Economics of Health and Environment - Part - IV

Enseignant : M.
ABU-ZAINEH
Aix-Marseille School of Economics (AMSE)
Aix-Marseille Université
mohammad.abu-zaineh@univ-amu.fr
1
Health Economics
Part IV: The Economics of Health and Health Care
Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 2

Demand for Medical Care
Basic Economic Concepts: The Demand for Medical Care
⊛ A Simple “Patient-Consumer” Model : Does the “standard” economic theory prevails?
◉ Are the demand curves for health care downward sloping as are the demand curves for other goods?
𝑈 = 𝑓(𝑚, 𝑥)
𝑥 = Other goods and services

𝑑𝑈 = 𝑈𝑥 𝑑𝑥 + 𝑈𝑚 𝑑𝑚
𝑑𝑥 𝑈𝑚
𝑈𝑥 𝑑𝑥 + 𝑈𝑚 𝑑𝑚 = 0 ⟹ =−
𝑑𝑚 𝑈𝑥 Figure: The Indifference Curve
𝑈𝑚 , 𝑈𝑥 > 0 ⟹ 𝑑𝑥Τ𝑑𝑚 < 0
∴ 𝐶𝐼 is negatively sloped.
(𝑚0 , 𝑥0 ) = 𝑚1 , 𝑥1
(𝑚2 , 𝑥2 ) ≻ 𝑚1 , 𝑥1 ⟹ 𝑈2 > 𝑈1
𝑑2𝑥 𝑑 𝑑𝑥Τ𝑑𝑚 𝑥0
=
𝑑𝑚 2 𝑑𝑚
𝑈𝑥 𝑈𝑚𝑚 − 𝑈𝑚 𝑈𝑥𝑚 ∆𝑥 𝑈𝑥
=− 𝑥2 𝑀𝑅𝑈𝑆 = 𝑠𝑙𝑜𝑝𝑒 = − =
𝑈𝑥 2 ∆𝑚 𝑈𝑚
𝑈2 = 𝑓(𝑚, 𝑥)
𝑈𝑥𝑚 < 0 et 𝑈𝑚𝑚 > 0 ⟹ 𝑑 2 𝑥Τ 𝑑𝑚 2
>0 𝑥1
𝑈1 = 𝑓(𝑚, 𝑥)
∴ 𝐶𝐼 is convex (convex preferences).
𝑚0 𝑚1 𝑚 = Health care

Is the demand curve for health care downward sloping?
⊛ Allowing for Exotic Preferences
𝑥 𝑥 𝑈 = 𝑓(𝑥|𝑚)
𝑈 = 𝑓(𝑚|𝑥)
𝑈0 𝑈1 𝑈2 ∆𝑥 𝑥0 − 𝑥0
∆𝑥 𝑥0′
− 𝑥0 𝑝𝑒𝑛𝑡𝑒 = = ′ =0
𝑝𝑒𝑛𝑡𝑒 = = =∞ ∆𝑚 𝑚0 − 𝑚0
∆𝑚 𝑚0 − 𝑚0 𝑥2
𝑥1
𝑥0′
∆𝑥 𝑥0
𝑥0
𝑚 𝑚
𝑚0 𝑚1 𝑚2 𝑚0 𝑚0′

Is the demand curve for health care downward sloping?
⊛ Allowing for Exotic Preferences
𝑥 𝑥 𝑈 = 𝑓(𝑥|𝑚)
𝑈 = 𝑓(𝑚|𝑥)
𝑈0 𝑈1 𝑈2 ∆𝑥 𝑥0 − 𝑥0
∆𝑥 𝑥0′
− 𝑥0 𝑝𝑒𝑛𝑡𝑒 = = ′ =0
𝑝𝑒𝑛𝑡𝑒 = = =∞ ∆𝑚 𝑚0 − 𝑚0
∆𝑚 𝑚0 − 𝑚0 𝑥2
𝑥1
𝑥0′
∆𝑥 𝑥0
𝑥0
𝑚 𝑚
𝑚0 𝑚1 𝑚2 𝑚0 𝑚0′
𝑥 𝑥
IC of a frail individual IC of a robust individual
𝑈 = 𝑓(𝑚, 𝑥)
𝑥0
𝑥0
∆𝑥 ∆𝑥
𝑥1 𝑥1 𝑈1
𝑈1 𝑚
𝑚 𝑚0′ 𝑚1′
𝑚0 𝑚1
The Demand for Medical Care
⊛ A Simple “Patient-Consumer” Model : Does the “standard” economic theory prevails?
Figure: Deriving the demand for health care
𝑥
Demand Concepts:
𝑅1 𝑅1 Τ𝑃𝑚1 > 𝑅2 Τ𝑃𝑚2 > 𝑅3 Τ𝑃𝑚3
Is health care a normal or
𝑃𝑥 𝑈1 > 𝑈2 > 𝑈3
luxury good?
𝑥 𝜕𝑞𝑖∗ Τ𝜕𝑅 > 0 ⟹ 𝜀𝑞,𝑅 > 0

◉ Like the demand curve for 𝜀𝑞,𝑅 > 1
𝑈1
other goods and services, 𝑈2
the demand curve for 𝑅2 𝑅1
𝑅3 𝑈3 • Ambulatory and inpatient
health care is downward Health care (𝑚)
care: complements or
sloping. Pm
substitutes?
① Substitution effect 𝑝3 • Over-the-counter drugs and

② Income effect physician visits: complements
𝑝2 or substitutes?
𝑝1
𝜕𝑞𝑖∗ Τ𝜕𝑝𝑗 > 0 ⟹ 𝜀𝑞𝑖,𝑝𝑗 > 0
𝐷
𝜕𝑞𝑖∗ Τ𝜕𝑝𝑗 < 0 ⟹ 𝜀𝑞𝑖,𝑝𝑗 < 0
𝑚3 𝑚2 𝑚1 Qm
⊛ Demand for Medical Care in the Context of Health Insurance Coverage
◉ How does health insurance coverage affects demand curve for medical care?
◉ Reducing the price of health care at the point of service.
◉ Effect on demand for medical care depends on the form of health insurance policy.
① Indemnity: The insurer pays a fixed dollar amount for a particular type of service.
② Ad valorem subsidy: The insurer pays a specific percentage of the price.
③ Deductible: The insured bears the full cost of health care up to a threshold amount above which the insurer pays
the rest of health care cost.
④ Copays: The insured pays a fixed dollar per unit of service and the insurer pays the rest.
⑤ Expenditure Cap: The insurer pays the health care cost up to a specified coverage ceiling.

① Indemnity: The insurer pays a fixed dollar amount for a particular type of service.
Figure : Effect of Indemnity on The Demand for Health Care

300
𝑸𝒅 = 𝟐𝟎 − 𝟎, 𝟏 𝒑 − 𝑰 ◉ NB. Change in 𝑊𝑇𝑃 = €𝐼.ҧ 𝑊𝑇𝑃 for

250
= 𝟐𝟎 + 𝟎, 𝟏 𝑰 − 𝟎, 𝟏𝒑 𝑞 = 15 post-insurance is:
𝑝(𝐼=€50) = 𝑝(𝐼=€0) + €𝐼 ҧ
Price
200
= 50 + 50 = €100.
150 I=€50
I=€0
𝑝(𝐼=€50) 100
𝑝(𝐼=€0)50 €𝐼 ҧ
0
0 5 10 𝑞= 15 20 25
Quantity demanded
◉ Amount of €𝐼,ҧ does not change as the price change (high-priced- vs. low-price doctors: GP vs. Specialist physicians).
◉ Rank poorly in terms of expenditure risk protection (risk of high out-of-pocket expenditures in the event of illness).
◉ Efficiency-enhancing aspect ⟹ If high-priced- and low-price doctors are of equal quality, consumers choose low-priced doctors.
② Ad valorem subsidy: The insurer pays a specific percentage of the price (“according to the value”).
◉ It increases with increases in the price of the subsidized good or service.
◉ The fraction of the bill that the patient pays is called “co-insurance”.
Figure : Effect of ad valorem on The Demand for Health Care
𝑸𝒅 = 𝟐𝟎 − 𝟎, 𝟏(𝝉 × 𝒑) 450
400
𝝉=0,25 𝝉=0
350
𝝉=0,50
300
250
NB. The demand curve
Price
𝝉=1
200 becomes less elastic as 𝜏 falls.
150
100
50
0
0 5 10 15 20 25
Quantity demanded

③ Deductible: The insured bears minimum amounts of expenditure before the insurer subsidizes care.
◉ The insurer will not pay for many services the Figure : Effect of Deductible on The Demand for Health Care
300
insured receive.
◉ Saving in administrative expenses to the insurer. 250
◉ Over the range covered by deductible, the
insurance will not affect demand for care. 200 Ds
Dh
Price
150
⌛ Example: 𝑝^∗=100
◉ With deductible of 100 × 12,5 = €1250,
Deductible « Free care »
• The healthily (ℎ) will consume 𝑞ℎ = 10 (same without 50
= 100 × 12,5 = €1250 = 100 × 25 − 12,5 = €1250
insurance).
• The sick (𝑠) will consume 𝑞𝑠′ = 25 (free care ∀𝑞 > 𝑞𝑓 ). 0 Q
0 5 10 15 20 25
• The insurance covers = 𝑝∗ × 𝑞𝑠′ − 𝑞𝑓 = €1250 𝑞ℎ 𝑞𝑠 𝑞𝑠′
• The patient’s expenditure = 𝑝∗ × 𝑞𝑓 = €1250. 𝑞𝑓 = 12,5

③ Deductible (cont.)
◉ No effect on the demand below the deductible threshold (𝑞𝑓 ).
◉ Free care ∀𝑞 > 𝑞𝑓 ⟹ Demand becomes inelastic at 𝑞𝑠′ .
Figure : Effect of Deductible on The Demand for Health Care
250
Ds
(without Ds'
200 deductible) (with deductible)
150
Price
𝑝∗ = 100
« Free care »
Franchise (Deductible)
50 = 100 × 25 − 12,5 =
= 100 × 12,5 = €1250
€1250
0
0 5 10 15 20 25 30
𝑞𝑓 = 12,5 𝑞𝑠 𝑞𝑠′ Q

③ Deductible (cont.)
◉ No effect on the demand of the healthy.
◉ Post-insurance demand of the sick becomes less elastic (rotation around point at which 𝐷 touches the 𝑞-axis).
◉ In our example, the deductible of €1250 can be represented by a 50% decrease in initial price.
Figure : Effect of Deductible on The Demand for Health Care

𝑝∗ 𝑞𝑠′
− 𝑞𝑓 300
𝑝′ =
𝑞𝑠′ 250 𝑸𝒅 = 𝟐𝟓 − 𝟎, 𝟏𝒑 ഥ 𝒅 = 𝟐𝟓 − 𝟎, 𝟏(𝟎, 𝟓𝟎 × 𝒑)
𝑸 ഥ 𝒅 = 𝟐𝟓
𝑸
′
𝑝∗ 25 − 12,5 Ds Ds
𝑝 = (with deductible)
25 200 (without
𝑝 = 0,50 × 𝑝∗
′ deductible)
Price
150
𝑝∗ = 100
Deductible « Free care »
𝑝′ = 50
= 100 × 12,5 = €1250 = 100 × 25 − 12,5 = €1250
0
0 5 10 15 20 25
𝑞𝑓 = 12,5 𝑞𝑠 𝑞𝑠′

