The Value of Life and

the Rise in Health Spending

Robert E. Hall
Hoover Institution and Department of Economics, Stanford University and NBER
E-mail: [email protected]
http://stanford.edu/˜rehall

and
Charles I. Jones*
Department of Economics, U.C. Berkeley and NBER
E-mail: [email protected]
http://www.econ.berkeley.edu/˜chad

April 7, 2006 — Version 5.0

Quarterly Journal of Economics, forthcoming.

Over the past half century, Americans spent a rising share of total economic
resources on health and enjoyed substantially longer lives as a result. Debate
on health policy often focuses on limiting the growth of health spending. We
investigate an issue central to this debate: Is the growth of health spending a ra-
tional response to changing economic conditions—notably the growth of income
per person? We develop a model based on standard economic assumptions and
argue that this is indeed the case. Standard preferences—of the kind used widely
in economics to study consumption, asset pricing, and labor supply—imply that
health spending is a superior good with an income elasticity well above one. As
people get richer and consumption rises, the marginal utility of consumption falls
rapidly. Spending on health to extend life allows individuals to purchase addi-
tional periods of utility. The marginal utility of life extension does not decline.
As a result, the optimal composition of total spending shifts toward health, and
the health share grows along with income. In projections based on the quantita-
tive analysis of our model, the optimal health share of spending seems likely to
exceed 30 percent by the middle of the century.

* We are grateful to David Cutler, Amy Finkelstein, Victor Fuchs, Alan Garber, Michael
Grossman, Emmett Keeler, Ron Lee, Joseph Newhouse, Tomas Philipson, David Romer,
Robert Topel, the editors and referees, and participants at numerous seminars and NBER
1
2 HALL AND JONES

1. INTRODUCTION
The United States devotes a rising share of its total resources to health care.
The share was 5.2 percent in 1950, 9.4 percent in 1975, and 15.4 percent in
2000. Over the same period, health has improved. Life expectancy at birth
was 68.2 years in 1950, 72.6 years in 1975, and 76.9 years in 2000.
Why has this health share been rising, and what is the likely time path of the
health share for the rest of the century? We present a framework for answering
these questions. In the model, the key decision is the division of total resources
between health care and non-health consumption. Utility depends on quantity
of life—life expectancy—and quality of life—consumption. People value
health spending because it allows them to live longer and to enjoy better
lives.
In our approach, standard preferences—of the kind economists use to study
issues ranging from consumption to asset pricing to labor supply—are able
to explain the rising share of health spending. As consumption increases, the
marginal utility of consumption falls quickly. In contrast, extending life does
not run into the same kind of diminishing returns. As we get older and richer,
which is more valuable: a third car, yet another television, more clothing —
or an extra year of life? There are diminishing returns to consumption in any
given period and a key way we increase our lifetime utility is by adding extra
periods of life.
Standard preferences imply that health is a superior good with an income
elasticity well above one. As people grow richer, consumption rises but
they devote an increasing share of resources to health care. Our quantitative
analysis suggests these effects can be large: projections in our model typically

meetings for helpful comments. Jones thanks the Center for Economic Demography and
Aging at Berkeley for financial support. Matlab programs that generate the numerical results
in this paper are available at Jones’s website.
 THE VALUE OF LIFE AND HEALTH SPENDING 3

lead to health shares that exceed 30 percent of GDP by the middle of the
century.
Many of the important questions related to health involve the institutional
arrangements that govern its financing—especially Medicare and employer-
provided health insurance. One approach would be to introduce these insti-
tutions into our model and to examine the allocation of resources that results.
We take an alternative approach. We examine the allocation of resources
that maximizes social welfare in our model. We abstract from the compli-
cated institutions that shape spending in the United States and ask a more
basic question: from a social welfare standpoint, how much should the nation
spend on health care, and what is the time path of optimal health spending?
The recent health literature has emphasized the importance of technolog-
ical change as an explanation for the rising health share—for example, see
Newhouse (1992). According to this explanation, the invention of new and
expensive medical technologies causes health spending to rise over time. Al-
though the development of new technologies unquestionably plays a role in
the rise of health spending, the technological explanation is incomplete for at
least two reasons.
First, expensive health technologies do not need to be used just because
they are invented. Although distortions in health insurance in the United
States might result in over-use of expensive new technologies, health shares
of GDP have risen in virtually every advanced country in the world, despite
wide variation in systems for allocating health care (Jones 2003). We inves-
tigate whether the social payoff associated with the use of new technologies
is in line with the cost. Second, the invention of the new technologies is itself
endogenous: Why is the U.S. investing so much in order to invent these ex-
pensive technologies? By focusing explicitly on the social value of extending
life and how this value changes over time, we shed light on these questions.
4 HALL AND JONES

We begin by documenting the facts about aggregate health spending and

life expectancy, the two key variables in our model. We then present a simple
stylized model that makes some strong assumptions but that delivers our basic
results. From this foundation, we consider a richer and more realistic frame-
work and develop a full dynamic model of health spending. The remainder
of the paper estimates the parameters of the model and discusses a number of
projections of future health spending derived from the model.
Our research is closely related to a number of empirical and theoretical
papers. Our work is a theoretical counterpart to the recent empirical arguments
of David Cutler and others that high levels and growth rates of health spending
may be economically justified (Cutler, McClellan, Newhouse and Remler
1998, Cutler and McClellan 2001, Cutler 2004). On the theoretical side,
our approach is closest in spirit to Grossman (1972) and Ehrlich and Chuma
(1990), who consider the optimal choice of consumption and health spending
in the presence of a quality-quantity tradeoff. Our work is also related to
a large literature on the value of life and the willingness of people to pay
to reduce mortality risk. Classic references include Schelling (1968) and
Usher (1973). Arthur (1981), Shepard and Zeckhauser (1984), Murphy and
Topel (2003), and Ehrlich and Yin (2004) are more recent examples that
include simulations of the willingness to pay to reduce mortality risk and
calculations of the value of life. Nordhaus (2003) and Becker, Philipson
and Soares (2005) conclude that increases in longevity have been roughly
as important to welfare as increases in non-health consumption, both for the
United States and for the world as a whole. Barro and Barro (1996) develop a
model where health investments reduce the depreciation rate of schooling and
health capital; health spending as a fraction of income can then rise through
standard transition dynamics.
We build on this literature in two ways. First and foremost, the focus of our
paper is on understanding the determinants of the aggregate health share. The
 THE VALUE OF LIFE AND HEALTH SPENDING 5

existing theoretical literature generally focuses on individual-level spending

and willingness to pay to reduce mortality. Second, we consider a broader
class of preferences for longevity and consumption. Many earlier papers
specialize for their numerical results to constant relative risk aversion utility,
with an elasticity of marginal utility between zero and one. This restriction
occurs because these papers do not consider a constant term in flow utility. As
we show below, careful attention to the constant is crucial to understanding the
rising health share. In particular, when a constant is included, a standard utility
function with an elasticity of marginal utility well above one is admissible.
This property is the key to the rising health share in the model.

