HEALTH CARE ECONOMICS

UNIT-1

Definitions of Economics
 The study of how men and society end up choosing to employ scarce resources that
could have alternative uses” (Samuelson)
 Economics is the study of how people allocate their limited resources in an attempt to
satisfy their unlimited wants.
 As such, economic is the study of how people make choices.
 It is also the study of scarcity and choice, finally helps how to use scarce or limited
resource.

What is health economics?

Health economics is an applied field of study that examines and finds systems-based
solutions to make health care more equitable, accessible, and affordable for all. Health
economists seek to understand the role that a broad range of stakeholders (such as health care
providers, patients, insurance companies, government agencies, corporations, and public
organizations) play in health care spending.

Health economists are curious about what affects health outcomes. In their research,
they’ll ask questions like

 How do we put a value on health?

 What factors influence health, besides health care?

 What influences the supply and demand for health care?

 Behaviors of health care providers vs. those seeking care

 What are some alternative approaches to health care production and delivery?

 How can we improve the ways in which we plan, budget, and monitor health care?

Taking the concept of payment reform as an example, doctors can be compensated in

different ways than traditionally existed. In recent years, value-based care models such as
episode-based payment, fee-for-service, and population-based payment models are
contributing to more equitable health care. Payment reform affects health care providers,
insurance companies, and patients.

Importance of Health Care Economics

Health economics is important because it focuses on how the economic behavior of

stakeholders and recipients affects the quality and cost of medical care.

1. It includes how people pay for care,

2. how those payments are processed, and
3. How health systems around the world can be restructured and improved.
4. Tackling any systemic issue at the root cause can alleviate the same problems from
arising again.

In examining the questions listed above,

 health economists address global issues such as migration and displacement,

 climate change,
 pandemics and vaccine access,
 disorders,
 Obesity, and more.

They apply economic theories to inform both the public and private sectors on cost-effective
solutions to improve equity in health care.

For example, a health economist might research disparities in the quality of health and
income in West Africa by evaluating the average cost of health care and insurance in the
region. Potential solutions include employing digital technologies to provide health care
directly through a mobile phone or laptop.

Who should study health economics?

Understanding how economic behavior factors into health and health care decisions can be
beneficial for anyone interested in this field. However, the following groups of individuals
may benefit most from the study health economics:

 Medical providers: Doctors, nurses, and assistants can evaluate new treatments,
technologies, and services to determine ways to deliver value-based care. Medical
providers benefit from understanding the economics behind these developments.

 Administrators: Health care administrators process insurance co-payments and

manage financial metrics for health care providers. Learning the complexities of
 health care economics can provide the necessary context as they liaise with insurance
providers and use new technologies to process payments.

 Policymakers or public health officials: Those who are in charge of policy decisions
at the local, state, federal, or international levels benefit from understanding the
economic relationship between stakeholders and the general public.

 Business leaders: Because many Americans receive private insurance, health care
becomes a major expense for employers. Business leaders must understand the health
economics outlook to appease their employees, shareholders, and even their
customers.

The Demand for Health Care:

Response to Price

The law of demand applies to health care as in other markets: as the price of health care
increases, you demand less of it. But we must be careful. What matters is the price of health
care to you. If you have health insurance, this price may be much lower than the actual cost of
providing you with care.

Health as Investment

Everyone prefers being healthy to being sick. The demand for health care is in part an
expression of this preference. One thing that makes health care different from most other
goods and services, though, is that it is simultaneously an investment. Money you spend on
being healthy today will also benefit you in the future. There are several different ways in
which spending on health care represents an investment.

Productivity. Being healthy also means that you can work and earn wages. One of the costs
of poor health is lost days at work. This is a cost not only to the individual but also to society
as a whole: the economy’s population is producing less output. If you are in poor health, then
you risk losing wages for the days when you cannot come to work. Many employers provide
insurance for these lost wages through the provision of sick days: if you are sick, you are not
expected to work but you will still be compensated up to a contracted number of days per
year.

Information Problems

Health care is an example of a good for which the typical individual is unable to determine
the quality of what is being purchased. You can think of other examples, such as legal
services and used cars. In such situations, how can we make good decisions? Generally we do
so by relying on the advice of experts. In the case of health, these are the doctors, dentists,
and other health professionals who are trained to analyze our health situation and make
suggestions to us. We listen, try to understand, and, using their advice, make an informed
choice.