④ Copays: The insured pays a fixed dollar per unit of service and the insurer pays the rest.
Figure: Effect of Co-Pay on The Demand for Health Care

200
180 Dco-pay
160 ◉ The insurance renders the demand curve
140 perfectly inelastic above the co-pay amount:
120
D0 whatever the price of service is, the insured
always pays the same amount of the “co-pay”.
Price
100
80
60 ◉ The insurance has no effect on the demand

40 curve up to the amount of the “co-pay”.
€Co-pay 20
0
0 5 10 15 20 25
Q
𝑞𝑐𝑜−𝑝𝑎𝑦

⑤ Expenditure Cap: The insurer pays the health care cost up to a specified coverage ceiling.
Figure: Effect of Expenditure Cap on the Demand for Health Care

250
◉ Let the maximum amount of
coverage by the insurance be
200
100 × 150 = €15 000.
◉ With this cap, the insured can 𝑝𝑝 150
Price
consume up to 𝑞𝑝 and incur zero
expenditure. This implies a 100
Plafond
horizontal demand (perfectly = 100 × 150
elastic) up to 𝑞𝑝 . 50 = €15 000
◉ Beyond the ceiling 𝑝𝑝 × 𝑞𝑝 , the 0

0 50 100 150 200 250 300
demand will be downward sloping. Q
𝑞𝑝

The Demand for Medical Care in the Context of Health Insurance Coverage
⊛ Effect of deductible and co-insurance on the demand for health care
◉ Recall: Deductible has no effect on the demand below the deductible threshold (in our previous e.g., 𝑞𝑓 = 12,5).
◉ Free care ∀𝑞 > 𝑞𝑓 ⟹ Demand is perfectly inelastic at 𝑞𝑠′ = 25.

⊛ Effect of deductible and co-insurance on the demand for health care
◉ Recall: Deductible has no effect on the demand below the deductible threshold (in our previous e.g., 𝑞𝑓 = 12,5).
◉ Free care ∀𝑞 > 𝑞𝑓 ⟹ Demand is perfectly inelastic at 𝑞𝑠′ = 25.
◉ To render the post-deductible demand price-sensitive, the insurer can impose co-insurance, 𝜏 = 25%.
◉ This causes post-deductible demand price-sensitive to rotate to left around the point 𝑞𝑠′ .
Figure : Effect of Deductible and Co-insurance
250
225
D D'
without deductible with deductible
200 D''
with co-insurance
175
150
Prix
125
100
75
Beyond deductible threshold
insurance pays only 75%. 50
Deductible
= 100 × 12,5 = €1250
25
0
0 5 10 𝑞𝑓 = 12,5 15 20 25 30
Q
𝑞𝑠′
Empirical Studies of Demand for Medical Care
⊛ Concepts of Time Price and Full Price
◉ The out-of-pocket price one pays for care is not the only price the consumer of health care services face.
◉ The full price of an effective visit, 𝑝𝑓 can be defined as:
𝑝𝑓 = 𝑐. 𝑝 + 𝑤. 𝑡
• 𝑐 = coinsurance rate, 𝑝 = physician’s fee, 𝑤 = value of the patient’s time spent doing other activities (e.g.,
foregone earnings…) and 𝑡 = total patient time consumed by a visit.

Empirical Studies of Demand for Medical Care
⊛ Concepts of Time Price and Full Price
◉ The out-of-pocket price one pays for care is not the only price the consumer of health care services face.
◉ The full price of an effective visit, 𝑝𝑓 can be defined as:
𝑝𝑓 = 𝑐. 𝑝 + 𝑤. 𝑡
• 𝑐 = coinsurance rate, 𝑝 = physician’s fee, 𝑤 = value of the patient’s time spent doing other activities (e.g.,
foregone earnings…) and 𝑡 = total patient time consumed by a visit.
◉ A useful framework for explaining several stylized facts

① In many countries “free care” is provided in public clinics where typically patients have long waiting time. Patients
differ in their 𝑤, and so in the importance of 𝑤. 𝑡 as a fraction of 𝑝𝑓 .
• People with low 𝑤 would select sources of care with a higher 𝑡 (e.g., public facilities).
• People with higher 𝑤 would select sources of care with low 𝑡 even if the 𝑝 is higher (e.g., private facilities).
② As 𝑐 is reduced, persons have an incentive to select care with low 𝑡.

• When 𝑐 = 0, people will not be concerned about fees at all. They will select sources of care with lowest 𝑤. 𝑡.
• The demand for free public clinic may be expected to fall. Thus, the public provision of complete insurance 𝑐 = 0
should lead to a decline in the number of free public clinic.
③ Reduction in 𝑐 will reduce the elasticity of demand with respect to fees. At 𝑐 = 0, this elasticity will be zero.
⊛ Empirical studies of demand for health care
◉ Many studies of demand for health care have been conducted since 1970s.
◉ Economists emphasized the role of of prices and income as determinants of demand.
◉ Others have focused on the other determinants (psychological, sociological, cultural factors and public policies…).
◉ Vast majority of studies are based on observational data (surveys, medical records and insurers’ claims data).
• Disadvantage of observational data : In low-coverage setting (or when insurance is voluntary), healthy individuals
may forgo health insurance while unhealthy may choose more generous converge (adverse selection problem).
◉ Few studies have relied on data from natural experiments (NEs) or randomized control trials (RCTs).
• Both involve randomization of subjects to treatment (𝑇) and control (𝐶) groups.
◉ NEs:
• Take advantage of changes in features of health insurance plan (and less costly than RCTs).
• Example: Cockx & Brasseur (2003). The demand for physician services: evidence from a natural experiment.
Journal of Health Economics, 22(6): 881-913.
◉ RCTs :
• Avoid the adverse (self-) selection problem, but are costly and attrition is likely.
• Individuals are randomly assigned to treatment and control groups.
• Example: The Rand health insurance experiment (RHIE).

⊛ Empirical Studies of Demand for Health Care (cont.): Example on Natural Experiments (NEs)
◉ Consider the impact of an increase in co-payments, 𝑐𝑝, on the use of certain care services (GPs, SPs).
• If insurance is compulsory, then any change in use can be attributed to change in 𝑐𝑝 ( which are exogenous to
those affected by the change – treatment group, 𝑇).
• There are possibly other factors (e.g., recession) that may have also affected the use, thus, a control group, 𝐶
can consist of those who have been affected by “the other factors”, but for whom 𝑐𝑝 did not change.
• To compute the effect of treatment (i.e., ∆𝑐𝑝) on the outcome (use of care services), compare the average
change in the outcome variable for the treatment group, 𝑇, compared to the average change for the control
group, 𝐶, between the two time periods (pre- and post change).
• The difference in the mean difference in quantity of use post- vs. pre-change between 𝑇 and 𝐶 groups :
∆𝑥𝑇 − ∆𝑥𝐶 = 𝑥𝑇−𝑝𝑜𝑠𝑡 − 𝑥𝑇−𝑝𝑟𝑒 − 𝑥𝐶−𝑝𝑜𝑠𝑡 − 𝑥𝐶−𝑝𝑟𝑒
• Change in price of 𝑗 service for 𝑇 group = ∆𝑐𝑝𝑗𝑇 and for 𝐶 group ∆𝑐𝑝𝑗𝑇 = 0.
• The difference in difference between 𝑇 and 𝐶 groups is called the difference-in-difference estimator.

⊛ Empirical studies of demand for health care (cont.): Rand Health Insurance Experiment (RHIE)
◉ RHIE was conducted in 1970s and remains till now the classic study of demand for health care services.
◉ Research issues and questions:
(1) How does cost-sharing (out-of-pocket payments) affect demand for health care services?
(2) How does cost-sharing affect demand for particular services; e.g., hospital care, mental and dental services?
(3) Is the demand response to increased cost-sharing different for the poor than for the non poor individuals?
(4) Does use of health care services improve health?
(5) How does a change from fee-for-service payment to capitation (under which provision of additional services
does not result in additional payment to providers) affect demand for health care services?

⊛ Empirical studies of demand for health care (cont.): Rand Health Insurance Experiment (RHIE)
◉ RHIE was conducted in 1970s and remains till now the classic study of demand for health care services.
◉ Research issues and questions:
(1) How does cost-sharing (out-of-pocket payments) affect demand for health care services?
(2) How does cost-sharing affect demand for particular services; e.g., hospital care, mental and dental services?
(3) Is the demand response to increased cost-sharing different for the poor than for the non poor individuals?
(4) Does use of health care services improve health?
(5) How does a change from fee-for-service payment to capitation (under which provision of additional services
does not result in additional payment to providers) affect demand for health care services?
◉ Study design
• RHIE enrolled about 2000 non-elderly families from six different areas in the USA for a period of 3 to 5 years.
• Persons older than age 62 were excluded.
• Families randomly assigned to 1 of 14 fee-for-service insurance plans differing in :
(1) Coinsurance or cost-sharing rates (out-of-pocket, 𝑜𝑜𝑝, payments).
(2) Maximum dollar expenditures per year (𝑀𝐷𝐸 : a limit on total 𝑜𝑜𝑝 expenditures for medical services incurred in
a year – also called stop loss).
• Plans ranging from full coverage (zero cost to families) to shallow coverage (families paid 95% of expenses 𝑜𝑜𝑝
up to the stop loss (10% of the family’s income).
• Some participants randomly assigned to capitation insurance plan.
• Participation was entirely voluntary.
⊛ Empirical Studies of Demand for Health Care: Results From RHIE
Table: Annual Use of Medical Services per Capita, by Plan
Insurance plan Share of
Outpatient Inpatient Inpatient Total
with different co- Likelihood of Outpatient care enrollees with
Expenditures admissions expenditures expenditures
payment rates any use (%) (𝒒𝒇 ) one or more
(1991 $) (𝒒𝑨 ) (1991 $) (1991 $)
(𝒑) admission (%)
Free 86.8 4.55 $446 10.3 0.128 $536 $982
25% 78.7 3.33 341 8.4 0.105 489 831
50% 77.2 3.03 294 7.2 0.092 590 884
95% 67.7 2.73 266 7.9 0.099 413 679
Insurance plan
72.3 3.02 $308 9.6 0.115 489 $797
with deductible
Source: Newhouse and the Insurance Experiment Group (1993), p. 41
◉ Key RHIE results on use:

