MLS 2409 HEALTH ECONOMICS

1. CONCEPT OF HEALTH ECONOMICS

1.1. Health economics;
“Health economics” is the study of how scarce resources are allocated among alternative uses
for the treatment of sick people and the promotion, maintenance and improvement of health
standards in the economy, including the study of how healthcare and health-related services,
their costs and benefits, and health itself are distributed among the various segments of a
society.
It can, broadly, be defined as ‘the application of the theories, concepts and techniques of
economics to the health sector’.
It is, thus, concerned with such matters as the allocation of resources between various health
promoting activities, the quantity of resources used in health services delivery; the organization
and funding of health service institutions, the efficiency with which resources are allocated
and used for health purposes, and the effects of preventive, curative and rehabilitative health
services on individuals and society.
Thus, health economics is the application of the principles of economics to the healthcare
sector.
Since health economics is concerned with issues related to the allocation of scarce resources to
improve health, this includes both resource allocation within the economy to the health sector
and within the health care system to different activities and individuals.
Generally, the need for health care is increasing due to rapid population growth and changes in
disease pattern. In relation to this, health care costs are expected to be rapidly increasing.
Apart from explosion of costs, inequity, misallocation and inefficiency are believed to be
serious challenges to the health care system. These problems put a considerable strain on our
limited health care resources.
Health economics examines the problem of scarcity as it arises with respect to health and
healthcare.
It examines how we as individuals and societies confront the fact that while the resources
available to us are limited, the alternative uses for these resources are unlimited. Thus, health
economists are interested in some very important questions:
 How is health produced?
 What role does healthcare play in its production?
 What is the value of health?
 How do we go about measuring health status?
 What influences demand for health and healthcare?
 What influences the supply of healthcare?
 How can equilibrium between demand and supply be achieved?
NB: The principles of health economics consider supply and demand issues and how the two
might interact given that the standard market solution generally fails due to problems such as:
1. Adverse selection,
2. Moral hazard,
3. Asymmetric information
1. Adverse selections – probability of riskiness
A situation often resulting from asymmetric information in which individuals are able to
purchase insurance at the rates that are below actuarially fair rates plus loading (filling) costs.
An event in healthcare whereby one party decides not to reveal the full extent of their risk
profile to the other party (i.e. insurance model).
2. Moral hazard – the change of behaviour pattern by the insured
It arises where the attitudes and behaviour of a person or organization change once they are
covered for potential costs or losses (e.g. healthcare consumption may be higher when insured).
The possibility of consumers or providers exploiting a benefit system unduly to the
disadvantages of other consumers, providers or the financing community as a whole.
An insurance term that represents the disincentives created by insurance for individual to take
measures that would reduce the amount of care demanded.
In the health services literature, it is more commonly used to express the additional quantity of
health care demanded, resulting from a decrease in the net price of care attributable to
insurance.
3. Asymmetric information – doctors acts as agents of the patients demand
Situations in which the parties on the opposite sides of transaction have differing amounts of
relevant information.
Doctors have more knowledge and information about medicine than patients/consumers, the
individual may not be the best judge of his/her own interests, the doctor acts as an agent of the
patients demand.

1.2. General features of the health Care

The difference between health and ‘healthcare’.
The term health refers to a state either of an individual or of a community. A number of factors
including ‘healthcare’ may influence this state of health.
However, other factors that affect health are poverty, level of education, food intake, access to
clean water and sanitary and housing conditions.
The narrowest concept of health sees it as a measure of the state of the physical body organs.
An individual is unhealthy if there is a malfunctioning of part of the body. A broader, but
related, definition sees health just in terms of the mechanics of the different bodily organs, but
in the ability of the body as a whole to function.
In contrast, the WHO definition of health as “a state of physical, mental and social well-being
and not merely the absence of disease or infirmity (illness)” indicates a clear shift away from
earlier narrow organic or functionally-based definitions of health to a more holistic view, it
sees the health of an individual or community as being concerned not only with physical (and
mental) status, but also with social and economic relationships.
 1.2.1 Perspectives of Health
a) Health as a right;
Health is viewed by some as a right analogous (equivalent) to justice or political freedom.
Indeed, the WHO constitution states that ‘… the enjoyment of the highest attainable standard
of health is one of the fundamental rights of every human being without distinction of race,
religion, political belief, economic or social condition’. Although it is difficult to believe that
equal health status is attainable in the same way that equal political freedom may be, health is
seen as so fundamental that constraints to its full attainment must be minimized. In part, this
involves ensuring access to health care. The government is seen as having a responsibility to
ensure this, comparable with its role in ensuring equal justice. According to such a view, a
government will be particularly concerned with issues of equity in health and healthcare.
b) Health as consumption good; - health is compared to the quality of food
For others, health is seen as an important individual objective that is not comparable with
justice, but rather with material aspects of life. Such a view often refers to health as
consumption good. The government here has no special responsibilities in the promotion of
health, but leaves decisions as to its comparative importance to individual consumers. The role
of the state under such a view might be limited to ensuring that the healthcare provided is of
an adequate quality (such as ensuring professional standards in the same way that it would
monitor the quality of any good or service, such as food).
c) Health as an investment; -effects of health in production
A third view of health is that it is important, but largely it affects the productive ability of the
workforce. Illness may affect overall production, either through absenteeism or by lowering
productivity through its debilitating (unbearable or incapacitating) effects.

