ME33ES MEDICINE AND ECONOMICSDEMAND AND SUPPLY I

Summary

• Applying economics to health and health care• The allocation of scarce resources• Markets, demand and supply• Assumptions of theory of free markets• Information about health and health care• Health insurance• Asymmetry of information and the agency relationship• Competition in the provision of health care• Spillover effects• Equity and distribution effects• Market failure and government intervention in health care

DEMAND AND SUPPLY I

Question for discussion/reflection

Why is there a National Health Service in the UK but not a National Food Service?

DEMAND AND SUPPLY I

Applying economics to health and health care

• The resources – skilled health workers, buildings, drugs and equipment – available to provide health care are limited

• With limited resources, providing one service necessarily displaces another service

• Reasons for pressure on resources include:- an ageing population- expensive new health technologies- increased expectations

DEMAND AND SUPPLY I

• Health economics aims to inform decision makers so that the choices they make maximise health benefits for the population

• It is not about ‘saving money’ as such

• It can be difficult to define health and the impact of ill health

• Health is affected by health care but also in a whole variety of other ways:

- diet and exercise- tobacco, alcohol and other drugs- road accidents, air and water quality, safety regulations

DEMAND AND SUPPLY I

• Socio-economic status is a major determinant of life expectancy and health

• Generally, people do not wish or demand health care for itself

• However, people do seek health care as a route to better health

• The demand for health care is a derived demand, derived from the demand for health

DEMAND AND SUPPLY I 

The allocation of scarce resources

• Economics is the study of how society makes arrangements for the production and distribution of goods and services:

- what to produce- how to produce- for whom to produce

DEMAND AND SUPPLY I

• What to produce: which goods and services are society’s resources used to produce

• How to produce: what technologies and types of organisation are used to produce goods and services

• For whom to produce: who receives the goods and services society produces

• The basic economic problem is that society has limited resources but almost unlimited wants

DEMAND AND SUPPLY I

• Choice has to be exercised about what to do – and what not to do

• Opportunity cost is the alternative foregone by choosing to devote resources to a particular end

• An economic approach can help in understanding a variety of issues, including:

- what resources are available for health care- what drugs and equipment should be used- what organisations should provide health care- how access to health care should be organised

DEMAND AND SUPPLY I

Markets, demand and supply

• A market is a set of arrangements by which buyers and sellers come together to exchange goods and services (such as apples or treatment for a bad back)

• The function of markets is to determine prices which ensure that the quantity people wish to buy equals the quantity people wish to sell

• Demand is about how willing consumers are to pay for different goods and services

DEMAND AND SUPPLY I

• Demand is the quantity of a good buyers wish to purchase at each possible price

• Demand elasticity is a measure of the responsiveness of demand to changes in price

• If price increases, the quantity demanded falls; if by more than the price increase, demand is elastic; if by less, demand is inelastic

• Supply is about how the costs of the resources used to produce goods and services affect the amount supplied

DEMAND AND SUPPLY I

• Supply is the quantity of a good sellers wish to sell at each possible price

• Supply elasticity is a measure of the responsiveness of supply to changes in price

• If price increases, the quantity supplied increases: if by more than the price increase, supply is elastic; if by less, supply is inelastic

• At the equilibrium price, demand = supply and the market is stable

DEMAND AND SUPPLY I

• At low prices, below the equilibrium price, demand exceeds supply

• There is a shortage, or excess demand, and the available supply has to be shared out in some other way such as rationing or queueing

• However, in a free market – not controlled by government – excess demand should lead to the price being bid up to the equilibrium price

• At high prices, above the equilibrium price, supply exceeds demand

DEMAND AND SUPPLY I

• There is a surplus, or excess supply, and producers will be left with excess stock

• However, in a free market excess supply should lead to the price being forced down to the equilibrium price

• In theory, therefore, markets should ensure that there is equilibrium, where demand = supply, and resources are allocated to the uses where they are most highly valued

DEMAND AND SUPPLY I

• Thus - in theory - markets will ensure efficiency

• The maximum production will be obtained for given resources or, equivalently, a given level of production will be obtained at minimum cost

• An efficient market ensures that the price of different varieties of apple, the resources devoted to growing apples, and consumer expenditure on apples all accurately reflect the value which society places on apples

DEMAND AND SUPPLY I

• While markets may be efficient, the allocation of resources by markets may not result in equity (fairness, justice)

• If people have insufficient income to pay the market price for apples and every other type of food, this is generally considered inequitable/unfair/unjust

DEMAND AND SUPPLY I

Assumptions of theory of free markets

• The argument that free markets will lead to maximum efficiency requires a number of assumptions:

- consumers have good information- demand and supply sides of the market are kept separate- competition between producers- no spillover effects

DEMAND AND SUPPLY I

• In a world of free markets, sovereign consumers are able to pursue their own best interests

• Similarly, firms pursue their own interests, making (maximising) profits

• The outcome is mutually satisfactory to everyone

• There is no role for government

DEMAND AND SUPPLY I

• These assumptions often do not hold in the real world – hence, there may be market failure to achieve efficiency

• In addition, free markets may not lead to equity

• Market failure provides an argument for government intervention

DEMAND AND SUPPLY I

Information about health and health care

• Consumers may feel well informed when purchasing most goods and services – including apples – but not when purchasing health care – such as treatment for a bad back

• The economic theory of free markets would require the consumer of health care to be well informed of:

DEMAND AND SUPPLY I

- existing health status- prospective health status- available treatments- the cost of treatments

• Consumers will generally lack the expertise to make effective judgements about these matters