• Compute the arc price-elasticities of demand for GP visits (𝑞 𝑓 ) and total admissions (𝑞 𝐴 ).
∆𝑞 𝑝2 + 𝑝1 (2.73 − 3.33) 120%
⌛ Example: 25% copayment ⟹ 95% copayment rate. 𝜀𝑎𝑟𝑐 = × = × = −0.17
∆𝑝 𝑞2 + 𝑞1 (95% − 25%) 6,06
• Compare the individual deductible plan with the free plan, both of which offered free hospital care.
• Imposing a deductible on outpatient care resulted in lower use of both outpatient and inpatient care. Does this
imply that outpatient and inpatient care are complements or substitutes.
⊛ Empirical Studies of Demand for Health Care: Results From RHIE (cont.)
Table: Annual Expenditure and Use by Income Tercile
Income range
Insurance plan Lowest Tercile Middle Tercile Highest Tercile
Free 82.8 87.4 90.1
25% 71.8 80.1 84.8
Probability of
50% 64.7 76.2 82.3
any use
95% 61.7 68.9 73.8
Deductible 65.3 73.9 79.1
Free 10.63 10.14 10.35
Probability of 25% 10.03 8.44 7.97
any inpatient 50% 9.08 8.06 7.77
use 95% 8.77 7.38 7.07
Deductible 9.26 9.44 9.88
Free 1093 965 1060
Expenses 25% 891 771 817
(1991$) 50% 800 721 773
95% 762 648 691
Deductible 798 778 878
Source: Newhouse and the Insurance Experiment Group (1993), p. 46
• Example: Among those randomized to the free care plan, 82.8% and 90.1%, respectively, on average used at least one unit of
care during the year. For inpatient use, the relationship between income and utilization is U-shaped: 10.6% of those in the lowest
income tercile were admitted at least once in the year, but only 10.1% of those in the middle tercile were admitted. But among
persons in the highest tercile of family income, 10.4% were admitted to hospitals at least once in a year.
The Demand for Medical Care: Concluding Remarks
⊛ Critics
◉ Can we consider that, like other goods and services, the patient is really responsible for the level and nature of his
consumption of health goods and services? Does s/he choose it?
◉ In the patient-consumer model, behavior reflects utility obtained from the consumption of medical services.
• Health care in itself may not provide immediate utility (anxiety, adverse effects of treatment, etc.).
• Getting vaccines does not provide utility but staying healthy does.
• The utility is rather derived from the improvement of the state of health ⟹ The notion of “the demand for health”.
◉ Specific features of health care : Health care is not like others goods and services:
• Consumer ignorance: Individuals do not possess a high degree of rationality and information.
• Irrationality of the consumer is due to the asymmetry of information and the uncertainty.
• The consumer (patient) is not the only “decision-maker” since it is the doctor who prescribes the treatment.
• The consumer is also not the one who bears the full cost since the financing can be collective.
• The health care market is subject to market failures.
◉ Many theoretical extensions have enriched the basic model.

• Health care demand models vs. health demand models.
• Health care consumption vs. investment in health capital.

Demand for Health
The Demande for Health
The Demand for Health:

The Grossman Model

Demand for Health
⊛ The Health Demand Model: The Grossman Model
◉ Modelling the evolution of “health” itself, or “health capital”, based on the theory of human capital.
• Consider health as an endogenous variable:
- It is similar to a durable good or a capital which the individual has at birth and which depreciates over time and
which evolves according to the consumption choices adopted by the individual over his life cycle.
- It is both demanded and produced by consumers.
- It is a variable of choice because it is a source of utility (determining income levels).

Demand for Health
⊛ The Health Demand Model: The Grossman Model
◉ Modelling the evolution of “health” itself, or “health capital”, based on the theory of human capital.
• Consider health as an endogenous variable:
- It is similar to a durable good or a capital which the individual has at birth and which depreciates over time and
which evolves according to the consumption choices adopted by the individual over his life cycle.
- It is both demanded and produced by consumers.
- It is a variable of choice because it is a source of utility (determining income levels).
◉ Grossman distinguishes two models:

① The consumption model:
• Health as a “consumption good” ⟹ Utility function.
• Improvement of health status is valued: Being in better health increases the well-being of the individual.
② The investment model:
• Health as “stock of capital” ⟹ Production function of health capital.
• Improving health status allows the individual to increase their ability to consume and to produce.
• Investment decision is considered as a demand for prevention that increases the time in good health or as a
demand for health care to compensate for the depreciation in the health capital.
Demand for Health
The Health Demand Model: The Grossman Model
① The Health Consumption Model: Single-Period Utility At Time t
◉ Health as a “consumption good” ⟹ Utility function.
◉ One’s health contributes directly to utility: Health is a source of utility (well-being).
◉ Health enters directly into utility as a “choice variable”.
𝑈𝑡 = 𝑈(𝐻𝑡 , 𝑍𝑡 )
• 𝐻𝑡 = Level of health at time 𝑡 and 𝑍𝑡 = A composite good representing every thing else 𝑡.

Demand for Health
◉ Nota Bene:
• Health care does not appear explicitly in 𝑈𝑡 .
• Choices made by the individual may simultaneously change 𝐻 and 𝑍.
• Eating a double-double cheese-burger may contribute positively to 𝑍
but also clog the individuals’ arteries and cause a reduction in 𝐻.
• Exercising may increase both 𝑍 and 𝐻.

Demand for Health
◉ Nota Bene:
• Health care does not appear explicitly in 𝑈𝑡 .
• Choices made by the individual may simultaneously change 𝐻 and 𝑍.
• Eating a double-double cheese-burger may contribute positively to 𝑍
but also clog the individuals’ arteries and cause a reduction in 𝐻.
• Exercising may increase both 𝑍 and 𝐻.
• Besides possible tradeoffs between 𝑍 and 𝐻, other constraints limit the individual’s ability to gain utility:
Time constraint Budget constraint

Demand for Health
① The Health Consumption Model: Single-Period Utility At Time t (cont.)
◉ Time constraint within a single-period
• Assume that the individual has to allocate Θ = 24h between four different activities:
𝑇𝑊 𝑇𝐻
Time spent working Time spent improving health
contributes to 𝑈 from 𝐻𝑡 .
𝑇𝑍 𝑇𝑆
Time spent playing
contributes to 𝑈 from 𝑍𝑡 . Time spent sick
does not contribute to 𝑈.
Θ = 24 = 𝑇 𝑊 + 𝑇 𝑍 + 𝑇 𝐻 + 𝑇 𝑆

Demand for Health
① The Health Consumption Model: Single-Period Utility At Time t (cont.)
◉ Time constraint within a single-period
• Assume that the individual has to allocate Θ = 24h between four different activities:
𝑇𝑊 𝑇𝐻
Time spent working Time spent improving health
contributes to 𝑈 from 𝐻𝑡 .
𝑇𝑍 𝑇𝑆
Time spent playing
contributes to 𝑈 from 𝑍𝑡 . Time spent sick
does not contribute to 𝑈.
Θ = 24 = 𝑇 𝑊 + 𝑇 𝑍 + 𝑇 𝐻 + 𝑇 𝑆
◉ Nota Bene: Time constraint means time tradeoffs
• Each activity plays a different role in the Grossman model and contributes to individual’s utility in different ways.
• Each hour spent working (𝑇 𝑊 ) produces income, which can then be used to buy things that contribute to utility (𝐻, 𝑍).
• The individual needs to spend time on those activities (𝑇 𝐻 , 𝑇 𝑍 ).
• E.g., She might buy a yoga mat with her income, but she must spend time using it (𝑇 𝐻 ) in order to actually produce 𝐻.
• 𝑇 𝑆 does not increase utility: every hour spent sick takes away time to do other utility-increasing activities (loss time).
Demand for Health
① The Health Consumption Model (cont.): The Labor-Leisure Tradeoff
For given levels of 𝑇 𝑆 and 𝑇 𝐻 ,

Figure : The Labor-Leisure Tradeoff
𝑇𝑊
individual can choose to allocate
time Θ − 𝑇 𝐻 + 𝑇 𝑆 , between
work 𝑇 𝑊 and play 𝑇 𝑍 .
Time constraint
24 − 𝑇 𝐻 − 𝑇 𝑆 = 𝑇 𝑊 + 𝑇 𝑍
24h − 𝑇 𝐻 + 𝑇 𝑆
𝑇𝑍
24h − 𝑇 𝐻 + 𝑇 𝑆

Demand for Health

𝑇𝑊
Time constraint
24 − 𝑇 𝐻 − 𝑇 𝑆 = 𝑇 𝑊 + 𝑇 𝑍
24h − 𝑇 𝐻 + 𝑇 𝑆
Optimal point decides on
indifference curves
𝐷
𝑇0𝑊
𝑈0
𝑇𝑍
𝑇0𝑍
24h − 𝑇 𝐻 + 𝑇 𝑆

Demand for Health

𝑇𝑊
24h • When health improves ⟹ less 𝑇 𝐻 and 𝑇 𝑆
⟹ more productive time is available for
Time constraint 𝑇 𝑊 and 𝑇 𝑍 .
24 − 𝑇 𝐻 − 𝑇 𝑆 = 𝑇 𝑊 + 𝑇 𝑍
24h − 𝑇 𝐻 + 𝑇 𝑆
𝑇 𝐻 , 𝑇 𝑆 ⟶ 0 ⟹ 𝑇 𝑊 + 𝑇 𝑍 ⟶ 24ℎ
indifference curves
𝐷
𝑇0𝑊
𝑈0
𝑇𝑍
𝑇0𝑍 24h
24h − 𝑇 𝐻 + 𝑇 𝑆

Demand for Health

𝑇𝑊
24h • When health improves ⟹ less 𝑇 𝐻 and 𝑇 𝑆
⟹ more productive time is available for
Time constraint 𝑇 𝑊 and 𝑇 𝑍 .
24 − 𝑇 𝐻 − 𝑇 𝑆 = 𝑇 𝑊 + 𝑇 𝑍
24h − 𝑇 𝐻 + 𝑇 𝑆
𝑇 𝐻 , 𝑇 𝑆 ⟶ 0 ⟹ 𝑇 𝑊 + 𝑇 𝑍 ⟶ 24ℎ
indifference curves
• Health improvement, 𝐻, pushes time
𝐷′ constraint outward and the individual can
𝑇1𝑊 reach higher utilities (from 𝑈0 to 𝑈1 ).
𝐷
𝑇0𝑊 𝑈1
𝑈0
𝑇𝑍
𝑇0𝑍 𝑇1𝑍 24h
24h − 𝑇 𝐻 + 𝑇 𝑆

Demand for Health
Health as an input into production
⊛ The Health Capital Production Function: The Production Process of 𝐻𝑡 and 𝑍𝑡
◉ Unlike the usual economic model of consumer behavior, where all inputs into utility are purchase directly on the
market, in our model neither 𝐻 nor 𝑍 can be purchase in a store.

Demand for Health
◉ To produce the two inputs into utility 𝑈(𝐻𝑡 , 𝑍𝑡 ), she must combine market goods she purchases with personal time.
◉ For both health, 𝐻, and the home good, 𝑍, there are two distinct categories of input:
• 𝑇 𝐻 and 𝑇 𝑍 : Personal time inputs that create 𝐻 and 𝑍, resp.
• 𝑀𝑡 : Market goods (inputs) for 𝐻.
Eg., Treadmill Eg., Video games
• 𝐽𝑡 : Market goods (inputs) for 𝑍.

Demand for Health
Despite the similarities between 𝐻 and 𝑍, there is at least two important difference:
• 𝑍 is a flow created and consumed each period, while 𝐻 is a stock that accumulates and deteriorates from period to period.
• Today’s health 𝐻𝑡 also depends on yesterday’s health 𝐻𝑡−1 (A form of stock/capital (an investment)).

