Individual consumer and producer of health

Key concepts Individual = consumer and producer of health• Health behaviours viewed as health investment• Health treated as human capital (depreciates over time)• Individuals invest in human capital to increase productivity in the market sector where they produce money earnings, and in non-market sector where they produce commodities that enter their utility function • Introduction GM organises thoughts regarding health related behaviours•

Amount of health depends on decisions: eg. junk food vs healthy eating•

Trade-offs involved: eg. Gym membership vs new shoes•

Health has three roles:

Consumption good: we enjoy being healthy○

Input good: affects how hard we can work (to make more money) and

how much we can relax ○

Human capital: health decisions today affect our health tomorrow○

• Demand for health capital

Individuals invest in themselves through education, training and health. Goal:

increase earnings.•

Two NB concepts: Cost of Capital and Marginal Efficiency of Investment (MEI)•

Cost of Capital (C) C = Opportunity cost + rate at which capital good depreciates○ C = r + ∂○ • MEI –rate of return vs amount of resources invested If RoR on capital goods is greater (less) than cost of capital, then the good will (not) be purchased.○

Capital good will be purchased only up to the point where:

RoR = Cost of Capital▪ ○ • Relationship of healthy days to health stock Production of Healthy Days Health is a productive good which produces healthy days• Greater health stock leads to more healthy days –with diminishing returns• Hminis health stock minimum –production of healthy days here is zero (death) • Natural maximum of 365 days• Optimal Health Stock MEI If cost of capital is r + ∂0, then the optimal quantity of capital is H0, A represents the point of equilibrium • An x-ray machine that costs £50,000 and has 20% RoR (£10,000) will only be purchased if (r + ∂D) <= £10,000 • A second machine will only be purchased if its RoR >= (r + ∂D) • Diminishing Marginal Returns to investment –the rate of return to the second machine would probably be less than the first, therefore MEI is downward sloping • Changes in Equilibrium –Age Rate at which health stock depreciates may increase during some periods of life and decline during others • As an individual ages, the ∂rate of health stock is likely to increase (ie. The health of older individuals is likely to deteriorate faster than that of younger) • Assume wage and other factors determining MEI are not substantially altered by age • Optimal health stock decreases with age• Changes in Equilibrium –Wage Wage change will not affect Cost of Capital (r + ∂is constant)• Increased wage rate will increase returns obtained from healthy days, hence higher MEI curve • If original MEI curve represents lower-wage case, then optimal health stock is

H0. MEI

2 shows MEI for someone with higher wages, with higher optimal health stock (H2) • Optimal health stock increases with level of wages. Benefits of being healthy are greater for higher-wage workers • Changes in Equilibrium –Education Education improves efficiency in production• Higher education level raises marginal product of direct inputs• Higher education level means a higher MEI curve• Optimal health stock increases with level of education. A more educated person will choose a higher optimal stock of health than the less educated person • The Integrated Grossman Model In maximising utility subject to both time and money in a given time period, a

consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce health capital that may help in future yearsD.Quadrant 1 Labour-leisure trade-off w.r.t. allocation of time to wage earning activities• Budget constraint (BC-BC) indicates trade-off between labour and leisure (steeper line indicates higher wages) • Slope of indifference curve (U1) shows consumer's subjective trade-off between leisure and earnings • Consumer's optimal division between market work (TW) and leisure is equilibrium point A –assuming no days are lost to illness (TL), he will work for (365-OT*) days and earn income G* [to be spent on medical inputs (for health production) and home good inputs].• Quadrant 2 Trade-off between health investment (I) and home good (B) given consumer's income and time • Consumer divides his time and money in producing I and B based on his preferences and productivity • Production Possibility Curve (PPC) shows all efficient combinations of I and B that can be produced when all of consumer's income (G*) and time (OT*) are used to their full potential • Quadrant 3 Relates medical expenditure (M) to level of health investment (I)• If he spends THtime and M* amount of money on producing health, then I* level of health investment will be made • Note that he will spend (OT* -TH) on, and invest B* in, the home good• The higher M is, the higher I will be• Quadrant 4 Shows production of either I or B based on his preferences• Width of 'Edgeworth box' is amount of time remaining after allocation of time between work and leisure, and height is income earned • Contract curve –shows only combinations that are efficient for consumer to produce I or B • If he spends no time or money on health, he spends all of both on B and is at O; if he spends all his money (G*) and time (TH= non-work time) oh health, he is spending none on B and is at southeast corner of box • Equilibrium in the Integrated Grossman Model Consumer picks point A in QI, generating income of G* and has OT* leisure time • From QII, consumer's equilibrium is at A1, giving optimal investment in health of I* and in home good of B* • In QIV, THand M* are spent on health care• M* is translated through QIII to determine level of health in investment I*• Key Messages from Grossman Model

To maximise utility, a consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce or invest in health capital for future useD.• Summary Optimal health stock will decline as the person ages if the depreciation rate of health increases as a person ages • Benefits of good health are greater for high wage workers so they demand higher optimal health stock • The more educated people are, the less costly it is to generate health resulting in a higher optimal health stock for this group • Individuals will allocate resources in order to produce health capital• Predictions of Grossman Model Better health among the educated?• Declining health among the aging?• Increasing health with increasing wage?• Research consistent/inconsistent with the model

Gerdtham, UG; Johannesson M. New estimates of the demand for health:

results based on a categorical health measure and Swedish micro data. Social

Science & Medicine, 1999; 49(10):1325-1332.

https://www.sciencedirect.com/science/article/abs/pii/S0277953699002063

• Sickles, RC., Yazbeck, A. On the Dynamics for Leisure and the Production of

Health. Journal of Business & Economic Statistics, 1998; 16(2):187-197.

•

Wagstaff A. The demand for health: Some new empirical evidence. 1986,

Journal of Health Economics 5: 195-233.

• Duan et. al (1984), Newhouse & Phelps 1974, Zweifel (1985) rejected empirically the prediction that demand for health services increased with age.• The Production and Costs of Health Care Production Function Summarises the relationship between inputs and outputs from a firm's

productive process:

Q = Q(X1, X2, …, Xn, s, e)○ • Q is the output quantity, Xs are the input quantity, s represents returns to scale, e is efficiency of the production process • It describes how various inputs, commonly categorised into labour, land or raw materials and capital, combine to produce output •

Can be used to:

Quantify how output will change as more of the inputs are employed○ How the inputs can be substituted for one another to produce the same level of output ○ How efficient a particular production process is○ • Isoquants Graphical representation of a production function, showing all the combinations of inputs that will produce a particular output, Q • On isoquant = technically efficient• Marginal Products The production function generates a different isoquant for each level of output, and a firm is technically efficient if it is producing at a point on the isoquant • The marginal product of an input is the change in output resulting from a change in the quantity of the input used, other things held constant •

MPX= ΔQ/ΔX•

Diminishing returns to health expenditure Health expenditures are proxy for the quantity of inputs that a country devotes to health care, and life expectancy is a proxy for health output •