1.3. Distinctive characteristics of the healthcare services from other commodities

Case against a free market:
 Market failure
 Problems of Risk and uncertainty
 Unequal information – Doctors as agents of patients
 Consumers as satisfaction maximisers
 Imperfect competition
 Externalities
 Equity and healthcare
Why not leave health care to the market? Most people believe that you cannot buy and sell
healthcare like other goods and services. They believe that healthcare is different. This is what
is sometimes called a “common-sense” approach to the issue
Economists approach the same question rather differently. They analyze the question of
healthcare and markets from a theoretical perspective. The main theory they use is called
market failure.
1.3.1 Market failure

1. Definition of Market,

Market can be defined in any of the following ways:

 It is used to describe any process of exchange between buyers and sellers.
 It is also defined as a set of arrangements that 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.
In theory, markets produce the goods and services we want in the right quantities and at the
lowest possible cost. This is why markets are so powerful. Nevertheless, in the real world
markets do not always work in the way theory predicts. It is possible for a free market to
produce a Pareto inefficient result - i.e. the market fails.
2. An information system
A market is an information system. We get the right goods at the lowest possible cost since the
market is able to transmit all the information about benefits and costs between producers and
consumers. If this information is less than perfect, then the market will fail.
Think about buying a CD. You know what a CD is, and you will have a good idea of the kind
of music on the disc. Therefore, you are able to relate your benefit to the price of the CD. If we
look at the market for CDs, people will go on buying CDs until the extra satisfaction from the
last CD is exactly equivalent to the price of the CD. We have reached the situation where we
as a society are consuming the ‘right’ quantity of CDs in the sense that we are gaining the
maximum possible satisfaction from CDs given their price.
However, health care is rather different from CDs. We face very acute information problems,
which make rational purchasing decisions difficult if not impossible. For instance, most people
do not know the best way to treat a stomach ulcer so they would find it difficult to buy such
treatment. This analysis also assumes that the only people receiving benefit or satisfaction from
the CDs are the people buying them. In other words, the price of a CD accurately conveys the
level of satisfaction received.
This ignores the possibility of externalities or ‘spillovers’. Think about someone hearing your
CD and enjoying it - they are also receiving satisfaction from the disc, but the market is unable
to provide any information about the benefits they are receiving unless they specifically share
the cost of buying the CD. Whenever externalities occur, the market fails. Many economists
believe that there are strong externality effects related to healthcare. For example caring for a
sick person can impose financial costs on that person’s family. Finally, the medical profession
often does little to inform the consumer concerning the results of alternative courses of
treatment.
3. Perfect competition
An efficient free market requires producers to be operating under conditions of perfect
competition. This requires a stringent set of conditions - perfect information, many buyers and
sellers, a uniform product and freedom of entry and exit - which ensure that firms are price
takers, producing for the lowest possible cost in the long run and only earning normal profits.
If producers do not operate in this way and, in particular, if they have a significant power to
influence price or the total quantity being produced, then the market will fail. Doctors and other
suppliers of health care often have this power.
1.3.2 Problems of Risk and uncertainty –

