QR 24 Economics Review Session

12/3/2009

Agenda

• Demand curves• Supply curves• Equilibrium• Market failures

– Moral hazard– Adverse selection

• Net Present Value

Demand Curves

• y-axis: price• x-axis: quantity of (something) consumed• Slope: usually negative

– Why? decreasing marginal benefits– Marginal benefit: if I already have 100 (or 1000, or 10,000)

of something, how much would I get out of having 1 more?

Demand Curve for Medical Care

4

Price

$50

$100

Quantity of medical care

Demand

An odd thing about demand equations is that they usually express quantity (x-axis) as a function of price (y-axis):

For example, Qd = 100 – 4P

This is the opposite of how you usually see this relationship expressed: y = a + bx

Demand Curves (cont.)

• Health care example: Physician visits• Patient willing to pay a lot for that first visit

– Perhaps the initial diagnosis is the most important piece of information needed

• Patient willing to pay less for each additional visit– Perhaps 2nd, 3rd, 4th, …, opinions don’t add much

new information

• This is decreasing marginal benefits

What Shapes Demand Curves?

• Personal Income– For most goods, demand increases with income

• People who make more money buy more stuff

• Other prices– If substitute goods become cheaper, demand will decrease

• During a sale at CVS’s in-store medical clinics, demand for routine care (e.g., vaccinations) would decrease at local doctors’ offices

• Tastes/Need– People choose to spend their money in different ways

• Sicker people demand more health care than healthier people

Medical Care Demand by Society

7

Price

sick

healthy$50

$100

Quantity of medical care

Price-Responsiveness (Elasticity)

• The responsiveness of the quantity demanded of a good or service to a change in its price

• “Elastic demand” : |Ed|>1– If the price goes up a little, demand goes down a lot

• “Inelastic demand”: |Ed|<1– If the price goes up a little, demand doesn’t change much

Price Elasticity of Demand

9

Price

sick

healthy$50

$100

Quantity of medical care

Less elastic

*technical note:While elasticity is related to the slope of the demand curve, it is not exactly the same thing

More elastic

Supply Curves

• y-axis: price• x-axis: quantity of (something) produced• Slope: usually positive

– Why? higher prices give suppliers incentive to produce more

• With constant marginal costs and perfect competition, supply curve is horizontal – Marginal cost: if we’re already making 100 (or 1000, or 10,000)

of something, how much would it cost to make 1 more?

Supply Curve for Medical Care

11

Price

$50

$100

Quantity of medical care

Supply

Sample equation:

Qs = 3P

Market Equilibrium• The price-quantity pair where the quantity

demanded is equal to the quantity supplied– Set demand and supply equations equal (Qd = Qs) to solve

for P, then plug in P to find Qd or Qs.

• Represented by the intersection of the demand and supply curves

• Economists call this the “optimal point” – Why? It’s efficient since the value of the last unit

consumed (marginal benefit) is equal to the cost of producing it (marginal cost)

– Optimal points are usually noted with a “*”

Market Equilibrium

13

Price

$50

$100

Quantity of medical careQ*

P*

Demand Supply

First Fundamental Theorem of Welfare Economics

• If we assume– Rational individuals– Price-taking behavior (no monopolies)– Complete markets– Complete information

• Then market exchange leads to a socially optimal (Pareto) outcome.

Market Failures in Health

• Incomplete information -> – adverse selection– moral hazard

• The quantity consumed (and produced) is not efficient (i.e., is not at the “optimal point”)

• Other market failures in health:– Consumers not well-informed– Consumers not rational– Monopolies

Demand for Health Care• Demand for health differs from standard demand

because (Grossman model, 1972)1) Health not health care produces utility2) Consumers can purchase health care or produce it

through time inputs / behaviors / decisions3) Demand for health care both raises utility (you feel

better) and also can increase your ability to work, gain income, increase utility from additional consumption.

• BUT… this model account for uncertainty in health outcomes.

Demand for Insurance and Moral Hazard

• The real world involves significant uncertainty• Insurance smoothes income shocks (raising

overall utility), but produces moral hazard.

• Optimal insurance: trade-off cost of moral hazard which induces unnecessary care with the welfare benefit of reduced uncertainty.

Moral Hazard

• Consumers who are insulated from risk behave differently than they would if they were exposed to full risks

• Health insurance insulates patients from full financial risks – Good because we are risk averse

• (So we’re willing to pay a “risk premium” for insurance)

– Bad because of moral hazard

Deadweight Loss

• The loss of economic efficiency that occurs when the quantity consumed (and produced) is not optimal

• When patients are insured, they face a lower price for any amount of medical care

• Because they are insulated from the full price, they will consume more care (moral hazard)

Moral Hazard

20

Price

$50

$100

Quantity of medical careQ*

P*

Pins

Qins

Quantity consumed (Qins) > Optimal quantity (Q*)

Demand Supply

Deadweight Loss

21

Price

$50

$100

Quantity of medical careQ*

P*

Pins

Qins

Deadweight loss here = all the money that is spent on health care above what it is worth to patients (area of the yellow triangle)

PMD

Price received by providers

Price facedby patients

Demand Supply

Providers are supplying more than they would at the efficient point, and patients are demanding more

Evidence for Moral Hazard

• RAND Health Insurance Experiment:• Families enrolled over 3 or 5 years with levels

of cost-sharing that vary 0%- 95%.• Spending at 25% cost-sharing at 81% of

spending level with no cost-sharing and 69% with cost-sharing at 95%.

• Estimated price elasticity of -0.2• Little measured impact on health outcomes

Adverse Selection

• One of the two fundamental problems with the market for health insurance

• Four conditions necessary for adverse selection:– Heterogeneity in health status of patients– Competing health plans– Premiums do not account for heterogeneity in

health status of patients– KEY CONDITION: **Information asymmetry

(insurers don’t know health status of patients)**

Adverse Selection – Death Spiral

• Sicker patients are attracted to the more generous plans

• These plans will have to increase premiums to make up for the higher costs

• Healthier individuals move out of generous plans because the premiums have increased

• These plans will have to increase premiums again to make up for the higher costs…

Adverse Selection

• Potential solutions:– Single-payer– Risk-adjusted premiums– Reinsurance to compensate plans that experience

higher-than expected usage

Net Present Value

• Asks how much a gain or a loss in the future is valued in today’s dollars.

• Why? If I get $100 three years from now, this is equivalent to putting $x in the bank now and receiving interest on it. I only need to put x = 100 * (1 / (1 + r) )t in the bank (t = time, r = interest rate).

• Discount factor: (1 / (1 + r) )t = (1/(1.03))^3 =.91• If r = 0.03 and t = 3, then $x = 91.