MPX= ΔQ/ΔX•

Additional expenditure beyond $4,200 per capita has a negligible incremental effect on life expectancy • This is called 'diminishing' returns• Substitutability between inputs The slope of the isoquant is called the marginal rate of technical substitution of the inputs, which measures how substitutable the factors of production are (MRTSYX= ΔX/ΔY) • Y axis = Number of nurses X axis = Number of doctors Production Frontiers Another view of the production process using real data is the production frontier = a set of boundary points consisting of all firms which are technically efficient • Sometimes called a best practice frontier, because it does not compare firms to a theoretical idea but to the best observable performance within an industry • Costs of Production Depend on the quantity and combination of resource inputs that are

employed and the unit costs of the inputs:

C = Px1X1 + Px2X2 + … + PxnXn○ • An isocost line defines all the different combinations of the inputs that will cost a particular amount. The slope of this line is the ratio of the unit costs of

the two inputs: Pnurse/Pdoctor

• Isocost lines are used with isoquants to determine the cost-minimising combination of inputs to produce a given output level, or the output- maximising combination of inputs for a given cost These occur where the slope of the isoquant is equal to the slope of the isocost line; the marginal rate of technical substitution is equal to the ratio of the inputs unit costs.○ • Maximising output subject to a cost constraint Minimising cost for a given output level Allocative efficiency in production means achieving producing output at the lowest possible cost (e.g. economic efficiency) • Point A = input combination of an inefficient hospital producing Q1• Point C = not the allocatively efficient on isoquant• Point D = technically not efficient, but allocatively efficient• Point E = technically and allocatively efficient• Economies of Scale At low levels of output, average cost falls because of increasing returns to

scale: there are economies of scale

• However, returns to scale diminish, so average cost falls more slowly until all economies of scale are exploited; then there are constant returns to scale

(CRTS)

• This point, which is the minimum point of the average cost function, is the minimum efficient scale. Beyond this point, average costs may start to rise, indicating decreasing returns to scale (DRTS) • The Supply of Health Care Firms, markets and industries in the health care sector of the economy A market is a place where those who wish to supply goods and those who wish to buy goods come together to make an exchange - A firm is an economic unit that produces and sells goods, such as medical equipment, or services, such as dental care or health insurance - An industry is a collection of firms that sell similar products, such as the pharmaceutical, insurance or hospital industries - An industry is the supply side of the market. To analyse the supply of health care we therefore need to develop a theory of the firm which can be used to explain how health care firms behave - -The healthcare industry is large and heterogeneous, containing many different types of economic unit, which can be grouped into sectors Health insurance companies cover the costs of health risks○ Pharmaceutical firms and suppliers of medical/capital equipment provide inputs into the provision of primary and hospital care ○ GP and hospitals provide outpatient/inpatient services○ Local authorities may run health promotion activities○ Structure, conduct and performance in the health care industry -A useful framework with which to analyse supply of health care is the structure-conduct-performance paradigm

Structure: how many firms in industry, how big each firms market share

is, substitutability between goods, barriers to entry. Degree of competition influences firm behaviour.○

Conduct: how firms behave. Partly determined by market structure.

Concerns whether firms compete or collude.○

Performance: relates to how efficient firms and industries are, either

from private and social point of view. Influenced by conduct.○ Profit maximisation models In traditional theories of the firm, the assumption is that firms maximise profits - There are different profit maximisation models depending on the market structure assumed - -The following market characteristics are particularly NB in defining the

market structure:

Number of competitors○ Freedom of entry to market○ Whether different firms in market sell homogenous, differentiated or unique health products ○

Four types of market structures:-

Market structure Number of firms in the market Entry into market Type of product Control of provider over price Example Perfect competiti on Many Unrestric ted Undifferenti ated NoneInternet pharmacies Monopoli stic competiti on Many Unrestric ted Differentiat ed SomeMedicines in the medium and long run OligopolyFew Restricte d Either undifferenti ated or differentiate d SomeHospital services, GP services, private health insurance Monopoly One Restricte d/ complete ly blocked UniqueConsidera ble Medicines in the short run, public health insurance - How do firms maximise profits?-The level of profit depends on the difference between the revenue received from sales and the cost of production Total profit (π) = TP = TR -TC○ Total revenue (earnings) = TR = PQ○ Average revenue = AR = TR/Q○ Marginal revenue = MR = ∆TR/∆Q○ The profit maximising level of output occurs where the marginal revenue received from sales of the product equals the marginal cost of producing it - - - - Perfect competition -4 Key Characteristics Large number of sellers in market○ Product homogeneity○ No barriers to entry or exit○ Perfect knowledge○

Firms have no control over price: they are price takers-

The implication of these assumptions is that in the long-run firms will earn zero profits -

Example: internet pharmacy-

Long run equilibrium in the internet pharmacy sector under perfect competition (Q is pharmaceutical sales) - - Short run- - Monopoly

-3 Key Characteristics:

Single seller○ No close substitutes○ Significant barriers to entry○ Monopoly firm is price-maker-

-Causes of monopoly:

Size of market○ Lower costs for established firm○ Ownership of raw materials or exclusive knowledge of production techniques ○ Patent rights○ Brand loyalty○

Example: pharmaceutical companies-

-Short run equilibrium for pharmaceutical company with a medicine under patent Downward sloping MR and AR○

Profit maximising QM: MR = MC○

PM >○ - Oligopoly

-5 Key Characteristics:

Few firms in an industry○ Homogeneous or differentiated products○ Some control over price○ Barriers to entry○ Firms are mutually dependent○

A potential behaviour: Oligopolistic firms may collude in order to limit

competition among themselves; collusion may be formal (cartel) or informal.-

Example: hospitals acting collusively to increase their revenue-

Other goals While the goal of profit maximisation may be applied to some sectors of the health care industry, for example, the pharmaceutical industry, goals other than profit maximisation also arise - Some might aim to make some profits but not maximise them, others might aim to break even - Owners might want to make profits, but managers might not share this view- Health care professionals might want to maximise patient utility- Alternatives to profit maximisation -In the health care industry there are several alternatives to profit

maximisation:

Growth maximisation○ Behavioural theories, which recognise that health care firms are complex organisational units with multiple goals and multiple decision- making units ○ Utility maximisation, where utility is a function of the quality and quantity of care provided ○ Maximising net income per physician○ Readings Morris S.,Devlin N., Parkin., Spencer A. “Economicanalysis in health care”.

Second Edition. Chichester: Wiley.2012. e-book/online version available.

(chapters 2, 3, 4)).- Grossman, M. (1972). On the concept of health capital and the demand for

health, Journal of Political Economy, 80: 223-255.

-

Bhattacharya, Jay., Hyde T. “Health economics”. Basingstoke: Palgrave

Macmillan; 2014 (chapter 3 covers the Grossman model in detail).-

Wagstaff, A. (1986). The demand for health: a simplified Grossman model.

Bulletin of Economic Research, 38(1): 93-95.