One cannot predict when he/she will become taken ill

If we are going to buy healthcare in a free market, then we have to have enough money to pay
for it.
Nevertheless, healthcare is expensive and we cannot predict when we are going to be ill. What
makes this worse is that postponing buying healthcare is often risky. So, we face the problems
of risk and uncertainty.
The market response to this problem is to develop an insurance market to remove the
uncertainty and risk from health care spending. We pay an agreed amount of money per year
whether we need health care or not. Then, when we need care, the insurer pays the bills,
however large they are. So, a free market in health care requires an effective healthcare
insurance market.
Unfortunately, the health care insurance market itself is often not efficient. Moral hazard and
adverse selection both cause significant market failure.
I. Moral hazard
Having insurance can change the way in which we act. Imagine you are in a cinema and the
film is just about to start. Then you remember that you have left your bicycle unlocked. What
do you do? If you have comprehensive, insurance this will compensate you against any loss
you are much more likely to carry on watching the film. Your attitudes have been changed by
the fact that you have got insurance - this is what economists call moral hazard. Moral hazard
can affect any insurance market, but is a particularly serious problem for health care insurance.
Consumers who are insured have an incentive to over-consume health care - to demand
operations and treatments, which they would not choose if they were directly paying for them.
They may also not bother to follow a healthy lifestyle or to get preventative check-ups. As a
result, when they do fall ill, the cost of treatment is higher than it would otherwise have been.
Doctors too are affected by moral hazard. They know that the costs of treatment are covered
by insurance so the temptation is to over-treat and over-prescribe medicines for their patients.
Moral hazard thus leads to an inefficiently large quantity of resources being allocated to
healthcare.
II. Adverse selection
A company selling health care insurance has to estimate the level of risk accurately. This is
difficult because they will not have complete information on the risk status of the person they
are insuring. One solution is to set the premium at an average risk level. But this makes the
policy expensive for low risk customers who therefore may choose not to buy the insurance.
The process whereby the best risks select themselves out of the insured group is called adverse
selection. Insurance companies know that this is likely to happen so they offer different
premiums according to the level of risk and the person’s experience of ill health. This is why
most companies will offer non-smokers a lower premium than smokers.
Offering low insurance premiums to low risk groups, often called ‘cream skimming’ or ‘cherry
picking’, means high premiums have to be charged to high risk groups such as the elderly or
chronically sick. Therefore, in a free market, health care insurance is likely to be too expensive
for many people, and especially for those most in need of health care.
1.3.3 Unequal information
Moral hazard and adverse selection help to explain why a free market in health insurance is
unlikely to be efficient. However, healthcare markets face even more fundamental information
problems.
Consequences of unequal information
1. Rational choices –the doctor has more information the patient
When you go into a shop to buy a CD, you have enough information to make a rational choice
and you do not need the shop assistant to tell you what you should buy. Going to the doctor is
very different. You know that you perhaps do not feel well and that you have particular
symptoms, but most people are not able to diagnose their complaint and they want the doctor
to do that. What is more, you then rely upon the doctor to specify the treatment – if the doctor
says you need an expensive operation then you buy it. In the healthcare market, information is
not equally shared between buyers and sellers, instead, the seller, the doctor, has far more
information than the buyer does, the patient does. This asymmetry of information undermines
the separation of buyers and sellers. This situation is not unique to health care, but there are a
number of factors, which make this information asymmetry particularly acute there.
2. Information problems –technical and complex information
Most medical information is technically complex and so not easily understood by a layman and
this is made worse by the fact that many illnesses do not repeat themselves, so that the cost of
gaining the information is very high. You could argue that the only way a patient could become
fully informed would be by training to be a doctor!
The costs of a mistaken choice are much greater and less reversible than in other cases in the
worst situation if you make the wrong decision you will be dead. It is also often difficult to
postpone treatment and so virtually impossible to shop around, and anyway how do you judge
between different doctors’ opinions?
3. Doctors as agents – asymmetry of information makes the doctor-patient relationship
difficult than in buyers and sellers. They become agents of patients as buyers and on the on
the hand they also act as sellers of healthcare
The asymmetry of information makes the relationship between patients and doctors rather
different from the usual relationship between buyers and sellers. We rely upon our doctor to
act in our best interests, to act as our agent. This means we are expecting our doctor to divide
herself in half - on the one hand to act in our interests as the buyer of healthcare for us, but on
the other to act in her own interests as the seller of healthcare.
In a free market situation where the doctor is primarily motivated by the profit motive, the
possibility exists for doctors to exploit patients by advising more treatment to be purchased
than is necessary - supplier induced demand e.g. caesarean deliveries. Traditionally, doctors’
behaviour has been controlled by a professional code and a system of licensure. In other words,
