1. 317_L3_Jan 11, 20081 Review of the Last Lecture Discussed the case for and against applying economic analysis to healthcare looked at a simple flow chart that depicts the various resource allocation decisions facing society then looked at two concepts of optimal resource allocation to the healthcare sector: 1) medical technical (health status maximization) 2) economic (MB = MC) (utility maximization) today finish the introduction to the course (four types of goods) then begin Section III of the course outline: the production of health Section II is covered by assignment I, due January 25

2. Four Types of Goods 317_L3_Jan 11, 20082 Goods can be categorized as private goods, pure public goods, other-public-goods, and merit goods Two basic criteria are used to distinguish between private goods, pure public goods, and other public goods: 1)the excludability principle 2)the rivalry-in- consumption principle Merit goods are private goods supplied by government (or heavily subsidized by government) for equity (fairness) reasons Other Public Goods are private goods for which it is difficult or costly to exclude consumers by charging a price

3. The Excludability and Rivalry Principles 317_L3_Jan 11, 20083 There is excludability if, once a good is produced, people can be prevented from consuming the good - applies for most goods/services (don’t pay, don’t consume) - doesn’t apply for some goods (street lighting, national defense, policing, sidewalks) There is rivalry in consumption if, once a quantity of the good is produced, the consumption of that good by one person reduces the amount available for consumption by other persons.

4. Allocating Goods by Criteria 317_L3_Jan 11, 20084 rivalry in non-rivalry in consumption consumption Excludabilty private good pure public good Non-excludability other public good pure public good if there is rivalry in consumption the standard efficiency criterion for optimal output (MB = MC) applies (due to rivalry in consumption) with rivalry in cons’n each consumer can select their own quantity of the good to the point where MB = P. For the firm in a perfectly competitive market profit maximization occurs at P = MC. Since P is the same for consumer and producer: MB = MC

5. With Non-Rivalry in Consumption: MB = MC doesn’t apply 317_L3_Jan 11, 20085 If there is non-rivalry in consumption, consumers can’t select their own unique quantity of the good. Everyone must consume the same quantity, which is the total quantity supplied! Thus can’t have each consumer selecting their own unique optimum quantity of a pure public good where MB = P. A different efficiency rule is needed (won’t be derived in this course) Thus private and pure public goods are distinguished from each other by the different efficiency conditions for optimal output. This difference is due to rivalry in cons’n for private goods, and non-rivalry- in-consumption for pure public goods.

6. Merit Goods 317_L3_Jan 11, 20086 a merit good is a private good that society feels should be available to all, even if the person can’t pay examples: education, healthcare education and healthcare are private goods: there is rivalry in consumption and the excludability principle applies Thus the private sector could supply it. however, excluding people from accessing the good if they can’t afford the price is deemed unacceptable by society public supply free of charge, or government insurance plan

7. 317_L3_Jan 11, 20087 Section III of the Course Outline: The Production of Health HS is a function of HC, lifestyle, environment, human biology (genetics) Can draw a production function in two dimensions holding lifestyle, environment, human biology constant (see diagram) HS = HS(HC, Lifestyle, Environment, Human Biology) The shape of the production function (see diagram): - average physical product (APP) +ve everywhere - marginal physical product (MPP) +ve, 0, -ve Changes in lifestyle, environment and human biology shift the function up or down: e.g. aging, better nutrition, lack of exercise.///

8. 317_L3_Jan 11, 20088 The Intensive and Extensive Margins in HC MPP at the intensive margin: more healthcare is applied to the same group of patients, e.g., - 60+ year old men are required to go for a full physical twice a year rather than just once a year MPP at the extensive margin: a HC good or service is applied to a more broadly defined group of patients, e.g., - extending the requirement of a full physical exam to include all 50+ year-old men rather than all 60+ year-old men Examples of the two margins (Table 3.1 in C. E. Phelps, 2003, p. 73, on an overhead transparency).///

9. 317_L3_Jan 11, 20089 Can the MPP of HC Be Negative at the Intensive Margin? The MPP of HC at the intensive margin will be negative if additional HC yields very little positive benefit for the group and continues to yield the same negative side effects. /// YES! Healthcare exerts both positive and negative effects (recall the concept of iatrogenic disease) For initial quantities of HC applied to an ill segment of the population the positive benefits will outweigh the negative side effects, thus the positive benefits of additional care for this group (intensive margin) will outweigh any negative side effects.

10. 317_L3_Jan 11, 200810 Can the MPP of HC at the Extensive Margin be Negative? Yes The MPP of HC can also be negative at the extensive margin This may occur if the population, to which a HC procedure is applied, is expanded to include an ever healthier group of people At the margin, the positive benefits from applying the HC to an ever larger proportion of the population will become less and less until finally the negative side effects of additional HC outweigh the positive health effects and the MPP of HC at the extensive margin becomes negative. ///

11. 317_L3_Jan 11, 200811 Uncertainty About the MPP of HC At the Two Margins Extensive debate in the literature on the value of HC at the two margins e.g., correct frequency of preventive care visits to the dentist/optometrist? correct cut-off age for prostate/breast cancer screening? how reliable are diagnostic tests: PSA test for prostate cancer? This uncertainty has led to variations in medical practice. There are substantial unexplained differences in the frequency with which many medical procedures are performed across geographic areas and across practitioners. Overhead transparency of high to low ratios for various HC procedures performed in 16 large community hospital markets (Phelps, 2003, p. 84).

12. 317_L3_Jan 11, 200812 Variability in HC Practice and Welfare Loss Variability in HC practice results in a welfare loss, i.e., Where there is too much HC, cost of the marginal resources used exceeds the value of the marginal benefit generated => MB suboptimal use of resources. Where there is insufficient HC, there is a chance to generate additional consumer surplus (cost of the additional resources is less than the value of the additional benefit generated, i.e. MB > MC. Illustrate with a diagram. ///