- Goudie R., Goddard M. (2011). Review of evidence on what drives economies of scope and scale in the provision of NHS services, focusing on A&E and associated hospital services. A report for the OHE Commission on

Competition in the NHS. https://www.ohe.org/sites/default/files/Review%

20of%20evidence%20on%20what%20drives%20economies%20of%20scale% 202011.pdf - Grossman Model of the Demand for Health

20 January 202009:05 1 / 4

Key concepts Individual = consumer and producer of health• Health behaviours viewed as health investment• Health treated as human capital (depreciates over time)• Individuals invest in human capital to increase productivity in the market sector where they produce money earnings, and in non-market sector where they produce commodities that enter their utility function • Introduction GM organises thoughts regarding health related behaviours•

Amount of health depends on decisions: eg. junk food vs healthy eating•

Trade-offs involved: eg. Gym membership vs new shoes•

Health has three roles:

Consumption good: we enjoy being healthy○

Input good: affects how hard we can work (to make more money) and

how much we can relax ○

Human capital: health decisions today affect our health tomorrow○

• Demand for health capital

Individuals invest in themselves through education, training and health. Goal:

increase earnings.•

Two NB concepts: Cost of Capital and Marginal Efficiency of Investment (MEI)•

Cost of Capital (C) C = Opportunity cost + rate at which capital good depreciates○ C = r + ∂○ • MEI –rate of return vs amount of resources invested If RoR on capital goods is greater (less) than cost of capital, then the good will (not) be purchased.○

Capital good will be purchased only up to the point where:

RoR = Cost of Capital▪ ○ • Relationship of healthy days to health stock Production of Healthy Days Health is a productive good which produces healthy days• Greater health stock leads to more healthy days –with diminishing returns• Hminis health stock minimum –production of healthy days here is zero (death) • Natural maximum of 365 days• Optimal Health Stock MEI If cost of capital is r + ∂0, then the optimal quantity of capital is H0, A represents the point of equilibrium • An x-ray machine that costs £50,000 and has 20% RoR (£10,000) will only be purchased if (r + ∂D) <= £10,000 • A second machine will only be purchased if its RoR >= (r + ∂D) • Diminishing Marginal Returns to investment –the rate of return to the second machine would probably be less than the first, therefore MEI is downward sloping • Changes in Equilibrium –Age Rate at which health stock depreciates may increase during some periods of life and decline during others • As an individual ages, the ∂rate of health stock is likely to increase (ie. The health of older individuals is likely to deteriorate faster than that of younger) • Assume wage and other factors determining MEI are not substantially altered by age • Optimal health stock decreases with age• Changes in Equilibrium –Wage Wage change will not affect Cost of Capital (r + ∂is constant)• Increased wage rate will increase returns obtained from healthy days, hence higher MEI curve • If original MEI curve represents lower-wage case, then optimal health stock is

H0. MEI

2 shows MEI for someone with higher wages, with higher optimal health stock (H2) • Optimal health stock increases with level of wages. Benefits of being healthy are greater for higher-wage workers • Changes in Equilibrium –Education Education improves efficiency in production• Higher education level raises marginal product of direct inputs• Higher education level means a higher MEI curve• Optimal health stock increases with level of education. A more educated person will choose a higher optimal stock of health than the less educated person • The Integrated Grossman Model In maximising utility subject to both time and money in a given time period, a

consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce health capital that may help in future yearsD.Quadrant 1 Labour-leisure trade-off w.r.t. allocation of time to wage earning activities• Budget constraint (BC-BC) indicates trade-off between labour and leisure (steeper line indicates higher wages) • Slope of indifference curve (U1) shows consumer's subjective trade-off between leisure and earnings • Consumer's optimal division between market work (TW) and leisure is equilibrium point A –assuming no days are lost to illness (TL), he will work for (365-OT*) days and earn income G* [to be spent on medical inputs (for health production) and home good inputs].• Quadrant 2 Trade-off between health investment (I) and home good (B) given consumer's income and time • Consumer divides his time and money in producing I and B based on his preferences and productivity • Production Possibility Curve (PPC) shows all efficient combinations of I and B that can be produced when all of consumer's income (G*) and time (OT*) are used to their full potential • Quadrant 3 Relates medical expenditure (M) to level of health investment (I)• If he spends THtime and M* amount of money on producing health, then I* level of health investment will be made • Note that he will spend (OT* -TH) on, and invest B* in, the home good• The higher M is, the higher I will be• Quadrant 4 Shows production of either I or B based on his preferences• Width of 'Edgeworth box' is amount of time remaining after allocation of time between work and leisure, and height is income earned • Contract curve –shows only combinations that are efficient for consumer to produce I or B • If he spends no time or money on health, he spends all of both on B and is at O; if he spends all his money (G*) and time (TH= non-work time) oh health, he is spending none on B and is at southeast corner of box • Equilibrium in the Integrated Grossman Model Consumer picks point A in QI, generating income of G* and has OT* leisure time • From QII, consumer's equilibrium is at A1, giving optimal investment in health of I* and in home good of B* • In QIV, THand M* are spent on health care• M* is translated through QIII to determine level of health in investment I*• Key Messages from Grossman Model

To maximise utility, a consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce or invest in health capital for future useD.• Summary Optimal health stock will decline as the person ages if the depreciation rate of health increases as a person ages • Benefits of good health are greater for high wage workers so they demand higher optimal health stock • The more educated people are, the less costly it is to generate health resulting in a higher optimal health stock for this group • Individuals will allocate resources in order to produce health capital• Predictions of Grossman Model Better health among the educated?• Declining health among the aging?• Increasing health with increasing wage?• Research consistent/inconsistent with the model

Gerdtham, UG; Johannesson M. New estimates of the demand for health:

results based on a categorical health measure and Swedish micro data. Social

Science & Medicine, 1999; 49(10):1325-1332.

https://www.sciencedirect.com/science/article/abs/pii/S0277953699002063

• Sickles, RC., Yazbeck, A. On the Dynamics for Leisure and the Production of

Health. Journal of Business & Economic Statistics, 1998; 16(2):187-197.

•

Wagstaff A. The demand for health: Some new empirical evidence. 1986,

Journal of Health Economics 5: 195-233.

• Duan et. al (1984), Newhouse & Phelps 1974, Zweifel (1985) rejected empirically the prediction that demand for health services increased with age.• The Production and Costs of Health Care Production Function Summarises the relationship between inputs and outputs from a firm's

productive process:

Q = Q(X1, X2, …, Xn, s, e)○ • Q is the output quantity, Xs are the input quantity, s represents returns to scale, e is efficiency of the production process • It describes how various inputs, commonly categorised into labour, land or raw materials and capital, combine to produce output •

Can be used to:

Quantify how output will change as more of the inputs are employed○ How the inputs can be substituted for one another to produce the same level of output ○ How efficient a particular production process is○ • Isoquants Graphical representation of a production function, showing all the combinations of inputs that will produce a particular output, Q • On isoquant = technically efficient• Marginal Products The production function generates a different isoquant for each level of output, and a firm is technically efficient if it is producing at a point on the isoquant • The marginal product of an input is the change in output resulting from a change in the quantity of the input used, other things held constant •

MPX= ΔQ/ΔX•

Diminishing returns to health expenditure Health expenditures are proxy for the quantity of inputs that a country devotes to health care, and life expectancy is a proxy for health output •