people can only work as doctors provided they are licensed and this in turn depends upon their
acceptance of a code, which makes the obligations of being an agent explicit, or as Kenneth
Arrow put it, “The control that is exercised ordinarily by informed buyers is replaced by
internalized values”
4. Supplier Induced Demand (SID) – when the doctors aim at maximizing profit out of their
patients’ demands
The change in demand associated with the discretionary influence of providers, especially
physicians, over their patients. Demand that is provided for the self-interests of providers rather
than solely for patients interests. For example; if doctors behaved like some financial advisers
or computer salespersons in the past and maximized profits without any limit from a
professional code.
1.3.4 Consumers as satisfaction maximisers
Market theory assumes that consumers know what is best for themselves - that is they can make
choices, which will maximize their total satisfaction. If this assumption is wrong, then markets
will not automatically produce efficient results.
Economists call the satisfaction that consumers get from consuming a good or service utility.
So, the extra satisfaction from consuming a bit more is called marginal utility, while the total
satisfaction gained from consuming the whole amount is referred to as total utility. The
satisfaction gained simply depends on the quantity and mix of goods and services chosen. The
theory assumes that consumers get more satisfaction from more goods and services, but that
the increase in satisfaction from consuming another unit - the marginal utility - diminishes as
consumption rises.
1. Maximizing utility
How do consumers go about choosing the mix of goods and services, which give them the
maximum total utility? They start by thinking about what they like (their tastes/preferences)
and then look at how much money they have to spend (their income) and the prices of the
different goods and services. They then choose the combination, which gives them the highest
utility for the money spent.
From our previous illustration of a consumer buying CDs, we saw that, “You are able to relate
your benefit to the price of the CD. If we look at the market for CDs, people will go on buying
CDs until the extra satisfaction from the last CD is exactly equivalent to the price of the CD.
We have reached the situation where we as a society are consuming the ‘right’ quantity of CDs
in the sense that we are gaining the maximum possible satisfaction from CDs given their price.”
“By choosing a particular bundle of goods, people demonstrate that they prefer it to all others;
consequently, it is best for them. In addition, if all people are in their best position, then society
- which is simply the aggregation of all people - is in its best position. Therefore, allowing
people to choose in the marketplace results in the best of all possible economic worlds” Thomas
Rice.
2. Another view of consumers
However, Thomas Rice in the Economics of Health Reconsidered, suggests a range of reasons
why this view of consumer behaviour could be mistaken. Here are three of them:
 I. The idea that consumer utility just depends on the bundle of goods and services consumed. If
this were true then people in rich developed economies ought to be appreciably happier than
people in poor developing economies. However, research by Easterlin in 1974 showed that
“average levels of happiness are fairly constant across countries; people in poor countries
and wealthy countries claim to be equally happy” – Rice. Easterlin’s research suggested that
utility depended on your relative consumption - so rich people were happier than poor people
in all societies. This means that if you consume more that could reduce my utility because I
am now relatively worse off.
II. Traditional theory ignores the issue of how tastes are determined. Evidence from social
psychology suggests that tastes are determined by people’s past and present environments.
So for instance, if you are in a peer group which smokes then you are likely to develop a
‘taste’ for smoking, which will remain, even after you have left the peer group. If this is true,
then it is not clear that satisfying tastes will actually make people better off. In fact, “If one
believes that tastes are determined in such a way, then it becomes clear that a society might
be better off pursuing some goods and services that are not demanded most strongly by the
public. This is because people might not know what alternatives are available that will make
them better off”.
III. Are consumers rational? What do economists mean by the concept of rationality? In a narrow
sense, they mean that people will behave consistently - so if they prefer A to B and B to C
then, they will prefer A to C. More widely, they mean that people will behave in a reasonable
manner. If consumers are not rational in this sense, then they will not necessarily make
decisions, which maximize their welfare. Social psychology suggests that people are often
not rational in this sense - instead they exhibit what is called cognitive dissonance. In other
words, they simultaneously hold two ideas that are psychologically inconsistent and use
various forms of self-justification and rationalization to overcome the tension. Take the issue
of saving for old age. It is rational to do this, but often people do not do it. Why not? Well the
act of saving forces you to face up to the reality of ageing. If you are scared of getting old
then, you are likely to refuse to contemplate this and so choose not to save. Cognitive
dissonance suggests that people will often not make decisions, which maximize their utility.
Rice argues that the issues raised above are particularly important in healthcare markets.
Consumers are unlikely to be in a position to appreciate the full range of possibilities available
to them and so need expert help to guide them. This is particularly true as many situations
affecting health are likely to produce cognitive dissonance. If utility is relative, then, this
suggests that society would be better off with some form of universal provision rather than one
based on individual health care purchases.

