Health Economics

Demand for health capital Gerald J. Pruckner

University of Linz &

Lecture Notes, Summer Term 2010

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An individuals production of health

The Grossman model: how do age, education, health status and income inuence the production of health through the demand for health capital? Special features: deviations from traditional demand approaches People want health they demand medical care inputs to produce it Health is not passively purchased from markets it is produced in combining time with purchased medical inputs Health is a capital good it does not depreciate instantly Health can be treated both as a consumption and an investment good
consumption: health makes people feel better investment: it increases the number of healthy days to work and to earn income
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Health capital
The stock of health capital provides the output of healthy days Consumers apply a set of inputs to make investments in health capital
market inputs of health care diet, exercise, time, . . .

The health stock may grow, decline, or remain constant over time (depending on age, illness or injury) Optimal resource allocation We will see how much time and money people will invest in their health capital. The prices of health care, peoples wages and their productivity in the production of health will determine how resources are to be allocated between health capital and other goods and services that people buy.
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Investing in health capital

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Grossman model: health investment & the home good

I = I (M , TH ) B = B (X , TB ) I: M: TH : B: X: TB : health investment market health inputs (medical services, drugs, . . . ) time spent improving health home good production (reading, playing, preparing meals, watching television, . . . ) market goods necessary for the production of the home good time spent in producing the home good

(1) (2)

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Time constraint
T = 365 days = TH + TB + TL + TW T: TW : TL : total time available (365 days per period) working time (income is necessary to buy medical care goods M and other goods X) time lost to illness (some of the time is taken over by ill health) (4) (3)

Time available for work or leisure = 365 TH 0 TL0 = TW + TB TB : TH 0 : TL0 : is now called leisure time xed health enhancing time xed time lost to illness

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Labor-leisure trade-o

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Investment in health-improving activities I

TH increases: TH 0 TH 1 ; as a consequence TL decreases: TL0 TL1 two eects: (1) less time available for other activities; (2) the increased health stock reduces time lost to illness If the net eect is positive: the pure investment eect of health demand Health investments add to potential leisure and increase potential income

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Investment in health-improving activities II

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Investment in health-improving activities III

The income-leisure line is shifted outward: VS RQ Utility is increased (E E )

more (future) income more leisure (see gure) and the individual is feeling better

The improved health status might also increase a persons productivity at work (higher wages and a steeper income-leisure curve) The investment aspect of health demand An individual wishes to invest in her health even if the only value of health is its eect on earning future income.

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Production of healthy days

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Investment & consumption aspects of health

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Production of health and home goods

The production possibility trade-o between H and B given the total amount of time available
A C : health improvements increase the amount of B H > Hmin : a minimum health capital stock is necessary to obtain income and leisure time necessary to produce B E C : more time is made available for health more leisure time and income for the production of the home good

Suppose the utility from health is solely the ability to produce income and leisure time to produce the home good
vertical indierence curves utility-maximizing choice in C

If instead utility is not only derived from producing B but also directly from health itself (the consumption feature)
the more familiar indierence curve U2 utility-maximizing choice in D a higher health stock is chosen (B1 < B0 )
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Investment over time

Cost of capital People make choices for the many periods over their life cycles (we start with the pure investment model; point C in the gure) Example: investment in an X-ray equipment Cost of the X-ray machine: A C 100,000 Annual income attributable to the machine: A C 20,000 Alternat. savings account: i = 0.05 Yt = 100, 000 (1 + i )t Depreciation: A C 50,000 in ve years Capital cost for any one year: interest foregone (r ) + depreciation rate (0 : 10 %)

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Demand for health capital

Marginal eciency of investment (MEI) MEI for investments in health is downward sloping The production function for healthy days exhibits diminishing marginal returns The cost of capital reect the interest rate plus the rate of depreciation in health Optimal demand for health: intersection of the MEI curve and the cost of capital curve (r + 0 )

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Optimal health stock

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Equilibrium: the role of age, wage, and education

Thus far an equilibrium level of health stock has been chosen

how much to work how much time spent on health what kind of diet how much exercising, . . .

resources are allocated such that a person maintains a constant health stock every year How do the investments in health change with age, wage, and education?