MPX= ΔQ/ΔX•

Additional expenditure beyond $4,200 per capita has a negligible incremental effect on life expectancy • This is called 'diminishing' returns• Substitutability between inputs The slope of the isoquant is called the marginal rate of technical substitution of the inputs, which measures how substitutable the factors of production are (MRTSYX= ΔX/ΔY) • Y axis = Number of nurses X axis = Number of doctors Production Frontiers Another view of the production process using real data is the production frontier = a set of boundary points consisting of all firms which are technically efficient • Sometimes called a best practice frontier, because it does not compare firms to a theoretical idea but to the best observable performance within an industry • Costs of Production Depend on the quantity and combination of resource inputs that are

employed and the unit costs of the inputs:

C = Px1X1 + Px2X2 + … + PxnXn○ • An isocost line defines all the different combinations of the inputs that will cost a particular amount. The slope of this line is the ratio of the unit costs of

the two inputs: Pnurse/Pdoctor

• Isocost lines are used with isoquants to determine the cost-minimising combination of inputs to produce a given output level, or the output- maximising combination of inputs for a given cost These occur where the slope of the isoquant is equal to the slope of the isocost line; the marginal rate of technical substitution is equal to the ratio of the inputs unit costs.○ • Maximising output subject to a cost constraint Minimising cost for a given output level Allocative efficiency in production means achieving producing output at the lowest possible cost (e.g. economic efficiency) • Point A = input combination of an inefficient hospital producing Q1• Point C = not the allocatively efficient on isoquant• Point D = technically not efficient, but allocatively efficient• Point E = technically and allocatively efficient• Economies of Scale At low levels of output, average cost falls because of increasing returns to

scale: there are economies of scale

• However, returns to scale diminish, so average cost falls more slowly until all economies of scale are exploited; then there are constant returns to scale

(CRTS)

• This point, which is the minimum point of the average cost function, is the minimum efficient scale. Beyond this point, average costs may start to rise, indicating decreasing returns to scale (DRTS) • The Supply of Health Care Firms, markets and industries in the health care sector of the economy A market is a place where those who wish to supply goods and those who wish to buy goods come together to make an exchange - A firm is an economic unit that produces and sells goods, such as medical equipment, or services, such as dental care or health insurance - An industry is a collection of firms that sell similar products, such as the pharmaceutical, insurance or hospital industries - An industry is the supply side of the market. To analyse the supply of health care we therefore need to develop a theory of the firm which can be used to explain how health care firms behave - -The healthcare industry is large and heterogeneous, containing many different types of economic unit, which can be grouped into sectors Health insurance companies cover the costs of health risks○ Pharmaceutical firms and suppliers of medical/capital equipment provide inputs into the provision of primary and hospital care ○ GP and hospitals provide outpatient/inpatient services○ Local authorities may run health promotion activities○ Structure, conduct and performance in the health care industry -A useful framework with which to analyse supply of health care is the structure-conduct-performance paradigm

Structure: how many firms in industry, how big each firms market share

is, substitutability between goods, barriers to entry. Degree of competition influences firm behaviour.○

Conduct: how firms behave. Partly determined by market structure.

Concerns whether firms compete or collude.○

Performance: relates to how efficient firms and industries are, either

from private and social point of view. Influenced by conduct.○ Profit maximisation models In traditional theories of the firm, the assumption is that firms maximise profits - There are different profit maximisation models depending on the market structure assumed - -The following market characteristics are particularly NB in defining the

market structure:

Number of competitors○ Freedom of entry to market○ Whether different firms in market sell homogenous, differentiated or unique health products ○

Four types of market structures:-

Market structure Number of firms in the market Entry into market Type of product Control of provider over price Example Perfect competiti on Many Unrestric ted Undifferenti ated NoneInternet pharmacies Monopoli stic competiti on Many Unrestric ted Differentiat ed SomeMedicines in the medium and long run OligopolyFew Restricte d Either undifferenti ated or differentiate d SomeHospital services, GP services, private health insurance Monopoly One Restricte d/ complete ly blocked UniqueConsidera ble Medicines in the short run, public health insurance - How do firms maximise profits?-The level of profit depends on the difference between the revenue received from sales and the cost of production Total profit (π) = TP = TR -TC○ Total revenue (earnings) = TR = PQ○ Average revenue = AR = TR/Q○ Marginal revenue = MR = ∆TR/∆Q○ The profit maximising level of output occurs where the marginal revenue received from sales of the product equals the marginal cost of producing it - - - - Perfect competition -4 Key Characteristics Large number of sellers in market○ Product homogeneity○ No barriers to entry or exit○ Perfect knowledge○

Firms have no control over price: they are price takers-

The implication of these assumptions is that in the long-run firms will earn zero profits -

Example: internet pharmacy-

Long run equilibrium in the internet pharmacy sector under perfect competition (Q is pharmaceutical sales) - - Short run- - Monopoly

-3 Key Characteristics:

Single seller○ No close substitutes○ Significant barriers to entry○ Monopoly firm is price-maker-

-Causes of monopoly:

Size of market○ Lower costs for established firm○ Ownership of raw materials or exclusive knowledge of production techniques ○ Patent rights○ Brand loyalty○

Example: pharmaceutical companies-

-Short run equilibrium for pharmaceutical company with a medicine under patent Downward sloping MR and AR○

Profit maximising QM: MR = MC○

PM >○ - Oligopoly

-5 Key Characteristics:

Few firms in an industry○ Homogeneous or differentiated products○ Some control over price○ Barriers to entry○ Firms are mutually dependent○

A potential behaviour: Oligopolistic firms may collude in order to limit

competition among themselves; collusion may be formal (cartel) or informal.-

Example: hospitals acting collusively to increase their revenue-

Other goals While the goal of profit maximisation may be applied to some sectors of the health care industry, for example, the pharmaceutical industry, goals other than profit maximisation also arise - Some might aim to make some profits but not maximise them, others might aim to break even - Owners might want to make profits, but managers might not share this view- Health care professionals might want to maximise patient utility- Alternatives to profit maximisation -In the health care industry there are several alternatives to profit

maximisation:

Growth maximisation○ Behavioural theories, which recognise that health care firms are complex organisational units with multiple goals and multiple decision- making units ○ Utility maximisation, where utility is a function of the quality and quantity of care provided ○ Maximising net income per physician○ Readings Morris S.,Devlin N., Parkin., Spencer A. “Economicanalysis in health care”.

Second Edition. Chichester: Wiley.2012. e-book/online version available.

(chapters 2, 3, 4)).- Grossman, M. (1972). On the concept of health capital and the demand for

health, Journal of Political Economy, 80: 223-255.

-

Bhattacharya, Jay., Hyde T. “Health economics”. Basingstoke: Palgrave

Macmillan; 2014 (chapter 3 covers the Grossman model in detail).-

Wagstaff, A. (1986). The demand for health: a simplified Grossman model.

Bulletin of Economic Research, 38(1): 93-95.