2. BASIC FACTS
We will be concerned with the allocation of total resources to health and
other uses. We believe that the most appropriate measure of total resources
is consumption plus government purchases of goods and services. That is,
we treat investment and net imports as intermediate products. Similarly, we
measure spending on health as the delivery of health services to the public and
do not include investment in medical facilities. Thus we differ conceptually
(but hardly at all quantitatively) from other measures that include investment
in both the numerator and denominator. When we speak of consumption of
goods and services, we include government purchases of non-health goods
and services.
Figure 1 shows the fraction of total spending devoted to health care, ac-
cording to the U.S. National Income and Product Accounts. The numerator
is consumption of health services plus government purchases of health ser-
vices and the denominator is consumption plus total government purchases
of goods and services. The fraction has a sharp upward trend, but growth is
irregular. In particular, the fraction grew rapidly in the early 1990s and flat-
6 HALL AND JONES

FIGURE 1. The Health Share in the United States

Health Share

0.16

0.14

0.12

0.1

0.08

0.06

0.04
1950 1960 1970 1980 1990 2000
Year

Note: The numerator of the health share is consumption of health services plus
government purchases of health services and the denominator is consumption
plus total government purchases of goods and services. For further information
on sources, see Section 5.
 THE VALUE OF LIFE AND HEALTH SPENDING 7

FIGURE 2. Life Expectancy in the United States

Life Expectancy

78

76

74

72

70

68
1950 1960 1970 1980 1990 2000
Year

Note: Life expectancy at birth data are from Table 12 of National Vital Statistics
Report Volume 51, Number 3 “United States Life Tables, 2000", December 19,
2002. Center for Disease Control.

tened in the late 1990s. Not shown in the figure is the resumption of growth
after 2000.
Figure 2 shows life expectancy at birth for the United States. Following
the tradition in demography, this life expectancy measure is not expected
remaining years of life (which depends on unknown future mortality rates),
but is life expectancy for a hypothetical individual who faces the cross-section
of mortality rates from a given year. Life expectancy has grown about 1.7
years per decade. It shows no sign of slowing over the 50 years reported in
the figure. In the first half of the 20th century, however, life expectancy grew
at about twice this rate, so a longer times series would show some curvature.
8 HALL AND JONES

3. BASIC MODEL
We begin with a model based on the simple but unrealistic assumption that
mortality is the same in all age groups. We also assume that preferences are
unchanging over time, and income and productivity are constant. This model
sets the stage for our full model where we incorporate age-specific mortality
and productivity growth. As we will show in Section 4, the stark assumptions
we make in this section lead the full dynamic model to collapse to the simple
static problem considered here.
The economy consists of a collection of people of different ages who are
otherwise identical, allowing us to focus on a representative person. Let x
denote the person’s health status. The mortality rate of an individual is the
inverse of her health status, 1/x. Since people of all ages face this same
mortality rate, x is also equal to life expectancy. For simplicity at this stage,
we assume zero time preference.
Expected lifetime utility for the representative individual is
Z ∞
U (c, x) = e−(1/x)t u(c)dt = xu(c). (1)
0

That is, lifetime utility is the present value of her per-period utility u(c) dis-
counted for mortality at rate 1/x. In this stationary environment, consumption
is constant so that expected utility is the number of years an individual ex-
pects to live multiplied by per-period utility. We assume for now that period
utility depends only on consumption; in the next section, we will introduce
a quality-of-life term associated with health. Here and throughout the paper,
we normalize utility after death at zero.
Rosen (1988) pointed out the following important implication of a specifi-
cation of utility involving life expectancy: When lifetime utility is per-period
utility, u, multiplied by life expectancy, the level of u matters a great deal. In
many other settings, adding a constant to u has no effect on consumer choice.
Here, adding a constant raises the value the consumer places on longevity
 THE VALUE OF LIFE AND HEALTH SPENDING 9

relative to consumption of goods. Negative utility also creates an anomaly—

indifference curves have the wrong curvature and the first-order conditions do
not maximize utility. As long as u is positive, preferences are well behaved. 1
The representative individual receives a constant flow of resources y that
can be spent on consumption or health:

c + h = y. (2)

The economy has no physical capital or foreign trade that permits shifting
resources from one period to another.
Finally, a health production function governs the individual’s state of health:

x = f (h). (3)

The social planner chooses consumption and health spending to maximize

the utility of the individual in (1) subject to the resource constraint (2) and
the production function for health status (3). That is, the optimal allocation
solves

max f (h)u(c) s.t. c + h = y. (4)

c,h

The optimal allocation equates the ratio of health spending to consumption

to the ratio of the elasticities of the health production function and the flow
utility function. With s ≡ h/y, the optimum is
s∗ h∗ ηh
∗
= ∗
= , (5)
1−s c ηc
1
Rosen also discussed the following issue: If the elasticity of utility rises above one for
low values of consumption—as it can for the preferences we estimate in this paper—mortality
becomes a good rather than a bad. A consumer would achieve a higher expected utility by
accepting higher mortality and the correspondingly higher level of later consumption. Thus
one cannot take expected utility for a given mortality rate as an indicator of the welfare of an
individual who can choose a lower rate. This issue does not arise in our work, because we
consider explicit optimization over the mortality rate. An opportunity for improvement of the
type Rosen identified would mean that we had not maximized expected utility.
10 HALL AND JONES

where ηh ≡ f 0 (h) hx , and ηc ≡ u0 (c) uc .

Now suppose we ignore the fact that income and life expectancy are taken
as constant in this static model and instead consider what happens if income
grows. The short-cut of using a static model to answer a dynamic question
anticipates the findings of our full dynamic model quite well.
The response of the health share to rising income depends on the movements
of the two elasticities in equation (5). The crux of our argument is that the
consumption elasticity falls relative to the health elasticity as income rises,
causing the health share to rise. Health is a superior good because satiation
occurs more rapidly in non-health consumption.
Why is ηc decreasing in consumption? In most branches of applied eco-
nomics, only marginal utility matters. For questions of life and death, how-
ever, this is not the case. We have normalized the utility associated with death
at zero in our framework, and how much a person will pay to live an extra
year hinges on the level of utility associated with life. In our application,
adding a constant to the flow of utility u(c) has a material effect—it permits
the elasticity of utility to vary with consumption.
Thus our approach is to take the standard constant-elastic specification for
marginal utility but to add a constant to the level of utility. In this way, we
stay close to the approach of many branches of applied economics that make
good use of a utility function with constant elasticity for marginal utility. In
finance, it has constant relative risk aversion. In dynamic macroeconomics, it
has constant elasticity of intertemporal substitution. In the economics of the
household, it has constant elasticity of substitution between pairs of goods.
What matters for the choice of health spending, however, is not just the
elasticity of marginal utility, but also the elasticity of the flow utility func-
tion itself. With the constant term added to a utility function with constant-
elastic marginal utility, the utility elasticity declines with consumption for
 THE VALUE OF LIFE AND HEALTH SPENDING 11

conventional parameter values. The resulting specification is then capable of

explaining the rising share of health spending.
With this motivation, we specify flow utility as:

c1−γ
u(c) = b + , (6)
1−γ

where γ is the constant elasticity of marginal utility. Based on evidence

discussed later in the paper, we consider γ > 1 to be likely. In this case, the
second term is negative, so the base level of utility, b, needs to be positive
enough to ensure that flow utility is positive over the relevant values of c. The
flow of utility u(c) is always less than b, so the elasticity ηc is decreasing in
consumption. More generally, any bounded utility function u(c) will deliver
a declining elasticity, at least eventually, as will the unbounded u(c) = α +
β log c. Thus the key to our explanation of the rising health share—a marginal
utility of consumption that falls sufficiently quickly — is obtained by adding
a constant to a standard class of utility functions.
An alternative interpretation of the first-order condition is also informative.
Let L(c, x) ≡ U (c, x)/u0 (c) denote the value of a life in units of output.
Then, the optimal allocation of resources can also be characterized as

L(c∗ , x∗ )/x∗
s∗ = η h · . (7)
y

The optimal health share is proportional to the value of a year of life L/x
divided by per-capita income. If the flow of utility is given as in equation (6),
it is straightforward to show that the value of a year of life satisfies

L(c, x) c
= bcγ − . (8)
x γ−1

For γ > 1, the growth rate of the value of a life year approaches γ times
the growth rate of consumption from above. Therefore, the value of a year
of life will grow faster than consumption (and income) if γ is larger than 1.
12 HALL AND JONES

According to equation (7), this is one of the key ingredients needed for the
model to generate a rising health share.
A rapidly-declining marginal utility of consumption leads to a rising health
share provided the health production elasticity ηh does not itself fall too
rapidly. For example, if the marginal product of health spending in extending
life were to fall to zero—say it was technologically impossible to live be-
yond the age of 100—then health spending would cease to rise at that point.
Whether or not the health share rises over time is then an empirical question:
there is a race between diminishing marginal utility of consumption and the
diminishing returns to the production of health. As we discuss later, for the
kind of health production functions that match the data, the production elastic-
ity declines very gradually, and the declining marginal utility of consumption
does indeed dominate, producing a rising health share.
Finally, we can also generalize the utility function to U (c, x) in place of
xu(c), so that lifetime satisfaction is not necessarily proportional to the length
of the lifetime. The solution for this case is s∗ /(1 − s∗ ) = ηh ηx /ηc , where
ηx ≡ Ux x/U is the elasticity of utility with respect to life expectancy. Our
result, then, is that the health share rises when the consumption elasticity falls
faster than the product of the production and life expectancy elasticities. As
just one example U (c, x) = xα u(c) delivers a constant ηx even with sharply
diminishing returns to life expectancy (that is, α close to zero), so our main
results are unchanged in this case.
The simple model develops intuition, but it falls short on a number of
dimensions. Most importantly, the model assumes constant total resources
and constant health productivity. This means it is inappropriate to use this
model to study how a growing income leads to a rising health share, the
comparative static results not withstanding. Still, the basic intuition for a
rising health share emerges clearly. The health share rises over time as income
grows if the marginal utility of consumption falls sufficiently rapidly relative
 THE VALUE OF LIFE AND HEALTH SPENDING 13

to the joy of living an extra year and the ability of health spending to generate
that extra year.

