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Chapter 2: The Role of
Economics
Learning Objectives
• In this chapter, you will learn about:
– the role of economics in health care
– the use of economic models to explain
phenomena
– the concept of the market and
equilibrium
Economics and Policy
• Economics can offer a framework to study the
implications of individual decision making and help
define the alternative mechanisms available to
improve resource allocation
• Sound policy making is based on sound economic
principles applied in a sensitive and uniform manner
– Lessons can be learned from basic economics
• lessons about human behavior and the way
individuals make decisions, respond to
incentives, interact with each other—and about
the efficient allocation of scarce resources
What is Health Economics?
• Health economists examine a wide range of
issues from the nature and production of health
to the market for health and medical care to the
micro-evaluation of interventions
– The principle activity of economists outside of
the United States is the evaluation of medical
interventions
What is Health Economics?
– The primary focus of United States health
economists is the market for health care
• Factors affecting the demand for medical
care include: socioeconomic factors of the
population, patient demographics, access
barriers and the role of providers in
determining the services to be provided
• The supply of health care encompasses a
broad spectrum of economics on such
topics as production theory, input markets,
and industrial organization.
• Demand and supply intersect with one
another to establish market equilibrium
Why Health Economics is
Important
• Understanding the economics of health care is
important for a number of reasons
– Health is important to us as individuals and as
a society, and health care is one, though not
the only, way of modifying the incidence and
impact of ill health and disease
• Economic analysis offers a unique and
systematic intellectual framework for
analyzing important issues in health care
and for identifying solutions to common
problems
– Healthcare sector is very large
Why Health Economics is
Important
– Third, decisions about how health care is
funded, provided, and distributed are strongly
influenced by the economic environment and
economic constraints
• One good reason for understanding health
economics is to engage in policy debates
as an informed critic
• Health economics is an application of
economic theory, models, and empirical
techniques to the analysis of decision
making by individuals, healthcare
providers, and governments with respect to
health and health care
Why Health Economics is
Important
–Health economics is solidly based in
economic theory, but it also comprises a
body of theory developed specifically to
understand the behavior of patients,
doctors, and hospitals, and analytical
techniques developed to facilitate
resource allocation decisions related to
health care
–Health economics has evolved into a
highly specialized field, drawing on
related disciplines including epidemiology,
statistics, psychology, sociology,
operations research, and mathematics in
its approach
Key Economic Concepts
•
These terms will serve as unifying themes
throughout the course:
– Scarcity addresses the problem of limited
resources and the need to make choices
– Opportunity cost recognizes the role of
alternatives
– Marginal analysis recognizes that choices
are made at the margin, not on an all-ornothing basis
– Self-interest is the primary motivator of
economic actors
– The Market accomplishes its tasks through
a system of prices, or the invisible hand
Key Economic Concepts
– Supply and demand serve as the foundation of
economic analysis
• Pricing and output decisions are based on forces
underlying these two economic concepts.
– Competition forces resource owners to use their
resources to promote the highest possible satisfaction of
society: consumers, producers, and investors
– Efficiency measures how well resources are being used
to promote social welfare
– Market failure arises when the free market fails to
promote efficient use of resources by either producing
more or less than the optimal level of output
• Sources of market failure include: natural monopoly,
oligopoly, externalities of production or consumption,
and public goods
The Use of Economics in
Healthcare
• Economic Modeling
– In microeconomics, the assumption of rational
behavior establishes a consistent framework
for individual decision making
• Decision makers, motivated by incentives,
pursue their self-interest
Economic Modeling, continued
• The five basic steps in the scientific method are as
follows:
– Every analyst begins with a hypothesis based on his or
her perception of how the world works
– Analysts then observe the real-world phenomena
– A theory is then developed to explain behavior or the
phenomena or predict future behavior
• These models are abstractions of reality that capture
the influential features of the observed behavior
– The tests of hypotheses are then performed
using gathered facts and data
– Rethinking the model: If the empirical evidence is
contrary to the model and its hypothesis, then
the analyst may rethink the theory being tested.