1.3.5 Imperfect competition

The free market models predict large numbers of buyers and sellers - all of whom have no
power individually to influence the market price. However, a significant proportion of
healthcare is delivered by hospitals and these hospitals can often exercise monopoly power
within the health care market in the local area.
1. Monopolies
Why should hospitals be able to act like monopolies? The answer is that hospitals have an
incentive to grow in size and in the range of services provided. This leads to the emergence of
one large hospital in an area rather than a large number of small hospitals. The incentive to
grow is falling unit costs - what economists call internal economies of scale and economies of
scope.
2. Economies of scale
The average cost of providing treatment fall as a Hospital becomes larger. There are a number
of reasons as follows:
a) A large institution is able to make more use of specialization. This can involve both people
and capital. A large hospital is able to develop specialist medical units employing both
highly skilled surgeons and specialist capital equipment. Such a hospital is also able to
employ specialized managers and ancillary (additional) staff, which will allow it to operate
more efficiently.
b) A large institution is able to achieve purchasing economies of scale through bulk buying.
c) A large hospital prevents wasteful duplication of facilities. There will only be a limited
number of patients with a particular condition needing particular skills and equipment in
any one area. Concentrating the treatment in one place allows the most efficient use of
resources.

3. Economies of scope –to provide a range of services in a single hospital

In many cases, it costs less to provide a range of services in a single hospital rather than have
several hospitals each just producing one or two services. For example, emergency surgery and
treatment of heart attacks are more cost effectively provided in a single hospital rather than two
separate ones.
4. Price maker
In this situation, the hospital as a supplier of healthcare services has considerable power to
bargain over price. Instead of being a price taker, it is a price maker. In this situation, a free
market does not lead automatically to a Pareto efficient outcome. In particular, if the hospital
is profit maximising then it will set price above marginal costs giving an allocative inefficient
outcome. In addition, it is likely that the hospital will be productively inefficient, since it lacks
the incentive to reduce costs, which would be provided by competition.
1.3.6 Externalities -spillovers
The economist defines external effects as involving positive and negative results for others that
are the consequences of one’s own actions. Externalities or spillover effects provide another
source of market failure. Again the problem is related to information. This time the market
price does not accurately contain all the information about the benefits and costs of the market
transaction. Earlier we outlined how this might occur when a consumer bought a CD. Now we
are interested in how this might operate in a health care market.
For example: Suppose vaccination against infectious diseases were bought and sold through a free
market. You are thinking about the benefits to you of not catching whooping cough – the price you are
prepared to pay for vaccination will depend on your personal, private valuation of the benefits you
receive. Going from a single consumer to the market, we can analyse the interaction of supply and
demand for vaccinations using a diagram.
In the Figure below, DD shows the market demand for vaccinations. The amount of vaccination that
private individuals will be prepared to buy at each price will depend upon their estimate of their personal
benefit from being protected against whooping cough. In formal terms, this means that DD represents
the marginal private benefit (MPB) that consumers receive. The market supply of vaccinations is shown
by SS. The free market equilibrium is at price P' giving Q' vaccinations. However, when you are
vaccinated against whooping cough you are not the only person to benefit. Other people also gain since
they are now protected against catching whooping cough from you. This extra or externality benefit is
missed by the free market. We can show the effect of this on the diagram. MSB represents the marginal
social benefit from vaccination, which is that all the benefits received by society. MSB is made up of
the entire private benefits consumers receive (MPB) plus the additional externality benefits. The Pareto
efficient equilibrium is E'' which corresponds to Q'' vaccinations. A free market will thus underprovide
vaccinations and this in turn will impose a cost upon society. This cost is shown in the diagram by the
shaded area E'FE'', which equals the excess of MSB over the cost of producing the further Q'' – Q'
vaccinations.

F
Price of
Vaccinations D S
Cost

P1 MSB

D
D = MPB

Q’ Q’’
Quantity of Vaccinations

Figure 1.1 “Selfish” versus “caring” externalities

Some economists refer to this type of externality as a ‘selfish’ externality to distinguish it from
a ‘caring’ externality. A ‘caring’ externality occurs when individuals receive benefit from
knowing that other people are receiving medical treatment. Knowing that someone is in pain
simply because they cannot afford medical treatment makes many people upset. In other words,
the poor sick person’s pain and lack of treatment causes disutility for other people in society.
This helps to explain also why some people are prepared to pay higher taxes to fund health care
for all. Again, a market demand curve reflecting each individual’s wish to buy care for them is
unable to express this willingness to pay for external benefits. So, a free market will further
under-provide health care.
1.3.7 Equity and health care
Equity is more than efficiency.
Efficiency is not everything. We are also concerned with what is fair. If we had a market
distribution of health care, then only those who could afford to pay would be able to purchase
it. Most people regard that as unacceptable. This is a major reason why most societies regard
health care as different from other commodities.
As Donaldson and Gerard put it: “Within most societies there exists, in some form or another,
a concern that health care resources and benefits should be distributed in some fair or just way”.
A concern about equity was one of the main motivating forces behind the creation of the
National Health Service (NHS) in the developed Nations. William Beveridge, the architect of
the welfare state, argued for a health service which would provide treatment “to every citizen
without exception, without remuneration limit and without an economic barrier at any point to
delay recourse to it”. Equity has remained a major goal within the developed nation’s health
system.
1.4 Demand for health services
Most observers agree that consumers demand are affected by various factors such as more
ignorant, taste and uncertain in their role as consumers of health services than as purchasers of
most other commodities. They cannot assess the quality and character of the health services
they consume and are generally unaware of the variety of health care alternatives available for
treating a given illness. Ethical standards adopted by the health professions preclude
advertising, so consumers are denied access to this form of information concerning the relative
merits and costs of various forms of care and treatment. Moreover, the reluctance of some
physicians to discuss illness in non-ethical terms also tends to keep consumers ignorant of
feasible treatment alternatives and makes it nearly impossible for them to exercise rational
choice. While individuals can choose their physicians, doctors usually determine the kind and
quantity of health services individuals consume. While doctors may have some knowledge of
the individual’s financial resources, these considerations are unlikely to have much influence
on the type of care prescribed.
Consumers also generally lack knowledge concerning their actual need for care. Thus, the
overall benefit of health services is generally uncertain from the consumer’s point of view and
the demand for a significant portion of health services is based on the doctor’s judgment.
The demand and need for medical care is not always the same. For instance, an individual may
demand more care than is required medically. Conversely, he may need medical care, but may
not be aware of its value. Need is generated by the incidence of illness, while demand is
generated by the interrelationship of illness with other factors. To plan for future use of
facilities and personnel, demand rather than need for such resources must be projected.
Demand analysis can be applied with appropriate modifications to explain variations in
expenditures on medical care services. From the patient’s viewpoint, the need for medical care
is not always clear-cut. For example, the distinction between a severe cold and pneumonia
may not be noticeable to the consumer. Chest pains may indicate either bronchitis or a serious
heart condition. In such instances, a high-income family would be expected to take greater
precautions and thus incur higher medical care expenditures than a low-income family.
Moreover, even after treatment is begun economic factors may influence its duration. A poor
family may decide to forego the possible benefit from an extra day in hospital or an additional
visit to the physician. Medical care is characterized by a low degree of substitutability, most
medical needs are highly specific and alternative goods are not able to supply the same level
of satisfaction. Moreover, medical care is generally wanted for its own sake, most medical care
and treatment are unpleasant and generally are not wanted until it becomes a preferable
alternative to the pain and other consequences of illness. This implies that the price elasticity
of demand for medical care would tend to be low.
Grover C. Wirick has identified five fundamental factors that can have an impact on the demand
for health care services. The first is need, when a person suffers from a condition that requires
attention, or he/she has some other reason for seeking medical care or examination. Secondly,
there must be a realization of the need. Either the individual or someone acting in his/her behalf
must know that the need exists. A number of psychological processes may be involved
including awareness of the existence and availability of medical skills as well as the benefit
likely to be gained through health services. In addition to these, the hopes, fears and beliefs of
the individual, as well as the other personal factors such as his/ her previous experiences,
customers and religion play a significant role. For example, a person with a strong religious
conviction against a particular kind of medical treatment may have a different realization of
need for care from that of someone with other religious beliefs. Third financial resources must
be available to implement the care. This capability may take many forms, including the income
and assets possessed by the individual or his/her family, insurance coverage, eligibility for free
care under a group or government program and availability of care through welfare programs.
Fourth, there must be a specific motivation to obtain the needed care even with the availability
of the other forces such as need, realization and resources, something must initiate the action.
Fifth is availability of service.
The first three forces are characteristics of the patient, while the fifth is a phenomenon of his
environment. The fourth force is somewhat indistinct and could be characteristic of either or
both.