Demand for Health
Despite the similarities between 𝐻 and 𝑍, there is at least two important difference:
• 𝑍 is a flow created and consumed each period, while 𝐻 is a stock that accumulates and deteriorates from period to period.
• Today’s health 𝐻𝑡 also depends on yesterday’s health 𝐻𝑡−1 (A form of stock/capital (an investment)).
◉ Thus, 𝐻 and 𝑍 are determined by the following production functions:
𝐻𝑡 = 𝐻(𝐻𝑡−1 , 𝑇𝑡𝐻 , 𝑀𝑡 )
𝑍𝑡 = 𝑍(𝑇𝑡𝑍 , 𝐽𝑡 )

Demand for Health
◉ Besides the time constraint, Θ, the individual faces another “traditional” budget constraint.
◉ Let 𝑤 be the wage per unit of time, 𝑇𝑡𝑊 ; 𝑝𝑀 and 𝑝𝐽 be the prices of 𝑀𝑡 and 𝐽𝑡 , resp. Then, the budget constraint is:
𝑝𝑀 × 𝑀𝑡 + 𝑝𝐽 × 𝐽𝑡 ≤ 𝑤 × 𝑇𝑡𝑊 = 𝑌𝑡
◉ Assume no saving leftover income to spend in future periods. So,
𝑝𝑀 × 𝑀𝑡 + 𝑝𝐽 × 𝐽𝑡 = 𝑤 × 𝑇𝑡𝑊 = 𝑌𝑡

Demand for Health
◉ Besides the time constraint, Θ, the individual faces another “traditional” budget constraint.
◉ Let 𝑤 be the wage per unit of time, 𝑇𝑡𝑊 ; 𝑝𝑀 and 𝑝𝐽 be the prices of 𝑀𝑡 and 𝐽𝑡 , resp. Then, the budget constraint is:
𝑝𝑀 × 𝑀𝑡 + 𝑝𝐽 × 𝐽𝑡 ≤ 𝑤 × 𝑇𝑡𝑊 = 𝑌𝑡
◉ Assume no saving leftover income to spend in future periods. So,
𝑝𝑀 × 𝑀𝑡 + 𝑝𝐽 × 𝐽𝑡 = 𝑤 × 𝑇𝑡𝑊 = 𝑌𝑡
◉ Nota Bene: Time and budget constraints are linked through the individual’s decision about time spent working
(𝑇𝑡𝑊 ).
• Recall: The time constraint is Θ = 𝑇 𝑊 + 𝑇 𝑍 + 𝑇 𝐻 + 𝑇 𝑆 .
𝑝𝑀 × 𝑀𝑡 + 𝑝𝐽 × 𝐽𝑡 = 𝑤 × Θ − 𝑇 𝑍 − 𝑇 𝐻 − 𝑇 𝑆
• Let 𝑇 𝑃 be the productive time spent on useful activities (the complement of 𝑇 𝑆 ):

𝑇𝑃 = Θ − 𝑇 𝑆 = 𝑇𝑊 + 𝑇 𝑍 + 𝑇𝐻
☞ ⬆ 𝐻𝑡 ⟹ ⬇ 𝑇 𝑆 ⟹ ⬆ 𝑇 𝑃 ⟹ either 𝑇 𝐻 ⬆, or 𝑇 𝑊 and 𝑇 𝑍 ⬆.
• Increased productive time (𝑇 𝑃 ) can be reinvested into health (𝑇 𝐻 ) or other useful endeavors (𝑇 𝑊 , 𝑇 𝑍 ).
Demand for Health
⊛ The Health Capital Production Function (cont.): Sick Time, 𝑻𝑺 , and Productive Time, 𝑇 𝑃
◉ In the Grossman model, there are diminishing marginal returns to productive time from health. If a person is very
unhealthy, even small improvements in 𝐻 can yield substantial decreases in 𝑇 𝑆 . Conversely, If a person is already
healthy enough to have very little sick time, then additional improvements in 𝐻 yield little additional 𝑇 𝑃 .

Demand for Health
Figure : The « Illness Avoidance Function »
𝑇𝑆
Θ = 24h
∆𝑻𝑺
∀ 𝐻 > 𝐻𝑚𝑖𝑛 ⬇
∆𝐻
No productive time left; cannot

generate any more health.
𝐻𝑡
𝐻𝑚𝑖𝑛
• As 𝐻𝑡 ⬆ ⟹ 𝑇 𝑆 ⬇ ⟹ ⬆ 𝑇 𝑃 = Θ − 𝑇 𝑆 ⟹ reinvested into health, 𝑇 𝐻 ⬆.
• Effect of 𝑇 𝑆 (complement of 𝑇 𝑃 ) on 𝐻𝑡 shrinks as health improves.

Demand for Health
𝑆 Figure : The « Illness Avoidance Function » 𝑇𝑃 Figure : The Health Capital Production Function
𝑇
Θ = 24h
Θ = 24h
∆𝑻𝑺 ∆𝑻𝑷
∀ 𝐻 > 𝐻𝑚𝑖𝑛 ⬇= ⬇
∆𝐻 ∆𝐻
No productive time left; cannot

generate any more health.
𝐻𝑡 𝐻𝑡
𝐻𝑚𝑖𝑛 𝐻𝑚𝑖𝑛
• As 𝐻𝑡 ⬆ ⟹ 𝑇 𝑆 ⬇ ⟹ ⬆ 𝑇 𝑃 = Θ − 𝑇 𝑆 ⟹ reinvested into health, 𝑇 𝐻 ⬆. • As 𝐻𝑡 ⬆ ⟹ ⬆ 𝑇 𝑃 = Θ − 𝑇 𝑆 ⟹ reinvested into health, 𝑇 𝐻 ⬆.
• Effect of 𝑇 𝑆 (complement of 𝑇 𝑃 ) on 𝐻𝑡 shrinks as health improves. • The effect of 𝑇 𝑃 (complement of 𝑇 𝑆 ) on 𝐻𝑡 shrinks as health ⬆.

Demand for Health
⊛ Production Possibility Frontier for H and Z
◉ Standard 𝑃𝑃𝐹 shows 𝐻 and 𝑍 as substitutes. Wrong! Why?
Figure : Production Possibility Frontier for 𝐻 and 𝑍

𝑍 ( 𝐻 vs. 𝑍)

Demand for Health

𝑃
Impossible : 𝐻𝑚𝑖𝑛 > 0

Demand for Health

𝑃
𝑍 = 0 ⟹ 𝑇𝑃 = 0 ⟹ 𝑇𝑆 = Θ
Minimum level of health ⟹ No
productive time for other
activities.
𝐴
𝐻
𝐻𝑚𝑖𝑛

Demand for Health

𝑃
« Free-lunch zone »
∀ 𝐵 ∈ (𝐴, 𝐶)
𝐻 ⬆ ⟹ 𝑇 < Θ ⟹ 𝑇 𝑃 > 0 ⟹ 𝑍⬆
𝑆
More of 𝑍 and of 𝐻
𝑍 = 0 ⟹ 𝑇𝑃 = 0 ⟹ 𝑇𝑆 = Θ
activities. 𝐵
𝐴
𝐻
𝐻𝑚𝑖𝑛

Demand for Health

𝑃
Maximum 𝑍 possible
« Free-lunch zone »
∀ 𝐵 ∈ (𝐴, 𝐶)
𝐻 ⬆ ⟹ 𝑇 < Θ ⟹ 𝑇 𝑃 > 0 ⟹ 𝑍⬆
𝑆
𝑍 = 0 ⟹ 𝑇𝑃 = 0 ⟹ 𝑇𝑆 = Θ 𝐶
activities. 𝐵
𝐴
𝐻
𝐻𝑚𝑖𝑛

Demand for Health

𝑃
« Free-lunch zone » « Tradeoff zone »

∀ 𝐵 ∈ (𝐴, 𝐶) ∀ 𝐷 ∈ 𝐶, 𝐸 : 𝐻 ⬆ ⟹ 𝑍⬇
𝐻 ⬆ ⟹ 𝑇 < Θ ⟹ 𝑇 𝑃 > 0 ⟹ 𝑍⬆
𝑆
Increases in 𝐻, takes away from 𝑍
𝑍 = 0 ⟹ 𝑇𝑃 = 0 ⟹ 𝑇𝑆 = Θ 𝐶
productive time for other 𝐷
activities. 𝐵
𝐴
𝐻
𝐻𝑚𝑖𝑛

Demand for Health

𝑃
« Free-lunch zone » « Tradeoff zone »

∀ 𝐵 ∈ (𝐴, 𝐶) ∀ 𝐷 ∈ 𝐶, 𝐸 : 𝐻 ⬆ ⟹ 𝑍⬇
𝐻 ⬆ ⟹ 𝑇 < Θ ⟹ 𝑇 𝑃 > 0 ⟹ 𝑍⬆
𝑆
Increases in 𝐻, takes away from 𝑍
𝑍 = 0 ⟹ 𝑇𝑃 = 0 ⟹ 𝑇𝑆 = Θ 𝐶
productive time for other 𝐷 𝑍 = 0 ⟹ 𝑇 𝑆 = 0 ⟹ 𝑇 𝑃 = 𝑇 𝐻 = Θ ⟹ 𝐻 = 𝐻𝑚𝑎𝑥
activities. 𝐵 Spend all time and money on health.
𝐴 𝐸 𝐻
𝐻𝑚𝑖𝑛 𝐻𝑚𝑎𝑥
Demand for Health
⊛ Choosing optimal H* and Z*
◉ Let ℙ be the set of preferences reflecting the importance an individual attach to 𝐻 and 𝑍:
• ℙ ⊄ (𝐴, 𝐶), since ∀𝐵 ∈ (𝐴, 𝐶), 𝐶 ≻ 𝐵 ⟹ ℙ ⊂ 𝐶, 𝐸
◉ To maximize her utility, the individual chooses point 𝐹 = (𝐻 ∗, 𝑍 ∗ ) (WHY?)
• 𝑈 𝐽 , 𝑈 𝐺 = 𝑈0 < 𝑈1 ⟹ 𝐽, 𝐺 ≺ 𝐹.
𝑍 Figure: The PPF of health good (𝐻) and other goods (𝑍)
𝐵
𝑍∗
𝐴 𝐸
𝐻𝑚𝑖𝑛 𝐻∗ 𝐻
Demand for Health
⊛ Choosing optimal H* and Z*
◉ Let ℙ be the set of preferences reflecting the importance an individual attach to 𝐻 and 𝑍:
• ℙ ⊄ (𝐴, 𝐶), since ∀𝐵 ∈ (𝐴, 𝐶), 𝐶 ≻ 𝐵 ⟹ ℙ ⊂ 𝐶, 𝐸
◉ To maximize her utility, the individual chooses point 𝐹 = (𝐻 ∗, 𝑍 ∗ ) (WHY?)
• 𝑈 𝐽 , 𝑈 𝐺 = 𝑈0 < 𝑈1 ⟹ 𝐽, 𝐺 ≺ 𝐹.
𝑍 Figure: The PPF of health good (𝐻) and other goods (𝑍)
𝑀𝑅𝑇 = 𝑀𝑅𝑈𝑆
𝐾 ∆𝑍 𝑈𝑍
𝐶 =
∆𝐻 𝑈𝐻
𝐺
𝐵 𝐹
𝑍∗
𝑈2
𝐿
𝑁
𝑈1
𝐽 𝑈0
𝐴 𝐸
Demand for Health
⊛ Choosing optimal H* and Z* with Exotic Preferences
Figure: The PPF of health good (𝐻) vs. other goods (𝑍)
𝑍
Cares only about Health (H)
𝑍∗
𝐻𝑚𝑖𝑛 𝐻

Demand for Health
𝑍
𝑈0 𝑈1 𝑈2
𝑍∗ 𝐸
∆𝑍
𝑀𝑅𝑈𝑆 = =∞
∆𝐻
The individual only care about his health.
Its opportunity cost is infinity.