The Supply of Health Care

We now turn to the supply side of health care. Economists often talk of output being
produced using a production function that uses labor, capital, and intermediate inputs. What
is the production function of a hospital?

 The labor in a hospital includes doctors, surgeons, orderlies, technicians, nurses,

administrative staff, janitors, and many others.

 The hospital buildings are part of the hospital’s capital stock. In addition, hospitals
contain an immense quantity of other capital goods, such as hospital beds and
diagnostic tools—everything from stethoscopes to x-ray machines.

 Intermediate inputs in a hospital include dressings for wounds, and pharmaceutical

products, such as anesthetics used for operations.

Other sectors of the health-care industry likewise employ labor, capital, and intermediate
inputs.
Price Determination

If this chapter were like most others in this book, we would now turn to a discussion of how
supply and demand interact in a competitive market to determine the price. Or, recognizing
that firms with market power set prices, we might use the condition that marginal revenue
equals marginal cost to talk about price determination. Unfortunately, when it comes to
understanding the market for health care, these tools are not as useful.

Branches of economics

Macroeconomics versus microeconomics

A major distinction is made between macroeconomics, which studies the functioning of the
economy as a whole, and microeconomics, which analyses the behavior of individual
components like industries, firms and households.

1.Macroeconomics: The study of the behavior of the entire economy and concerned with the
behavior of the economy as a whole or with the broad aggregate of economic life such as
national output, income, the overall price level, unemployment, and foreign trade. It
examines such historical issues as why did production and prices in some countries and the
rest of the industrial world collapse during the great depression of the 1930s.

In addition to helping people in their personal lives, economics is required to understand key
national issues and to make progress in dealing with them.

Economics plays two distinct roles in promoting the understanding of national economic
issues. First it helps to describe, explain and predict economic behavior-as for example when
it helps us understand the causes of poverty. But for many people the pay-off from such
economic knowledge comes when it is applied to a second task, that of improving economic
performances. This distinction between description and prescription is central to modern
economics.

2. Microeconomics: Deals with the behavior of individual prices and quantities (Issues
at individual level). Our knowledge of economics helps us to manage our personal lives, to
understand society and to design better economic policies. The role of better economic
understanding in guiding our individual lives will be as varied as are our personalities or
physiognomies. Learning about the stock market or about interest rates may help people
manage their own finances better; knowledge about price theory and antitrust policy may
improve the skills of lawyer; better awareness of the determinants of cost and revenue will
produce better business decisions. The doctor, the investor and the farmer all need to
understand about accounting and regulation to make the highest profits from their businesses.

Normative versus positive economics (Fact or opinion?)

When using economics we must be careful to distinguish between normative statements (or
value judgments) and positive (or factual) statements. In the world today, yet health care
seems to be in almost permanent crisis – there are shortages of hospital beds and patients are
left to lie in corridors, while politicians argue endlessly over whether more or less is being
spent on the National Health System (NHS). Why is it that health care is such a controversial
area? Why is there never enough money to give us the level of health care we want? To
answer these questions we need to introduce and apply a range of economic concepts. How
can we resolve the kind of dilemmas expressed in these Headlines?

A statement such as “Specialist in heart-lung transplants resigns from the national health
system in protest at lack of funding” is a positive statement: it can be shown to be true or
false and is not dependent upon the value system of the observer. In contrast, “Health care is
a basic right and should be provided free” is a normative statement. It cannot be proved true
or false: our view of it depends on our value system. One of the things which make the debate
over the provision of health care difficult to resolve is that positive and normative issues are
very much intertwined. Sorting out fact from opinion is a first step, but it does not explain
why there are not enough beds in hospitals or why people might be refused treatment.
Economists believe that it is important to distinguish questions of fact from value judgments
and opinions.

