Lecture Slide Four

Demand for Health Capital

 Outline

• The consumer as a health producer

• Labour – leisure trade off
• Marginal efficiency of investment and
equilibrium
• Changes in equilibrium

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 The consumer as a health producer
Grossman used the theory of human
K to explain dd for health
It is not medical care per se that the
consumer wants, but rather health
itself.
Medical care demand is a derived demand for
an input to produce health.
People want health, they demand inputs to
produce it.
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 The consumer as a health producer…
• The consumer does not merely purchase
health passively from the market, but
instead produces it, spending time on
health – improving efforts.

• Health lasts for more than one period. It

does not depreciate instantly and thus can
be treated like the capital good that it is.

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 The consumer as a health producer…
 Health can be treated both as a consumption
good and as an investment good.
 As a consumption good, health is desired
because it makes people feel better.
 As an investment good, health is desired
because it increases the number of healthy days
available to work, and thus to earn more income.
 E.g a consumer buys market i/ps (medical care,
food, clothing), and combines them with his/her
own time to reproduce the services that increase
the individual’s level of utility.
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 The consumer as a health producer…
 The consumer not only increases his/her stock health,
but using market inputs and personal time produces the
other satisfaction and enjoyment of life.

 These satisfactions and enjoyment include all other

things the consumer does, e.g time spent tending to
children, time spent watching T.V, time spent preparing
meals, etc.
 these are intended to represent a composite of other
things we do with our “leisure time,” both for pleasure
and out of a sense of duty to family and community.
i.e composite home good B.

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 Time spent producing health
 An increment to K stock such as health is called an
investment.
 Consumer produces an investment in health, I.
 Health investment I is produced by time spent
improving health TH, and market health i/ps (drugs,
exercises, etc), M.
 Home good B is produced with time TB, and market
purchased goods, X.
i) the consumer is using money to buy health care i/ps M,
or home good i/ps X,
ii) he is using leisure time either for healthcare (TH) or for
producing home good (TB).
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 Time spent producing health…
I = I(M,TH, E), and B = B (X, TB, E)
• The functions indicate that increased
amounts of M and TH increase I, and that
increased amounts of X and TB increase
B.
• E is a variable included to suggest that
productivity in producing I or B may vary
from person to person.
 this technical efficiency level would be
related to the individual’s education
level, E.
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 Time spent producing health…

• In this model, the major resource is time.

Suppose each period of analysis is taken to be
one year, 365 days.
 To buy market goods like medical care M, or
other goods X, one must trade some of this time
for income (work at a job), TW.
 Some time during the year will be taken over by
ill health, TL.

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 Time spent producing health cont’d

• T = 365 days = TH + TB + TL + TW
T = total time of the year
TH = time spent improving health
TB = time spent in producing home
goods
TL = time lost due to illness.
TW = time devoted to work.

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 Labour – Leisure trade – offs…
• Suppose time spent creating health
investment is “health –improvement time”
and leisure is TB.
• assume no. of days lost to ill health and
no. of days spent on health- enhancing
activity are fixed i.e., TLo and THo
respectively. > the maximum amount of
time that is available for either work, Tw or
leisure, TB, is thus: 365 – THo – TLo i.e,
time available for work or Leisure =
365 – THo – TLo = TW + TB
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 Labour – Leisure trade – offs…
• leisure time TB is measured towards the right
while time spent at work TW is measured
towards the left e.g;

• at eqbm e, OA = amount of time allocated to

leisure

AS = amount of time allocated to work.

OS is total time allocated for work and leisure.

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 Labour– Leisure trade – offs
• Y can be used to purchase either market health gds, M
or other market gds, X.

 if you choose point S (i.e, Zero work time), he earns

zero income hence purchases no market gds.

• At point N, he works for time Bs and earns income OY,:

OY, represents income divided by days worked i.e. the
daily wage. Thus the slope of the line VS showing labor
–leisure trade off is the wage rate.

• At eqbm, he takes amount OA of leisure ,and trades

amount AS of leisure for income OY2
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 Preference btn leisure and income
The consumer prefers more Y and more leisure
so that indifference curves are normally shaped.

Suppose time spent on health –producing

activities, TH, is raised from THO to TH1, and that
the number of days lost to ill health has been
reduced from TLo to TL1,

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 Preference btn leisure and income

Implications
• i) Time spent producing health reduces time available for
other activities

• ii) Time spent on health investment rises health stock

and in turn reduces time lost in business

• If the net effect is a gain in available time, then this

illustrates the pure investment aspects of health dd. → a
parallel shift outward of the income-leisure curve.