4. THE FULL DYNAMIC MODEL

We turn now to the full dynamic model, allowing age-specific mortality
and the associated heterogeneity, as well as growth in total resources and
productivity growth in the health sector. This model also incorporates a
quality-of-life component associated with health spending.
An individual of age a in period t has an age-specific state of health, x a,t .
As in the basic model, the mortality rate for an individual is the inverse of her
health status. Therefore, 1 − 1/xa,t is the per-period survival probability of
an individual with health xa,t .
An individual’s state of health is produced by spending on health h a,t :

xa,t = f (ha,t ; a, t). (9)

In this production function, health status depends on both age and time. Forces
outside the model that vary with age and time may also influence health status;
examples include technological change and education.
The starting point for our specification of preferences is the flow utility of
the individual, u(ca,t , xa,t ). In addition to depending on consumption, flow
utility depends on health status, xa,t . Spending on health therefore affects
utility in two ways, by increasing the quantity of life through a mortality
reduction and by increasing the quality of life.
We assume this utility function takes the following form:
c1−γ
a,t x1−σ
a,t
u(ca,t , xa,t ) = b + +α , (10)
1−γ 1−σ
where γ, α, and σ are all positive. The first term is the baseline level of util-
ity whose importance we stressed earlier.2 The second term is the standard
2
Previous versions of this paper considered the possibility that this intercept varied by age
and time. In some of our estimation, we treated these ba,t terms as residuals that rationalized
14 HALL AND JONES

constant-elastic specification for consumption. We assume further that health

status and consumption are additively separable in utility and that quality of
life is a constant-elastic function of health status. Additive separability is of
course a strong assumption. It implies that the marginal utility of consump-
tion does not vary with health status and ultimately delivers the result that
consumption itself will optimally be invariant to health status. We could relax
this assumption in our framework and still obtain our main results. However,
even the direction of the effect is unclear: Is the marginal utility of consump-
tion higher or lower for sick people? One can easily think of reasons why it
might be lower. On the other hand, the marginal utility of having a personal
assistant or of staying in a nice hotel with lots of amenities might actually be
higher for people with a lower health status.3 Our separability assumption
can be viewed as a natural intermediate case.
In this environment, we consider the allocation of resources that would be
chosen by a social planner who places equal weights on each person alive at
a point in time and who discounts future flows of utility at rate β. Let N a,t
denote the number of people of age a alive at time t. Then social welfare is
∞ X
X ∞
Na,t β t u(ca,t , xa,t ). (11)
t=0 a=0

The optimal allocation of resources is a choice of consumption and health

spending at each age that maximizes social welfare subject to the production
function for health in (9) and subject to a resource constraint we will specify
momentarily.
It is convenient to express this problem in the form of a Bellman equation.
Let Vt (Nt ) denote the social planner’s value function when the age distribu-
tion of the population is the vector Nt ≡ (N1,t , N2,t , ..., Na,t , ...). Then the
the observed health spending data as optimal. See Hall and Jones (2004) for more on this
approach.
3
We thank a referee for this observation.
 THE VALUE OF LIFE AND HEALTH SPENDING 15

Bellman equation for the planner’s problem is

∞
X
Vt (Nt ) = max Na,t u(ca,t , xa,t ) + βVt+1 (Nt+1 ) (12)
{ha,t ,ca,t }
a=0

subject to
∞
X
Na,t (yt − ca,t − ha,t ) = 0, (13)
a=0
!
1
Na+1,t+1 = 1− Na,t , (14)
xa,t
N0,t = N0 , (15)

xa,t = f (ha,t ; a, t). (16)

yt+1 = egy yt , (17)

The first constraint is the economy-wide resource constraint. Note that we

assume that people of all ages contribute the same flow of resources, y t . The
second is the law of motion for the population. We assume a large enough
population so that the number of people aged a + 1 next period can be taken
equal to the number aged a today multiplied by the survival probability. The
third constraint specifies that births are exogenous and constant at N 0 . The
final two constraints are the production function for health and the law of
motion for resources, which grow exogenously at rate g y .
Let λt denote the Lagrange multiplier on the resource constraint. The
optimal allocation satisfies the following first order conditions for all a:

uc (ca,t , xa,t ) = λt , (18)

∂Vt+1 f 0 (ha,t )
β · + ux (ca,t , xa,t )f 0 (ha,t ) = λt , (19)
∂Na+1,t+1 x2a,t
where we use f 0 (ha,t ) to represent ∂f (ha,t ; a, t)/∂ha,t . That is, the marginal
utility of consumption and the marginal utility of health spending are equated
16 HALL AND JONES

across people and to each other at all times. This condition together with
the additive separability of flow utility implies that people of all ages have
the same consumption ct at each point in time, but they have different health
expenditures ha,t depending on age.
∂Vt
Let va,t ≡ ∂Na,t denote the change in social welfare associated with having
an additional person of age a alive. That is, va,t is the social value of life at
age a in units of utility. Combining the two first-order conditions, we get:

βva+1,t+1 ux x2a,t x2a,t

+ = 0 , (20)
uc uc f (ha,t )

The optimal allocation sets health spending at each age to equate the marginal
benefit of saving a life to its marginal cost. The marginal benefit is the sum
of two terms. The first is the social value of life βva+1,t+1 /uc . The second
is the additional quality of life enjoyed by people as a result of the increase
in health status.
The marginal cost of saving a life is dh/dm, where dh is the increase in
resources devoted to health care and dm is the reduction in the mortality rate.
For example, if reducing the mortality rate by .001 costs $2000, then saving
a statistical life requires 1/.001 = 1000 people to undertake this change, at a
total cost of $2 million. Our model contains health status x as an intermediate
dh dh/dx
variable, so it is useful to write the marginal cost as dm = dm/dx . Since health
status is defined as inverse mortality, m = 1/x so that dm = dx/x 2 . In the
previous example, we required 1/dm people to reduce their mortality rate
by dm to save a life. Equivalently, setting dx = 1, we require x 2 people to
increase their health status by one unit in order to save a statistical life. Since
the cost of increasing x is dh/dx = 1/f 0 (h), the marginal cost of saving a
life is therefore x2 /f 0 (h).
 THE VALUE OF LIFE AND HEALTH SPENDING 17

By taking the derivative of the value function, we find that the social value
of life satisfies the recursive equation:
!
1
va,t = u(ct , xa,t ) + β 1 − va+1,t+1 + λt (yt − ct − ha,t ). (21)
xa,t

The additional social welfare associated with having an extra person alive at
age a is the sum of three terms. The first is the level of flow utility enjoyed by
that person. The second is the expected social welfare associated with having
a person of age a + 1 alive next period, where the expectation employs the
survival probability 1 − 1/xa,t . Finally, the last term is the net social resource
contribution from a person of age a, her production less her consumption and
health spending.
The literature on competing risks of mortality suggests that a decline in
mortality from one cause may increase the optimal level of spending on other
causes, as discussed by Dow, Philipson and Sala-i-Martin (1999). This prop-
erty holds in our model as well. Declines in future mortality will increase the
value of life, va,t , raising the marginal benefit of health spending at age a.

