1. Demand for Medical Services Part 1 Health Economics Professor Vivian Ho Fall 2009

2. Outline l Theoretical derivation of the demand curve for medical services l Economic and noneconomic variables that influence demand l Elasticities l The impact of health insurance on demand

3. Medical Care and Utility Medical Care and Utility Medical care is an input in producing health  Subject to law of diminishing marginal productivity Health yields utility to the consumer  Subject to law of diminishing marginal utility

4. We can generally graph the relation between medical care and utility as follows: Utility Medical Care Medical Care and Utility

5. l The graph shows that as the level of medical care rises, each additional unit of medical care yields a smaller increase in utility l Given this fact, how does the consumer decide how much health care to purchase? Medical Care and Utility

6. Define : MU = marginal utility of medical care P = price q = quantity of medical services z = quantity of all other goods Consumer’s Optimal Choice of Health tradeoffs l Given the consumer’s income, she chooses q and z to maximize utility. l Utility maximization rule : MU q MU Z P q P z

7. l Total utility reaches its peak when the marginal utility gained from the last $ spent on each product is equalized Consumer’s Optimal Choice of Health i.e. The consumer equalizes “the bang for the buck” across all goods

8. Proof l Suppose that instead : MU q MU Z P q P z > X Then MU q would fall, MU z would rise, until the 2 ratios are equalized  Last $ spent on medical care generates more U than last $ spent on other goods  Consumer could U by purchasing more medical care (q), and less other goods (z)

9. Deriving a Demand Curve for Physician Visits Suppose P q rises. This will lead to : MU q MU z P q P z < Note : Now let q represent physician visits l Consumer can U by purchasing less q, and more z l P q lower demand for q

10. Deriving a Demand Curve for Physician Visits l Downward sloping demand curve for physician visits Price P1P1 P0P0 q0q0 q1q1 Price changes lead to movements along D curve

11. Deriving a Demand Curve for Physician Visits (cont.) l Consumer’s purchase of medical care is a “derived demand” i.e., “no direct” utility from visiting the doctor U derived from health resulting from dr. visit: U = U(h,z) h = h(q,…)

12. Other Economic Factors Affecting Demand l The demand curve illustrates the effect of changes in the price of the good on quantity demanded holding all other factors (income, prices of other goods) constant l Changes in factors other than the price of the good itself lead to shifts in the demand curve

13. Other Economic Factors Affecting Demand l If income increases, then at any given price, consumer is willing and able to purchase more q 1. Income q0q0 q1q1 Price P0P0 DODO D1D1 Physician Visits

14. Other Economic Factors Affecting Demand l e.g. left shoes and right shoes l e.g. laser printers and toner cartridges l e.g. alcohol and cigarettes? l e.g. contact lenses and optometrist visits 2. Complements - 2 or more goods which are consumed together

15. Other Economic Factors Affecting Demand l e.g. contact lenses and optometrist visits l If contact lenses become cheaper, demand for optometrist visits ___ 2. Complements Price D0D0 D1D1 Optometrist Visits Price of complement falls

16. Other Economic Factors Affecting Demand l e.g. Coke and Pepsi l e.g. Physicians and Nurse practitioners? l e.g. generic and brand name drugs 3. Substitutes - other goods which satisfy the same wants, or provide same characteristics

17. Other Economic Factors Affecting Demand l e.g. generic and brand name drugs l If generic drugs in price, D for brand name ___ 3. Substitutes - other goods which satisfy the same wants, or provide same characteristics Price D1D1 D0D0 Brand name drugs Demand for brand name drug falls

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21. Elasticities Price # Visits A relatively flat demand curve implies that a small increase in price leads to a large fall in # visits demanded

22. Price # Visits In this case demand is considered to be relatively “elastic” with respect to a change in price Elasticities

23. Price # Visits A relatively steep demand curve implies that a small increase in price leads to a small fall in # visits demanded Elasticities

24. Price # Visits In this case demand is considered to be relatively “inelastic” relative to a change in price Elasticities

25. l Own-Price Elasticity of Demand: l Example: If the elasticity of demand for physician visits is -.6, a 10% increase in price leads to a 6% decrease in the number of visits demanded l Elasticities are scale-free  We can compare the ED for physician visits vs. nursing home days, even though they are consumed in different units Elasticities (cont.)

26. l E D is expected to be negative. Thus, own- price elasticities of demand are often quoted in terms of absolute value l The demand curve is inelastic if l 0<|E D |<1 l The demand curve is elastic if 1<|E D |<  Elasticities (cont.)

27. l If you are given a formula for a demand curve, you can compute the elasticity of demand for any combination of price and quantity along that demand curve Elasticities (cont.)

28. Except in special cases, the E D is different on different points of the demand curve P Q 4 8 Demand curve: Q = 8 – 2P 4 2 E D = -1 E D = -  E D = 0

29. l Income elasticity of demand: l Example: If the elasticity of demand for physician visits is.1, a 10% increase in income leads to a 1% increase in the number of visits demanded l For most types of medical care, E Y should be positive Elasticities (cont.)

30. l Cross-price elasticity of demand: l Example: If the elasticity of demand for Tylenol with respect to the price of Advil is 1.5, a 10% increase in the price of Advil leads to a 15% increase in the quantity of Tylenol demanded  E C is negative for complements  E C is positive for substitutes Elasticities (cont.)

31.  Total revenue will increase if price is raised when demand is inelastic Own price elasticity of demand critical for determining a health care manager’s total revenue TR = PQ D Demand theory tells us that P Q D If demand for physician services is inelastic, and the price is raised, then I %DQ D I < I %DP I Elasticities

32. QUIZ l A 1991 study by Frank Chaloupka estimated the price elasticity demand for cigarettes to be: A..48 B..83 C. 1.02 D. 1.33

33. Insurance o The above demand analysis assumed that the patient pays for care out-of-pocket How does insurance affect the demand for care? 1. Coinsurance - Patient pays only a fixed % of the cost of each visit (often C =.20) e.g. If the visit costs $100 : patient pays $20, insurance pays $80

34. Insurance No insurance : consumer faces price P, makes q visits Price P cP qcqc q # Visits W/ coinsurance : consumer faces price cP, wants to make q c visits

35. Insurance (cont.)  Coinsurance leads to a demand of q c visits at price P, shared by consumer and insurance company Price P cP qcqc q # Visits  Demand curve rotates clock wise

36. What if the consumer has full coverage? i.e., copayment = 0 Price # Visits

37. Indemnity Insurance  Insurer pays a fixed amount for each purchased service l Insurer pays $150 for each overnight hospital stay, and patient pays the rest Price Visits D0D0 D1D1 $150

38. Fixed $ copayment  Patient pays up to $20 per visit, and insurer pays the rest Price Visits D0D0 $20 D1D1

39. Deductibles - Consumer must pay a fixed amount out of pocket per year before coverage begins  e.g. The initial $100 per year in health care expenditures must be paid by the customer  Lowers administrative costs, because fewer small claims are filed each year  Lowers demand for relatively inexpensive medical services near start of the year  Has much less impact on demand if relatively expensive medical services are required