until the 2 ratios
are equalized
Deriving a Demand Curve for
Physician Visits
Note : Now let q represent physician visits

Suppose Pq rises. This will lead to :
MUq
Pq
 Consumer can

Pq
<
MUz
Pz
U by purchasing less q, and more z
lower demand for q
Deriving a Demand Curve for
Physician Visits

Downward sloping demand curve for physician
visits
Price
P1
P0
q1
q0
• Price changes lead to movements along D curve
Deriving a Demand Curve for
Physician Visits (cont.)

Consumer’s purchase of medical care is a
“derived demand”
• i.e., “no direct” utility from visiting the doctor
• U derived from health resulting from
dr. visit:
U = U(h,z)
h = h(q,…)
Other Economic Factors
Affecting Demand

The demand curve illustrates the effect
of changes in the price of the good on
quantity demanded holding all other
factors (income, prices of other goods)
constant

Changes in factors other than the price
of the good itself lead to shifts in the
demand curve
Other Economic Factors
Affecting Demand
1. Income

If income increases, then at any given price,
consumer is willing and able to purchase more q
Price
D1
DO
P0
q0
q1
Physician Visits
Other Economic Factors
Affecting Demand
2. Complements - 2 or more goods which
are consumed together




e.g. left shoes and right shoes
e.g. laser printers and toner cartridges
e.g. alcohol and cigarettes?
e.g. contact lenses and optometrist visits
Other Economic Factors
Affecting Demand
2. Complements


e.g. contact lenses and optometrist visits
If contact lenses become cheaper, demand for optometrist
visits ___
Price
Price of complement
falls
D0
D1
Optometrist Visits
Other Economic Factors
Affecting Demand
3. Substitutes - other goods which satisfy the
same wants, or provide same characteristics



e.g. Coke and Pepsi
e.g. Physicians and Nurse practitioners?
e.g. generic and brand name drugs
Other Economic Factors
Affecting Demand
3. Substitutes - other goods which satisfy the
same wants, or provide same characteristics


e.g. generic and brand name drugs
If generic drugs in price, D for brand name ___
Price
Demand for brand name
drug falls
D1
D0
Brand name drugs
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Elasticities
Price
A relatively flat demand curve
implies that a small increase in
price leads to a large fall in #
visits demanded
# Visits
Elasticities
Price
In this case demand is
considered to be relatively
“elastic” with respect to a
change in price
# Visits
Elasticities
Price
A relatively steep demand curve
implies that a small increase in
price leads to a small fall in #
visits demanded
# Visits
Elasticities
Price
In this case demand is
considered to be relatively
“inelastic” relative to a change
in price
# Visits
Elasticities (cont.)

Own-Price Elasticity of Demand:
ED 
% QD
% change in quantity demanded

% P
% change in price

Example: If the elasticity of demand for
physician visits is -.6, a 10% increase in price
leads to a 6% decrease in the number of visits
demanded

Elasticities are scale-free
 We
can compare the ED for physician visits vs.
nursing home days, even though they are consumed
in different units
Elasticities (cont.)

ED is expected to be negative. Thus, ownprice elasticities of demand are often
quoted in terms of absolute value

The demand curve is inelastic if
 0<|ED|<1

The demand curve is elastic if
1<|ED|<
Elasticities (cont.)
Q
% QD
Q Q P



P
% P
P Q
P

If you are given a formula for a demand
curve, you can compute the elasticity of
demand for any combination of price and
quantity along that demand curve
Except in special cases, the ED is different
on different points of the demand curve
P
ED = -
4
ED = -1
2
ED = 0
4
Demand curve: Q = 8 – 2P
8
Q
Elasticities (cont.)

Income elasticity of demand:
EY 
% QD
% change in quantity demanded

% Y
% change in income

Example: If the elasticity of demand for
physician visits is .1, a 10% increase in income
leads to a 1% increase in the number of visits
demanded

For most types of medical care, EY should be
positive
Elasticities (cont.)

Cross-price elasticity of demand:
%QX
% change in quantity demanded of good X
EC 

%PY
% change in price of good Y

Example: If the elasticity of demand for
Tylenol with respect to the price of Advil is
1.5, a 10% increase in the price of Advil
leads to a 15% increase in the quantity of
Tylenol demanded
 EC
is negative for complements
 EC is positive for substitutes
Elasticities
•
Own price elasticity of demand critical for determining
a health care manager’s total revenue
TR = PQ D
• Demand theory tells us that
P
QD
If demand for physician services is inelastic, and
the price is raised, then
I %QD I < I %P I
 Total revenue will increase if price is raised
when demand is inelastic
QUIZ

A 1991 study by Frank Chaloupka
estimated the price elasticity demand
for cigarettes to be:
A.
.48
.83
1.02
1.33
B.
C.
D.
Insurance
 The above demand analysis assumed that the
patient pays for care out-of-pocket
How does insurance affect the demand for care?
1. Coinsurance - Patient pays only a fixed % of the
cost of each visit (often C = .20)
e.g. If the visit costs \$100 :
patient pays \$20, insurance pays \$80
Insurance
Price
P
cP
q
qc
# Visits
• No insurance : consumer faces price P, makes q visits
• W/ coinsurance : consumer faces price cP, wants to
make qc visits
Insurance (cont.)
Price
P
cP
q
qc
# Visits
 Coinsurance leads to a demand of qc visits at price P,
shared by consumer and insurance company
 Demand curve rotates clock wise
What if the consumer has full
coverage?
• i.e., copayment = 0
Price
# Visits
• Indemnity Insurance
 Insurer
pays a fixed amount for each
purchased service
 Insurer
pays \$150 for each overnight hospital
stay, and patient pays the rest
Price
\$150
D1
D0
Visits
• Fixed \$ copayment
 Patient
pays up to \$20 per visit, and insurer
pays the rest
Price
D1
\$20
D0
Visits
• Deductibles - Consumer must pay a fixed
amount out of pocket per year before
coverage begins
 e.g.
The initial \$100 per year in health care
expenditures must be paid by the customer
 Lowers