Chapter 3 Demand for Health Care Services

Outline Theoretical derivation of the demand curve for medical services Economic and noneconomic variables that influence demand Elasticity 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 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

Last $ spent on medical care generates more U than Proof Suppose that instead : MUq MUZ Pq 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 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 changes lead to movements along D curve Price P1 P0 q0 q1

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 q0 q1 Price P0 DO D1 Physician Visits

Other Economic Factors Affecting Demand 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 Optometrist Visits Price of complement falls

Other Economic Factors Affecting Demand 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 Brand name drugs Demand for brand name drug falls

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 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: 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|<

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 Q 4 8 Demand curve: Q = 8 – 2P 2 ED = -1 ED = - ED = 0

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 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 %DQD I < I %DP 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: .48 .83 1.02 1.33

Insurance The above demand analysis assumed that the patient pays for care out-of-pocket How does insurance affect the demand for care? 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 No insurance : consumer faces price P, makes q visits W/coinsurance : consumer faces price cP, wants to make qc visits Price P cP qc q # Visits

Insurance (cont.) Price P cP qc q # 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 Visits D0 D1 $150

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 administrative costs, because fewer small claims are filed each year Lowers demand for relatively inexpensive medical services near start of the year Has much less impact on demand if relatively expensive medical services are required