Demand for Medical Services Chapter 5: Demand for Medical Services and Medical Spending Health Economics

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 Example: Do the following values of Medical Care and Utility imply diminishing marginal utility of care? Medical Care Utility MU 1 2 4 3 6 8

Medical Care and Utility Graph this relation between medical care and utility. Utility 8 6 4 2 1 2 3 4 Medical Care

Medical Care and Utility The previous graph illustrates an example of constant marginal utility Because each additional unit of medical care yields the same increase in utility, the relation can be graphed using a straight line.

Medical Care and Utility Because this relation is linear, it can also be represented using the following algebraic equation: Utility = 2*Medical Care In practice one would never see this relation between utility and medical care, because it violates the assumption of diminishing marginal utility.

Medical Care and Utility Example: What about these values? Do they satisfy the law of diminishing marginal utility? Medical Care Utility MU 1 2 6 3 9 4 11

Medical Care and Utility Graph this relation between medical care and utility. Utility 10 8 6 4 2 1 2 3 4 Medical Care

Medical Care and Utility The previous graph illustrates an example of diminishing marginal utility Because each additional unit of medical care yields a smaller increase in utility, the relation cannot be graphed using a straight line.

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 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 tradeoffs 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 Pq Pz Suppose that instead : > MUq MUZ 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 MUz Pq Pz < Consumer can U by purchasing less q, and more z. Pq 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

Demand Curve for Physician Visits The relation between price and the quantity demanded can be expressed using a demand schedule: Price per Visit Quantity of Visits Demanded $100 1 $75 2 $50 3 $25 4

Economists and Reverse Graph Reading When we read graphs, we usually ask how a change in the variable on the horizontal axis affects the variable on the y axis. However, when economists draw demand curves, price is on the vertical axis, and quantity is on the horizontal axis. The graph is read in reverse of the usual manner: How does a change along the vertical axis affect the variable on the horizontal axis?

Demand Curve for Physician Visits Graph the previous relation between price and the quantity of physician visits demanded. Price $100 $75 $50 $25 1 2 3 4 Physician Visits

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,…)

Deriving a Demand Curve for Physician Visits (cont.) 4 8 Demand curves are graphed in the form P = a – bQ. Q

Deriving a Demand Curve for Physician Visits (cont.) Which of the following equations is more likely to be a demand curve for physician visits? Q = 8 + 2P Q = 8 – 2P

Practice Question Can you come up with an algebraic formula for the demand curve for physician visits that we graphed? (e.g. where 1 visit was demanded at a price of $100) Try this at home, and we’ll look at the answer in the next class.

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 P0 DO D1 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 D0 D1 Price of complement falls 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 D1 D0 Demand for generic drug falls Brand name drugs

Demand Curve Terminology Price A to B: increase in quantity demanded A 10 B 8 4 6 Quantity

Demand Curve Terminology (cont.) Price D0 to D1: Increase in demand D1 D0 Quantity

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Elasticities A relatively flat demand curve implies that a small increase in price leads to a large fall in # visits demanded. Price # Visits

Elasticities In this case demand is considered to be relatively “elastic” with respect to a change in price. Price # Visits

Elasticities A relatively steep demand curve implies that a small increase in price leads to a small fall in # visits demanded. Price # Visits

Elasticities In this case demand is considered to be relatively “inelastic” relative to a change in price. Price # Visits

Elasticities We would like a way to quantify the elasticity of a demand curve with respect to price. More generaly, elasticity measures the responsiveness of quantity demanded to a change in an independent factor. Elasticities measure this responsiveness in terms of proportionality.

Elasticities (cont.) Own-Price Elasticity of Demand: 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, own-price 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|<

More price elastic demand leads to a flatter demand curve. Relatively elastic Relatively inelastic # Visits

Elasticities (cont.) 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. 4 ED = -1 2 ED = 0 4 8 Q Demand curve: Q = 8 – 2P

Elasticities (cont.) Income elasticity of demand: 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: 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 Tylenol leads to a 15% increase in the quantity of Advil 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 %DQD I < I %DP I Total revenue will increase if price is raised when demand is inelastic.

Health Care Expenditures Expenditure=Price x Quantity Although expenditures are rising, we have seen that health status has also improved. The size of the entire economy has grown, so that the % of GDP spent on health care has held steady.

Health Care Expenditures in the United States, 1960-2001 1960 1970 1980 1990 1995 1999 2001* Nominal health expenditures $26.9 73.2 247.3 699.4 987.0 1210.7 1424.2 (billions of dollars) Annual rate of growth -- 10.6% 12.9 10.9 6.7 5.2 8.4 (average annual % change from previous period shown) Nominal per capita health $143 341 1,052 2,690 3,686 4,358 5,043 expenditures Health expenditures as 5.1% 7.1 8.9 12.2 13.3 13.0 13.4 percentage of GDP *Projected Source: Health Care Financing Administration Homepage: http://www.hcfa.gov/stats/stats.htm

Health Care Expenditures 1999 (cont.) 100 1149.1 TOTAL 12.2 135.5 Oth. Gov’t 15.4 170.6 Medicaid 17.6 216.6 Medicare 45.3 522.7 PUBLIC 6.1 51.8 Other private payments 199.5 Out-of-pocket payments 33.1 375 Private health insurance 54.7 626.4 PRIVATE % of Total $billions Revenue Source

Health Care Expenditures (cont.) The private and public sources of health expenditure are relatively equal. Private health insurance pays for a substantial amount of health care. The Medicare and Medicaid programs account for a majority of public health care expenditures.