4.1. Relation to the Static Model

It is worth pausing for a moment to relate this full dynamic model to the
simple static framework. With constant income y, a time- and age-invariant
health production function f (h), β = 1, and a flow utility function that
depends only on consumption, the Bellman equation for a representative agent
can be written as

V (y) = max u(c) + (1 − 1/f (h))V (y) s.t. c + h = y. (22)

c,h

Given the stationarity of this environment, it is straightforward to see that the

value function is

V (y) = max f (h)u(c) s.t. c + h = y, (23)

c,h
18 HALL AND JONES

the static model we developed earlier, restated in discrete time.

5. QUANTITATIVE ANALYSIS
In the remainder of the paper, we estimate the parameters of our model
and provide a quantitative analysis of its predictions. We are conscious of
uncertainty in the literature regarding the values of many of the parameters
in our model. The calculations that follow should be viewed as illustrative
and suggestive, and we have done our best to indicate the range of outcomes
one would obtain with other plausible values of the parameters. We begin by
describing the data we use, then proceed to estimating the parameter values,
and finally conclude with solving the model.
We assume a period in the model is five years in the data. We organize the
data into 20 five-year age groups, starting at 0–4 and ending at 95–99. We
consider 11 time periods in the historical period, running from 1950 through
2000.
Data on age-specific mortality rates are taken from Table 35 of the National
Center for Health Statistics publication Health, United States 2004. This
source reports mortality rates every 10 years, with age breakdowns generally
in 10-year intervals. We interpolated by time and age groups to produce
estimates for 5-year time intervals and age categories. We also obtained
data on age-specific mortality rates from accidents and homicides from this
publication and from various issues of Vital Statistics of the United States.
Our main approach treats mortality from accidents and homicides separately
from non-accident mortality. The distinction between the two categories is
important mainly for older children and young adults, where health-related
mortality is so low that declines in accidents account for a substantial part
of the overall trend in mortality. Our model deals only with non-accident
mortality, so we slightly underestimate the total contribution of rising health
spending to declining mortality.
 THE VALUE OF LIFE AND HEALTH SPENDING 19

Data on age-specific health spending are taken from Meara, White and Cut-
ler (2004). These data are for 1963, 1970, 1977, 1987, 1996, and 2000. Using
the age breakdowns for these years, we distributed national totals for health
spending across age categories, interpolated to our 5-year time intervals.
National totals for health spending are from Table 2.5.5 of the revised
National Income and Product Accounts of the Bureau of Economic Analysis,
accessed at bea.gov on February 13, 2004 (for private spending) and Table
3.15 of the previous NIPAs, accessed December 2, 2003 (for government
spending). The empirical counterpart for our measure of total resources per
capita, y, is total private consumption plus total government purchases of
goods and services, from the sources described above, divided by population.

6. ESTIMATING THE HEALTH PRODUCTION FUNCTION

Our model has a set of parameters for the health production function and
a set related to preferences. Both play a key role in the determination of
optimal health spending. This section discusses the estimation of the health
production function while the next section considers the estimation of the
preference parameters.
We begin by assuming a functional form for the production of health status.
We assume the inverse of the non-accident mortality rate, x̃ a,t is a Cobb-
Douglas function of health inputs:4

x̃a,t = Aa (zt ha,t wa,t )θa . (25)

In this production function, Aa and θa are parameters that are allowed to

depend on age. zt is the efficiency of a unit of output devoted to health
4
The equation determining overall health status is therefore:
1 1
xa,t = fa,t (ha,t ) = non = , (24)
macc
a,t + ma,t macc
a,t + 1/x̃a,t

where macc is the mortality rate from accidents and homicides and mnon is non-accident
mortality.
20 HALL AND JONES

care, taken as an exogenous trend; it is the additional improvement in the

productivity of health care on top of the general trend in the productivity of
goods production. The unobserved variable wa,t captures the effect of all
other determinants of mortality, including education and pollution. 5

6.1. Identification and Estimation

To explain our approach to identifying the parameters of this production
function—Aa and θa —we introduce a new variable, sa,t ≡ ha,t /yt , the ratio
of age-specific health spending to income per capita. We rewrite our health
production function as

x̃a,t = Aa (zt yt · sa,t · wa,t )θa . (26)

The overall trend decline in age-specific mortality between 1950 and 2000
can then be decomposed into the three terms in parentheses. First is a trend
due to technological change, zt yt . In our benchmark scenario, we assume
technical change in the health sector occurs at the same rate as in the rest of
the economy, so that zt = 1 is constant. Because yt rises in our data at 2.31
percent per year, this is the rate of technical change assumed to apply in the
health sector. In a robustness check, we assume technical change is faster in
the health sector, allowing zt to grow at one percent per year so that technical
change in the health sector is 3.31 percent.
The second cause of a trend decline in age-specific mortality is resource
allocation: as the economy allocates an increasing share of per capita income
to health spending at age a, mortality declines. This effect is captured by s a,t .
Third, unobserved movements of wa,t cause age-specific mortality to de-
cline. We have already removed accidents and homicides from our mortality
5
In principle, this specification allows non-accident mortality rates to fall to zero with enough
technical progress or health spending, potentially leading life expectancy to rise to arbitrarily
high levels. In practice, this is not a serious concern for the time horizons we consider. Life
expectancy in our simulations rises only to about 81 years by 2050.
 THE VALUE OF LIFE AND HEALTH SPENDING 21

measure, but increases in the education of the population, declines in pollu-

tion, and declines in smoking may all contribute to declines in mortality.
The key assumption that allows us to identify θa econometrically is that our
observed trends—technological change and resource allocation—account for
a known fraction µ of the trend decline in age-specific mortality. For example,
in our benchmark case, we assume that technical change and the increased
allocation of resources to health together account for µ = 2/3 of the decline
in non-accident mortality, leaving 1/3 to be explained by other factors. As
a robustness check, we also consider the case where these percentages are
50-50, so that µ = 1/2. We first discuss why this is a plausible identifying
assumption and then explain exactly how it allows us to estimate θ a .
A large body of research seeks to understand the causes of declines in mor-
tality; see Cutler, Deaton and Lleras-Muney (2006) for a recent survey. New-
house and Friedlander (1980) is one of the early cross-sectional studies doc-
umenting a low correlation between medical resources and health outcomes.
Subsequent work designed to solve the difficult identification problem (more
resources are needed where people are sicker) have generally supported this
finding (Newhouse 1993, McClellan, McNeil and Newhouse 1994, Skinner,
Fisher and Wennberg 2001, Card, Dobkin and Maestas 2004, Finkelstein and
McKnight 2005). This work often refers to “flat of the curve” medicine and
emphasizes the low marginal benefit of additional spending. On the other
hand, even this literature recognizes that certain kinds of spending—for ex-
ample the “effective care” category of Wennberg, Fisher and Skinner (2002)
that includes flu vaccines, screening for breast and colon cancer, and drug
treatments for heart attack victims—can have important effects on health.
Goldman and Cook (1984) attribute 40 percent of the decline in mortality
from heart disease between 1968 and 1976 to specific medical treatments;
Heidenreich and McClellan (2001) take this one step further and conclude
that the main reason for the decline in early mortality from heart attacks
22 HALL AND JONES

during the last 20 years is the increased use of medical treatments. Part of
the increased use may result from improvements in technology (Cutler et al.
1998). Skinner et al. (2001) emphasize that technological advances have been
responsible for “large average health benefits” in the U.S. population. Never-
theless, other factors including behavioral changes, increased education, and
declines in pollution have certainly contributed to the decline in mortality
(Chay and Greenstone 2003, Grossman 2005).
While it would be a stretch to say there is a consensus, this literature is
generally consistent with the identifying assumption made here: that µ =
2/3 of the trend decline in mortality is due to technological progress and
the increased allocation of resources to health care. When applied to our
estimation (as described further below), this identifying assumption leads to
the following decomposition. Averaged across our age groups, 35 percent of
the decline in age-specific mortality is due to technological change, 32 percent
to increased resource allocation to health, and 33 percent (by assumption) to
other factors. In our robustness check that assigns 50 percent to other factors,
the split is 26 percent to technological change and 24 percent to increased
resource allocation. When we allow technical change to be a percentage
point faster in the health sector, 40 percent of the mortality decline is due
to technical change, 27 percent to resource allocation, and 33 percent (by
assumption) to unobserved factors.
How does our assumption that µ is known allow us to identify the parameters
of the health production function? Take logs of equation (25) to get

log x̃a,t = log Aa + θa (log zt + log ha,t + log wa,t ) . (27)