- Goudie R., Goddard M. (2011). Review of evidence on what drives economies of scope and scale in the provision of NHS services, focusing on A&E and associated hospital services. A report for the OHE Commission on

Competition in the NHS. https://www.ohe.org/sites/default/files/Review%

20of%20evidence%20on%20what%20drives%20economies%20of%20scale% 202011.pdf - Grossman Model of the Demand for Health

20 January 202009:05 2 / 4

Key concepts Individual = consumer and producer of health• Health behaviours viewed as health investment• Health treated as human capital (depreciates over time)• Individuals invest in human capital to increase productivity in the market sector where they produce money earnings, and in non-market sector where they produce commodities that enter their utility function • Introduction GM organises thoughts regarding health related behaviours•

Amount of health depends on decisions: eg. junk food vs healthy eating•

Trade-offs involved: eg. Gym membership vs new shoes•

Health has three roles:

Consumption good: we enjoy being healthy○

Input good: affects how hard we can work (to make more money) and

how much we can relax ○

Human capital: health decisions today affect our health tomorrow○

• Demand for health capital

Individuals invest in themselves through education, training and health. Goal:

increase earnings.•

Two NB concepts: Cost of Capital and Marginal Efficiency of Investment (MEI)•

Cost of Capital (C) C = Opportunity cost + rate at which capital good depreciates○ C = r + ∂○ • MEI –rate of return vs amount of resources invested If RoR on capital goods is greater (less) than cost of capital, then the good will (not) be purchased.○

Capital good will be purchased only up to the point where:

RoR = Cost of Capital▪ ○ • Relationship of healthy days to health stock Production of Healthy Days Health is a productive good which produces healthy days• Greater health stock leads to more healthy days –with diminishing returns• Hminis health stock minimum –production of healthy days here is zero (death) • Natural maximum of 365 days• Optimal Health Stock MEI If cost of capital is r + ∂0, then the optimal quantity of capital is H0, A represents the point of equilibrium • An x-ray machine that costs £50,000 and has 20% RoR (£10,000) will only be purchased if (r + ∂D) <= £10,000 • A second machine will only be purchased if its RoR >= (r + ∂D) • Diminishing Marginal Returns to investment –the rate of return to the second machine would probably be less than the first, therefore MEI is downward sloping • Changes in Equilibrium –Age Rate at which health stock depreciates may increase during some periods of life and decline during others • As an individual ages, the ∂rate of health stock is likely to increase (ie. The health of older individuals is likely to deteriorate faster than that of younger) • Assume wage and other factors determining MEI are not substantially altered by age • Optimal health stock decreases with age• Changes in Equilibrium –Wage Wage change will not affect Cost of Capital (r + ∂is constant)• Increased wage rate will increase returns obtained from healthy days, hence higher MEI curve • If original MEI curve represents lower-wage case, then optimal health stock is

H0. MEI

2 shows MEI for someone with higher wages, with higher optimal health stock (H2) • Optimal health stock increases with level of wages. Benefits of being healthy are greater for higher-wage workers • Changes in Equilibrium –Education Education improves efficiency in production• Higher education level raises marginal product of direct inputs• Higher education level means a higher MEI curve• Optimal health stock increases with level of education. A more educated person will choose a higher optimal stock of health than the less educated person • The Integrated Grossman Model In maximising utility subject to both time and money in a given time period, a

consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce health capital that may help in future yearsD.Quadrant 1 Labour-leisure trade-off w.r.t. allocation of time to wage earning activities• Budget constraint (BC-BC) indicates trade-off between labour and leisure (steeper line indicates higher wages) • Slope of indifference curve (U1) shows consumer's subjective trade-off between leisure and earnings • Consumer's optimal division between market work (TW) and leisure is equilibrium point A –assuming no days are lost to illness (TL), he will work for (365-OT*) days and earn income G* [to be spent on medical inputs (for health production) and home good inputs].• Quadrant 2 Trade-off between health investment (I) and home good (B) given consumer's income and time • Consumer divides his time and money in producing I and B based on his preferences and productivity • Production Possibility Curve (PPC) shows all efficient combinations of I and B that can be produced when all of consumer's income (G*) and time (OT*) are used to their full potential • Quadrant 3 Relates medical expenditure (M) to level of health investment (I)• If he spends THtime and M* amount of money on producing health, then I* level of health investment will be made • Note that he will spend (OT* -TH) on, and invest B* in, the home good• The higher M is, the higher I will be• Quadrant 4 Shows production of either I or B based on his preferences• Width of 'Edgeworth box' is amount of time remaining after allocation of time between work and leisure, and height is income earned • Contract curve –shows only combinations that are efficient for consumer to produce I or B • If he spends no time or money on health, he spends all of both on B and is at O; if he spends all his money (G*) and time (TH= non-work time) oh health, he is spending none on B and is at southeast corner of box • Equilibrium in the Integrated Grossman Model Consumer picks point A in QI, generating income of G* and has OT* leisure time • From QII, consumer's equilibrium is at A1, giving optimal investment in health of I* and in home good of B* • In QIV, THand M* are spent on health care• M* is translated through QIII to determine level of health in investment I*• Key Messages from Grossman Model

To maximise utility, a consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce or invest in health capital for future useD.• Summary Optimal health stock will decline as the person ages if the depreciation rate of health increases as a person ages • Benefits of good health are greater for high wage workers so they demand higher optimal health stock • The more educated people are, the less costly it is to generate health resulting in a higher optimal health stock for this group • Individuals will allocate resources in order to produce health capital• Predictions of Grossman Model Better health among the educated?• Declining health among the aging?• Increasing health with increasing wage?• Research consistent/inconsistent with the model

Gerdtham, UG; Johannesson M. New estimates of the demand for health:

results based on a categorical health measure and Swedish micro data. Social

Science & Medicine, 1999; 49(10):1325-1332.

https://www.sciencedirect.com/science/article/abs/pii/S0277953699002063

• Sickles, RC., Yazbeck, A. On the Dynamics for Leisure and the Production of

Health. Journal of Business & Economic Statistics, 1998; 16(2):187-197.

•

Wagstaff A. The demand for health: Some new empirical evidence. 1986,

Journal of Health Economics 5: 195-233.

• Duan et. al (1984), Newhouse & Phelps 1974, Zweifel (1985) rejected empirically the prediction that demand for health services increased with age.• The Production and Costs of Health Care Production Function Summarises the relationship between inputs and outputs from a firm's

productive process:

Q = Q(X1, X2, …, Xn, s, e)○ • Q is the output quantity, Xs are the input quantity, s represents returns to scale, e is efficiency of the production process • It describes how various inputs, commonly categorised into labour, land or raw materials and capital, combine to produce output •

Can be used to:

Quantify how output will change as more of the inputs are employed○ How the inputs can be substituted for one another to produce the same level of output ○ How efficient a particular production process is○ • Isoquants Graphical representation of a production function, showing all the combinations of inputs that will produce a particular output, Q • On isoquant = technically efficient• Marginal Products The production function generates a different isoquant for each level of output, and a firm is technically efficient if it is producing at a point on the isoquant • The marginal product of an input is the change in output resulting from a change in the quantity of the input used, other things held constant •

MPX= ΔQ/ΔX•

Diminishing returns to health expenditure Health expenditures are proxy for the quantity of inputs that a country devotes to health care, and life expectancy is a proxy for health output •