1. Positive economics: describes the facts and behavior in the economy. What
percentages of teenagers are unemployed? How many people earn less that Birr 6,000 a
year? What will be the effect of higher cigarette taxes on the number of smokers? These are
questions that can be resolved only by reference to facts; they are all the realm of positive
economics.
2. Normative economics: involves ethics and value judgments. Should the government
give money to poor people? Should the public sectors (government) or the private sector
(business) provide extra jobs for unemployed teenagers? Should higher taxes or lower
spending reduce the budget deficit? These are questions involving deeply held values or
moral judgments. They can be argued about, but they can never be settled by science or by
appeal to facts. There simply is no right or wrong answer to how high inflation should be,
whether society should help poor people or how much the nation should spend on defense.
These questions are best resolved by political decision, not by economic science.

Basic concepts of supply and demand analysis

Definition of Demand: Need + ability and willingness to pay for a commodity

- The schedule of amounts of any product that buyers will purchase at different prices
during some stated time period

- Desire refers to people’s willingness to own a good.

- Demand is the amount of a good that consumers are willing and able to buy at a given
price.

2. Definition Supply: the amounts of a good producer are willing and able to sell at a
given price.

Principal-agent theory

Principal-agent theory is a fundamental concept in economics that is often applied to the field
of health economics to understand the relationships and incentives between different
stakeholders in the healthcare system. This theory helps us analyze how individuals or
entities (the principal) can delegate tasks and responsibilities to another party (the agent) and
how to align their interests to achieve desired outcomes. Below are some lecture notes on the
principal-agent theory in health economics: Principal-Agent Theory in Health Economics

I. Introduction to Principal-Agent Theory

A. Definition: Principal-agent theory is a framework used to analyze situations where one
party (the principal) delegates decision-making authority to another party (the agent) to
pursue the principal's interests.

B. Application in Health Economics: In healthcare, principal-agent relationships are

common, such as patients delegating their healthcare decisions to physicians or insurance
companies contracting with healthcare providers.

II. Key Concepts

A. Information Asymmetry: One of the central issues in principal-agent theory is the

presence of information asymmetry, where the agent has more information than the principal.
In healthcare, this often occurs when physicians possess more medical knowledge than
patients.

B. Moral Hazard: Moral hazard arises when the agent's actions are not perfectly observable,
and they may take actions that benefit themselves at the expense of the principal. For
example, doctors might order unnecessary tests or procedures if they are paid on a fee-for-
service basis.

C. Adverse Selection: Adverse selection occurs when the principal cannot fully observe the
agent's characteristics before entering into a contract. In health insurance, this can happen
when individuals with high health risks are more likely to purchase insurance.

III. Applications in Healthcare

A. Patient-Physician Relationship: The patient (principal) delegates’ decision-making

authority to the physician (agent) based on trust and expertise. The challenge is ensuring that
the physician acts in the patient's best interest.
B. Health Insurance: Health insurance companies (principals) contract with healthcare
providers (agents) to deliver care. To align their interests, insurance companies may use
various mechanisms such as capitation or pay-for-performance.

C. Government Regulation: Governments often act as principals, regulating healthcare

providers to ensure quality and access to care. This involves setting rules, standards, and
reimbursement rates to influence agent behavior.

IV. Solutions to Principal-Agent Problems in Healthcare

A. Incentive Alignment: Developing contracts and payment mechanisms that align the
interests of principals and agents. For example, pay-for-performance incentives can
encourage physicians to provide high-quality care.

B. Monitoring and Information: Increasing transparency and monitoring of agent behavior

can mitigate moral hazard. In healthcare, this can involve audits, performance reviews, and
public reporting of healthcare quality.

C. Regulation: Government regulations and oversight can help address principal-agent

problems by setting standards, enforcing transparency, and penalizing misconduct.

V. Conclusion

Principal-agent theory is a valuable framework for understanding the dynamics of decision-

making and incentives in healthcare systems. It helps us analyze the challenges of
information asymmetry, moral hazard, and adverse selection and provides insights into
designing effective healthcare policies and contracts that align the interests of all
stakeholders.
For many people the word market conjures up a picture of a town square with lots of small
stall holders selling everything from fruit and vegetables to meat and fish. For economists,
the term has a much wider meaning. It is used to describe any process of exchange between
buyers and sellers. Formally, a market can be defined as any set of arrangements which
allows buyers and sellers to communicate and thus arrange exchange of goods, services or
resources. A free market is where such exchange occurs without interference from the
government. Information is a vital ingredient for any market. Both buyers and sellers need to
have access to sufficient information to allow them to make rational decisions.