1.4.1 Changes in demand for medical care

By ‘quantity demanded’ we mean the quantity demanded at any specific price, all other causal
factors held constant. By ‘demand’ we mean the set of quantities demanded at various price
levels, all other causal factors held constant. Change in quantity demanded is shown by a
movement across the demand curve, while change in demand is expressed in a shift in the
demand curve itself. In the analysis of demand for medical care the focus is on health care,
hence the commodity physician care’ is used as the major example. Physician care is defined
as examinations and treatments administered by physicians to their patients. Physician care is
only one of the many commodities in the health care sector.
The effects of factors other than the out-of-pocket price on the economic behaviour of
consumers are introduced by way of their influence on the basic price-quantity relation. These
other factors can be placed into three broad categories.
1. Income
Income of consumers is generally assumed to be positively related to demand. That is, if
income increases, the quantity demanded at each price will be greater. Change in the level of
income results in a shift in the demand curve. Income is a variable used to measure the ability
of the individual to afford medical care, but it is only an approximate measure. Another
measure of the affordability of medical care is the individual’s level of wealth, including bank
deposits, real estate and other assets, less any debt, such as bank loans and mortgages. All these
are supposed to measure the individual’s ability to pay for medical care.
2. Price of related commodities
The demand for a particular commodity is also influenced by the quantities of related
commodities consumed. The quantities of these related commodities are, in turn, influenced by
their prices. Two classes of commodity relations are of concern to us: complements and
substitutes.
3. Tastes
Tastes have sometimes been called wants, a term connecting the intensity of desire for
particular commodities. The elements that influence the intensity of an individual’s desire for
medical care include health status, educational background, sex, age, race and upbringing. Any
of these can explain differences in the intensity of desire for medical care among individuals.
That is, other factors remaining constant, these differences offer explanations as to why one
individual’s demand shift. The explanation might simply be that the health status of the first
individual is lower than that of the second individual.
1.5 Health and Economic Development
Development is the concern of all developing countries. The health planner, manager, etc., is
equally charged with that concern and must be knowledgeable about what development implies
and the role health should play in the development of a given country. The following questions
are of paramount importance for the health worker in a developing country such as Ethiopia:
what is development? How does it differ from economic growth? How can development be
measured? What role does health play in development? What role should the health worker
play in facilitating development? This subsection will be attempting to provide some answers
and insights to these questions.
1.5.1 The meaning of Economic Development
Development has been variously defined. The modern view of development perceives it as
both a physical reality and state of mind in which society has, through some combination of
social, economic and institutional processes, secured the means for obtaining a better life. The
definition of “a better life” may vary from one society to another. Development in all societies,
however, must consist of at least the following three objectives:
1. To increase the availability, distribution and accessibility of life-sustaining goods such as
food, shelter, health, security and protection to all members of society;
2. To raise standards of living, including higher incomes, the provision of more jobs, better
education and better health, and more attention to cultural and humanistic values so as to
enhance not only material well-being, but also to generate greater individual community
and national esteem.
3. To expand the range of economic and social opportunities and services to individuals and
communities by freeing them from servitude and dependence on other people and
communities and from ignorance and human misery.

