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Lecture 2:

Economics & Efficiency

Jan Abel OlsenUniversity of Tromsø, Norway

www.janabelolsen.org

Teaching programmes: Master of Public Health, University of Tromsø, NorwayHEL-3007 Health Economics and Policy

Master of Public Health, Monash University, AustraliaECC-5979 Health Economics

Master of Health Administration, Monash UniversityECC-5970 Introduction to Health Economics

Main text: Olsen JA (2009): Principles in Health Economics and Policy, Oxford University Press, Oxford

Micro economics

• Producers (firms, sellers)

– Profit-maximizers

• We’re only in it for the money

• Consumers (households, buyers)

– Utility-maximizers

• We’re only here to get satisfaction

The subject of Economics

‘How scarce resources are used to produce and distribute goods and services to meet human wants’

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1: Production

Input output

X

Labour

Capital

Raw materials

The typical relationship between one input factor and output

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Average vs marginal

• Average productivity: X/L

– Total output / Total input

• Marginal productivity: ∆X/∆L

– Changed output / Changed input

– Or, what is the change in output following a one unit increased input?

Production function

• X = f(L, K)

– L = Labour

– K = Capital

• Substitution of input factors

– If less L, more K is required to maintain a given X0

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Substitution of input factors

Isoquant

Cost-effective combination

Isoquant

Budget line

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Producing more than one good

• Scarcity

– Society has a fixed amount of production factors

• The more production factors used for producing X, the less become available for producing Y

– The ‘opportunity costs’ of producing 1 extra X is measured in terms of how many Y the same production factors alternatively could have produced.

• The production possibility curve:

– Impossible to increase X without reducing Y

Production possibility frontier (PPF)

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2: Consumer behaviour

The ‘law’ of diminishing marginal utility

‘satiation point’

Many ways to get some satisfaction

Indifference curve

Utility function: U = u(X, Y)

Substitution of consumption goods

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The cheapest way to get some satisfaction

Indifference curve

Budget line

Robinson Crusoe’s optimum(a one-person-economy)

Marginal costs of producing one extra X in terms of reduced number of Y (marginal rate of transformation, MRTXY)

=Marginal value of X in terms of how many units of Y one is willing to sacrifice (marginal rate of substitution, MRSXY)

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Distributing goods across individuals

• Scarcity

– Society has a fixed amount of goods

• The more goods to Anne, the less become available for Betty

• The utility possibility curve:

– Impossible to increase Ann’s utility without reducing Betty’s utility

Utility possibility frontier(a two-persons economy)

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3: Production of health care

HC

Doctors, nurses

Buildings,machinery

Drugs

Production function in health care and health

• Two separate production relationships

Input factors HC H

• HC = f(doctors, nurses, drugs …)

• H = f(HC)

• H = f[HC(doctors, nurses, drugs …)]

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The opportunity cost of health care

• More money for health care

less for consumption goods

• More money for the public health sector

less for other public sectors

• More money for hospitals

less for primary care

• More money for hospital ward A

less for ward B

• More GP-time for patient X

less for patient Y

Health possibility frontier

HA

HB

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4: The wealth-health spaceIt is certainly better to be rich&healthy than poor&sick!,

but is it better to be rich&sick than poor&healthy???

Health

Wealth

rich

poor

sick healthy

?

?

Trade-offs in the wealth-health space

Health

Wealth

rich

poor

sick healthy

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5: The concept of efficiency I

• Technical efficiency– All points on the isoquant, i.e.

• No waste of input factors

• Cost efficiency – Where the isoquant is tangential to the budget line, i.e.

• The maximum quantity produced with the given budget, OR• The cheapest way of producing a given quantity

The concept of efficiency II

• Pareto-efficiency in production – all points on the production possibility frontier (PPF), i.e.

• Impossible to increase the production of X without reducing the production of Y

• Pareto-efficiency in consumption – all points on the utility possibility frontier (UPF), i.e.

• Impossible to increase Ann’s utility without reducing Betty’s utility

• Pareto-efficiency in the production of health – all points on the health possibility frontier (HPF), i.e.

• Impossible to increase Ann’s health without reducing Betty’s health

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The concept of efficiency III

• Allocative efficiency – in theoretical welfare economics– the allocation of scarce resources that maximize social welfare

• the marginal costs of producing one additional X in terms of reduced number of Y (the marginal rate of transformation, MRTXY) =

• the marginal value of X in terms of how many units of Y one is willing to sacrifice (the marginal rate of substitution MRSXY)

• Allocative efficiency – in applied health economics– the allocation of health care that maximizes policy objectives,

• Allocative efficiency crucially depends on the policy objective

6: Supply and demand

• Supply curve reflects marginal costs

– Technical reason: Diminishing marginal productivity

– Input price reason: Increasing unit costs

• Demand curve reflects marginal benefits

– The ‘law’ of diminishing marginal utility

– Income effect: The more we’ve already bought, the less money we have left for buying more

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Market equilibrium: Supply = Demand

Q*

P*

Elasticities of demand: DX = f(px, pY, I)

• The own price elasticity of demand is the relative change in quantity, X, following a relative change in its own price: ε = (ΔX/X) / (ΔpX/pX)

• The cross price elasticity of demand is the relative change in quantity of good X following a relative change in the price of a related good Y: εC = (ΔX/X) / (ΔpY/pY)

• The income elasticity is the relative increased demand following a relative income increase: εI = (ΔX/X) / (ΔI/I)

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Health policy relevance: DX = f(px)

• The own price elasticity of demand is the relative change in quantity, X, following a relative change in its own price: ε = (ΔX/X) / (ΔpX/pX)

• If we aim to increase the consumption of healthy goods through subsidies, it is important to know how sensitive demand is to lower prices. – To which extent will people demand more?

• If we aim to decrease the consumption of unhealthy goods through indirect taxes, it is important to know how sensitive demand is to higher prices. – To which extent will people demand less?

Health policy relevance: DX = f(pY)

• The cross price elasticity of demand is the relative change in quantity of good X following a relative change in the price of a related good Y: εC = (ΔX/X) / (ΔpY/pY)

• If we increase the price of a certain good, Y, that may lead to some ‘indirect effects’ on the demand for a different good, X. – If X is a substitute to Y, people will consume more X when

Y gets more expensive.• E.g. taxing tobacco may increase the demand for e-cigarettes

– If X and Y are complementary goods, people will consume less X, when they consume less Y.

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Health policy relevance: DX = f(I)

• The income elasticity is the relative increased demand following a relative income increase: εI = (ΔX/X) / (ΔI/I)

• When income increases, the relative increase in the demand for goods differ– Health care appears to be income-elastic, i.e. the relative

increase in the demand for health care is higher than the relative increase in income.

Lessons

• The dismal science

– Scarce resources opportunity costs

• Technology

– Production function; Substitution of input factors

• Preferences

– Choices and trade-offs

• Objectives

– Maximize social welfare, or a given policy objective

• Application to health and health care