317_L6_Jan 18, 2008 J. Schaafsma 1 Review of the Last Lecture Are discussing the production of health: section III of the course outline have discussed the aggregate production function HS=HS(HC) and some of its properties discussed the output elasticity for health and looked at some estimates of it => low => suggest “flat of the curve medicine” then began discussion of substitution in the production of health => two types: 1) between healthcare and non-healthcare factors that affect HS, 2) between different kinds of HC inputs ended the lecture by looking at the first kind of substitution in terms => HC vs highway safety discussed the isoquant map, the budget constraint, their slopes and the efficient combination of inputs for a given HS (life expectancy)

317_L6_Jan 18, 2008 J. Schaafsma 2 Efficiency Condition for Production recall that the slope of the isoquant is: - MPP HSG / MPP HCG Recall that the slope of the budget constraint is: - P HSG / P HCG efficiency condition: budget constraint tangent to the isoquant, i.e, MPP HSG / MPP HCG = P HSG / P HCG (2) equation (2) can be rewritten as: MPP HSG / P HSG = MPP HCG / P HCG (3) note: MPP HSG / P HSG = (output/unit)/($/unit) = output/$ also true for MPP HCG / P HCG thus equation (3) states that efficiency requires that the last dollar spent on each input creates the same addition to total output

317_L6_Jan 18, 2008 J. Schaafsma 3 Changes in the Budget Constraint Two changes: 1) parallel shifts 2) change in the slope 1) effect of a parallel upward shift (an increase in funding): (i) result in increased spending on both healthcare and highway safety (ii) more output (longer life expectancy) So what should the funding level for HC and highway safety be????? => Depends on how we value life expectancy at the margin 2) a change in relative input prices will change the factor input combination (as the price of healthcare goods rises relative to the price of highway safety goods => shift out of HCG into HSG (DIAGRAM) two reasons: 1. relative price effect 2. possibly also a wealth effect

317_L6_Jan 18, 2008 J. Schaafsma 4 The Objective of Public Policy: Social Welfare Maximization have shown that a combination of HCG and HSG can achieve a given HS at a lower cost than using all the funds for HC only => strong argument for finding the optimal allocation of the funds between HCG and HSG However, efficiency is not the ultimate objective of public policy social welfare maximization is the ultimate objective of public policy Social welfare depends on the utility (level of satisfaction or enjoyment in life) experienced by individual members of society and on the distribution of utility across the members. Individual utility depends on personal tastes and preferences, and on income

317_L6_Jan 18, 2008 J. Schaafsma 5 Does an Efficiency Gain Necessarily Result in a Social Welfare Gain? Might Argue (incorrectly): Shifting resources from HC to highway safety to lower the cost of achieving the current aggregate life expectancy must increase social welfare => HC and highway safety goods do not appear in an individual’s consumption bundle, and aggregate life expectancy which does, is unchanged Furthermore, the cost of achieving current aggregate life expectancy has decreased => taxes can be cut, or more public goods supplied => at least some people better off, no one worse off => Social Welfare increases THERE IS A PROBLEM WITH THIS ARGUMENT!!!

317_L6_Jan 18, 2008 J. Schaafsma 6 Efficiency Gains May Have distributional Effects assume that we are currently producing LE with an inefficient combination of HC (too much) and Highway safety goods (too few) (diagram) reducing healthcare inputs and increasing highway safety inputs allows us to reduce total spending and achieve the same aggregate life expectancy (on same isoquant) However, while aggregate life expectancy remains unchanged there is a redistribution of life expectancy within society drivers (the non-poor) gain life expectancy from the safer roads non-drivers (the poor) don’t gain from safer roads, but lose out from less HC spending => life expectancy down isoquant)

317_L6_Jan 18, 2008 J. Schaafsma 7 Redistribution and Social Welfare The impact on social welfare from a move from an inefficient combination of HCG and HSG (for attaining a given aggregate Life Expectancy) to the efficient combination depends not only on the redistribution of life expectancies within society (poor to non-poor) in our example) it also depends on how the cost savings from moving to the efficient combination are used if the cost savings are used to cut personal income taxes, the poor don’t benefit and are worse off than before (lower life expectancy) and the non-poor are better off (lower taxes and longer life expectancy) => Social Welfare could decline => occurs if adverse redistribution of utility from poor to non-poor more than offsets the utility gain from improved efficiency!

If Cost Savings are used for Low Income Housing 317_L6_Jan 18, 2008 J. Schaafsma 8 social welfare will likely increase if the cost savings are used for programs to help the poor, e.g. low income housing, food vouchers, income assistance, retraining programs Such programs yield utility directly to the poor and also improve life expectancy BOTTOM LINE: whether a move to greater efficiency improves social welfare depends on who gains and who loses from the direct effects of the move to efficiency and on how the cost savings from the efficiency gain are distributed across the population

317_L6_Jan 18, 2008 J. Schaafsma 9 Lifestyle and HC as determinants of HS a healthier lifestyle leads to a better HS more HCG also lead to a better health status (up to a point: iatrogenic effects) isoquant diagram applies here using units of healthy life style promotion by government and HCG as inputs (DIAGRAM) get the same efficiency conditions => last dollar spent on healthcare should have the same impact on life expectancy as the last dollar spent on healthy lifestyle promotion Should government engage in healthy life style promotion if there are efficiency gains to be had? (same aggregate life expectancy at lower cost)

317_L6_Jan 18, 2008 J. Schaafsma 10 The Key Question with Healthy Lifestyle promotion When healthy lifestyle promotion causes people to adopt healthier lifestyles are they better off? Depends!!!! Consider each of the following: tobacco consumption, sugar consumption, skiing Tobacco consumption is bad for health. Should we campaign to eliminate its consumption? Sugar consumption is bad for health. Should we campaign to eliminate sugar consumption? skiing is a high injury sport. Should we campaign to eliminate skiing as a sport and persuade people to take up some safer sport with the same health benefits?

317_L6_Jan 18, 2008 J. Schaafsma 11 Substitution between Healthcare Goods Now consider that HC is not a homogeneous good => consists of many components: doctors, nurses, hospital beds etc. Question is: is there substitutability in production across these HC inputs? e.g., can nurses substitute for doctors, or can equipment substitute for labour input, etc.? Can draw the isoquant diagram using doctors and nurses time as inputs: fixed factor proportions or substitutability at the margin? Expect some substitutability => US studies suggest that properly trained nurses could substitute for 25 – 50 % of doctor’s services without loss of quality.

317_L6_Jan 18, 2008 J. Schaafsma 12 Can we be Confident that the Combination of HC goods is Efficient? can we be confident that the combination of nurses and doctors time is efficient, i.e., that at the current combination the budget constraint is tangent to the isoquant if yes => we are getting the maximum HS for our expenditure on doctors and nurses if no => we can in principle reallocate the funds to achieve the same HS at a lower cost

317_L6_Jan 18, 2008 J. Schaafsma 13 Empirical Evidence: the ratio of Doctors to Nurses is too High empirical evidence suggests that the current combination of doctor/nurses inputs is inefficient could substitute lower cost nurses’ time for some doctors’ time without lowering HS outcomes (DIAGRAM) why does this inefficiency exist? likely reason => tradition and physician preferences, not relative factor prices, determine factor input combinations (we’ll return to this later in the context of modeling the practitioner firm)