ECON 236 -- Professor Atal 1

Demand for Health and

Health Care: Grossman
Model
 ECON 236 -- Professor Atal 2

Demand for Health: Grossman Model

• Last class we analyzed demand for health care:
• Consumers are price sensitive to some extent
• Elasticity of demand for different health care services

• What is the purpose of buying health care?

• Grossman model is lifetime economic model of demand

for health: health care is just one input
• What do we want to get out of an economic model?
 ECON 236 -- Professor Atal 3

Grossman Model: Overview

In this model, individuals decide their health status… by:

1. buying health care in the market (e.g. visiting doctors,

taking drugs) and
2. investing in health-enhancing activities (e.g. exercising)

…and in order to
1. feel better
2. be able to work and thus earn wages to buy goods and
services
3. have leisure time.
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Three Roles of Health (H)

Health plays three roles in the Grossman Model:

ROLE 1: A consumption good

ROLE 2: As an input into production

ROLE 3: As an investment
 ECON 236 -- Professor Atal 5

Three Roles of Health (H)

Health plays three roles in the Grossman Model:

ROLE 1: A consumption good

Having a headache just doesn’t feel right

 ECON 236 -- Professor Atal 6

Health as a Consumption Good

One-Period Perspective
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Role 1: Health as a consumption good

• As a consumption good, health directly impacts utility

• Single-period utility at time t:

Ut= U(Ht, Zt)
• Ht = level of health
• Zt = “home good” or everything non-health that contributes to utility
(such as time with friends, video games, movies)

• Health Care is not explicitly in utility function

• E.g. vaccines do not provide utility, but staying healthy does
 ECON 236 -- Professor Atal 8

Three Roles of Health (H)

Health plays three roles in the Grossman Model:

ROLE 1: A consumption good

ROLE 2: As an input into production

ROLE 3: As an investment
 ECON 236 -- Professor Atal 9

Health as Input into Production

One-Period Perspective
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Role 2: An input into production..

If I’m sick…

... I need to spend time

a) going to the doctor
b) staying at home in bed

… which means I can’t

a) work, make money, and buy things I like
b) have fun.
.
 ECON 236 -- Professor Atal 11

Time Constraints in Grossman Model

• In a single period t (let’s say one day), time is limited and
constrains health consumption and production

Θ = 24 hours = TW + TZ + TH + TS (1)

• Divide total time Θ between:

• Working TW
• Playing (Leisure) TZ
• Improving Health TH
• Being sick TS
ECON 236 -- Professor Atal 12
 ECON 236 -- Professor Atal 13

Some things are not clear cut

TH ... and TZ … and TW

How would you incorporate this into the model?

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Production: H and Z
• Both health H and “home good” Z must be produced
with time inputs and market inputs
Ht = H (Ht-1, TtH, Mt) (2)
Zt = Z (TtZ, Jt) (3)

• Mt = “Health Care” - market inputs for health H

• Ex: treadmill, vaccines, doctor visit
• Jt = market inputs for home good Z (i.e. “stuff you buy”)
• Ex: video games, housing, food.
• Today’s health Ht also depends on yesterday’s health Ht-1
• Health’s 3rd role as investment which we discuss later
 ECON 236 -- Professor Atal 15

Budget Constraint
• In a single period t (let’s say one day), consumption of
inputs is limited by income.

• Assuming no savings, consumption is equal to income

PJ x J + PM x M = w x TW (4)

• Where :
• PJ : price of inputs for other goods (movie tickets, etc.)
• PM : price of health care inputs (doctor visits, drugs, etc.)
• w : wage
 ECON 236 -- Professor Atal 16

Health Affects Production By Lowering Time Sick

TS
TS =TS(Ht) (5)
Θ Decreasing and convex
function.

What is the intuition?

Do you agree?

Key for what comes next..