Moral Hazard in Healthcare:

Moral hazard is a term commonly used in economics and insurance to describe a situation in
which one party can take risks because it does not have to bear the full consequences of those
risks. In the context of healthcare, moral hazard refers to the idea that individuals may
consume more healthcare services or take greater health risks when they are insured, leading
to increased healthcare costs.

Here are some key points related to moral hazard in healthcare:

Insurance Impact: When individuals have health insurance that covers a significant portion
of their medical expenses, they may be more likely to seek medical care even for minor
ailments or engage in riskier behaviors because they are insulated from the full financial
consequences. This can drive up healthcare costs.

Overutilization: Moral hazard can lead to overutilization of healthcare services, including

unnecessary tests, procedures, and doctor visits, which can strain healthcare resources and
increase overall costs.

Balancing Act: Health insurers and policymakers must strike a balance between providing
access to necessary care and managing moral hazard to control costs. This often involves
cost-sharing mechanisms like copayments, deductibles, and coinsurance.
Preventive Care: Encouraging preventive care and wellness initiatives can help reduce
moral hazard by focusing on keeping individuals healthy and preventing the need for costly
treatments.

Care in Healthcare:

Care in healthcare refers to the quality and level of medical attention and services provided to
patients. It encompasses not only the medical treatment itself but also the interpersonal
aspects of healthcare delivery, such as communication, empathy, and patient-centeredness.

Here are some key points related to care in healthcare:

Quality of Care: Quality of care is a critical factor in healthcare delivery. It includes factors
such as the accuracy of diagnoses, effectiveness of treatments, and patient outcomes. High-
quality care is essential to achieving positive health outcomes.

Patient-Centered Care: Healthcare providers should prioritize patient-centered care, which

means considering the individual preferences, values, and needs of each patient. Effective
communication and shared decision-making are crucial elements of patient-centered care.

Empathy and Compassion: Healthcare providers should show empathy and compassion
towards their patients. This not only improves the patient experience but can also lead to
better compliance with treatment plans and improved outcomes.

Continuity of Care: Continuity of care refers to the coordination and consistency of

healthcare services over time. Ensuring that patients receive consistent and coordinated care
can lead to better health outcomes.
Cultural Competence: Healthcare providers should be culturally competent, meaning they
are sensitive to the cultural backgrounds and beliefs of their patients. Cultural competence
can help bridge communication gaps and improve the quality of care.

In summary, understanding moral hazard helps in managing the financial aspects of

healthcare, while focusing on care in healthcare ensures that patients receive high-quality,
patient-centered, and compassionate medical services. Balancing these two aspects is
essential for effective and sustainable healthcare delivery.

In the context of healthcare, the concept of "care" as a market externality is a complex and
multifaceted issue. Market externalities refer to the unintended consequences of economic
activities that affect third parties who are not directly involved in the transaction. In
healthcare, the provision of care and its impact on individuals and society at large can be
considered a market externality in several ways. Below are some key points that might be
discussed in lecture notes on this topic:

Positive Externalities of Care:

When individuals receive adequate healthcare and care, they tend to become healthier, which
can have positive spillover effects on society. For example, healthier individuals are more
productive, leading to increased economic output and tax revenue.

Improved population health can reduce the overall burden on the healthcare system, including
lower healthcare costs in the long term.

Negative Externalities of Insufficient Care:

Conversely, when individuals do not receive appropriate care, it can lead to negative
externalities. For example, untreated infectious diseases can spread within the community,
affecting others.

Lack of preventive care and early intervention can result in more severe health problems
down the line, increasing the overall cost of healthcare.
Information Asymmetry and Market Failures:

Information asymmetry is a significant issue in healthcare, where providers often possess

more knowledge than patients. This can lead to market failures as patients may not be able to
make fully informed decisions.

When patients do not have access to accurate information about their healthcare choices, they
may not seek care when needed or may make suboptimal decisions.

Healthcare as a Merit Good:

Healthcare is often considered a merit good, meaning that it has positive externalities that
may not be fully captured by the market. As a result, governments often intervene in
healthcare markets to ensure that care is accessible to all, regardless of their ability to pay.