Our approach to identification is to construct a model whose disturbance is

known not to have a trend. That orthogonality condition makes a time trend
eligible as an instrumental variable—we apply GMM based on that condition.
 THE VALUE OF LIFE AND HEALTH SPENDING 23

If the unobserved component wa,t itself had no time trend, we would use
the time trend as an instrument in estimating equation (27) directly. But our
disturbance, wa,t , surely does have a time trend: part of the reduction in
mortality at a given age is due to factors other than technological change and
increased resource reallocation. We use information about the contribution
of the other factors to arrive at an equation where the time trend is a proper
instrument.
We decompose the disturbance wa,t as

log wa,t = gw,a t + ηa,t , (28)

where gw,a is the age-specific trend in other determinants of mortality and

ηa,t is the random, non-trended part of the disturbance.
Combining (27) and (28) gives our estimating equation

log x̃a,t = log Aa + θa (log zt + log ha,t + gw,a t) + a,t , (29)

where the new disturbance a,t ≡ θa ηa,t is orthogonal to a linear trend.

Therefore if we knew the value of gw,a , we could use a linear time trend
as an instrument to estimate θa .
Our assumption that we know µ allows us to compute gw,a . Note that 1 − µ
is the fraction of trend mortality decline that is due to wa,t . Therefore,

gw,a
1−µ= . (30)
gz + gh,a + gw,a

But if we know µ, then we know every term in this equation other than g w,a
(gz by assumption and gh,a from data), so we can use this equation to calculate
the trend growth rate in wa,t , and we are done.
We use GMM to estimate Aa and θa in equation (29). Our two orthogonality
conditions are that a,t has zero mean and that is has zero covariance with
24 HALL AND JONES

FIGURE 3. Estimates of the elasticity of health status with respect to health

inputs

0.5

0.4

0.3

0.2

0.1

0
0 20 40 60 80 100
Age

Note: The height of each bar reports our estimate of the production function param-
eter θa , the elasticity of adjusted health status with respect to health inputs: x̃ a,t =
Aa (zt ha,t wa,t )θa . The ranges at the top of the bars indicate ± two standard errors.

a linear time trend. Because health spending is strongly trending, the trend
instrument is strong and the resulting estimator has small standard errors. 6
Figure 3 shows the GMM estimates of θa , the elasticity of adjusted health
status, x̃, with respect to health inputs, by age category. The groups with the
largest improvements in health status over the 50-year period, the very young
and the middle-aged, have the highest elasticities, ranging from 0.25 to 0.40.
The fact that the estimates of θa generally decline with age, particularly at the
older ages, constitutes an additional source of diminishing returns to health
6
The data we use in this estimation are the spending and mortality data discussed in Section 5.
For each age, we have data at 5-year intervals for the period 1950 to 2000.
 THE VALUE OF LIFE AND HEALTH SPENDING 25

FIGURE 4. Goodness of fit for the health technology

110 12

Age 35 − 39,
100 10
left scale
Health status, 35 − 39

Health status, 65 − 69
90 8

Age 65 − 69,
80 right scale 6

70 4

60 2

50 0
0 2000 4000 6000 8000 10000 12000
Health spending (in 2000 dollars)

Note: The solid lines show data on health spending h on the horizontal axis and
health status, x, on the vertical axis, for two age groups, 35-39 and 65-69, for
the period 1950 through 2000. The dashed lines show the fitted values from the
estimated production function in equation (29).

spending as life expectancy rises. For the oldest age groups, the elasticity of
health status with respect to health inputs is only 0.042.
Figure 4 shows the actual and fitted values of health status for two repre-
sentative age groups. Because the health technology has two parameters for
each age—intercept and slope—the equations are successful in matching the
level and trend of health status. The same is true in the other age categories.

6.2. The Marginal Cost of Saving a Life

Our estimates of the health production function imply a value for the
marginal cost of saving a life. Recall, from the discussion surrounding equa-
tion (20), that this marginal cost is x2 /f 0 (h). With our functional form for
26 HALL AND JONES

TABLE 1.
The Marginal Cost of Saving a Life (thousands of 2000 dollars)
Robust Per Year of Growth
Maximum Life Saved Rate
Age 1950 1980 2000 2000 2000 1950–2000
0-4 10 160 590 (790) 8 7.8
10-14 270 2,320 9,830 (13,110) 152 7.2
20-24 1,170 3,840 8,520 (11,360) 155 4.0
30-34 500 2,120 4,910 (6,540) 108 4.6
40-44 160 740 1,890 (2,520) 52 4.9
50-54 70 330 1,050 (1,400) 39 5.4
60-64 50 280 880 (1,180) 47 5.9
70-74 40 280 790 (1,050) 67 6.2
80-84 40 340 750 (1,000) 125 6.1
90-94 50 420 820 (1,090) 379 5.6

Note: The middle columns of the table report estimates of the marginal cost of saving a life for
various age groups. These estimates are calculated as hx̃/θ, using the estimates of θ given
in Figure 4 and using actual data on health spending and mortality by age. Standard errors
for these values based on the standard errors of θa are small. The Robust Maximum column
shows the maximum marginal cost we obtained in the various robustness checks described
in the text; see Table 2. The “Per Year of Life Saved” column divides the cost of saving a
life by life expectancy at that age.

the health technology, the marginal cost of saving a life is hx̃/θ. 7 Our work
provides estimates of the value of life that can be compared to others de-
rived either from other approaches on the cost side or from consumer choice
involving mortality hazards, the demand side.
Table 1 shows this marginal cost of saving a life for various age groups.
We can interpret these results in terms of the literature estimating the value
of a statistical life (VSL). For example, the marginal cost of saving the life
of a 40-year old in the year 2000 was about $1.9 million. In our robustness
checks, this marginal cost reached as high as $2.5 million (in the case where
7
This expression has a nice interpretation: x̃ is the inverse of the non-accident mortality
rate, so it can be thought of as the number of living people per non-accident death. h is health
spending per person, so hx̃ is the total amount of health spending per death. The division by θ
adjusts for the fact that we are interested in the marginal cost of saving a life, not the average.
 THE VALUE OF LIFE AND HEALTH SPENDING 27

θa is identified with the assumption that only 1/2 rather than 2/3 of declines in
mortality are due to technical change and resource allocation). These numbers
are at the lower end of the estimates of the VSL from the literature, which
range from about $2 million to $9 million (Viscusi and Aldy 2003, Ashenfelter
and Greenstone 2004, Murphy and Topel 2005). If one believes the lower
numbers, this suggests that health spending was at approximately the right
level as a whole for this age group in 2000. Alternatively, of course, if one
believes the higher estimates of the VSL from the literature, the calculation
from Table 1 suggests that health spending for this group was too low.
The second-to-last column of the table provides an alternative view of the
marginal cost of saving a life by stating the cost per year of life saved. It shows
the cost of saving a statistical life in the year 2000, divided by life expectancy
at each age. For example, the marginal cost of saving an extra year of life
at age 50 is about $39,000. Interestingly, the cost of saving a life year in
the youngest age category is only about $8,000, while the cost for saving a
life year for the oldest ages rises to well above $100,000. These numbers
are again typically below conventional estimates of the value of a year of
life. Cutler (2004) reviews the literature and takes a rough value of $100,000
per year as reasonable. Murphy and Topel (2005) use theory to assign a $6
million average value of life across ages and find life year values that are
even higher. Taking our marginal cost estimates seriously then suggests the
possibility that optimal health spending is substantially higher than actual
spending. This finding will reappear later in our simulation results based on
the full model.