1.5.2 Growth and Development

For a long time, Development and Economic growth were used interchangeably. Although the
two are closely related they are, however, different. Economic growth can be defined as an
increase in a country’s productive capacity, identifiable by a sustained rise in real national
income over a period of years.
The main differences between growth and development can be outlined as follows:
1. Development encompasses the total well-being of the individual, a community or a nation,
while economic growth is concerned with the increase in per capita earnings of the people
making up the nation.
2. Economic growth is one characteristic of development, yet development must not be
measured by the rate of economic growth. It is possible for a country to experience
 economic growth without becoming developed. A country, for example, may acquire a
great wealth from its mineral deposits, but have a low level of health services. This is due
to the fact that the wealth goes into the hands of a very small minority who might squander
it on luxury goods instead of establishing a viable infrastructure.
3. Development is concerned with the total person, his economic, social, political,
physiological, psychic and environmental requirements. If one of these is not fully cater
for, development has not been achieved.

1.5.3 Measurement of Economic Development

The measurement of development has presented social scientists with a problem of finding the
suitable tools and techniques to do so and of interpreting the results of such measurements.
Several suggestions have been presented for measuring development. One line of research has
suggested the use of so-called social indicators. The purpose of these is to measure the well-
being of the population by examining factors such as health and nutritional status, level of
education, housing conditions and so forth. However, it is easier to calculate GNP, per capita
incomes and growth rates. As a result, in most reports these variables are used as indicators of
Development.
Economic Development, in addition to a rise in per-capita income, implies fundamental
changes in the structure of the economy characterized by:
1. Rising share of industry, along with the failing share of agriculture in GNP and increasing
percentage of people who live in cities rather than the countryside
2. Passing through periods of accelerating, then decelerating population growth, during which
the age structure of the country changes dramatically.
3. Changes in consumption patterns as people no longer spend all their income on necessities,
but instead move on to consume durables and eventually to leisure-time products and
services.
4. Meeting the needs of the present without compromising the ability of future generations to
meets their own needs (sustainability).
5. Participation (mainly) by the citizens of the country in the process as well as the benefit,
While economic development and modern economic growth involve much more than arise
in per capita income, there can be no development without economic growth.

1.5.4 Health Implications of Economic Development

The associations between health and national development are complex. The interaction is a
two-way phenomenon with health being both influenced by and influencing economic
development. Improved health has been considered solely a result of economic growth, a part
of the product of growth rather than one of its causes.
Some development experts have maintained that health should have low priority in
development funding and have tried to justify their opinions with comments such as “only a
rich nation can afford the programs to assure its population’s health”, or “a poor nation cannot
afford improved health”. The concern of development planners is accentuated by the fact that
during the demographic transition, lower death rates are often associated with sustained high
birth rates which results in rapid population growth.
While the supply of labour may increase as a result of improved health and reduced death rates,
there may be no corresponding gain in per capita output. Thus, if economic growth is too slow
to absorb the additions to the labour force associated with expanded health programs, greater
unemployment, both open and disgusted, may result. Thus, improved health in poor societies
can be postulated to produce larger populations, greater poverty and ultimately deterioration in
health.
However, other development planners and economists are more optimistic regarding the
impact of health and nutrition programs on economic growth. There are three different ways
by which improved health programs can accelerate development.
 Improved health may increase productivity or efficiency of the labour force leading to
greater output and reduced cost per unit of output
 Better health conditions may serve to open new regions of a country of settlement and
subsequent development.
 Attitudinal changes towards achievement and entrepreneurship may be lined to health and
nutrition programs. This linkage has a significant importance to stimulate entrepreneur ship
in poor countries.
It has been apparent that where conditions are worst, relatively simple and low cost health
programs can produce dramatic reductions of debility and disability of the labour force. In
these situations major increments in productivity are most readily apparent. For instance, in the
Philippines at one time a survey of major enterprises indicated a daily absenteeism rate of 35
percent, attributed largely to malaria. After initiation of an ant-malaria program the rate of
absenteeism was reduced to 2-4 percent and nearly one fourth fewer labourers were required
for any given task. Although one could argue that economic growth has to accelerate the
eradication of poverty many economists felt that its impact occurred too slowly. In other words
many end not to believe in an instantaneous trickle-down effect of economic growth.
Subsequently, a more direct method of poverty reduction, namely the basic needs approach,
was advocated; its aim was the direct fulfilment of basic needs such as health, clothing,
sanitation, shelter, nutrition and education.
1.5.5 Major determinants of poor health
The following are some of the main determinants of poor health which have direct or indirect
interdependence with Economic Development:
 Population growth: rapid population growth implies an increased need for medical and
other social services
 Malnutrition
 Sanitary conditions and inadequate shelter
 Education
There remains a debate on the relation between health status improvements and economic
growth. It is argued that health status improvements are attained at the expense of fixed capital
entailing a smaller economic growth. That is, the investment funds that could have been used
for the growth of the economy at large are to be used for investments in the health service
sector which has in part a consumption character. Some argue, however, that investment in
basic needs, such as in the health service sector, are investments in the health service sector
which has in part a consumption character. Some argue, however, that investment in basic
needs, such as in the health service sector, are investments in human capital which in turn is
growth promoting. Although some tend to conclude that there is a positive relationship
between health and economic development, this does not prove that improvement of the health
service sector is a sufficient condition for economic development. On the other hand, a better
health status does not guarantee a faster economic growth.
The following conclusions may be drawn from the discussions of the relations between health
and development.
1. Development is not a simple process. It is a complex intermingling of economic, social,
environmental, physiological, psychic, cultural and political factors.
2. The measurement of development is not an easy task. Economics provides certain tools
which can be brought to bear on crucial areas of choice where decisions are required.
Further research is required in this area so as to develop tools and techniques for evaluation
in those areas that are not readily quantifiable.
3. Development is linked not just to the improvement of economic indicators or the attainment
of basic needs, but with wider aspirations such as high health status, and with social well-
being and change. The Development process embraces not only the so-called “productive”
sectors of the economy, but also the social sectors.