MPX= ΔQ/ΔX•

Additional expenditure beyond $4,200 per capita has a negligible incremental effect on life expectancy • This is called 'diminishing' returns• Substitutability between inputs The slope of the isoquant is called the marginal rate of technical substitution of the inputs, which measures how substitutable the factors of production are (MRTSYX= ΔX/ΔY) • Y axis = Number of nurses X axis = Number of doctors Production Frontiers Another view of the production process using real data is the production frontier = a set of boundary points consisting of all firms which are technically efficient • Sometimes called a best practice frontier, because it does not compare firms to a theoretical idea but to the best observable performance within an industry • Costs of Production Depend on the quantity and combination of resource inputs that are

employed and the unit costs of the inputs:

C = Px1X1 + Px2X2 + … + PxnXn○ • An isocost line defines all the different combinations of the inputs that will cost a particular amount. The slope of this line is the ratio of the unit costs of

the two inputs: Pnurse/Pdoctor

• Isocost lines are used with isoquants to determine the cost-minimising combination of inputs to produce a given output level, or the output- maximising combination of inputs for a given cost These occur where the slope of the isoquant is equal to the slope of the isocost line; the marginal rate of technical substitution is equal to the ratio of the inputs unit costs.○ • Maximising output subject to a cost constraint Minimising cost for a given output level Allocative efficiency in production means achieving producing output at the lowest possible cost (e.g. economic efficiency) • Point A = input combination of an inefficient hospital producing Q1• Point C = not the allocatively efficient on isoquant• Point D = technically not efficient, but allocatively efficient• Point E = technically and allocatively efficient• Economies of Scale At low levels of output, average cost falls because of increasing returns to

scale: there are economies of scale

• However, returns to scale diminish, so average cost falls more slowly until all economies of scale are exploited; then there are constant returns to scale

(CRTS)

• This point, which is the minimum point of the average cost function, is the minimum efficient scale. Beyond this point, average costs may start to rise, indicating decreasing returns to scale (DRTS) • The Supply of Health Care Firms, markets and industries in the health care sector of the economy A market is a place where those who wish to supply goods and those who wish to buy goods come together to make an exchange - A firm is an economic unit that produces and sells goods, such as medical equipment, or services, such as dental care or health insurance - An industry is a collection of firms that sell similar products, such as the pharmaceutical, insurance or hospital industries - An industry is the supply side of the market. To analyse the supply of health care we therefore need to develop a theory of the firm which can be used to explain how health care firms behave - -The healthcare industry is large and heterogeneous, containing many different types of economic unit, which can be grouped into sectors Health insurance companies cover the costs of health risks○ Pharmaceutical firms and suppliers of medical/capital equipment provide inputs into the provision of primary and hospital care ○ GP and hospitals provide outpatient/inpatient services○ Local authorities may run health promotion activities○ Structure, conduct and performance in the health care industry -A useful framework with which to analyse supply of health care is the structure-conduct-performance paradigm

Structure: how many firms in industry, how big each firms market share

is, substitutability between goods, barriers to entry. Degree of competition influences firm behaviour.○

Conduct: how firms behave. Partly determined by market structure.

Concerns whether firms compete or collude.○

Performance: relates to how efficient firms and industries are, either

from private and social point of view. Influenced by conduct.○ Profit maximisation models In traditional theories of the firm, the assumption is that firms maximise profits - There are different profit maximisation models depending on the market structure assumed - -The following market characteristics are particularly NB in defining the

market structure:

Number of competitors○ Freedom of entry to market○ Whether different firms in market sell homogenous, differentiated or unique health products ○

Four types of market structures:-

Market structure Number of firms in the market Entry into market Type of product Control of provider over price Example Perfect competiti on Many Unrestric ted Undifferenti ated NoneInternet pharmacies Monopoli stic competiti on Many Unrestric ted Differentiat ed SomeMedicines in the medium and long run OligopolyFew Restricte d Either undifferenti ated or differentiate d SomeHospital services, GP services, private health insurance Monopoly One Restricte d/ complete ly blocked UniqueConsidera ble Medicines in the short run, public health insurance - How do firms maximise profits?-The level of profit depends on the difference between the revenue received from sales and the cost of production Total profit (π) = TP = TR -TC○ Total revenue (earnings) = TR = PQ○ Average revenue = AR = TR/Q○ Marginal revenue = MR = ∆TR/∆Q○ The profit maximising level of output occurs where the marginal revenue received from sales of the product equals the marginal cost of producing it - - - - Perfect competition -4 Key Characteristics Large number of sellers in market○ Product homogeneity○ No barriers to entry or exit○ Perfect knowledge○

Firms have no control over price: they are price takers-

The implication of these assumptions is that in the long-run firms will earn zero profits -

Example: internet pharmacy-

Long run equilibrium in the internet pharmacy sector under perfect competition (Q is pharmaceutical sales) - - Short run- - Monopoly

-3 Key Characteristics:

Single seller○ No close substitutes○ Significant barriers to entry○ Monopoly firm is price-maker-

-Causes of monopoly:

Size of market○ Lower costs for established firm○ Ownership of raw materials or exclusive knowledge of production techniques ○ Patent rights○ Brand loyalty○

Example: pharmaceutical companies-

-Short run equilibrium for pharmaceutical company with a medicine under patent Downward sloping MR and AR○

Profit maximising QM: MR = MC○

PM >○ - Oligopoly

-5 Key Characteristics:

Few firms in an industry○ Homogeneous or differentiated products○ Some control over price○ Barriers to entry○ Firms are mutually dependent○

A potential behaviour: Oligopolistic firms may collude in order to limit

competition among themselves; collusion may be formal (cartel) or informal.-

Example: hospitals acting collusively to increase their revenue-

Other goals While the goal of profit maximisation may be applied to some sectors of the health care industry, for example, the pharmaceutical industry, goals other than profit maximisation also arise - Some might aim to make some profits but not maximise them, others might aim to break even - Owners might want to make profits, but managers might not share this view- Health care professionals might want to maximise patient utility- Alternatives to profit maximisation -In the health care industry there are several alternatives to profit

maximisation:

Growth maximisation○ Behavioural theories, which recognise that health care firms are complex organisational units with multiple goals and multiple decision- making units ○ Utility maximisation, where utility is a function of the quality and quantity of care provided ○ Maximising net income per physician○ Readings Morris S.,Devlin N., Parkin., Spencer A. “Economicanalysis in health care”.

Second Edition. Chichester: Wiley.2012. e-book/online version available.

(chapters 2, 3, 4)).- Grossman, M. (1972). On the concept of health capital and the demand for

health, Journal of Political Economy, 80: 223-255.

-

Bhattacharya, Jay., Hyde T. “Health economics”. Basingstoke: Palgrave

Macmillan; 2014 (chapter 3 covers the Grossman model in detail).-

Wagstaff, A. (1986). The demand for health: a simplified Grossman model.

Bulletin of Economic Research, 38(1): 93-95.