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Age and the optimal health stock

Cost Depreciation rate is expected to increase with age (health of older people deteriorates faster than health of younger ones) 0 1 D (see the gure on slide 16): The optimal health stock decreases with age (H1 < H0 ) Consistent with the observation that elderly people purchase a greater amount of medical care though Returns from investment As the expected length of life decreases the MEI curve shifts to the left: the returns from an investment will last for a shorter period of time (e.g. an older person may choose not to undergo a complicated knee surgery) This reinforces the decrease in investment due to increased depreciation
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Health stock over the life cycle

Predictions The pure investment model predicts that health will decline with age If health is also valued for consumption reasons (people feel better): if people increase their valuation of healthy days as they age partial oset of the predicted health stock decline

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Wage and the optimal health stock

Increased wage rates increase the returns from healthy days MEI shifts to MEI (see the gure on slide 16) Higher-wage workers will tend to increase their optimal health capital stock (H2 > H0 ) The result may be ambiguous, however: increased opportunity cost of time in producing health investment a downward shift of the MEI curve is possible Retirement drops the wage to zero
no further investment in health under the pure investment version health capital would depreciate until death under consumption eects: health stock would not necessarily drop to Hmin directly upon retirement even if we include consumption eects: retirees would reduce their health stock since the investment motive has vanished
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Education and the optimal health stock

Education is assumed to improve the eciency to produce health investments (better knowledge of harmful eects of smoking; better ability to follow medical instructions, . . . ) Education raises the marginal product of direct inputs given investments in health capital can be generated at less cost for educated people higher rates of return to a given health stock MEI MEI (H2 > H0 ) Apart from this supply side eect a demand eect may exist as well dicult to disentangle
likely to recognize the benets of improved health may enjoy feeling and looking good greater taste for health

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Grossman model: a dynamic optimization problem I

Utility
T

W =
0

e U (t k (H ( )); X ( ))d

(I)

2U U 2U tk U < 0 , > 0 , > 0 , < 0, <0 2 k k 2 X X H t (t ) Health capital ( ) = I (M ( ), t I ( )) ( )H ( ) H I I > 0, > 0, >0 I M t 2I 2I ( ) = dH < 0, < 0, H 2 M d (t I )2
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{ ( ) }

(II)

Grossman model: a dynamic optimization problem II

Wealth ( ) = rA( )+Y [t k (H ( ))+t I ( )]P ( )M ( )D ( )X ( ) A Y Y ( ) = dA = I < 0, A k d t t Boundary values H [0] > 0, A[0] > 0, H [T ] H min , A[T ] 0 (IV) {( )} (III)

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Grossman model: a dynamic optimization problem III

Maximization problem (I)-(IV) Lagrange: maximize (I) under constraints (II)-(IV) Control theory dynamic optimization Solution
U e t k ( ) [0]e r

Y ( ) t k ( )

t k ( ) q ( ) = r + ( ) q ( ) H ( ) q ( )

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Grossman model: a dynamic optimization problem IV

Marginal revenue of an investment into health must be equal the marginal cost The left-hand side expression is positive () ()
Health a consumption good: marginal utility in point of time due to better health Health an investment good: the reduction of days spent Y ( ) increases labor income by t k ( )

Marginal cost of holding an additional unit of health capital

foregone interest per monetary unit depreciation per monetary unit

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Grossman model: list of variables

W: U: H: : A: r: Y: X: D: M: P: I: q: : tk : tI : : , : individual welfare utility per period health capital depreciation rate of health capital nancial wealth interest rate labor income consumption goods price per unit of consumption goods medical service price per unit of medical service health investment (quantities) price per unit of investment in health time time spent ill time for preventive actions time preference rate Lagrange multipliers

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Demand for health

Assuming specic functional forms for the Grossman model logarithmic demand functions for health (H ( )) and health services (M ( )) can be derived from the pure investment model Health demand (lnH ( )) Wages increasing returns of health capital + Price of medical services more expensive investment Age increasing depreciation rate Education higher productivity of health investment +

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Demand for health services

Demand for health services (lnM ( )) An increase of the optimal health capital stock increases the demand for health services + Wage increases the opportunity cost of preventive actions substitution by medical services + Price of medical services substitution by preventive actions t I ( ) Age demand for health services increases to compensate for higher depreciation rates + Education increases the productivity of medical services less medical services are necessary for a given stock of health capital

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Empirical evidence in support of the Grossman model

Many predictions of the Grossman model can be supported by empirical evidence Leu & Doppmann (1986) and Leu & Gern (1992) conrm a decrease of health capital with age Strauss et al. (1993) nd that health based on activity limitation decreases with age and that higher education leads to improved health Sickles & Yazbeck (1998) nd that health care and leisure consumption tend to improve health Gerdtham and Johannesson (1999) nd that demand for health increases with income and education, and decreases with age, urbanization, being overweight, and being single. ...
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Empirical evidence . . . unexpected regression results

Health
Wagsta (1986) and Leu & Gern (1992) nd a negative correlation between demand for medical services and health

Age
The prediction of an increase in the demand for medical services with age is rejected comprehensively by the empirical literature (Duan et al. 1984, Newhouse & Phelps 1974, Zweifel 1985)

Education
Estimating a structural demand function for medical services Wagsta (1986) nds a positive correlation between education and the demand for medical services

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Conclusion

The Grossman model The GM has yielded considerable insight into the determinants of health and into the allocation of time and money into health production. Empirical studies reveal, however, a negative correlation between health status and the demand for medical services. This challenges the perception that expenditure for medical services can be unequivocally derived from (health) demand.

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