Role of Health Insurance:

Health insurance can be seen as a mechanism to address care as a market externality. By

pooling risk and providing access to care, insurance helps mitigate the negative externalities
associated with individuals not seeking care due to cost concerns.

Public Health Initiatives:

Governments and public health agencies often implement initiatives aimed at improving the
overall health of the population. These initiatives can include vaccination campaigns, health
education, and disease prevention programs.

Ethical Considerations:
Discussions on care as a market externality often touch on ethical considerations. Is access to
care a basic human right, or is it a commodity to be bought and sold in the market?

The Role of Market Regulation:

Governments may implement regulations to address market failures in healthcare. These

regulations can take the form of price controls, quality standards, and mandates for certain
types of care.

Healthcare Financing Models:

Lecture notes might also explore different healthcare financing models, such as single-payer
systems, private insurance markets, and hybrid systems, and how they address or fail to
address care as a market externality.

In summary, the concept of care as a market externality in healthcare lectures involves

examining the broader societal implications of healthcare decisions and how they impact
individuals and the community. It often leads to discussions about the role of government,
ethics, and market regulations in ensuring that care is accessible and of high quality for all
members of society.

Caring externalities

Caring externalities refer to the positive spillover effects that occur when one individual's
healthcare choices and behaviors benefit others in society. These externalities highlight the
interconnectedness of healthcare and emphasize that individual health decisions can have
broader impacts on the well-being of the community.

Here are some key points to consider:

Vaccination Programs: One of the most well-known examples of caring externalities is

vaccination. When a significant portion of the population is vaccinated against contagious
diseases, it not only protects those individuals from illness but also creates herd immunity.
This indirectly benefits those who cannot be vaccinated, such as people with certain medical
conditions or allergies, by reducing the spread of the disease in the community.

Healthy Lifestyle Choices: When individuals make healthy lifestyle choices, such as
maintaining a balanced diet, exercising regularly, and avoiding tobacco and excessive alcohol
consumption, it not only improves their own health but also reduces the burden on the
healthcare system. This, in turn, can lead to lower healthcare costs for everyone.

Preventive Care: Seeking preventive healthcare, such as regular check-ups and screenings,
can detect and address health issues early on, preventing the development of more severe and
costly conditions. When individuals engage in preventive care, it can help reduce healthcare
costs for the entire population and improve overall public health.

Reducing the Spread of Infectious Diseases: Practicing good hygiene, like frequent
handwashing, wearing masks during contagious outbreaks, and following public health
guidelines, helps limit the spread of infectious diseases. This benefits not only the individual
but also the broader community by reducing the risk of outbreaks.

Health Education and Promotion: Public health campaigns and educational programs can
raise awareness about health issues and encourage positive behaviors. When individuals are
better informed about health risks and the benefits of healthy choices, they are more likely to
make decisions that positively impact their health and that of their community.

Access to Healthcare Services: Ensuring that everyone has access to healthcare services,
regardless of their income or socioeconomic status, is another way to address caring
externalities. When vulnerable populations have access to healthcare, it can prevent the
spread of diseases and improve overall community health.

Environmental Factors: Environmental policies and regulations can also play a role in
caring externalities. Efforts to reduce pollution and promote clean air and water can have
significant positive effects on public health by reducing the incidence of respiratory and
cardiovascular diseases.

In summary, caring externalities in healthcare underscore the importance of recognizing that

individual health choices and behaviors can have far-reaching effects on the health and well-
being of the entire community. Policies and interventions that promote healthy behaviors,
access to healthcare, and disease prevention can help maximize the positive externalities
associated with healthcare decisions.

The Socially Embedded Individual:

The Socially Embedded Individual: This concept recognizes that individuals are not isolated
entities but are embedded within social, cultural, and economic contexts. In healthcare
economics, understanding the socially embedded individual is crucial because health and
healthcare decisions are often influenced by social factors, including family, community, and
cultural norms.

Social Determinants of Health: The socially embedded individual concept highlights the
impact of social determinants of health. These are conditions in the environments where
people are born, live, learn, work, play, and age that affect a wide range of health,
functioning, and quality-of-life outcomes and risks. Examples include income, education,
employment, and access to healthcare services.

Ethical Considerations: In healthcare economics, the socially embedded individual raises

ethical questions about how healthcare resources should be allocated. Should resources be
distributed solely based on individual health needs, or should social factors also be
considered? Ethical frameworks like utilitarianism, egalitarianism, and communitarianism
play a role in these discussions.