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 Preference btn leisure and income
• Increased amount of healthy time due to Investment
Income Y

E1

O s TB
Q
(365 – TH I – TLI )
Leisure time

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 Preference btn leisure &income…
• The expenditure of time (and medical care)
for health producing activities may later on
improve consumer’s available hrs) of
productive activity.
• As a result of this investment, can ↑utility,
moving from pt E to E′
note that investment in health leads to consumer
feeling better and also leads to more future income. It
may lead to more leisure as well .
• Improvement in health status may also ↑
productivity at work, perhaps resulting to a
higher wage rate.
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 Marginal Efficiency of Investment
MEI
• Cost of K, in terms of foregone
resources (for health K, both time and
money ),is a supply concept .
• MEI is a demand concept that relates
the return to Investment to the
amount of resources invested.
MEI is a decreasing function of Investment.

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 Marginal Efficiency of Investment: MEI…
• A busy clinic may wish to own more than one X-
ray machine. But how many? The clinic
management may logically consider them in
sequence.
– The management would buy this machine if the
incremental revenue of the machine covered its
opportunity cost of capital and the depreciation. A
second X-ray machine would have a lower rate of
return than the first, because it is assigned only to
lesser – priority uses (and might be idle on occasion).
The clinic would then purchase the second machine
only if its rate of return were still higher than interest
plus depreciation.
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 Marginal Efficiency of Investment: MEI…
• Concentrating on pure investment model for the
moment, demand for health is dd for capital
good.
• What is the cost of capital?
• Cost of holding capital good = opportunity cost
(what money could have earned elsewhere i.e.
interest rate)+ rate at which capital good
depreciates. Thus c = r +δ .

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 Marginal Efficiency of Investment: MEI…

• Marginal efficiency of investment = rate of

return = (W*G)/C; where W = wage rate, G
= marginal product (rate of return) of
health investment which is subject to
diminishing MR, C = direct cost of
investment in health (e.g. cost of gym
membership).
– If return on capital good exceeds cost of capital then good will be
purchased – if it is less, then good will not be purchased.
– Thus capital good will be purchased up to point
where return =cost of capital.

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Marginal Efficiency of Investment: MEI…

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 Marginal Efficiency of Investment MEI…
• MEI curve: the pattern of rate of return, declining
as the amount of investment ↑s.
The cost of K(i.e. interest rate plus the depreciation
rate, ) is shown by the horizontal line,
• Optimum amount of k demanded is thus Ho
which represents the amount of K at which the
MEI just equals the cost of capital. Equilibrium
occurs at point A.
MEI curve for investments in health would
also be downward sloping b’se;
i. the prodn function for health days exhibits diminishing marginal
returns.
ii. cost of K for health reflects the interest rate plus the rate of
depreciation in health. (a person’s health depreciates every time)

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 Marginal Efficiency of Investment MEI…

• The optimal demand for health is

likewise given at the intersection of
the MEI curve and the cost of capital
curve.

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 Changes in equilibrium
AGE
• The rate at which one’s health stock depreciates
may increase during some periods of life and
decline during others.
i.e the health of older people is likely to
deteriorate faster than the health of younger
people .
Consider the effect of aging on the optimal health
stock. Assume all other factors determining the
MEI remain constant:
 depreciation rate increases with age as shown.
 optimal health stock decreases with age for e.g the
optimal health at the younger age is H0 , which is
greater than H1 , the optimal health stock at the older
age .
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 Changes in equilibrium: Age…
Higher depreciation rates increase the
cost of holding health capital stock . In
very old age , depreciation rates are
extremely high, and the optimal health
stock falls to Hmin at point B .
• This suggests, people will
generally increase their gross
investment in health as they age
i.e the old will demand more
medical care than the young .
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 Changes in equilibrium …
WAGE RATE
• A wage change does not affect the cost of K ,
and so the horizontal line remains constant .
Instead increased wage rates will ↑the returns
obtained from healthy days.
Thus, higher wages imply a higher MEI leading to
shift in the curve to MEI′ .
new eqbm is at point C with higher optimal level of
health stock H2 .
Therefore increased wages will tend to increase one’s
optimal K stock.

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 Changes in equilibrium …
EDUCATION
• improves the efficiency with which one can
produce both I to health and the home good.
Higher levels of education shift the M EI curve
to M E I’ . i.e M E I curve illustrates the
marginal efficiency of investment for the
consumer with low level of education , while
M E I’ shows the same person with a higher
level of education .
Since education raises the marginal product
of the direct inputs, it reduces the qty of
these inputs required to produce a given
amount of gross I .
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 Changes in equilibrium: Educ…
Therefore a given I in health can be
generated at less cost for educated and he
experiences a higher rate of return to a given
stock of health .
 a more educated person will choose a higher optimal health
stock H2 than the less educated person who will choose H0.
This explains the observed correlation between
health status and educ. i.e ceteris paribus ,
educated pple tend to be significantly healthier .
bcoz they are likely to recognize the benefits of improved health by
eating nutritious foods , doing exercise , know the dangers of
smoking , etc .

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