DEMAND AND SUPPLY I

• Health status and health care are very complicated issues

• Opportunities for “learning by doing” through repeated decision making are limited

• The consequences of mistaken judgements may be serious or catastrophic

DEMAND AND SUPPLY I

Health insurance

• The assumption of good information includes future information but there is considerable uncertainty about the prospect of future ill health

• Insurance is a means of dealing with uncertainty

• Some free market economists suggest we should base our health care system on private health insurance

DEMAND AND SUPPLY I

• Insurance provides benefits through the pooling of risk where, if many people are covered, average probabilities of events can be calculated

• Private health care insurance confronts various problems, notably moral hazard and adverse selection

• Moral hazard is a change in behaviour towards an event as a consequence of being protected against the full cost of the event

DEMAND AND SUPPLY I

• Insurance reduces the direct financial costs of treatment for ill health and thus the incentive to avoid ill health

• If already ill, the provision of health care at zero or subsidised prices encourages increased use of care

• Suppliers of health care may allow this, and provide increased care, especially if they are unaware of and/or not accountable for the costs of care

DEMAND AND SUPPLY I

• The result is premiums charged by insurance companies are higher than they should be, some people choose not to insure, and there is under insurance against illness

• Moral hazard does not just occur under private insurance but also under other systems, including the NHS, whenever users do not directly pay the full cost of care

• Adverse selection is where those who take out insurance are more likely to claim than the population as a whole

DEMAND AND SUPPLY I

• It results from people seeking insurance being better informed of their risk of ill health than insurance companies

• If insurance companies set premiums according to average risk levels, but most of their payments are to above average risk individuals, the long term result will be that premium levels rise

• Low risk people would then drop out, making the problem worse

DEMAND AND SUPPLY I

• Although for different reasons, the outcome is the same as with moral hazard, under insurance against illness

• These problems suggest that a health care system based on private health insurance would not be efficient

• In addition to the inefficiencies of a private health insurance system, most would judge it inequitable

DEMAND AND SUPPLY I

Asymmetry of information and the agency relationship

• Lack of patients’ technical expertise in medicine gives rise to asymmetry of information

• Doctors know more about patients’ health status and potential gains from treatment than patients

• In addition, patients often actively seek to avoid personal decision making and to shift decision making on to doctors

DEMAND AND SUPPLY I

• Patients cannot or do not wish to act as fully informed consumers

• Instead, there is an agency relationship (principal-agent relationship) in which doctors act as agents on behalf of patients

• The ‘perfect agency relationship’ requires that:- the agent objectively supplies information to the patient- the patient can then decide what is best for themselves- the agent then implements the decision

DEMAND AND SUPPLY I

• Assumptions of the “perfect agency relationship”:- doctors have full knowledge of their patients’ health,

attitudes and income- patients can act on the information provided by doctors- doctors are not subject to conflicting incentives which may

compromise their objectivity

• These assumptions do not hold: doctors are not perfect agents

DEMAND AND SUPPLY I

• There is a need for licensure where those permitted to practise must hold some minimum qualification

• Supplier induced demand (SID) may arise

• SID is the power of health care providers to recommend or induce demand for their services beyond the point which a fully informed consumer of health care – or perfect agent – would choose

DEMAND AND SUPPLY I

Competition in the provision of health care

• Licensure of health care professionals gives them a degree of power to restrict entry into their occupations

• If entry to health care professions is limited, competition is reduced; less health care may be provided and at a higher price than if there were more competition

DEMAND AND SUPPLY I

• The degree of market power is enhanced when it is the profession itself which decides on the number of entrants; for example, the British Medical Association advises on entry levels into British university medical schools

• Limited competition also applies to the provision of hospital based services

• If there is only one hospital within ready travelling distance, there is effectively a monopoly; this is true of most of the UK apart from London and a few other large cities

DEMAND AND SUPPLY I

• Limited degree of competition between hospitals was a major problem in attempts to create an ‘internal market’ in the NHS during the 1990s

• The ‘internal market’ or ‘purchaser-provider split’ was introduced in 1990

• GP fundholders, as ‘purchasers’, sought health care on behalf of their patients from hospital trusts and other ‘providers’

DEMAND AND SUPPLY I

• Theory was that competition between hospitals for contracts awarded by GP fundholders would stimulate improvements in efficiency

• In practice, most GP fundholders continued to refer to their ‘traditional’/’local’ hospital

DEMAND AND SUPPLY I

Spillover effects

• Spillover effects (externalities) occur where people experience benefits or costs from the consumption or production of a commodity by others

• Pollution is an example of spillover costs

• In health care, the standard example is vaccination against communicable diseases which benefits the person who is vaccinated but also has spillover benefits for others

DEMAND AND SUPPLY I

• In a free market, these spillover effects would not occur, or not to the same extent

• People will make judgements about the benefits they alone receive from vaccination and ignore the wider benefits to others

DEMAND AND SUPPLY I

Equity and distribution effects

• In addition to their failure to achieve efficiency, free markets in health care are not equitable/fair/just

• Concern with equity implies the availability of some goods, including health care, should not be based, or based solely, on willingness to pay

• Willingness to pay often reflects ability to pay and thus the existing distribution of income and wealth

DEMAND AND SUPPLY I

• The market distribution of income will seldom if ever be judged equitable

• Various conceptual and operational definitions of equity

• The NHS has sought to promote equity in health care across socio-economic classes and geographically

DEMAND AND SUPPLY I

Market failure and government intervention in health care

• Markets in health care are not efficient, mainly because consumers do not have good information

• Market failure provides the rationale for government intervention in health care

• Given government intervention, because of market failure on efficiency grounds, the opportunity can be taken to address market failure on equity grounds