Hmin Ht
 ECON 236 -- Professor Atal 17

Solution to the Grossman Model

One-Period Perspective
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Intuition behind the solution

• Similar to what you have seen before: Consumption of
goods is decided to maximize utility given a “budget
constraint”

• In Grossman model: Consumption of health and “other

goods” is decided to maximize utility given a
“production possibility frontier”, PPF
 ECON 236 -- Professor Atal 19

Production Possibility Frontier (PPF)

• Shape of the PPF is the key/distinctive part of

the Grossman model.

• PPF combines the time constraint, budget

constraint, “illness-avoidance
Θ
function”, and
production functions for health and leisure.
(Combines equations (1) to (5))
 ECON 236 -- Professor Atal 20

PPF equations

• Θ = 24 hours = TW + TZ + TH + TS (1)

• Ht = H (Ht-1, TtH, Mt) (2)

• Zt = Z (TtZ, Jt) (3)

• PJ x J + PM x M = w x TW (4)

• TS =TS(Ht) (5)
 ECON 236 -- Professor Atal 21

PPF in the Grossman Model

• Point A: Hmin: no productive time
for work, play, or improvement of
health:

From eq (5) TS =Θ
From eq (1) TW=TH=TZ=0

From eq (4) J = M = 0

From eq (3) Z = 0 (*)

From eq (2) H = Hmin (can’t escape!)

 ECON 236 -- Professor Atal 22

PPF in the Grossman Model

• Point B: “Free lunch zone”.
Small improvements in health
yield large increases in
productive time; can increase Z
and H

• H increases:

• TS falls substantially (eq

(5) (convexity important)

• productive time increases

substantially (eq (1)), and
so does income (eq (4)),
and therefore Z and H (eqs
2-4)
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PPF in the Grossman Model

• Point C:
• Maximum Z possible
• Illness avoidance function is
flat :
• After this point, can’t improve H
without taking away Z.

• Increases in health (moving

towards D) will not produce
enough extra time to offset time
spent improving health

• Shifting resources away from H

(moving towards B) increases
sick time that outweigh the gain in
resources available for Z
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PPF in the Grossman Model

• Point D:
• “Tradeoff Zone”

• Increases in H only yield

small decreases in sick time
(illness-avoidance function is
flat).

• Increases in H take away

from Z (money and time)

• Point E:
• Spend all time and money on
health

• Ignores all other goods Z

 ECON 236 -- Professor Atal 25

Choosing Optimal H and Z: One Period

• Someone who values
both health H and other
things Z chooses point
between C and E to
maximize one-period
utility

• Choose point F:
• U2 unattainable
• At U0 can still do better
• At F U1 tangent to PPF
• H* and Z* optimal
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“Exotic” Preferences
Care only about H Care only about Z
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Assumptions to Discuss

• Assumption: Individuals fully understand the mapping

between choices and health impacts in the short and long run

• Question: Why don’t people get enough preventive health

care?

• Assumption: Health is one-dimensional so health affects

current utility as well as current time for production with one
value

• Question: Why might this not be true? Example.

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Health as Investment
Lifetime Perspective
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Three Roles of Health (H)

Health plays three roles in the Grossman Model:

ROLE 1: A consumption good

ROLE 2: As an input into production

ROLE 3: As an investment
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Lifetime Utility
• On any day, an individual considers not only today’s utility
U(H0,Z0) but future utility as well!

• Health H is a stock: some of it carries over each new period

• Home good Z is a flow: it lasts for only one period
• δ = individual’s discount rate
• Ω = individual’s lifespan (total number of periods)
 ECON 236 -- Professor Atal 31

Health Depreciates Over Time

• γ = rate of depreciation

• Depreciation: Some of yesterday’s health is naturally lost today

Ht = H ( (1- γ)Ht-1, TtH, Mt )

• Recall:
• Ht = health at time period t
• Ht-1 = health at time period t-1
• TtH = time spent on health at t
• Mt = market inputs for health (e.g. checkups, prescriptions)
 ECON 236 -- Professor Atal 32

Example: Running as Investment

• Running as something that
enhances H

• Spend time TH running,

leading to higher H now.