Demand for Health
𝑍 𝑍 Cares only about Other goods (Z)
𝑈0 𝑈1 𝑈2
𝐶 𝐶
𝑍∗ 𝐸 𝑍∗ 𝐸
𝐻𝑚𝑖𝑛 𝐻∗ 𝐻 𝐻𝑚𝑖𝑛 𝐻 ∗ 𝐻
∆𝑍
𝑀𝑅𝑈𝑆 = =∞
∆𝐻
The individual only care about his health.
Its opportunity cost is infinity.

Demand for Health
𝑍 𝑍 Cares only about Other goods (Z)
𝑈0 𝑈1 𝑈2
𝑈2
𝐶 𝐶
𝑈1
𝑈0
𝑍∗ 𝐸 𝑍∗ 𝐸
𝐻𝑚𝑖𝑛 𝐻∗ 𝐻 𝐻𝑚𝑖𝑛 𝐻 ∗ 𝐻
∆𝑍
𝑀𝑅𝑈𝑆 = =∞ ∆𝑍
∆𝐻 𝑀𝑅𝑈𝑆 = =0
∆𝐻
The individual only care about his health. The individual does not care about his
Its opportunity cost is infinity. health. Its opportunity cost is zero.

Demand for Health
⊛ Extending the Grossman Model from Cradle to Grave (cont.): The Multi-Period Utility Function
◉ Assume that the individual values health and other goods in every single period of her/his life.
◉ Consider a version of utility function in which individual separates decisions in each period (additively separable).
◉ Each period produces a flow of utility, 𝑈 𝐻𝑡 , 𝑍𝑡 , that contributes to the overall lifetime utility.
◉ The individual maximizes her/his utility function, 𝑈 𝐻𝑡 , 𝑍𝑡 , over her/his life cycle (𝑡0 , Ω).
Ω
𝑈 = 𝑈 𝐻0 , 𝑍0 + 𝛿𝑈 𝐻1 , 𝑍1 + 𝛿 2 𝑈 𝐻2 , 𝑍2 + ⋯ + 𝛿 Ω 𝑈 𝐻Ω , 𝑍Ω = ෍ 𝛿 𝑡 𝑈 𝐻𝑡 , 𝑍𝑡
𝑡=0
• 𝐻𝑡 : Level of health in period 𝑡 = 0 … Ω; 𝑍𝑡 : Amount of other goods in period 𝑡; Ω: Length of lifespan in periods.
• 𝛿 ∈ 0,1 : Time discount factor (current utility flow is worth more than the same amount of utility flow in future).

Demand for Health
⊛ Extending the Grossman Model from Cradle to Grave (cont.): The Multi-Period Utility Function
◉ Assume that the individual values health and other goods in every single period of her/his life.
◉ Consider a version of utility function in which individual separates decisions in each period (additively separable).
◉ Each period produces a flow of utility, 𝑈 𝐻𝑡 , 𝑍𝑡 , that contributes to the overall lifetime utility.
◉ The individual maximizes her/his utility function, 𝑈 𝐻𝑡 , 𝑍𝑡 , over her/his life cycle (𝑡0 , Ω).
Ω
𝑈 = 𝑈 𝐻0 , 𝑍0 + 𝛿𝑈 𝐻1 , 𝑍1 + 𝛿 2 𝑈 𝐻2 , 𝑍2 + ⋯ + 𝛿 Ω 𝑈 𝐻Ω , 𝑍Ω = ෍ 𝛿 𝑡 𝑈 𝐻𝑡 , 𝑍𝑡
𝑡=0
• 𝐻𝑡 : Level of health in period 𝑡 = 0 … Ω; 𝑍𝑡 : Amount of other goods in period 𝑡; Ω: Length of lifespan in periods.
• 𝛿 ∈ 0,1 : Time discount factor (current utility flow is worth more than the same amount of utility flow in future).
◉ The individual attributes 𝛿 𝑡 to the utility of each period 𝑡 : 𝛿 𝑡 = 1, 𝛿, 𝛿 2 , … , 𝛿 Ω ⟶ 0 , 𝑡 = {0,1, … , Ω}.
• The smaller 𝛿 ⟹ the higher the preference for the present: 𝑈 𝑍𝑡0 , 𝐻𝑡0 ≻ 𝑈 𝑍𝑡0+1 , 𝐻𝑡0+1 ≻ ⋯ ≻ 𝑈 𝑍Ω , 𝐻Ω
⊛ The Health Production Function
◉ Health is a form of human capital akin to knowledge or education.
◉ Human body may last for a long time but suffers the typical wear and tear.
◉ Let 𝛾 be the rate of depreciation (how fast 𝐻 dissipates from period to period). The health production function is:
𝐻𝑡 = 𝐻 1 − 𝛾 𝐻𝑡−1 , 𝑇𝑡𝐻 , 𝑀𝑡
Demand for Health
The Demande for Health: Health As An Investment Good
⊛ Extending the Grossman Model from Cradle to Grave: Return to Health Capital (Investment)
◉ People invest in health capital as they do in education (to increase their capacity to work and generate income).
◉ What are the costs of investment in 𝐻 (The effective price of health capital)?
① The opportunity cost of other alternative investments (market rate of return to alternative investment,𝑟𝑍 ).
② The rate of depreciation of health capital, 𝛾 (due to ageing).
Figure: Marginal Efficiency of Health Capital

• 𝑀𝐸𝐶 indicates how efficient each
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑡𝑜 ℎ𝑒𝑎𝑙𝑡ℎ, 𝑟𝐻

unit of health capital is in
increasing lifetime utility.
• It captures all lifetime return from
a marginal investment in health at
any given level of health stock.
• It reflects the diminishing marginal
returns to health.
• Individuals choose invest in health
capital up to 𝑀𝐸𝐶 = 𝑀𝐶.
𝐻𝑚𝑖𝑛 𝐻

Demand for Health
The Demande for Health: Health As An Investment Good
⊛ Extending the Grossman Model from Cradle to Grave: Return to Health Capital (Investment)
◉ People invest in health capital as they do in education (to increase their capacity to work and generate income).
◉ What are the costs of investment in 𝐻 (The effective price of health capital)?
① The opportunity cost of other alternative investments (market rate of return to alternative investment,𝑟𝑍 ).
② The rate of depreciation of health capital, 𝛾 (due to ageing).

• 𝑀𝐸𝐶 indicates how efficient each
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑡𝑜 ℎ𝑒𝑎𝑙𝑡ℎ, 𝑟𝐻

• Health must pay a return of at least unit of health capital is in
𝑟𝑍 + 𝛾. Let 𝑟𝐻 be the return to 𝐻, increasing lifetime utility.
then, 𝑀𝐸𝐶 > 𝑀𝐶
• It captures all lifetime return from
𝑟𝐻 > 𝑟𝑍 + 𝛾
a marginal investment in health at
• If 𝑟𝐻 < 𝑟𝑍 + 𝛾 ⟹ return to alternative any given level of health stock.
market investment is higher. 𝑀𝐶 = 𝑟𝑍 + γ
• It reflects the diminishing marginal
• 𝑟𝐻 = 𝑟𝑍 + 𝛾 ⟹ marginal benefit of returns to health.
health investment balances the • Individuals choose invest in health
𝑀𝐸𝐶 < 𝑀𝐶 capital up to 𝑀𝐸𝐶 = 𝑀𝐶.
marginal cost of health investment
𝑟𝐻 < 𝑟𝑍 + 𝛾
⟹ 𝐻 ∗ is optimal.
𝐻
𝐻𝑚𝑖𝑛 𝐻∗
Demand for Health
⊛ Predictions of The Grossman Model
❶ Declining health among the aging population
• Recall: 𝐻𝑡 = 𝐻 1 − γ 𝐻𝑡−1 , 𝑇𝑡𝐻 , 𝑀𝑡
• Depreciation rate, γ, does not stay constant over a 𝑀𝐸𝐶
life time: γ increases with age.
𝑟𝑍ҧ + γ𝐻𝑚𝑖𝑛
• At the beginning of life, γ = γ0 ⟶ 0, the level of the
optimal health capital is large (𝐻0∗ in the Figure).
• The costs of capital (𝑟𝑍ҧ + 𝛾) rises with age (as γ is ⬆)

⟹ It takes more resources to maintain same level of 𝑟𝑍ҧ + γ1
𝐻 ⟹ The optimal health will ⬇.
• As 𝛾 continues its inexorable climb, 𝐻 ∗ falls to 𝐻𝑚𝑖𝑛 .

𝑟𝑍ҧ + γ0 𝑀𝐸𝐶
• Another example: An individual with prolonged and
repeated stress faces a higher rate of health
deprecation, γ1 , thus has a lower optimal health 𝐻1∗ . 𝐻𝑚𝑖𝑛 𝐻1∗ 𝐻0∗ 𝐻

Demand for Health
⊛ Predictions of the Grossman model: Education and the Efficiency of Producing Health
❷ Better health among the educated.
MEC
• Better educated are more efficient at each level of

𝑀𝐸𝐶𝑈 = University degree
health investment (ceteris paribus) ⟹ upward 𝑀𝐸𝐶𝑆 = High school dropout
shift of the 𝑀𝐸𝐶.
𝑀𝐸𝐶𝑈 > 𝑀𝐸𝐶𝑆
• The health capital of the educated, 𝐻𝑈∗ , is higher
𝑟𝑍 + γ
than that of the less educated, 𝐻𝑆∗ , given the same
cost of investing in the health capital (𝑟𝑍 + γ). 𝑀𝐸𝐶𝑈
𝐻𝑈∗ > 𝐻𝑆∗ 𝑀𝐸𝐶𝑆
𝐻𝑚𝑖𝑛 𝐻𝑆∗ 𝐻𝑈∗ H

Demand for Health
Unifying the Grossman Model of Health
⊛ Predictions of The Grossman Model
◉ The Grossman model can be used to analyze and explain (socio-economic) inequalities (disparities) in health.
◉ The Grossman model is constructed based on a number of functions and parameters such as:
• The utility function 𝑈(𝐻𝑡 , 𝑍𝑡 ) : Individuals’ preferences vis-à-vis their health.
• The production function 𝐻𝑡 (𝐻(𝐻𝑡−1 , 𝑇𝑡𝐻 , 𝑀𝑡 ).
• Time and budget constraints Θ = 24 = 𝑇 𝑊 + 𝑇 𝑍 + 𝑇 𝐻 + 𝑇 𝑆 ; 𝑝𝑀 × 𝑀𝑡 + 𝑝𝐽 + 𝐽𝑡 = 𝑤 × Θ − 𝑇 𝑍 − 𝑇 𝐻 − 𝑇 𝑆 , resp.
• Total productive time 𝑇 𝑃 .
• The depreciation rate 𝛾.
• The Time discount factor 𝛿.
◉ Different functions and parameters give rise to different 𝑀𝐸𝐶 curves, so to different optimal levels of health capital.
⌛ Examples
• Different socio-economic groups (rich vs. poor): Different budget constraints.
• Different socio-demographic groups (young vs. elderly): Different rates of depreciation 𝛾.
• Deferred gratification (the ability to resist an immediate reward temptation to obtain a reward later): Different
discounting factors 𝛿 (patients vs. impatient).

