1. 317_L23, Mar 7, 2008, J. Schaafsma 1 Review of the Last Lecture Began our discussion of the econ. evaluation of healthcare programs Will be looking at three methods: - cost benefit analysis (CBA) - cost effectiveness analysis (CEA) - cost utility analysis (CUA) started our discussion of CBA in CBA all annual costs and benefits are expressed in dollars the flow of annual benefits is converted to a present value (PVB), as is the flow of annual costs (PVC) econ. viability is determined on the basis of the NPV, i.e., PVB-PVC

2. 317_L23, Mar 7, 2008, J. Schaafsma 2 Calculating the $ values of the Benefits and Costs formula for B t ($ value of all the benefits in year t) B t =  i,k p ikt b ikt t =time index, k = viewpoint index, i = benefit index B 1, B 2, B 3, …, B n where the B’s are the dollar values of the total benefits in year 1, 2, 3, …, n respectively. -formula for C t (the $ value of all costs in year t) C t =  j,k v jkt c jkt t =time index, k = viewpoint index, j = cost index C 1, C 2, C 3, …, C m where the C’s are the dollar values of the total costs in year 1, 2, 3, …, m respectively. ///

3. 317_L23, Mar 7, 2008, J. Schaafsma 3 The Present Value of the Benefits and of the Costs, and the NPV -compute the present value of the benefits (in $s): PVB = B 1 /(1+r) + B 2 /(1+r) 2 +…+ B T /(1+r) T =  t B t /(1+r) t t = 1, …, T - compute the present value of the costs (in $s): PVC = C 1 /(1+r) + C 2 /(1+r) 2 +…+ C T /(1+r) T =  t C t /(1+r) t t = 1, …, T compute the net present value  NPV = PVB – PVC ///

4. 317_L23, Mar 7, 2008, J. Schaafsma 4 The Net Present Value Criterion -if NPV > 0 project is economically feasible - if NPV = 0 indifferent - if NPV < 0 project is not economically feasible - if funds are limitless  implement all projects that are economically feasible - if funds are limited  implement the set of projects that maximizes NPV for the available funds. ///

5. 317_L23, Mar 7, 2008, J. Schaafsma 5 The Incremental Net Present Value compute the incremental net present value as: INPV =  PVB -  PVC Where :  PVB =  t (B new – B comp ) t /(1+r) t t = 1, …, T  PVC =  t (C new – C comp ) t /(1+r) t t = 1, …, T Where B new = monetary benefit in year t from the proposed project Where C new = monetary cost in year t for the proposed project Where B comp = monetary benefit in year t from the comparator Where C comp = monetary cost in year t for the comparator Project is viable if INPV ≥ 0

6. 317_L23, Mar 7, 2008, J. Schaafsma 6 2 Reasons for Shadow Prices in program evaluation : Market Prices May Not Capture Opportunity Costs -ve externalities: market price will understate true opportunity cost, e.g., charge for hazardous waste disposal may understate true cost. monopoly price  overstates true opportunity cost to society of using the input (e.g., suppose a medical specialist is paid $200,000 due to restricted entry into the profession, and that if these persons didn’t become medical specialists they would be lawyers earning $100,000. society’s opportunity cost for another specialist is not $200,000 but the $100,000 of lawyer services it must give up. of course, there is also an annual $100,000 internal redistribution of wealth from society to the specialist (who would have been a lawyer)

7. 317_L23, Mar 7, 2008, J. Schaafsma 7 A Third Reason for Shadow Pricing: Non-Market Goods (Life and Limb) in HC no prices observable for many, if not most, outputs: life, limb, absence of pain, mobility nevertheless programs that produce such outputs need to be evaluated can’t argue  HC outputs are priceless  should not be evaluated. we do implicitly place a value on life and limb in our everyday activities  drive cars, ski, ride bicycles, smoke cigarettes i.e. we trade off life expectancy for other satisfactions also have safety regulations, but only to a point thus place a finite value on life & limb; but what is it? ///

8. 317_L23, Mar 7, 2008, J. Schaafsma 8 Two Ways to Deal with the Valuation of Life & Limb 1.Replace CBA with another kind of analysis where $/unit values for life and limb not needed  CEA, CUA - benefits measured in their own units, e.g. lives saved, utility gained (will discuss later). 2.Use a variety of techniques to compute shadow prices for life & limb, and use these prices consistently everywhere shadow price: indirect measure of the value of a real cost or real benefit using information from choices made in everyday life Currently no consistent shadow price used in policy decisions  get many inconsistencies  inefficient resource allocation. ///

9. 317_L23, Mar 7, 2008, J. Schaafsma 9 Inconsistent Implicit Policy Valuations of Human Lives in the absence of explicit valuations of human lives  get inconsistent implicit valuations K. Viscusi (Journal of Economics Literature, Dec 93, pp. 1912-13) summarizes various implicit valuations: cost per life saved -airplane cabin fire protection standards $0.2 million -Automobile side door protection standards $1.3 million - Occ’n Safety Health Admin Asbestos Removal Reg $89.3 million can save more lives by equalizing cost per life saved at the margin /

10. 317_L23, Mar 7, 2008, J. Schaafsma 10 Techniques for Shadow pricing Life and Limb have discussed why shadow prices are needed: true opportunity costs are not captured by market prices (eg., externalities, monopoly prices), market prices not available (life and limb). Will look at three techniques for shadow pricing life and limb i) human capital method ii) revealed preference method (WTP and WTA). This method uses market data iii) contingent valuation method (WTP and WTA). This method uses interview data (responses to hypothetical scenarios)

11. 317_L23, Mar 7, 2008, J. Schaafsma 11 Techniques for Shadow Pricing: The Human Capital Approach basic concept  a life cut short is a loss of output value of a human life = PV of stream of future earnings lost if life were ended now (or limb lost, or physical function lost) this method yields very specific results However, the method is: a) ethically indefensible b) inconsistent with standard theory of value. ///

12. 317_L23, Mar 7, 2008, J. Schaafsma 12 The Human Capital Approach: Ethically Indefensible retired elderly  don’t produce  valueless very young  earnings twenty or more years into the future  very low PV  very low value women  generally earn less than men  female’s life worth less than a male’s life blacks  generally earn less than whites  a black’s life worth less than a white’s life These are all ethically offensive conclusions ///

13. 317_L23, Mar 7, 2008, J. Schaafsma 13 The Human Capital Approach: Theoretically Problematic two basic theoretical issues ignored by this method: 1.Can’t value all of a person’s contribution by the value society places on the last unit produced  ignores the consumer surplus (see diagram) - a simple non healthcare example: what is the value we place on our consumption of water? Can’t compute this by multiplying our consumption of water by the price of water! 2.Economic value is determined by the opportunity cost we are willing to incur to have the good or service  what are we willing to give up to have the good or service? ///