- Goudie R., Goddard M. (2011). Review of evidence on what drives economies of scope and scale in the provision of NHS services, focusing on A&E and associated hospital services. A report for the OHE Commission on

Competition in the NHS. https://www.ohe.org/sites/default/files/Review%

20of%20evidence%20on%20what%20drives%20economies%20of%20scale% 202011.pdf - Grossman Model of the Demand for Health

20 January 202009:05 3 / 4

Key concepts Individual = consumer and producer of health• Health behaviours viewed as health investment• Health treated as human capital (depreciates over time)• Individuals invest in human capital to increase productivity in the market sector where they produce money earnings, and in non-market sector where they produce commodities that enter their utility function • Introduction GM organises thoughts regarding health related behaviours•

Amount of health depends on decisions: eg. junk food vs healthy eating•

Trade-offs involved: eg. Gym membership vs new shoes•

Health has three roles:

Consumption good: we enjoy being healthy○

Input good: affects how hard we can work (to make more money) and

how much we can relax ○

Human capital: health decisions today affect our health tomorrow○

• Demand for health capital

Individuals invest in themselves through education, training and health. Goal:

increase earnings.•

Two NB concepts: Cost of Capital and Marginal Efficiency of Investment (MEI)•

Cost of Capital (C) C = Opportunity cost + rate at which capital good depreciates○ C = r + ∂○ • MEI –rate of return vs amount of resources invested If RoR on capital goods is greater (less) than cost of capital, then the good will (not) be purchased.○

Capital good will be purchased only up to the point where:

RoR = Cost of Capital▪ ○ • Relationship of healthy days to health stock Production of Healthy Days Health is a productive good which produces healthy days• Greater health stock leads to more healthy days –with diminishing returns• Hminis health stock minimum –production of healthy days here is zero (death) • Natural maximum of 365 days• Optimal Health Stock MEI If cost of capital is r + ∂0, then the optimal quantity of capital is H0, A represents the point of equilibrium • An x-ray machine that costs £50,000 and has 20% RoR (£10,000) will only be purchased if (r + ∂D) <= £10,000 • A second machine will only be purchased if its RoR >= (r + ∂D) • Diminishing Marginal Returns to investment –the rate of return to the second machine would probably be less than the first, therefore MEI is downward sloping • Changes in Equilibrium –Age Rate at which health stock depreciates may increase during some periods of life and decline during others • As an individual ages, the ∂rate of health stock is likely to increase (ie. The health of older individuals is likely to deteriorate faster than that of younger) • Assume wage and other factors determining MEI are not substantially altered by age • Optimal health stock decreases with age• Changes in Equilibrium –Wage Wage change will not affect Cost of Capital (r + ∂is constant)• Increased wage rate will increase returns obtained from healthy days, hence higher MEI curve • If original MEI curve represents lower-wage case, then optimal health stock is

H0. MEI

2 shows MEI for someone with higher wages, with higher optimal health stock (H2) • Optimal health stock increases with level of wages. Benefits of being healthy are greater for higher-wage workers • Changes in Equilibrium –Education Education improves efficiency in production• Higher education level raises marginal product of direct inputs• Higher education level means a higher MEI curve• Optimal health stock increases with level of education. A more educated person will choose a higher optimal stock of health than the less educated person • The Integrated Grossman Model In maximising utility subject to both time and money in a given time period, a

consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce health capital that may help in future yearsD.Quadrant 1 Labour-leisure trade-off w.r.t. allocation of time to wage earning activities• Budget constraint (BC-BC) indicates trade-off between labour and leisure (steeper line indicates higher wages) • Slope of indifference curve (U1) shows consumer's subjective trade-off between leisure and earnings • Consumer's optimal division between market work (TW) and leisure is equilibrium point A –assuming no days are lost to illness (TL), he will work for (365-OT*) days and earn income G* [to be spent on medical inputs (for health production) and home good inputs].• Quadrant 2 Trade-off between health investment (I) and home good (B) given consumer's income and time • Consumer divides his time and money in producing I and B based on his preferences and productivity • Production Possibility Curve (PPC) shows all efficient combinations of I and B that can be produced when all of consumer's income (G*) and time (OT*) are used to their full potential • Quadrant 3 Relates medical expenditure (M) to level of health investment (I)• If he spends THtime and M* amount of money on producing health, then I* level of health investment will be made • Note that he will spend (OT* -TH) on, and invest B* in, the home good• The higher M is, the higher I will be• Quadrant 4 Shows production of either I or B based on his preferences• Width of 'Edgeworth box' is amount of time remaining after allocation of time between work and leisure, and height is income earned • Contract curve –shows only combinations that are efficient for consumer to produce I or B • If he spends no time or money on health, he spends all of both on B and is at O; if he spends all his money (G*) and time (TH= non-work time) oh health, he is spending none on B and is at southeast corner of box • Equilibrium in the Integrated Grossman Model Consumer picks point A in QI, generating income of G* and has OT* leisure time • From QII, consumer's equilibrium is at A1, giving optimal investment in health of I* and in home good of B* • In QIV, THand M* are spent on health care• M* is translated through QIII to determine level of health in investment I*• Key Messages from Grossman Model

To maximise utility, a consumer must:

Allocate time between work and leisureA.Spend remaining leisure time on health and non-health activitiesB.Spend income earned on health and non-health resourcesC.Produce or invest in health capital for future useD.• Summary Optimal health stock will decline as the person ages if the depreciation rate of health increases as a person ages • Benefits of good health are greater for high wage workers so they demand higher optimal health stock • The more educated people are, the less costly it is to generate health resulting in a higher optimal health stock for this group • Individuals will allocate resources in order to produce health capital• Predictions of Grossman Model Better health among the educated?• Declining health among the aging?• Increasing health with increasing wage?• Research consistent/inconsistent with the model

Gerdtham, UG; Johannesson M. New estimates of the demand for health:

results based on a categorical health measure and Swedish micro data. Social

Science & Medicine, 1999; 49(10):1325-1332.

https://www.sciencedirect.com/science/article/abs/pii/S0277953699002063

• Sickles, RC., Yazbeck, A. On the Dynamics for Leisure and the Production of

Health. Journal of Business & Economic Statistics, 1998; 16(2):187-197.

•

Wagstaff A. The demand for health: Some new empirical evidence. 1986,

Journal of Health Economics 5: 195-233.

• Duan et. al (1984), Newhouse & Phelps 1974, Zweifel (1985) rejected empirically the prediction that demand for health services increased with age.• The Production and Costs of Health Care Production Function Summarises the relationship between inputs and outputs from a firm's

productive process:

Q = Q(X1, X2, …, Xn, s, e)○ • Q is the output quantity, Xs are the input quantity, s represents returns to scale, e is efficiency of the production process • It describes how various inputs, commonly categorised into labour, land or raw materials and capital, combine to produce output •

Can be used to:

Quantify how output will change as more of the inputs are employed○ How the inputs can be substituted for one another to produce the same level of output ○ How efficient a particular production process is○ • Isoquants Graphical representation of a production function, showing all the combinations of inputs that will produce a particular output, Q • On isoquant = technically efficient• Marginal Products The production function generates a different isoquant for each level of output, and a firm is technically efficient if it is producing at a point on the isoquant • The marginal product of an input is the change in output resulting from a change in the quantity of the input used, other things held constant •

MPX= ΔQ/ΔX•

Diminishing returns to health expenditure Health expenditures are proxy for the quantity of inputs that a country devotes to health care, and life expectancy is a proxy for health output •