Unifying the Grossman Model of Health: Predictions of the Grossman model
⊛ The Combined Grossman Model
⌛ Example: The Rich, 𝑅, vs. The Poor, 𝑃
◉ 𝑅 earns higher wages than 𝑃 ⟹ 𝑅 has more

money at her disposal to purchase medical 𝑍
goods and other goods. Thus, her 𝑃𝑃𝐹 The PPF of 𝐻 and 𝑍
curve is shifted outward and her optimal
level of health is higher.
𝑃𝑃𝐹𝑅 > 𝑃𝑃𝐹𝑃 ⟹ 𝑈𝑅 > 𝑈𝑃 𝑍𝑅∗ 𝑈𝑅
⟹ 𝐻𝑅∗ > 𝐻𝑃∗ and 𝑍𝑅∗ > 𝑍𝑃∗ 𝑍𝑃∗

𝑈𝑃
𝐻𝑚𝑖𝑛 𝐻𝑃∗ 𝐻𝑅∗ 𝐻
Aix-Marseille université M. ABU-ZAINEH 67
⊛ The Combined Grossman Model
The Health Capital Production Function

𝑇𝑃
Θ
𝑇𝑅𝑃 𝐻𝑅
𝐻𝑃
𝑇𝑃𝑃
◉ 𝑅 earns higher wages than 𝑃 ⟹ 𝑅 has more 𝐻𝑚𝑖𝑛 𝐻𝑃∗ 𝐻𝑅∗ 𝐻


𝑈𝑃
⊛ The Combined Grossman Model Marginal Efficiency of Health Capital
𝑟𝑍 + γ
𝑀𝐸𝐶𝑅 > 𝑀𝐸𝐶𝑃 .
𝑀𝐸𝐶𝑅
For a given (𝑟𝑍 + γ) ⟹ 𝐻𝑅∗ > 𝐻𝑃∗ . 𝑀𝐸𝐶𝑃
The Health Capital Production Function
𝑇𝑃
Θ
𝐻𝑃
𝑇𝑃𝑃
◉ 𝑅 earns higher wages than 𝑃 ⟹ 𝑅 has more 𝐻𝑚𝑖𝑛 𝐻𝑃∗ 𝐻𝑅∗ 𝐻


𝑈𝑃
⊛ The Combined Grossman Model Marginal Efficiency of Health Capital
𝑟𝑍 + γ
𝑀𝐸𝐶𝑅 > 𝑀𝐸𝐶𝑃 .
𝑀𝐸𝐶𝑅
For a given (𝑟𝑍 + γ) ⟹ 𝐻𝑅∗ > 𝐻𝑃∗ . 𝑀𝐸𝐶𝑃
The Health Capital Production Function 𝑇 𝑊 The Labor-Leisure Tradeoff
𝑇𝑃
Θ
𝑇𝑅𝑃
𝑇𝑅𝑊
𝐻𝑃 𝑇𝑃𝑃 𝑈𝑅
𝑇𝑃𝑃
𝑇𝑃𝑊 𝑈𝑃
◉ 𝑅 earns higher wages than 𝑃 ⟹ 𝑅 has more 𝐻𝑚𝑖𝑛 𝐻𝑃∗ 𝐻𝑅∗ 𝐻 𝑇𝑅𝑍 𝑇𝑃𝑍 𝑇𝑍
goods and other goods. Thus, her 𝑃𝑃𝐹 The PPF of 𝐻 and 𝑍 𝑇𝑅𝑃 > 𝑇𝑃𝑃 .
level of health is higher. 𝑇𝑅𝑊 > 𝑇𝑃𝑊 ⟹ 𝑇𝑅𝑍 > 𝑇𝑃𝑍 .

𝑈𝑃
Demand for Health
Exercises
⊛ Exercise ①
◉ Assume the health production function is ℎ = 365 − 1/𝐻 where ℎ is the number of healthy days a person has in
each year and 𝐻 is the person’s health capital. Assume this person earns a wage of 100€ per day, and the marginal
cost of health investment is : 𝜋 = 25 and is constant overtime. The annual interest rate is 5% and health capital
depreciates at a rate of 15% per annum.
a) Calculate the marginal return to health capital investment, 𝜕ℎΤ𝜕𝐶𝐻 , where 𝐶𝐻 denotes total cost of investment in
health capital.
b) Calculate the marginal efficiency of the health capital (𝑀𝐸𝐶) in terms of the individual's income.
c) Draw the 𝑀𝐸𝐶 curve on a graph. Explain the shape of this 𝑀𝐸𝐶 curve.
d) Calculate the cost of health capital in this problem.
e) Find the optimal level of health this person demands under the above conditions?
f) Suppose the person acquires a chronic disease and his health depreciation rate rises to 35% annually. How does
this change your answer to part e).
g) Suppose instead of having a chronic disease the person experiences a recession and his wage falls to 50€ per
day. Assume the change in the price time inputs account for 20% of the total change in cost of a unit of health
investment. Show graphically how this change affect the 𝑀𝐸𝐶 curve. What is the person optimal health now?
h) Now, focus on the role of human capital in this model. Suppose the person’s educational attainment increases.
How does the 𝑀𝐸𝐶 curve shift in this case? How does this shift affect the person’s investment in health capital?
Demand for Health
Exercises
⊛ Exercise ②
A person with osteoarthritis of the knee (a common condition in middle-aged and early elderly individual) plans to
have knee replacement. Assume he has a quasi linear utility function (𝑈(. )) over wage 𝑤 and his health 𝐻. That is
𝑈 𝑤, 𝐻 = 𝑤 + 104 ln 𝐻. Suppose with an artificial knee the person can enjoy 20 additional healthy days annually
during the next 10 years. During which he can earn a wage of 150€/day. The annual interest rate is 2%.
a) What is the increase in the person’s wage income if the person decides to get his knee replacement?
b) What is the net present value of the monetary return on knee replacement surgery?
Now, suppose that in addition to the above conditions, the person also has a current health capital of 500 units. In
the next decade, the additional health capital attributable to the artificial knee is given in the following table:
Year 1 2 3 4 5 6 7 8 9 10
Health capital (𝐻) 50 49 48 46 43 39 34 28 21 12
The patient discounts his utility from health capital at 10% annual rate. That is he is indifferent between receiving
100 units of health capital this year and receiving 110 unit next year.
c) What is the present value of his utility gain from having knee replacement surgery ?
d) If the total cost (including both the monetary loss from paying the surgical fee and the disutility from undergoing
the surgery and recovering) is 30,000, should the person undergo the surgical procedure?

Demand for Health
Exercises
⊛ Exercise ③
An individuals has preferences for an aggregate consumption commodity (𝑥) and a health (𝐻) represented by a
utility function 𝑈 𝑥, 𝐻 = 𝛼 ln(𝑥) + 𝛽 ln(𝐻), the price of the aggregate commodity 𝑥 is 𝑝𝑥 and the price of medical
care (𝑚) is 𝑝𝑚 . The input of medical care (𝑚) produces health (𝐻) via a health production relationship that can
represented by the function 𝑔(𝑚) = ln(𝑚); 𝐻 = ln(𝑚)
a) Compute the optimal demand for medical care (𝑚), the aggregate consumption commodity (𝑥) and the health
capital (𝐻) as a function of prices 𝑝𝑚 and 𝑝𝑥 and income 𝑦, and the parameters of the model (𝛼, 𝛽). You may
assume a standard budget constraint.
b) Calculate the price elasticity of demand for medical care.

Demand for Health
The Demand for Health Insurance

Demand for Health
⊛ Risk Pooling Mechanisms
◉ Spreading the risk of falling ill and incurring unexpected high costs across individuals.
◉ Cross-subsidies is the core of risk-pooling: risk-subsidies and equity-subsidies
Risk-Subsidies
Younger active population Elderly and retired population

Low-risk individuals High-risk individuals
Healthy Less healthy
Equity-Subsidies
High-income individuals Redistributive role Low-income individuals

Demand for Health
⊛ Risk Pooling Mechanisms: Private (Voluntary) Health Insurance Scheme
◉ Main features:
• Supplements publicly-funded coverage (especially in HICs).
• Paid for by non-income–based premiums.
• Voluntary – except in a few countries (e.g., Switzerland).
• Primary as the main source of coverage for a population or subpopulation.
• Duplicate: covering the same services as public coverage but differing in providers, time of access and quality.
• Complementary covering cost-sharing under the public scheme.
• Supplementary for services not covered by the public scheme.
◉ The pros:
• Promote risk pooling of resources, otherwise paid out-of-pocket.
• Enhance access to services when public or mandatory financing is incomplete.
• Increase service capacity and can promote innovation and quality.
◉ The cons :
• Affordability and premium volatility ⟹ reach the wealthy and the healthy.
• Contribute to differential access to health care services ⟹ equity concerns.
• Subject of market failures ⟹ adverse selection and cream skimming.
Demand for Health
⊛ Uncertainty
◉ Let 𝑝 ∈ (0,1) be the probability of sickness (1 − 𝑝 the probability of staying healthy).
◉ Let 𝐼 be the individual’s income in case of insurance, regardless of her health state.
◉ If she is not insured, her income in case of sickness is 𝐼𝑆 and her income if she remains healthy is 𝐼𝐻 > 𝐼𝑆 .
◉ Her expected income 𝐸[𝐼] is
𝑝 × 𝐼𝑆 + 1 − 𝑝 × 𝐼𝐻 , 𝑈𝑛𝑖𝑛𝑠𝑢𝑟𝑒𝑑
𝐸[𝐼] = ቊ
𝐼, 𝐼𝑛𝑠𝑢𝑟𝑒𝑑
◉ Risk-attitudes:
① A risk-averse individual would prefer a certain income to less certain one ⟹ Insurance ≻ No-insurance.
② A risk-taker individual would opt for uncertainty (given 𝐼𝐻 > 𝐼𝑆 ) ⟹ Insurance ≺ No-insurance.
③ A risk-neutral individual would be indifferent between the two situations ⟹ Insurance = No-insurance.