Economic Modeling, continued
• Model Building
– One of the main goals of economics is to
understand, explain, and predict the actions of
economic actors
– Microeconomic models examine the behavior
of individual decision makers—individual
households and firms and government
agents—or specific markets
• Economic Optimization
– When more than one alternative is available,
the optimal choice produces an outcome that
is most consistent with the decision maker’s
stated objectives
Economic Modeling, continued
– Optimization is nothing more than determining
the best action given the decision maker’s
goals and objectives
• Constrained optimization takes into
account scarcity of resources
• Choices in the health economy are made at two
levels:
– Individual actors must decide the best course
of treatment or services to consume
– Policy makers must decide on the best course
of action for the entire community
Economic Modeling, continued
• The framework of this analysis is the neoclassical
model with its assumptions of rational behavior on
the part of decision makers
– Firms maximize profits given technology and the
costs of the resources; and consumers
maximize utility or satisfaction from consuming
various amounts of goods and services given
limited income and the prices of goods and
services considered
• The optimal consumption of goods and services is
where the marginal benefit (MB) from
consumption (i.e., the additional benefit received
from consuming the next unit of the good or
service) equals the marginal cost (MC) of
consumption (i.e., the additional cost of consuming
the next unit of a good or service)
Summary
• Central tenets of economics can be summarized
below:
– Resources are relatively scarce related to
wants
• To strike a balance between scarce
resources and unlimited wants involves
making choices
• Medical decisions involve costs and
benefits
• It is important to strike a balance between
incremental benefits and costs.
Chapter 5:
Health Economics
in a
Health Policy Context
Chapter Overview
• Chapter 5 provides a basic overview of
economics and why it is important for
health policymakers to be familiar with
basic economic concepts.
• Chapter 5 focuses on:
– How economists make decisions
– Supply
– Demand
– Markets
Economic Decision-making
• Economists believe that people are
rational actors who will never purposely
choose to make themselves worse off
– People seek to maximize utility
• Given the scarcity of resources, decisions
need to be made about the production,
distribution, and consumption of health
care resources
– Consider individual preference and efficiency
Demand
• Demand: the quantity of goods and services that
a consumer is willing and able to purchase over
a specified time
• Common demand shifters
– Price
• Of the original good
• Of a substitute good
• Of a complementary good
– Income
– Quality (actual or perceived)
Demand
• Demand elasticity: the percentage change
in the quantity demanded resulting from a
1% change in price or income.
• If a product is elastic, a change in
price/income will result in an equivalent or
greater change in demand
• If a product is inelastic, demand for the
good is not sensitive to a change in
price/income
Health Insurance and Demand
• Health insurance acts as a buffer between the
consumer and cost of health care goods and
services
– Goods and services cost the consumer less than the
charged price because of the presence of health
insurance
• Moral Hazard
– Because a consumer does not pay the full cost of a
good, the consumer may purchase more than goods
than he would otherwise purchase without insurance
Supply
• Supply: the amount of goods and services
that producers are able and willing to sell
at a given price over a given period of time
• Common supply shifters
– Input costs
– Sale price
– Number of sellers
– Change in technology
Supply
• Supply elasticity: the percentage change in
quantity supplied resulting from a 1% increase in
the price (or other variables, such as inputs) of
buying the good.
• If a product is elastic, a change in price (or other
variables) will result in an equivalent or greater
change in supply
• If a product is inelastic, supply of the good is not
sensitive to a change in price (or other variables)
Supply
• Suppliers are driven to maximize profit
• In a competitive market, profit is
maximized at the level of output where
marginal cost equals price
• Equilibrium exists in the market when
there is a balance between the quantity
supplied and the quantity demanded
Health Insurance and Supply
• The presence of health insurance may impact a
provider’s willingness to supply goods and services
• Competing concerns
– Providers act as patient’s agent and act in patient’s best interest
– Providers may have a financial incentive to act or refrain from
acting in a certain way due to insurance arrangements or the
lack of insurance
• Supplier-induced demand is the provider version of
moral hazard
– Providers create a demand beyond the amount the well-informed
consumer would have chosen
– It is debated whether supplier-induced demand actually occurs
Markets
• Market structures
– Perfectly competitive market
• efficiently allocate resources
– Monopolies
• Single seller controls market
– Oligopolies
• Few dominant firms, substantial barriers to entry
– Monopsonies
• Few consumers who control price paid to sellers
• Health care is a monopolistically competitive market
– Few dominant firms with significant market power and many
smaller firms without market power
Health Insurance and Markets
• A typical market transaction involves two parties
– Consumer and supplier
• Health care transaction with an insured patient
involves three parties
– Consumer (patient)
– Supplier (provider)
– Insurers
• Presence of third party (insurers) changes
consumer and supplier analysis of costs and
benefits of each transaction
Market Failure
• A market failure means that resources are
not produced or allocated efficiently
– Traditionally, inequitable distribution of
resources does not equal a market failure
• Common reasons for market failures
– Imperfect information
– Concentration of market power
– Consumption of public goods
– Presence of externalities
Market Failure
• Ways to address market failure
– Do nothing
– Gov’t finances or directly provides public
goods
– Gov’t increases taxes, tax deductions,
subsidies
– Gov’t issues regulatory mandates
– Gov’t prohibitions
– Redistribution of income