7. ESTIMATING THE PREFERENCE PARAMETERS

Earlier we showed that the evolution of the optimal health share involves
a race between diminishing returns to health spending and the diminishing
marginal utility of consumption. Having estimated the parameters of the
28 HALL AND JONES

health technology, we turn in this section to finding values for the prefer-
ence parameters: the curvature parameter γ, the discount factor β, the utility
intercept b, and the quality of life parameters α and σ.

7.1. Basic Preference Parameters

For the curvature parameter of the utility function, γ, we look to other
circumstances where curvature affects choice. Large literatures on intertem-
poral choice (Hall 1988), asset pricing (Lucas 1994), and labor supply (Chetty
2006) each suggest that γ = 2 is a reasonable value. We explore alternative
values ranging from near-log utility (γ = 1.01) to γ = 2.5. With respect to
the discount factor, β, we choose a value that is consistent with our choice of
γ and with a 6 percent real return to saving. Taking consumption growth from
the data of 2.08 percent per year, a standard Euler equation gives an annual
discount factor of 0.983, or, for the 5-year intervals in our model, 0.918.
With these values for γ and β, we estimate the intercept of flow utility
b to deliver a particular value of life for 35–39 year olds in the year 2000
given the observed path of health spending.8 As noted earlier, the empirical
literature on the value of a statistical life encompasses a wide range of values,
from a low of about $2 million (Ashenfelter and Greenstone 2004) to highs
of $9 million or more, as discussed in the survey of Viscusi and Aldy (2003).
Ashenfelter (2006) notes that the U.S. Department of Transportation uses a
value of $3 million in cost-benefit analysis. Murphy and Topel (2005) take as
their benchmark a $6.2 million dollar estimate used by the U.S. Environmental
Protection Agency.

8
For future values of health spending by age, we project the existing data forward at a
constant growth rate. Until the year 2020, this growth rate is the average across the age-
specific spending growth rates. After 2020 we assume spending grows at the rate of income
growth. The rate must slow at some point; otherwise the health share rises above one. Our
results are similar if we delay the date of the slowdown to 2050.
 THE VALUE OF LIFE AND HEALTH SPENDING 29

For our baseline case, we choose a value of $3 million, somewhat at the

lower end of the estimates. In robustness checks, we report results based on
the higher values of $4 million and $5 million. It will become clear why we
choose the lower end of the range of estimates and how our results would
change if even higher estimates were used.

7.2. The Quality-of-Life Parameters

Our model emphasizes the tradeoff between consumption and quantity of
life. As a robustness check, we also allow health spending to have a separate
effect on the quality of life.
To calibrate the quality-of-life parameters α and σ—recall the utility func-
tion specified in equation (10)—we draw upon the extensive literature on
quality-adjusted life years (QALYs); see Fryback et al. (1993) and Cutler and
Richardson (1997). This work focuses on the QALY weight, the flow utility
level of a person with a particular disease as a fraction of the flow utility level
of a similar person in perfect health. Surveys ask a range of people, including
medical experts, what probability p of perfect health with probability 1 − p of
certain death would make them indifferent to having a given health condition
or what fraction of a year of future perfect health would make them indifferent
to a year in that condition. Both of these measures correspond to the relative
flow utility in our framework.
Cutler and Richardson (1997) estimate QALY weights by age. With new-
borns normalized to have a weight of unity, they find QALY weights of 0.94,
0.73, and 0.62 for people of ages 20, 65, and 85, in the year 1990. We use
these weights to estimate α and σ based on the following two equations:

u(ct , x20,t ) u(ct , x65,t ) u(ct , x85,t )

= = ,
.94 .73 .62

for t = 1990. Because the value of life itself depends on these parameters,
we simultaneously reestimate the utility intercept b to match the benchmark
30 HALL AND JONES

$3 million value of life. The resulting estimates are α = 2.396, σ = 1.051,

and b = 66.27. With three equations and three unknowns, estimation is a
matter of solving for the values, so there are no standard errors.
In addition to the QALY interpretation, these numbers can be judged in
another way. They imply that a 65 year-old would give up 82 percent of her
consumption, and an 85 year-old would give up 87 percent of her consumption
to have the health status of a 20 year-old. The intuition behind these large
numbers is the sharp diminishing returns to consumption measured by γ. To
explain what may seem to be a small difference in relative utilities of .94
versus .73 requires large differences in consumption. Health is extremely
valuable.

7.3. Summary of Parameter Choices

Table 2 summarizes our choices of parameter values, both for the bench-
mark case and the various robustness checks discussed above.

8. SOLVING THE MODEL

We now solve the model over the years 1950 through 2050 for each of our
nine scenarios. For the historical period 1950–2000, we take resources per
person, y, at its actual value. For the projections into the future, we assume
income continues to grow at its average historical rate of 2.31 percent per
year. The details for the numerical solution of the model are available from
either author’s website.
Figure 5 shows the calculated share of health spending over the period 1950
through 2050 in the first four scenarios, those where γ is allowed to vary from
1.01 to 2.5. A rising health share is a robust feature of the optimal allocation
of resources in the health model, as long as γ is not too small. As suggested in
our simple model—for example, see equation (8)—the curvature of marginal
utility, γ, is a key determinant of the slope of optimal health spending over
 THE VALUE OF LIFE AND HEALTH SPENDING 31

TABLE 2.
Parameter Values for Different Simulation Runs

Baseline Parameter Values

Utility Empirical Quality Fraction of
curvature Value of of life Growth mortality trend Intercept
parameter Statistical parameter rate of from tech. in utility
Scenario γ Life, 2000 α zt and spending (µ) b
1 2 $3 million 0 0 2/3 26.00

Robustness Checks
Scenario Key change from baseline Explanation of change Intercept, b
2 γ = 2.5 Vary utility curvature parameter γ 22.12
3 γ = 1.5 " 30.53
4 γ = 1.01 " 131.87
5 VSL=$4 million Vary empirical value of life 34.35
6 VSL=$5 million " 42.70
7 α = 2.396, σ = 1.051 Allow quality of life effect 66.27
8 gz = .01 Vary production of health 25.96
9 µ = 1/2 " 25.92

Note: The first section of the table shows the values of various key parameters in our baseline
simulation. The remainder of the table shows how parameters are varied one at a time in our
robustness checks. The last column of the table reports the estimated value of the intercept
in the utility function, b, obtained by matching the specified value of life for 35–39 year olds
in the year 2000.
32 HALL AND JONES

FIGURE 5. Simulation Results: The Health Share of Spending

Health Share, s

0.5

γ=2.5
0.4
γ=2

γ=1.5
0.3
γ=1.01

0.2

0.1
Actual

0
1950 2000 2050
Year

Circles “o” show actual data for the health share. Solid lines show the models predictions
under the baseline scenario (γ = 2) and for alternative choices of the utility curvature
parameter. See Table 2 for other parameter values.

time. If marginal utility declines quickly so that γ is high, the optimal health
share rises rapidly. This growth in health spending reflects a value of life that
grows faster than income. In fact, in the simple model, the value of a year of
life is roughly proportional to cγ , illustrating the role of γ in governing the
slope of the optimal health share over time.
For near-log utility (where γ = 1.01), the optimal health share declines.
The reason for this is the declining elasticity of health status with respect to
health spending in our estimated health production technology (recall Fig-
ure 3). In this case, the marginal utility of consumption falls sufficiently
 THE VALUE OF LIFE AND HEALTH SPENDING 33

FIGURE 6. Robustness Checks: The Health Share of Spending

Health Share, s

0.5

Includes Quality
VSL=$5m
0.4 of Life (7)
VSL=$4m (5)

0.3

0.2 Faster technical change (8)

or 50% exogenous (9)