Demand for Health
⊛ Modeling Attitudes vis-à-vis Risk
◉ Let 𝑈 be function of income: 𝑈(𝐼); 𝑈 ′ 𝐼 > 0 (Utility increases with income …).
◉ What does the attitude vis-à-vis the risk imply for the utility function of income?
A risk-neutral would accord the
Figure: Income-Utility Diagram same value to extra unit of income
A risk-averse would accord
⟹ 𝑈 ′′ 𝐼 = 0 ⟹ linear utility
relatively less value to extra
function 𝑈2 (𝐼) ⟹ Indifferent ⟹
gain ⟹ 𝑈 ′′ 𝐼 < 0 ⟹ concave 𝑈3 (𝐼) Insurance = No-insurance.
utility function 𝑈1 (𝐼) ⟹ 𝑈2 (𝐼)
Insurance.
𝑈1 (𝐼)
Utility, U(I)
A risk-taker individual would accord

more value to extra unit of
income ⟹ 𝑈 ′′ 𝐼 > 0 ⟹ convex
utility function 𝑈3 (𝐼) ⟹ Take risk.
Income (I)

Demand for Health
⊛ Risk-Averse Case
◉ Utility function of a risk-averse individual is a concave function.
• If 𝑝 = 1, 𝐸[𝐼] = 𝐼𝑆 , then 𝐸 𝑈(𝐼) = 1 × 𝑈(𝐼𝑆 ) + 1 − 1 × 𝑈(𝐼𝐻 ) = 𝑈 𝐼𝑆 ⟹ point 𝑆.
• If 𝑝 = 0, 𝐸[𝐼] = 𝐼𝐻 , then 𝐸 𝑈(𝐼) = 0 × 𝑈(𝐼𝑆 ) + 1 − 0 × 𝑈 𝐼𝐻 = 𝑈 𝐼𝐻 ⟹ point 𝐻.
U(I) Figure: Risk-Averse Utility Function of Income

𝐻 U(I)
𝑈(𝐼𝐻 )
𝑆
𝑈(𝐼𝑆 )
𝐸[𝐼] = 𝐼𝑆 𝐸[𝐼] = 𝐼𝐻 Income

Demand for Health
⊛ Risk-Averse Case
◉ Utility function of a risk-averse individual is a concave function.
• If 𝑝 = 1, 𝐸[𝐼] = 𝐼𝑆 , then 𝐸 𝑈(𝐼) = 1 × 𝑈(𝐼𝑆 ) + 1 − 1 × 𝑈(𝐼𝐻 ) = 𝑈 𝐼𝑆 ⟹ point 𝑆.
• If 𝑝 = 0, 𝐸[𝐼] = 𝐼𝐻 , then 𝐸 𝑈(𝐼) = 0 × 𝑈(𝐼𝑆 ) + 1 − 0 × 𝑈 𝐼𝐻 = 𝑈 𝐼𝐻 ⟹ point 𝐻.
• If 0 < 𝑝 < 1: 𝐸[𝐼] = 𝑝 × 𝐼𝑆 + 1 − 𝑝 × 𝐼𝐻 ⟹ point 𝐶, then 𝐸 𝑈(𝐼) = 𝑝 × 𝑈 𝐼𝑆 + 1 − 𝑝 × 𝑈 𝐼𝐻

𝐻 U(I)
𝑈(𝐼𝐻 )
Utility from
expected income Utility from expected income:
𝐶′ 𝑈 𝐸 𝐼 = 𝑈 𝑝 × 𝐼𝑆 + (1 − 𝑝) × 𝐼𝐻
𝑈 𝐸𝐼
𝐶
𝐸[𝑈(𝐼)𝑝 ]
For concave utility function (risk-averse)
𝑈 𝐸 𝐼 > 𝐸 𝑈(𝐼)
𝑆 Expected utility 𝑈 𝐸 𝐼 > 𝑝 × 𝑈 𝐼𝑆 + 1 − 𝑝 × 𝑈 𝐼𝐻
𝑈(𝐼𝑆 )
from income
Health expenditure in case

of illness without insurance
𝐸[𝐼] = 𝐼𝑆 𝐸[𝐼]𝑝 𝐸[𝐼] = 𝐼𝐻 Income

Demand for Health
⊛ Risk Attitude and Demand for Insurance: Exercise
◉ Consider the following utility functions for three individuals: 𝑈1 = 𝐼0.5 ; 𝑈2 = 𝐼 ; 𝑈3 = 𝐼2 .
◉ Let 𝑝 = 0.5 be the probability of sickness. If insured, their incomes are 𝐼 = € 2400 regardless of their health states.
If uninsured, their sick-state income 𝐼𝑆 = € 1800 and their healthy-state income is 𝐼𝐻 = € 3000.
𝑝 × 𝐼𝑆 + 1 − 𝑝 × 𝐼𝐻 = 0.5 × 1800 + 0.5 × 3000 = €2400, 𝑖𝑓 𝑢𝑛𝑖𝑛𝑠𝑢𝑟𝑒𝑑
𝐸 𝐼 =ቊ
€2400, 𝑖𝑓 𝑖𝑛𝑠𝑢𝑟𝑒𝑑
◉ For individual 1
𝑈1 𝐸 𝐼 = 𝑝 × 𝐼𝑆 + 1 − 𝑝 × 𝐼𝐻 0.5 = 2400 0.5 = 49
𝐸 𝑈1 (𝐼) = 𝑝 × 𝑈1 𝐼𝑆 + 1 − 𝑝 × 𝑈1 𝐼𝐻 = 0.5 × 1800 0.5 +0.5 × 3000 0.5 = 48.6; ⟹ 𝑈 𝐸 𝐼 > 𝐸 𝑈(𝐼)
• This individual is risk-averse since he prefers a certain income over uncertain one with the same 𝐸 𝐼 .
𝑈2 𝐸 𝐼 = 𝐼 = 2400
𝐸 𝑈2 (𝐼) = 𝑝 × 𝑈2 𝐼𝑆 + 1 − 𝑝 × 𝑈2 𝐼𝐻 = 0.5 × 1800 + 0.5 × 3000 = 2400; ⟹ 𝑈 𝐸 𝐼 = 𝐸 𝑈(𝐼)
• This individual is risk-neutral since she is indifferent between two outcomes with the same 𝐸 𝐼 .
𝑈3 𝐸 𝐼 = 2400 2 = 57.6 × 105
𝐸 𝑈3 (𝐼) = 𝑝 × 𝑈3 𝐼𝑆 + 1 − 𝑝 × 𝑈3 𝐼𝐻 = 0.5 × 1800 2 + 0.5 × 3000 2 = 61.2 × 105; ⟹ 𝑈 𝐸 𝑅 < 𝐸 𝑈(𝑅)
• This individual is risk-taker since she prefers uncertain outcome over certain outcome with the same 𝐸 𝐼 .
Demand for Health
⊛ Certainty Equivalent, 𝑪𝑬
◉ The amount of money that provides the same level of expected utility as the risky situation (without insurance):
𝑈 𝐶𝐸 𝐼𝑆 , 𝐼𝐻 ; 𝑝, 1 − 𝑝 = 𝐸 𝑈 𝐼𝑆 , 𝐼𝐻 ; 𝑝, 1 − 𝑝 = 𝑝 × 𝑈 𝐼𝑆 + 1 − 𝑝 𝑈 𝐼𝐻
◉ What is the certain equivalent income that gives the same level of expected utility as the risky situation?

𝐻 U(I)
𝑈(𝐼𝐻 )
Expected utility of the risky situation.

𝐶′
𝑈 𝐸𝐼
𝐶
𝐸[𝑈(𝐼)𝑝 ]
𝑆
𝑈(𝐼𝑆 )
The difference between 𝐸[𝐼] and the 𝐶𝐸
is called risk premium (𝑅𝑃)
𝑅𝑃 = 𝐸 𝐼 − 𝐶𝐸
𝐸[𝐼] = 𝐼𝑆 𝐶𝐸 𝐸[𝐼]𝑝 𝐸[𝐼] = 𝐼𝐻 Income

Demand for Health
⊛ Certainty Equivalent, 𝑪𝑬: Exercise
◉ What is the certain equivalent income that gives the same level of expected utility as the risky situation for the
three individuals in the previous exercise?
𝑈 𝐶𝐸 = 𝐸 𝑈 𝐼𝑆 , 𝐼𝐻 ; 𝑝, 1 − 𝑝 = 𝑝 × 𝑈 𝐼𝑆 + 1 − 𝑝 𝑈 𝐼𝐻
• For individual 1: 𝑈1 = 𝐼0.5 and 𝐸 𝑈1 (𝐼) = 48.6
𝑈 𝐶𝐸1 = 48.6 ⟹ 𝐶𝐸1 0.5 = 48.6 ⟹ 𝐶𝐸1 = 48.6 2 = 2362€ < 𝐸[𝐼]
• For individual 2: 𝑈2 = 𝐼 and 𝐸 𝑈2 (𝐼) = 2400
𝑈 𝐶𝐸2 = 2400 ⟹ 𝐶𝐸2 = 2400€ = 𝐸[𝐼]
• For individual 3: 𝑈3 = 𝐼2 and 𝐸 𝑈3 (𝐼) = 61.2 × 105

𝑈 𝐶𝐸3 = 61.2 × 105 ⟹ 𝐶𝐸3 2 = 61.2 × 105 ⟹ 𝐶𝐸3 = 2474€ > 𝐸[𝐼]
> 0, risk−averse
◉ The risk premium: 𝑅𝑃 = 𝐸 𝐼 − 𝐶𝐸 ቐ = 0, risk−neutral
< 0, risk−taker
• For risk-averse 𝑅𝑃 > 0 ⟹ The maximum amount an individual is willing-to-pay to avoid the risk:
𝑅𝑃 = 2400 − 2362 = 38€
Demand for Health
⊛ Risk Premium: Willingness-To-Pay
U(I)
Figure: Income-Utility Diagram
𝐻 U(I)
𝑈 𝐼𝐻 = 54.8
𝐶′
𝑈 𝐸𝐼 = 49
𝐶
𝐸[𝑈(𝐼)𝑝 ] = 48.6 Expected utility of the risky situation.
𝑆
𝑈 𝐼𝑆 = 42.4
𝑅𝑃 = 38€
𝐼𝑆 = 1800 𝐶𝐸 = 2362 𝐸[𝐼]𝑝 = 2400 𝐼𝐻 = 3000 Income
The amount of money that provides the

same level of utility as the risky situation

Demand for Health
⊛ A Basic Health Insurance Contract
◉ To hedge against the risk of income loss due to illness (and to reduce uncertainty), the risk-averse individual will
buy a health insurance contract with premium 𝜋 and payout 𝑞.
◉ NB. ① With health insurance, an individual is just as likely to fall ill as before, but the financial burden of illness is
lower: Insurance doesn't make you healthier, but it can make you happier.
◉ NB. ② The indiviudal pays premium 𝜋 regardless whether she stays healthy or becomes ill.
• If gets sick, she receives payout (indemnity) 𝑞.
• If remains healthy, she receives nothing from the insurance (not even a refund of 𝜋).
◉ Let 𝐼𝐻′ and 𝐼𝑆′ be individual’s income in the health and sick states, resp. with the insurance contract.
𝐼𝐻′ = 𝐼𝐻 − 𝜋 + 0
𝐼𝑆′ = 𝐼𝑆 − 𝜋 + 𝑞
◉ A risk-averse individual will opt for an actuarially fair, full insurance:

• An insurance with a “fair price of risk”.
• An insurance that allows the individual to maintain the 𝐸[𝐼]𝑝 .
Demand for Health
⊛ A Basic Health Insurance Contract: A Full Insurance Contract
◉ An actuarially fair, full insurance implies that regardless of the future state of health (state independence):
𝐸𝐼 𝑝 = 𝐼𝑆′ = 𝐼𝐻′
◉ So, in the event of illness, the payout (𝑞) of the full insurance must be equal to the difference between the healthy-
state income, 𝐼𝐻 , and sick-state income, 𝐼𝑆 :
𝐼𝑆′ = 𝐼𝐻′
𝐼𝑆 − 𝜋 + 𝑞 = 𝐼𝐻 − 𝜋 + 0
𝐼𝑆 + 𝑞 = 𝐼𝐻
𝑞 = 𝐼𝐻 − 𝐼𝑆
◉ With an actuarially fair, full insurance, the insurance premium is 𝜋 = 𝑝𝑞:
𝐸 𝐼 𝑝 = 𝐼𝐻′ 𝐸 𝐼 𝑝 = 𝐼𝑆′
𝑝 𝐼𝑆 + 1 − 𝑝 𝐼𝐻 = 𝐼𝐻 − 𝜋 𝑝 𝐼𝑆 + 1 − 𝑝 𝐼𝐻 = 𝐼𝑆 − 𝜋 + 𝑞
𝑝 𝐼𝑆 + 1 − 𝑝 𝐼𝐻 − 𝐼𝐻 = −𝜋 𝑝 𝐼𝑆 + 1 − 𝑝 𝐼𝐻 = 𝐼𝑆 − 𝜋 + 𝐼𝐻 − 𝐼𝑆
𝜋 = 𝑝 𝐼𝐻 − 𝐼𝑆 = 𝑝𝑞 𝜋 = 𝑝 𝐼𝐻 − 𝐼𝑆 = 𝑝𝑞