1.6 Significance of Health Economics;

Health economics is a branch of economics which deals with the application of the principles
and theories of economics to healthcare sector. It addresses the issues such as the demand
for healthcare services in the economy, allocation of resources for the development of
healthcare facilities, their supply through public and private sector agencies and the gaps
that exists between the demand for and supply of healthcare services in the economy.
Healthcare services are limited in supply and the demand for healthcare services is ever-
increasing and unlimited. Again resources to meet the demand for healthcare services are
limited in supply. The demand for healthcare is a derived demand in the sense that it
derives its demand from the state of health and awareness among the population of the
country about significance of good health. Healthcare services are demanded by people as a
means by which people achieve good health that builds the standard of human capital
of a nation. Unlike other goods and services which are demanded for consumption,
healthcare services are demanded for both consumption as well as for ensuring good health.
Thus, health is a capital as well as consumer good.

Economic analysis, if applied properly, can often help to clarify what choices are for health
policy, how to choose among different health services, how to decide what to buy and how to
pay for it, and how to evaluate the end results of such consumption. The indirect effects of
good economic thinking, when dealing with such questions as the best use of taxes, insurance
and out-of-pocket payment, or the best way for governments to intervene in health, may
affect a population’s health and welfare more than decisions about how to combat particular
maladies or risk factors.

Thus, the main functions of a health economist include:

(1)To identify the present and potential areas of health demand,
 (2)To draw valuations in terms of market demand for health services, (3) To calculate the
cost of delivering health services,
(3)To estimate the real costs of acquiring health services in terms of time, loss of working
days and wages, travelling cost and cost of travelling the distance to seek health care in
terms of money as well as cost of not receiving timely treatment due to distance’; and
(4)To suggest right heath policies in terms of cost benefit analysis to the
government. For example, a health economist can study the effect of levying user-
charges in government hospitals on utilisation of health services and accordingly may
recommend the government and planners the effective allocation of financial resources
to the health sector and improving the health care delivery system.
Although there is no satisfactory measure of health benefits derived from the health service
expenditure a number of factors such as;
(i) assessment of productivity from good health,
(ii) Allocation of financial resources to healthcare sector on the principles of equity; and
(iii) Application of basic principles of economics to healthcare sector, may help to assess the
contribution made by healthcare sector expenditure to national productivity and national
income. A critical study of health economics may bring in certain pertinent solutions to
the problems faced by the health sector.
There is a strong correlation between increased healthcare expenditure and poverty reduction
and long term growth. The burden of diseases and poor health act as barriers to economic
growth in developing countries. Thus, good health is the single most important need essential
for formation of human capital and growth of an economy. Therefore, the most important task
before health economists is to address issues related to good health to facilitate health sector
reforms to achieve equity in health care for a country’s population.
Health economics is becoming a subject of increasing significance particularly in the
developing countries primarily because of:4
(1) An economic climate where resources are extremely scarce and decisions on priorities are
crucial but difficult;
(2) A growing appreciation among health professionals and policy-makers that health
economics and economists can help them formulate policies and make decisions;
(3) The increasing maturity of the sub-disciplines of health economics; and
(4) The growing of interest among economists and others in applying their economic
skills to health issues.
Review Questions
1. In what sense are the consumers of health services ignorant?
2. Economic development is a process, what are the necessary situations for a given country to
be considered that it is in this process?
3. Outline the major determinants of poor health