0.1
Actual

0
1950 2000 2050
Year

Circles “o” show actual data for the health share. Solid lines are predictions of the
model under alternative scenarios (the scenario numbers in parentheses correspond to
those reported in Table 2). Scenarios 5 and 6 allow the empirical value of life in 2000 to
be higher, at $4 and $5 million. Scenario 7 allows quality of life terms to enter utility.
Scenario 8 assumes that technical change in the health sector is 1 percentage point faster
than in the rest of the economy. Scenario 9 assumes that 1/2 of the decline in age-
specific mortality (rather than our baseline value of 2/3) is due to technological change
and increased resource allocation.

slowly relative to the diminishing returns in the production of health that the
optimal health share declines gradually over time.9
Figure 6 shows optimal health spending when other baseline parameter
values are changed. The changes considered in this figure essentially change
the level of optimal health spending, while the utility curvature parameter of
the previous figure governs the slope. Allowing for a higher empirical value
9
The careful reader might wonder why all of the optimal health shares intersect in the same
year, around 2010. This is related to the fact that the utility intercept b is chosen to match
a specific level for the value of life for 35–39 year olds and to the fact that our preferences
feature a constant elasticity of marginal utility.
34 HALL AND JONES

of life in the year 2000 or allowing quality of life to enter utility raises optimal
health spending substantially. For example, with a $5 million value of life,
optimal health spending in the year 2000 is 28 percent of GDP, almost double
the observed share.
On the other hand, allowing for more of the decline in trend mortality to
be explained by factors other than rising health resources leads to a lower
optimal health share. For example, allowing technical change in the health
sector to be one percentage point faster than in the rest of the economy or
reducing the share of mortality decline explained by technical change and
resource allocation from 2/3 to 1/2 deliver relatively similar results. In both
of these cases, less of the decline in age-specific mortality is due to health
spending, so the estimates of θa in the production function are smaller. Since
health spending runs into sharper diminishing returns, the overall health share
of spending is lower. These simulations suggest that the observed share in
the year 2000 was close to optimal.
Optimal health shares lie within a fairly large range, reflecting the fairly sub-
stantial uncertainty that exists surrounding the key parameters of the model.
Nevertheless, an interesting result of these simulations is that optimal health
spending is invariably high. This is true for the year 2000 but also out into
the future. For example, by 2050, optimal health spending as a share of GDP
ranges from a low of 23 percent for the case of log utility to a high of 45
percent.
Figure 7 examines the variation in health spending at the micro level in our
baseline scenario. This figure shows actual and simulated health spending
by age, for 1950, 2000, and 2050. A comparison of the results for the year
2000 shows that actual and optimal spending are fairly similar for most ages,
with two exceptions. Optimal health spending on the youngest age group
is substantially higher than actual spending: given the high mortality rate in
this group, the marginal benefit of health spending is very high, as was shown
 THE VALUE OF LIFE AND HEALTH SPENDING 35

FIGURE 7. Health Spending by Age

Constant 2000 dollars

60000
2050
20000

8000 2000

3000

1000 1950

400

0 20 40 60 80 100
Age

Note: Circles denote actual data and solid lines show simulation results for the
baseline scenario; see Table 2 for parameter values.
36 HALL AND JONES

FIGURE 8. Simulation Results: Life Expectancy at Birth

Life Expectancy

82

80

78

76

74

72
Actual
70

68
1950 2000 2050
Year

See notes to Figures 5 and 6. Life expectancy is calculated using the cross-section distri-
bution of mortality rates at each point in time.

earlier. Similarly, while optimal health spending generally rises until age 80,
it declines after that point. It is worth noting in this respect that the underlying
micro data we use for health spending groups all ages above 75 together.
Figure 8 shows actual and projected levels of life expectancy at birth for
all nine of our simulation runs. The first thing to note in the figure is the
overall similarity of the life expectancy numbers. Because there are such
sharp diminishing returns to health spending in our health production func-
tion, relatively large differences in health spending lead to relatively small
differences in life expectancy. A second thing to note is that the projected
path does not grow quite as fast as historical life expectancy. The reason is
again related to the relatively sharp diminishing returns to health spending
that we estimate. If the historical rate of increase of 1.7 years per decade were
 THE VALUE OF LIFE AND HEALTH SPENDING 37

to prevail, life expectancy would reach 85.5 years by 2050; instead it reaches
about 81.5 years in our simulations. If anything, it appears our estimation of
the health production function builds in too much diminishing returns, which
tends to hold down health spending.

9. CONCLUDING REMARKS
A model based on standard economic assumptions yields a strong predic-
tion for the health share. Provided the marginal utility of consumption falls
sufficiently rapidly—as it does for an intertemporal elasticity of substitution
well under one—the optimal health share rises over time. The rising health
share occurs as consumption continues to rise, but consumption grows more
slowly than income. The intuition for this result is that in any given period,
people become saturated in non-health consumption, driving its marginal util-
ity to low levels. As people get richer, the most valuable channel for spending
is to purchase additional years of life. Our numerical results suggest the em-
pirical relevance of this channel: optimal health spending is predicted to rise
to more than 30 percent of GDP by the year 2050 in most of our simulations,
compared to the current level of about 15 percent.
This fundamental mechanism in the model is supported empirically in a
number of different ways. First, as discussed earlier, it is consistent with
conventional estimates of the intertemporal elasticity of substitution. Second,
the mechanism predicts that the value of a statistical life should rise faster
than income. This is a strong prediction of the model, and a place where
careful empirical work in the future may be able to shed light on its validity.
Costa and Kahn (2004) and Hammitt, Liu and Liu (2000) provide support
for this prediction, suggesting that the value of life grows roughly twice as
fast as income, consistent with our baseline choice of γ = 2. Cross-country
evidence also suggests that health spending rises more than one-for-one with
income; this evidence is summarized by Gerdtham and Jonsson (2000).
38 HALL AND JONES

One source of evidence that runs counter to our prediction is the micro
evidence on health spending and income. At the individual level within the
United States, for example, income elasticities appear to be substantially less
than one, as discussed by Newhouse (1992). A serious problem with this
existing evidence, however, is that health insurance limits the choices facing
individuals, potentially explaining the absence of income effects. Our model
makes a strong prediction that if one looks hard enough and carefully enough,
one ought to be able to see income effects in the micro data. Future empirical
work will be needed to judge this prediction. A suggestive informal piece
of evidence is that exercise seems to be a luxury good: among people with
sedentary jobs, high wage people seem to spend more time exercising than
low wage people, despite the higher opportunity cost of their time.
As mentioned in the introduction, the recent health literature has empha-
sized the importance of technological change as an explanation for the rising
health share. In our view, this is a proximate rather than a fundamental ex-
planation. The development of new and expensive medical technologies is
surely part of the process of rising health spending, as the literature suggests;
Jones (2003) provides a model along these lines with exogenous technical
change. However, a more fundamental analysis looks at the reasons that new
technologies are developed. Distortions associated with health insurance in
the United States are probably part of the answer, as suggested by Weisbrod
(1991). But the fact that the health share is rising in virtually every advanced
country in the world—despite wide variation in systems for allocating health
care—suggests that deeper forces are at work. A fully-worked out techno-
logical story will need an analysis on the preference side to explain why it
is useful to invent and use new and expensive medical technologies. The
most obvious explanation is the model we propose in this paper: new and
expensive technologies are valued because of the rising value of life.
 THE VALUE OF LIFE AND HEALTH SPENDING 39

Viewed from every angle, our results support the proposition that both
historical and future increases in the health spending share are desirable. The
magnitude of the future increase depends on parameters whose values are
known with relatively low precision, including the value of life, the curvature
of marginal utility, and the fraction of the decline in age-specific mortality that
is due to technical change and the increased allocation of resources to health
care. Nevertheless, we believe it likely that maximizing social welfare in the
United States will require the development of institutions that are consistent
with spending 30 percent or more of GDP on health by the middle of the
century.

