Week 1: Introduction to Health Economics

Week 1: Introduction to health economics

Objectives
• To develop a broad understanding of health and health care from the viewpoint of
economics;
• To define the basic economic problem;
• To develop an appreciation of the importance of choice and scarcity in economics;
and
• To be able to describe the scope of health economics.

Contents
1. A brief overview of economics
2. What do we mean by the health system?
3. Opportunity cost
4. Scarcity and the production possibilities frontier
5. Efficiency in resource allocation
6. Summary
7. Keywords
_________________________________________________________________

1. A brief overview of economics

Economics has been described as the study of human behaviour. Underlying this
description of economics is the strong assumption of rationality, that economic agents will
behave rationally to maximise benefits when faced with choices between alternative uses
of scarce resources. Within the discipline of economics, analysis can be made of human
behaviour through observation of how individuals and firms behave under certain
conditions, or when faced with certain incentives. Indeed this knowledge not only enables
an analysis of the economic problem faced by individuals and firms, but also enables
predictions as to the behaviour and outcomes that may result.

The economic problem can be briefly described in the following way:

1. That resources are scarce relative to all the uses we want to put them to.
2. Limited resources and unlimited wants and desires means that choices have to be
made as to how to use scarce resources for consumption and production.
3. The ultimate choice from an economic perspective results in an efficient outcome.
4. That is, resources in a given activity are minimised to maximise the benefits or
outcomes achieved, therefore the result will bring the most overall benefit.

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This definition of the “economic problem” provides an insight into some of the basic
economic concepts that can be used to understand the economics of health care. This will
be introduced in Week 2.

2. What do we mean by the health system?

The scope of any country’s health system is obviously determined by the meaning attached
to ‘health’. A frequent starting point is the World Health Organisation’s (WHO) definition of
health as ‘a state of complete physical, mental and social well-being and not merely the
absence of disease and infirmity’.

This holistic view of health that emphasises ‘wellness’ rather than illness, serves as a useful
reminder that many of the determinants of good health lie outside traditional health
systems. It is evident that the health status of a population depends on many things,
including nutrition, housing, income and its distribution, educational attainment, lifestyle,
physical environment, employment and many others, as well as those health services
provided within the health system.

This broad definition has value as an inspirational goal, and as a deterrent to setting our
sights too low in the pursuit of better health. In addition, it provides a useful conceptual
basis for many health-related disciplines and as a framework for health policy. However,
the essence of economic thinking is that it is the study of choices between alternative
uses of scarce (in the sense of limited) resources. To define health as broadly as the
WHO definition would imply that health economics would extend into almost every facet of
human activity, ie. it would be the ‘economics of everything’.

If health economics is to be a useful discipline, especially for those working in public health,
the concept of health care must be narrower in scope. Evans (1984) 1 has proposed
confining the subject matter of health economics to activities related to ‘health care’,
defined as:
… that set of goods and services which consumers/patients use solely or primarily
because of their anticipated (positive) impact on health status. Health care is thus
clearly demarcated from other commodities which influence health, but which are
consumed for their perceived direct satisfactions rather than their health effects. (p.5)

This approach is somewhat broader than a view of health as simply the absence of disease
and disability, and is in line with current thinking that health systems should include health
promotion and illness prevention as well as diagnosis and treatment. It follows that the
term ‘health system’ or, (more accurately) ‘health care system’, will be used in the sense of
the sum total of all the entities – government, public authority, private sector, voluntary
organisations and individuals – engaged in activities related to the enhancement of the
health status of individuals or populations, whether of a curative, caring or preventative
kind.

1 Evans, RG (1984) ‘Strained mercy: The economics of Canadian health care’, Toronto: Butterworth.

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Components of health care systems include medical and other treating and caring
professions, hospitals of various kinds, manufacturers and distributors of drugs and
technologies, public health agencies, public regulators, and third parties (insurance
agencies) undertaking risk pooling and cross-subsidisation.

However, despite the uniformity of health conditions, medical knowledge and health
technology, there are also remarkable differences between health systems across
jurisdictions, which can only be explained by the fact that they are partly determined by
historical, cultural and economic characteristics of their local and/or national environments.
The scale of these differences also suggests that who gets what in health care systems is
not totally determined by technical considerations or by markets reflecting consumer
demand for ‘commodities’, but also by processes which reflect a complex set of social
objectives. Meeting these objectives, both individually and as a nation, involves choosing
between the purposes for which limited resources are used. Although it does not provide
all the answers, economics is an essential tool for analysing health system resource
allocation issues of this kind.

3. Opportunity Cost
What is the cost of eradicating measles? $50,000? $100,000? While it may be possible to
provide a fairly straightforward answer in accounting terms, this probably will not reflect the
real cost of the intervention. Often questions about the cost of health care are deceptively
simple.