Equity in Healthcare: Achieving equity in healthcare involves addressing disparities caused

by social determinants of health. This requires designing healthcare policies and systems that
consider the needs of socially disadvantaged groups, aiming to reduce health inequalities.

Patient-Centered Care: The concept of patient-centered care emphasizes tailoring

healthcare services to meet the unique needs and preferences of each patient. Understanding
the socially embedded individual is essential for delivering care that respects cultural beliefs
and social contexts.
Cultural Competence: Healthcare providers must be culturally competent to effectively care
for socially embedded individuals. Cultural competence involves understanding and
respecting the cultural backgrounds and values of patients to provide more personalized care.

Health Economics: In healthcare economics, the concept of the socially embedded

individual may be applied to modeling healthcare utilization, insurance decisions, and health
outcomes. It helps researchers and policymakers better understand why certain populations
may have different healthcare behaviors and outcomes.

Policy Implications: Policymakers often need to consider the social context when designing
healthcare policies. For instance, policies aimed at improving access to healthcare may need
to address transportation barriers, language differences, or income disparities that affect
healthcare access.

Community Health Initiatives: Recognizing the socially embedded individual also supports
the development of community health initiatives. These programs often aim to improve
population health by addressing the social determinants of health within specific
communities.

Health Economics Research: Researchers may use the concept of the socially embedded
individual to conduct studies on healthcare utilization patterns, disparities in healthcare
access, and the impact of social policies on health outcomes.

In summary, the concept of care and the socially embedded individual in healthcare
economics underscores the importance of considering social factors, cultural contexts, and
ethical considerations when analyzing and making decisions related to healthcare delivery,
policy, and economics. It emphasizes the interconnectedness of individuals within their
broader social environments and the need for healthcare systems to account for these
complexities.

Alternative Economic Models:

Neo-classical economics vs. behavioral economics in the context of healthcare.

How behavioral economics concepts (such as bounded rationality and prospect theory) apply
to health economics.

Demand for Healthcare:

Theory of demand for healthcare services.

Factors influencing healthcare demand (e.g., price, income, health insurance).

The concept of price elasticity of demand in healthcare.

Supply of Healthcare:

The role of healthcare providers (hospitals, physicians, clinics).

The market structure of healthcare.

Provider behavior, including supplier-induced demand.

Needs and demand

An important distinction between Need and Demand

Need

 Someone's subjective idea (may be based on a formula applied objectively, but the
choice to use the formula was someone's subjective idea).
 Money is not a factor. Objectively observable as behavior in the market.
 Money is a key factor. "Demand" is also called "effective demand," because it's
expressed only by spending money.

The Demand curve

The relationship between price and quantity demanded allows us to define demand formally
as the quantity of a good or service that buyers are willing and able to buy at every
conceivable price. The demand curve (see Figure1.1.below) shows this relationship
graphically. DD shows the quantity of Bone setting treatments that consumers are prepared to
buy at every conceivable price. A change in price leads to a movement along the demand
curve. When the price is P consumers will buy Q. If the price falls to P' then the quantity
demanded will rise to Q'. A change in price has led to a movement along the demand curve. It
is commonly observed that the quantity of a commodity that people will buy at any one time
depends on its price. The higher the price charged for an article, the less of it people will be
willing to buy; and

Market Equilibrium

Definition of Equilibrium: the situation when quantity supplied equals quantity demanded
at a particular price.

 The supply and demand forces in the market place will produce an equilibrium price
and equilibrium quantity, or market equilibrium.
 The market-equilibrium comes at that price and quantity where the supply and
demand forces are in balance.
 At such a price and quantity the amount that buyers wish to buy is just equal to the
amount that sellers wish to sell.
 At the equilibrium price and quantity tend to stay the same, as long as other things
remain equal, until there is only one price at which the quantity of treatments people
want to buy is the same as the quantity the services want to sell. This is called the
equilibrium price Pe. The corresponding quantity is the equilibrium quantity - Qe. The
equilibrium is a state of rest where there is no pressure for change. At any other price
either buyers or sellers are dissatisfied and act to change the quantity demanded or
supplied.