MPX= ΔQ/ΔX•

Additional expenditure beyond $4,200 per capita has a negligible incremental effect on life expectancy • This is called 'diminishing' returns• Substitutability between inputs The slope of the isoquant is called the marginal rate of technical substitution of the inputs, which measures how substitutable the factors of production are (MRTSYX= ΔX/ΔY) • Y axis = Number of nurses X axis = Number of doctors Production Frontiers Another view of the production process using real data is the production frontier = a set of boundary points consisting of all firms which are technically efficient • Sometimes called a best practice frontier, because it does not compare firms to a theoretical idea but to the best observable performance within an industry • Costs of Production Depend on the quantity and combination of resource inputs that are

employed and the unit costs of the inputs:

C = Px1X1 + Px2X2 + … + PxnXn○ • An isocost line defines all the different combinations of the inputs that will cost a particular amount. The slope of this line is the ratio of the unit costs of

the two inputs: Pnurse/Pdoctor

• Isocost lines are used with isoquants to determine the cost-minimising combination of inputs to produce a given output level, or the output- maximising combination of inputs for a given cost These occur where the slope of the isoquant is equal to the slope of the isocost line; the marginal rate of technical substitution is equal to the ratio of the inputs unit costs.○ • Maximising output subject to a cost constraint Minimising cost for a given output level Allocative efficiency in production means achieving producing output at the lowest possible cost (e.g. economic efficiency) • Point A = input combination of an inefficient hospital producing Q1• Point C = not the allocatively efficient on isoquant• Point D = technically not efficient, but allocatively efficient• Point E = technically and allocatively efficient• Economies of Scale At low levels of output, average cost falls because of increasing returns to

scale: there are economies of scale

• However, returns to scale diminish, so average cost falls more slowly until all economies of scale are exploited; then there are constant returns to scale

(CRTS)

• This point, which is the minimum point of the average cost function, is the minimum efficient scale. Beyond this point, average costs may start to rise, indicating decreasing returns to scale (DRTS) • The Supply of Health Care Firms, markets and industries in the health care sector of the economy A market is a place where those who wish to supply goods and those who wish to buy goods come together to make an exchange - A firm is an economic unit that produces and sells goods, such as medical equipment, or services, such as dental care or health insurance - An industry is a collection of firms that sell similar products, such as the pharmaceutical, insurance or hospital industries - An industry is the supply side of the market. To analyse the supply of health care we therefore need to develop a theory of the firm which can be used to explain how health care firms behave - -The healthcare industry is large and heterogeneous, containing many different types of economic unit, which can be grouped into sectors Health insurance companies cover the costs of health risks○ Pharmaceutical firms and suppliers of medical/capital equipment provide inputs into the provision of primary and hospital care ○ GP and hospitals provide outpatient/inpatient services○ Local authorities may run health promotion activities○ Structure, conduct and performance in the health care industry -A useful framework with which to analyse supply of health care is the structure-conduct-performance paradigm

Structure: how many firms in industry, how big each firms market share

is, substitutability between goods, barriers to entry. Degree of competition influences firm behaviour.○

Conduct: how firms behave. Partly determined by market structure.

Concerns whether firms compete or collude.○

Performance: relates to how efficient firms and industries are, either

from private and social point of view. Influenced by conduct.○ Profit maximisation models In traditional theories of the firm, the assumption is that firms maximise profits - There are different profit maximisation models depending on the market structure assumed - -The following market characteristics are particularly NB in defining the

market structure:

Number of competitors○ Freedom of entry to market○ Whether different firms in market sell homogenous, differentiated or unique health products ○

Four types of market structures:-

Market structure Number of firms in the market Entry into market Type of product Control of provider over price Example Perfect competiti on Many Unrestric ted Undifferenti ated NoneInternet pharmacies Monopoli stic competiti on Many Unrestric ted Differentiat ed SomeMedicines in the medium and long run OligopolyFew Restricte d Either undifferenti ated or differentiate d SomeHospital services, GP services, private health insurance Monopoly One Restricte d/ complete ly blocked UniqueConsidera ble Medicines in the short run, public health insurance - How do firms maximise profits?-The level of profit depends on the difference between the revenue received from sales and the cost of production Total profit (π) = TP = TR -TC○ Total revenue (earnings) = TR = PQ○ Average revenue = AR = TR/Q○ Marginal revenue = MR = ∆TR/∆Q○ The profit maximising level of output occurs where the marginal revenue received from sales of the product equals the marginal cost of producing it - - - - Perfect competition -4 Key Characteristics Large number of sellers in market○ Product homogeneity○ No barriers to entry or exit○ Perfect knowledge○

Firms have no control over price: they are price takers-

The implication of these assumptions is that in the long-run firms will earn zero profits -

Example: internet pharmacy-

Long run equilibrium in the internet pharmacy sector under perfect competition (Q is pharmaceutical sales) - - Short run- - Monopoly

-3 Key Characteristics:

Single seller○ No close substitutes○ Significant barriers to entry○ Monopoly firm is price-maker-

-Causes of monopoly:

Size of market○ Lower costs for established firm○ Ownership of raw materials or exclusive knowledge of production techniques ○ Patent rights○ Brand loyalty○

Example: pharmaceutical companies-

-Short run equilibrium for pharmaceutical company with a medicine under patent Downward sloping MR and AR○

Profit maximising QM: MR = MC○

PM >○ - Oligopoly

-5 Key Characteristics:

Few firms in an industry○ Homogeneous or differentiated products○ Some control over price○ Barriers to entry○ Firms are mutually dependent○

A potential behaviour: Oligopolistic firms may collude in order to limit

competition among themselves; collusion may be formal (cartel) or informal.-

Example: hospitals acting collusively to increase their revenue-

Other goals While the goal of profit maximisation may be applied to some sectors of the health care industry, for example, the pharmaceutical industry, goals other than profit maximisation also arise - Some might aim to make some profits but not maximise them, others might aim to break even - Owners might want to make profits, but managers might not share this view- Health care professionals might want to maximise patient utility- Alternatives to profit maximisation -In the health care industry there are several alternatives to profit

maximisation:

Growth maximisation○ Behavioural theories, which recognise that health care firms are complex organisational units with multiple goals and multiple decision- making units ○ Utility maximisation, where utility is a function of the quality and quantity of care provided ○ Maximising net income per physician○ Readings Morris S.,Devlin N., Parkin., Spencer A. “Economicanalysis in health care”.

Second Edition. Chichester: Wiley.2012. e-book/online version available.

(chapters 2, 3, 4)).- Grossman, M. (1972). On the concept of health capital and the demand for

health, Journal of Political Economy, 80: 223-255.

-

Bhattacharya, Jay., Hyde T. “Health economics”. Basingstoke: Palgrave

Macmillan; 2014 (chapter 3 covers the Grossman model in detail).-

Wagstaff, A. (1986). The demand for health: a simplified Grossman model.

Bulletin of Economic Research, 38(1): 93-95.

- Goudie R., Goddard M. (2011). Review of evidence on what drives economies of scope and scale in the provision of NHS services, focusing on A&E and associated hospital services. A report for the OHE Commission on

Competition in the NHS. https://www.ohe.org/sites/default/files/Review%

20of%20evidence%20on%20what%20drives%20economies%20of%20scale% 202011.pdf - Grossman Model of the Demand for Health

20 January 202009:05

• / 4