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

2. 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.

3. 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

4. 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

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

6. 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.

7. 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.

8. 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

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

10. 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.

11. Medical Care and Utility
We can generally graph the relation between medical care and utility as follows:
Utility
Medical Care

12. 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?

13. 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

14. 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.

15. 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.

16. 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

17. 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

18. 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

19. 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?

20. 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

21. 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,…)

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

23. 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

24. 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.

25. 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.

26. 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

27. Other Economic Factors Affecting Demand
2. Complements 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.

28. 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

29. 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.

30. 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

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

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

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Open Heart Surgery
Deliveries
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34. Online Health Care Purchases!

35. Online Health Care Purchases!
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36. Elasticities
A relatively flat demand curve implies that a small increase in price leads to a large fall in # visits demanded.
Price
# Visits

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

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

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

40. 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.

41. 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.

42. 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|<

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

44. 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.

45. 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

46. 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.

47. 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.

48. 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.

49. 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.

50. Health Care Expenditures in the United States, 1960-2001*
Nominal health expenditures $
(billions of dollars)
Annual rate of growth %
(average annual % change
from previous period shown)
Nominal per capita health $ ,052 2,690 3,686 4,358 5,043
expenditures
Health expenditures as 5.1%
percentage of GDP
*Projected
Source: Health Care Financing Administration Homepage:

51. 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

52. 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.