Each time we decide to use resources by taking a particular course of action (such as
measles eradication) we forego the opportunity to use those same resources in some other
way. This applies to all resources including land, labour (time) and capital equipment. For
example, the time you are devoting to studying this unit cannot also be spent in the cinema.
This is termed the opportunity cost of resource use, where the opportunity cost amounts
to the value of benefits foregone because a resource is not available for its best
alternative use. By making the decision to use your time for study you are implicitly or
explicitly deciding that you value this activity at least as much (if not more) than going to the
cinema. Your foregone benefits can therefore be measured as the satisfaction you would
have had from going to the cinema. Note that in this example it is time that is your limited
resource.

The concept of scarcity that we discussed in Topic 1 underlies opportunity cost. For an
economist, resources do not have to be close to exhaustion to be ‘scarce’; scarcity implies
only that resources are not unlimited. This concept of scarcity implies that we must make
choices between alternative courses of action and it is the act of choice which determines
the real economic cost of each course of action.

Opportunity costs arise whenever there is a choice to be made between competing uses
of resources. Thus in healthcare, they are incurred at all stages and levels of the decision
making process:
• between health services and other goods and services;
• between different health services;
• between alternative treatments for individual patients; and

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• between different patients.

If more resources are directed towards health services, these same resources cannot be
used to provide other types of goods and services, some of which may also improve health.
Expenditure on education or housing are obvious examples. Similarly if more resources
are spent on inpatient services, less of the health budget will be available to spend on
community health. An hour spent by a doctor attending to Mr Lee cannot be spent with any
other patient. A decision to devote resources to a particular type of service, a particular
patient or a particular pattern of treatment means that the opportunity to use those same
resources to yield benefits in some other way is foregone.

The concept of opportunity cost is central to measuring efficiency in health care: it is the
way that all health care resources should be valued. Valuing resources in terms of
foregone benefits rather than simply in dollars highlights a number of important points.
First, it implies that every time you decide to do something, you are also deciding not to do
something else. By deciding not to pursue the alternative you have also implicitly decided it
will be less beneficial to you than your chosen course of action. In each of the above
examples, using economics to inform the decision making process, the result would be that
outcome that provides the most value to society or the individual for the least amount of
resource inputs.

Table 1 provides a hypothetical example of valuing the resources used to treat fractured
hips in terms of preventing osteoporosis. Using all resources to prevent osteoporosis
means that there are none left to treat fractured hips, thus the opportunity cost in terms of
preventing osteoporosis is zero; that is all cases are prevented. However you lose the
benefits from treating 5 fractured hips. At the other end, if all resources are used to treat
fractured hips then there are none left to prevent osteoporosis, thus the opportunity cost of
treating fractured hips are the foregone benefits of preventing 60 cases of osteoporosis.

Table 1: Illustration of opportunity cost – Treatment of fractured hips and prevention

of osteoporosis

Opportunity cost of
Prevention of treating #hips in
Treatment of #hip (N
osteoporosis (N of terms of cases of
of cases treated)
cases prevented) osteoporosis
prevented
0 60 0

1 55 5

2 45 15

3 30 30

4 10 50

5 0 60

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Note that the notion of opportunity cost implies that a resource has value regardless of
whether it is bought and sold in a market. For a patient, the opportunity cost of time spent
waiting for a doctor’s appointment is valuable. The cost may amount to the value of
production lost because the waiting time cannot also be spent at (paid or unpaid) work.
Even if the time would otherwise have been spent at leisure there is an opportunity cost
because the benefits of that leisure have been sacrificed. Implicitly, the patient has decided
the benefits of the appointment (including the travel and waiting time associated with it) are
likely to outweigh the benefits of spending the time in some other activity.

It also means that costs can be incurred without money being spent. For instance, voluntary
services have an opportunity cost even though they are provided ‘free’ (zero dollar cost).
Volunteers spending their time collecting money at an intersection cannot at the same time
be taking senior citizens on a day trip. Nor do resources lie idle without a cost. If a hospital
has empty beds there may be no ‘cost’ in accounting terms, but in economic terms the cost
of an empty bed amounts to the value of the benefits foregone by not using it. However,
opportunity costs would be zero if a resource had no alternative use.

4. Scarcity and the production possibilities

frontier
A theoretical tool often used in microeconomics to illustrate opportunity cost and scarcity is
the production possibilities frontier. The graphical representation of this frontier is a
curve which shows all the possible combinations of goods which can be produced in an
economy. The normal stylistic representation of this is two dimensional, that is two goods
which can be traded-off against each other (see Figure 1). Essentially, however, this tool
can be used to describe an entire economy’s production possibilities.

Measles
vaccinations
• C

• B
• A

Measles
treatment
Figure 1: Production possibilities frontier

Each point on the curve represents the maximum number of measles vaccinations or
measles treatments which can be produced in the economy (Point A) given the current
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stock of resources and technological capabilities. Any point lying under the curve
represents an economy producing below its capacity (Point B), this reflects inefficient
production as more of one good can be attained without necessarily reducing the amount of
the other. Any point outside the frontier, that is, above and to the right of the frontier,
represents a combination of pathology and imaging tests which cannot be produced given
the economy’s available resources and technology (Point C).

Given any production possibilities frontier, choices can be made as to the optimal level of
goods and services to be produced. In this example the opportunity cost of producing more
measles treatments is the reduction in the number measles vaccinations able to be
produced. These trade-offs can occur in any direction along the frontier when the economy
is operating efficiently.