REFERENCES
Arthur, W. B., “The Economics of Risk to Life,” American Economic Review, March
1981, 71 (1), 54–64.
Ashenfelter, Orley, “Measuring the Value of a Statistical Life: Problems and
Prospects,” January 2006. NBER Working Paper 11916.
and Michael Greenstone, “Using Mandated Speed Limits to Measure the Value
of a Statistical Life,” Journal of Political Economy, February 2004, 112 (1),
S226–S267. Part 2.
Barro, Robert J. and Jason R. Barro, “Three Models of Health and Economic Growth,”
September 1996. Harvard University working paper.
Becker, Gary S., Tomas J. Philipson, and Rodrigo R. Soares, “The Quantity and
Quality of Life and the Evolution of World Inequality,” American Economic
Review, March 2005, 95 (1), 277–291.
Card, David, Carlos Dobkin, and Nicole Maestas, “The Impact of Nearly Univer-
sal Insurance coverage on Health Care Utilization and Health: Evidence from
Medicare,” 2004. NBER Working Paper No. 10365.
Chay, Kenneth Y. and Michael Greenstone, “The Impact of Air Pollution on Infant
Mortality: Evidence from Geographic Variation in Pollution Shocks Induced by a
Recession,” Quarterly Journal of Economics, August 2003, 118 (3), 1121–1167.
Chetty, Raj, “A Bound on Risk Aversion Using Labor Supply Elasticities,” American
Economic Review, forthcoming 2006, pp. xxx–xxx.
Costa, Dora L. and Matthew E. Kahn, “Changes in the Value of Life, 1940–1980,”
Journal of Risk and Uncertainty, September 2004, 29 (2), 159–180.
40 HALL AND JONES

Cutler, David, Your Money or Your Life: Strong Medicine for America’s Health Care
System, Oxford University Press, 2004.
Cutler, David M. and Elizabeth Richardson, “Measuring the Health of the U.S. Popula-
tion,” Brookings Papers on Economic Activity, 1997, Microeconomics, 217–282.
and Mark McClellan, “Is Technological Change in Medicine Worth It?,” Health
Affairs, September 2001, 20 (5), 11–29.
, Angus S. Deaton, and Adriana Lleras-Muney, “The Determinants of Mortality,”
Journal of Economic Perspectives, forthcoming 2006, 20, xxx–xxx.
, Mark B. McClellan, Joseph P. Newhouse, and Dahlia Remler, “Are Medical
Prices Declining? Evidence from Heart Attack Treatments,” Quarterly Journal
of Economics, November 1998, 113 (4), 991–1024.
Dow, William H., Tomas J. Philipson, and Xavier Sala-i-Martin, “Longevity Com-
plementarities Under Competing Risks,” American Economic Review, December
1999, 89 (5), 1358–1371.
Ehrlich, Isaac and Hiroyuki Chuma, “A Model of the Demand for Longevity and the
Value of Life Extension,” Journal of Political Economy, August 1990, 98 (4),
761–782.
and Yong Yin, “Explaining Diversities in Age-Specific Life Expectancies and
Values of Life Saving: A Numerical Analysis,” September 2004. NBER Working
Paper 10759.
Finkelstein, Amy and Robin McKnight, “What Did Medicare Do (And Was It Worth
It)?,” May 2005. NBER mimeo.
Fryback, Dennis G. et al., “The Beaver Dam Health Outcomes Study: Initial Catalog
of Health-State Quality Factors,” Medical Decision Making, 1993, 13, 89–102.
Gerdtham, Ulf-G. and Bengt Jonsson, “International Comparisons of Health Ex-
penditure: Theory, Data and Econometric Analysis,” in Anthony J. Culyer and
Joseph P. Newhouse, eds., Handbook of Health Economics, North Holland, 2000.
Goldman, L. and E.F. Cook, “The decline in ischemic heart disease mortality rates:
An analysis of the comparative effects of medical interventions and changes in
lifestyle,” Annals of Internal Medicine, December 1984, 101 (6), 825–836.
Grossman, Michael, “On the Concept of Health Capital and the Demand for Health,”
Journal of Political Economy, March/April 1972, 80 (2), 223–255.
, “Education and Nonmarket Outcomes,” in Eric Hanushek and Finis Welch, eds.,
Handbook on the Economics of Education, Amsterdam: North-Holland, 2005.
forthcoming.
Hall, Robert E., “Intertemporal Substitution in Consumption,” Journal of Political
Economy, April 1988, 96 (2), 339–357.
 THE VALUE OF LIFE AND HEALTH SPENDING 41

and Charles I. Jones, “The Value of Life and the Rise in Health Spending,”
September 2004. NBER Working Paper 10737.
Hammitt, James K., Jin-Tan Liu, and Jin-Long Liu, “Survival is a Luxury Good: The
Increasing Value of a Statistical Life,” July 2000. Harvard University mimeo.
Heidenreich, Paul A. and Mark McClellan, “Trends in Treatment and Outcomes
for Acute Myocardial Infarction: 1975-1995,” American Journal of Medicine,
February 15 2001, 110 (3), 165–174.
Jones, Charles I., “Why Have Health Expenditures as a Share of GDP Risen So
Much?,” July 2003. U.C. Berkeley mimeo.
Lucas, Deborah, “Asset Pricing with Undiversifiable Risk and Short Sales Constraints:
Deepening the Equity Premium Puzzle,” Journal of Monetary Economics, 1994,
34 (3), 325–342.
McClellan, Mark, Barbara J. McNeil, and Joseph P. Newhouse, “Does more intensive
treatment of acute myocardial infarction in the elderly reduce mortality? Analy-
sis using instrumental variables,” Journal of the American Medical Association,
September 1994, 272 (11), 859–866.
Meara, Ellen, Chapin White, and David M. Cutler, “Trends in Medical Spending by
Age, 1963–2000,” Health Affairs, July/August 2004, 23 (4), 176–183.
Murphy, Kevin M. and Robert Topel, “The Economic Value of Medical Research.” In
Measuring the Gains from Medical Research: An Economic Approach (Murphy
and Topel, eds 2003).
and , “The Value of Health and Longevity,” June 2005. NBER Working Paper
11405.
and , eds, Measuring the Gains from Medical Research: An Economic Ap-
proach, Chicago: University of Chicago Press, 2003.
Newhouse, Joseph P., “Medical Care Costs: How Much Welfare Loss?,” Journal of
Economic Perspectives, Summer 1992, 6 (3), 3–21.
, Free for All? Lessons from the RAND Health Insurance Experiment, Cambridge,
M.A.: Harvard University Press, 1993.
and Lindy J. Friedlander, “The Relationship between Medical Resources and
Measures of Health: Some Additional Evidence,” Journal of Human Resources,
Spring 1980, 15 (2), 200–218.
Nordhaus, William D., “The Health of Nations: The Contribution of Improved Health
to Living Standards.” In Murphy and Topel, eds (2003) pp. 9–40.
Rosen, Sherwin, “The Value of Changes in Life Expectancy,” Journal of Risk and
Uncertainty, 1988, 1, 285–304.
42 HALL AND JONES

Schelling, Thomas C., “The Life You Save May Be Your Own,” in Jr. Samuel B. Chase,
ed., Problems in Public Expenditure Analysis, Washington D.C.: Brookings In-
stitution, 1968, pp. 127–161.
Shepard, Donald S. and Richard J. Zeckhauser, “Survival versus Consumption,”
Management Science, 1984, 30, 423–439.
Skinner, Jonathan, Elliott Fisher, and John E. Wennberg, “The Efficiency of Medi-
care,” July 2001. NBER Working Paper 8395.
Usher, Daniel, “An Imputation to the Measure of Economic Growth for Changes in
Life Expectancy,” in M. Moss, ed., The Measurement of Economic and Social
Performance, New York: National Bureau of Economic Research, 1973.
Viscusi, W. Kip and Joseph E. Aldy, “The Value of a Statistical Life: A Critical Review
of Market Estimates throughout the World,” Journal of Risk and Uncertainty,
2003, 27, 5–76.
Weisbrod, Burton A., “The Health Care Quadrilemma: An Essay on Technological
Change, Insurance, Quality of Care, and Cost Containment,” Journal of Economic
Literature, June 1991, 29, 523–552.
Wennberg, John E., Elliott S. Fisher, and Jonathan S. Skinner, “Geography and the
Debate over Medicare Reform,” Health Affairs, February 13 2002, pp. W96–
W114.