Demand for Health
U(I) Figure: Income-Utility Diagram

𝐻
𝑈 𝐼𝐻 U(I)
′
𝐶
𝑈 𝐸[𝐼] with insurance
𝐸𝑈 𝐼 without insurance 𝐶
𝑆
𝑈(𝐼𝑆 )
Health expenditure borne

by the individual in case of
illness without insurance
𝐼𝑆 𝐸𝐼 𝑝 𝐼𝐻 Income

Demand for Health

𝐻
𝑈 𝐼𝐻 U(I)
′
𝐶
𝑆
𝑈(𝐼𝑆 )

𝜋
𝐼𝑆 𝐸𝐼 𝑝 𝐼𝐻 Income
𝐼𝐻′ = 𝐼𝐻 − 𝜋

Demand for Health

𝐻
𝑈 𝐼𝐻 U(I)
′
𝐶
𝑆
𝑈(𝐼𝑆 )

𝜋 𝜋
𝐼𝑆 − 𝜋 𝐼𝑆 𝐸𝐼 𝑝 𝐼𝐻 Income

Demand for Health

𝐻
𝑈 𝐼𝐻 U(I)
′
𝐶
𝑆
𝑈(𝐼𝑆 )

𝜋 𝜋
𝑞€
𝐼𝑆′ = 𝐼𝑆 − 𝜋 + 𝑞

Demand for Health

𝐻
𝑈 𝐼𝐻 U(I)
′
𝐶
𝑆
𝑈(𝐼𝑆 )

𝜋 𝜋
𝑞€ 𝐸𝐼 = 𝐼𝑆′ = 𝐼𝐻′
𝐼𝑆′ = 𝐼𝑆 − 𝜋 + 𝑞 𝑝

Demand for Health
⊛ Actuarially Fair vs. Unfair Insurance: From The Insurer Perspective
◉ Let 𝐸[Π] be the expected profits that the insurer makes from offering a contract with premium 𝜋 and payout 𝑞 to
any customer with probability of sickness, 𝑝.
◉ If the customer stays healthy, the insurer earns 𝜋€, otherwise, the insurer still receives 𝜋€ but loses 𝑞€.
◉ The expected profit of the insurer is:
𝐸 Π(𝑝, 𝑞, 𝜋) = 1 − 𝑝 𝜋 + 𝑝 𝜋 − q = 𝜋 − 𝑝𝑞
◉ In a perfectly competitive insurance market, the insurer’s profits will eventually be equal to zero. Thus:
Actuarial Premium
𝜋 = 𝑝𝑞 = 𝐸(𝑞) “Actuarial fairness condition”
• NB : Premiums are increasing with indemnity, 𝑞, and with the probability of illness, 𝑝.
◉ In practice, insurance market is not perfectly competitive, thus, insurer makes some positive profits. Hence,
premiums are not actuarially fair. In this case, the insurer offers an insurance with a loading factor such that
Non-Actuarial premium
𝜋 ′ = 1 + 𝜆 𝐸(𝑞) = 1 + 𝜆 𝑝𝑞 𝐸 Π(𝑝, I, 𝜋) > 0 ⇒ 𝜋 > 𝑝𝑞

Demand for Health
⊛ Full vs. Partial Insurance
◉ Unlike the full insurance, the partial insurance is a contact that is state dependent.
𝑭𝒖𝒍𝒍 𝑰𝒏𝒔𝒖𝒓𝒂𝒏𝒄𝒆 𝑷𝒂𝒓𝒕𝒊𝒂𝒍 𝑰𝒏𝒔𝒖𝒓𝒂𝒏𝒄𝒆

𝐼𝑆′ = 𝐼𝐻′ 𝐼𝑆′ < 𝐼𝐻′
𝐼𝑆 − 𝜋 + 𝑞 = 𝐼𝐻 − 𝜋 𝐼𝑆 − 𝜋 + 𝑞 < 𝐼𝐻 − 𝜋
𝐼𝑆 + 𝑞 = 𝐼𝐻 𝐼𝑆 + 𝑞 < 𝐼𝐻
𝒒 = 𝑰𝑯 − 𝑰𝑺 𝒒 < 𝑰𝑯 − 𝑰𝑺
◉ What is the actual extent of risk coverage?

• The size of the payout, 𝑞, determines the fullness of the insurance contract.
• A contract with a payout that fully covers the spread between 𝐼𝐻 and 𝐼𝑆 is full, while a contract with payout that
doesn’t full cover this difference is partial.
• The closer an insurance contract payout, 𝑞, comes to equaling 𝐼𝐻 − 𝐼𝑆 , the fuller we say that contract is.

Demand for Health
Figure: Comparing full-fair, partial fair and no insurance

𝐻 U(I)
𝑈 𝐼𝐻
𝐸 𝑈(𝐶) 𝐶
𝑆
𝑈(𝐼𝑆 )
𝐼𝑆 𝐸𝐼 𝐼𝐻 Income

Demand for Health

𝐻 U(I)
𝑈 𝐼𝐻
𝑆
𝑈(𝐼𝑆 )
𝜋𝐹
𝐼𝑆 𝐸𝐼 𝐼𝐻 Income

Demand for Health

𝐻 U(I)
𝑈 𝐼𝐻
𝑆
𝑈(𝐼𝑆 )
𝜋𝐹
𝜋𝐹
𝑞𝐹
𝐼𝑆 − 𝜋 𝐹 𝐼𝑆 𝐸𝐼 𝐼𝐻 Income

Demand for Health

𝐻 U(I)
𝑈 𝐼𝐻 𝐻𝑃
𝐹
𝐸[𝑈(𝐶 )] = 𝑈 𝐸 𝐼 𝐶𝐹
𝑆
𝑈(𝐼𝑆 )
𝜋𝑃
𝜋𝐹
𝜋𝐹
𝑞𝐹
𝐼𝑆 − 𝜋 𝐹 𝐼𝑆 𝐸 𝐼 𝐼𝐻𝑃 𝐼𝐻 Income
𝐼𝐻𝐹 = 𝐼𝑆𝐹

Demand for Health

𝐻 U(I)
𝐹
𝑆
𝑈(𝐼𝑆 )
𝜋𝑃
𝜋𝑃
𝜋𝐹
𝜋𝐹
𝑞𝐹
𝐼𝑆 − 𝜋 𝐹 𝐼𝑆 − 𝜋 𝑃 𝐼𝑆 𝐸 𝐼 𝐼𝐻𝑃 𝐼𝐻 Income

Demand for Health

𝐻 U(I)
𝐹
𝐸[𝑈(𝐶 𝑃 )]
𝐶𝑃
𝐸 𝑈(𝐶) 𝐶 𝜋𝐹 > 𝜋𝑃
𝑆𝑃
𝑞𝐹 > 𝑞𝑃
Income uncertainty is
largest under no insurance. 𝐸[𝑈(𝐶 𝐹 )] > 𝐸[𝑈(𝐶 𝑃 )] > 𝐸[𝑈(𝐶)]
𝑆
Full insurance 𝑈(𝐼𝑆 )
eliminate uncertainty. 𝜋𝑃
𝜋𝑃
Partial insurance 𝑞𝑃 𝜋𝐹
lowers uncertainty but 𝜋𝐹
𝑞𝐹
doesn’t eliminate it.
𝐼𝑆 − 𝜋 𝐹 𝐼𝑆 − 𝜋 𝑃 𝐼𝑆 𝐼𝑆𝑃 𝐸 𝐼 𝐼𝐻𝑃 𝐼𝐻 Income

Demand for Health
⊛ Comparing Insurance Contracts
Table : Premiums and Generosity of Different Insurance Contracts
Actuarial Non-Actuarial
Type of Insurance
(Fair) (Unfair)
𝜋 = 𝑝𝑞 𝜋 > 𝑝𝑞
Full
𝑞 = 𝐼𝐻 − 𝐼𝑆 𝑞 = 𝐼𝐻 − 𝐼𝑆
𝜋 = 𝑝𝑞 𝜋 > 𝑝𝑞
Partial
𝑞 < 𝐼𝐻 − 𝐼𝑆 q < 𝐼𝐻 − 𝐼𝑆

Demand for Health
• Slaon, F. A. and Hsieh, C-R. (2017). Health Economics. The MIT Press.
• Bhattacharya, J. Hyde, T. and Tu, P. (2014). Health Economics. Palgrave.

Economics of Health and Environment - Part - IV

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Economics of Health and Environment - Part - IV

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Enseignant : M.

Part IV: The Economics of Health and Health Care

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 2

𝑥 = Other goods and services

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 3

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 4

𝑥 𝜕𝑞𝑖∗ Τ𝜕𝑅 > 0 ⟹ 𝜀𝑞,𝑅 > 0

① Substitution effect 𝑝3 • Over-the-counter drugs and

◉ Reducing the price of health care at the point of service.

② Ad valorem subsidy: The insurer pays a specific percentage of the price.

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 7

Figure : Effect of Indemnity on The Demand for Health Care

𝑸𝒅 = 𝟐𝟎 − 𝟎, 𝟏 𝒑 − 𝑰 ◉ NB. Change in 𝑊𝑇𝑃 = €𝐼.ҧ 𝑊𝑇𝑃 for

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 9

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 10

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 11

Figure : Effect of Deductible on The Demand for Health Care

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 12

Figure: Effect of Co-Pay on The Demand for Health Care

60 ◉ The insurance has no effect on the demand

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 13

Figure: Effect of Expenditure Cap on the Demand for Health Care

◉ With this cap, the insured can 𝑝𝑝 150

◉ Beyond the ceiling 𝑝𝑝 × 𝑞𝑝 , the 0

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 14

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 15

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 17

◉ A useful framework for explaining several stylized facts

② As 𝑐 is reduced, persons have an incentive to select care with low 𝑡.

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 19

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 20

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 21

◉ Key RHIE results on use:

◉ Many theoretical extensions have enriched the basic model.

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 25

The Demand for Health:

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 26

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 27

◉ Grossman distinguishes two models:

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 29

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 30

Time constraint Budget constraint

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 32

For given levels of 𝑇 𝑆 and 𝑇 𝐻 ,

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 34

For given levels of 𝑇 𝑆 and 𝑇 𝐻 ,

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 35

For given levels of 𝑇 𝑆 and 𝑇 𝐻 ,

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 36

For given levels of 𝑇 𝑆 and 𝑇 𝐻 ,

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 37

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 38

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 39

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 40

◉ Thus, 𝐻 and 𝑍 are determined by the following production functions:

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 41

Aix-Marseille université Economics of Health and Environment M. ABU-ZAINEH 42