5. Efficiency in resource allocation

Because resources are limited it is both sensible and ethical to use them as efficiently as
possible. Contrary to some interpretations, efficiency is not about minimising costs. If it
was, then the most ‘efficient’ solution would be to provide no health care at all. Rather,
efficiency weighs both (opportunity) costs and benefits. In general terms efficiency means
doing the best we can with what we have; or about getting the most value from available
resources.

If the health system was efficient it would mean that no changes in priorities among health
services, methods of service delivery, groups of patients or alternative treatments for
particular patients could make society any better off.

Note that efficiency incorporates the effectiveness of a particular course of action. If a

service is effective it has been shown to work both in theory and in practice. In other words,
it does more good than harm to those to whom it is offered.

However, not all effective services are efficient. Whether or not a service is efficient
depends on the opportunity cost of providing it (ie a service will be efficient only where the
benefits derived from it are greater than the benefits foregone to provide it). The decision to
provide a service should not be based on effectiveness alone. We need to know what
alternatives we give up when making our choice so that we can choose efficiently.

There are two strands to economic efficiency. As the term implies, technical efficiency
concerns the way in which something is produced – the productive technique. It links the
value of inputs to the quantity of outputs. Technical efficiency is achieved when a given
output cannot be produced with fewer resources (or alternatively, when no more can be
produced with the same resources). For example, a hospital would be efficient if it was
impossible for it to treat the same type and number of patients with a reduced budget. This
is the limited context in which cost minimisation equates with efficiency. Technical
inefficiency is closely linked to waste or mismanagement.

Allocative efficiency is a broader concept, which includes, but goes beyond, technical
efficiency. As far as society as a whole is concerned, it is not enough to be efficient in the
production process. Resources must also be used to produce those goods and services

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which are of greatest value to society. If technical efficiency refers to how to produce
something, then allocative efficiency may be thought of as referring to what to produce and
to whom. Hospitals may provide their inpatient services very (technically) efficiently, but if
many of their patients could be treated equally effectively and at less cost in the community,
it would be unwise to continue to devote the same level of resources to inpatient care.
Allocative efficiency is achieved when the best possible mix of goods and services as
valued by society as a whole is being produced. Thus, allocative efficiency links the value
of inputs to the value of outputs. It requires that the health care system as a whole – from
the resources available to it – should produce that mix of services which society prefers
above all other possible mixes of services which could be produced.

6. In summary
We have learnt that economics is the study of choice between alternative uses of limited
resources. In recent years the limitations on health care resources have become
increasingly apparent. Does this mean that as a society we should be devoting more
resources to health care, regardless of the health benefits that result? Or should we be
more measured in our allocation of resources to the health care sector? If we are to take a
more rigorous approach to resource allocation, then what are the tools that we can use?
One of the tools used by economists is an analysis of efficiency. Regardless of how much
we spend, there will always be some limit to the resources that can be devoted to improving
health and prolonging life. Efficiency analysis helps us to decide how to achieve the best
(optimal) use of these limited resources. However, the economist’s notion of optimal
resource use in health care may not always align with the health care provider’s objective of
‘meeting all possible needs’. We will explore the meaning of optimal resource use and the
associated concepts of opportunity cost, and efficiency in some detail.

This topic introduces you to the discipline of economics and health economics and some
key economic concepts:

• The definition of the health sector is to some extent arbitrary. The generally
accepted solution is to define health care to include goods and services that are
used solely or primarily to improve health.
• Jurisdictions are likely to differ with respect to the organisation and delivery of health
care within their health system.
• Health economics includes tools and strategies for determining to what extent
different parts of the health care system conform to the traditional market model.
• Opportunity cost amounts to the value of foregone benefits because a resource is
not available for its best alternative use. Valuing resources in terms of opportunity
cost implies that:
- every time you decide to do something, you are making the decision not
to do something else;
- costs may be incurred without money being spent;
- resources have value even though they may not be tradeable in the
market;
- market prices do not always reflect opportunity cost.
• Efficiency means getting the maximum possible benefits from the resources
available. Economists distinguish between two measures of efficiency:
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- technical efficiency is achieved when no more of a given output can be

produced from the available resources; it links the value of inputs to the
quantity of output;
• allocative efficiency is achieved when the best possible mix of goods and services is
being produced, from the available resources; it links the value of inputs to the value
of outputs.

7. Keywords
 economics  economic problem
 rationality  health
 health care  health system
 opportunity cost  scarcity
 efficiency  production possibilities frontier
 allocative efficiency  technical efficiency

8. Readings
 McPake B & Normand C (2008) Health economics 2nd ed.
New York: Routledge. Chapter 1, pp1-8

 Morris S, Devlin N, & Parkin D (2012). Economic analysis in

health care, 2nd ed. England: John Wiley & Sons Chapter 1,
pp1-20 (link via eReadings)

 Guinness & Wiseman, Chapter 1, pp7-19

 Folland S, Goodman AC, & Stano M (2013) The economics

of health and health care 7th ed. New Jersey: Pearson.
pp20-23

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