• Higher H now means higher

H tomorrow.

• Higher H tomorrow, means

greater consumption and
production possibilities
tomorrow

• But benefits of running today

depreciate over time……
benefits of running today
don’t last forever.
 ECON 236 -- Professor Atal 33

Solution to long-run model

• We will use a graphic and intuitive approach to understand
the main message of the model.

• Simple setup:Individual can invest in health or in other

type of investment.

• Assume that individual increases investment in H by 1 dollar

(ceteris paribus) in period t. Increases utility by improving
health in t, t+1, t+2,… etc.

• Marginal Efficiency of Capital (MEC) :

• The marginal increase in lifetime utility following a 1 dollar
increase in health investment.
 ECON 236 -- Professor Atal 34

MEC Curve and Health Investments

• Marginal Efficiency of Capital
(MEC) Curve:
Indicates how efficient each unit of
health capital is in increasing
lifetime utility

• MEC is high when initial health is

low (b/c effect on productive time
and each period’s utility is high)

• Important Note: MEC is the result

of solving a very complicated
dynamic problem. It is not an
additional “assumption” of the
model.
 ECON 236 -- Professor Atal 35

Costs to Investing in Health

Opportunity Cost:
• Forgoes putting money into
other investments
• r = interest rate of alternative
market investment

Depreciation:
• Health must pay return of at
least r + γ
• If return lower than this, then
market return beats health
investment return

H* = optimal amount of health

• Marginal cost of health investment
balances with marginal benefit of
health investment
 ECON 236 -- Professor Atal 36

Grossman Model:
Some Implications
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Grossman Model Comparative Statics

Grossman model can be used to study / partially explain:

1. Better health among the educated

2. Declining health among the aging

3. Many other specific phenomena related to lifetime

health decisions
 ECON 236 -- Professor Atal 38

Grossman Model: Health and Education

• It is an empirical fact that better educated individuals
have higher health levels

• In Grossman Model:
• Assume that well-educated individuals are more efficient
producers of health

• This means that for given time / $ spent on health, better educated
individuals see more of a gain to health H

• Why might this be true?

• Why might this not be true?

 ECON 236 -- Professor Atal 39

MEC and Investment Efficiency

• Graphical representation
of different levels of
efficiency in health
investment

• C = College Graduate
• H = High-School Grad.

• MECC > MECH

• H C* > H H*
 ECON 236 -- Professor Atal 40

Grossman Model Comparative Statics

Grossman model can be used to study / partially explain:

1. Better health among the educated

2. Declining health among the aging

3. Many other specific phenomena related to lifetime

health decisions
 ECON 236 -- Professor Atal 41

MEC and Investment Efficiency

• Recall:
Ht = H ( (1- γ)Ht-1, TtH, Mt )

• Key Point:
Depreciation γ not
constant, instead it
increases with age

• As γ increases, costs /
required rate of return
(r + γ) increase and it
takes more resources to
maintain same level of
health As result of increasing γ over time, optimal
health H* also declines over time!
 ECON 236 -- Professor Atal 42

Death in the Grossman model

• Because of rising
depreciation, there are
better investments in the
market than health

• H* eventually reaches Hmin

• When depreciation
increases constantly, Hmin
becomes the only feasible
point (all health is
“destroyed” in the future)
If you prefer, you could think of stochastic
depreciation where sometimes γ = 1
 ECON 236 -- Professor Atal 43

Conclusion
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Conclusion
• Grossman model is flexible economic model that can be
used to think about variety of health-related decisions
• Time constraints
• Budget constraints
• Health flows and investment

• Grossman model can be applied to:

• Comparative statics (e.g. socioeconomic status, demographics)
• Study specific health behaviors (exercise, investment in health)