Lecture Slide Three

Demand for Medical Services

Part 1
 Lecture objectives
By the end of this discussion, the student should
be able to:
• Understand the Consumer’s optimal choice of
health
• Illustrate the effect of illness on: one’s health,
demand for medical care and income
• Understand how prices and other economic
factors affect demand for healthcare
• Appreciate the impact of insurance on the
demand for medical care
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 Outline

• Theoretical derivation of the demand curve

for medical services.
• Economic and non-economic variables
that influence demand.
• Elasticities.
• The impact of health insurance on
demand.

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 Medical Care and Utility
•Medical care is an input in producing
health
 Subject to law of diminishing marginal
productivity
•Health yields utility to the consumer
 Subject to law of diminishing marginal utility

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 Medical Care and Utility
 Example: Do the following values of
Medical Care and Utility imply
diminishing marginal utility of care?

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 Medical Care and Utility
Example: Do the following values of Medical
Care and Utility imply diminishing marginal
utility of care? NO

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 Medical Care and Utility
• Graph this relation between medical care and utility.

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 Medical Care and Utility
• The previous graph illustrates an example of
constant marginal utility

• In practice one would never see this relation

between utility and medical care, because it
violates the assumption of diminishing marginal
utility.

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 Medical Care and Utility
• The next graph illustrates an example of
diminishing marginal utility

• Because each additional unit of medical care

yields a smaller increase in utility, the relation
cannot be graphed using a straight line.

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 Medical Care and Utility
• We can generally graph the relation between
medical care and utility as follows:

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 Medical Care and Utility
• The graph shows that as the level of
medical care rises, each additional unit of
medical care yields a smaller increase in
utility.
• Given this fact, how does the consumer
decide how much health care to
purchase?

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 Consumer’s Optimal Choice of Health
Define : MU = marginal utility of medical care
P = price
q = quantity of medical services
tradeoffs
z = quantity of all other goods
 Given the consumer’s income, she chooses q and
z to maximize utility.
 Utility maximization rule :

MUq MUZ
Pq Pz
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 Consumer’s Optimal Choice of Health
• Total utility reaches its peak when the
marginal utility gained from the last $
spent on each product is equalized.
• i.e. The consumer equalizes “the bang for
the buck” across all goods.

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 Proof
 Suppose that instead :
MUq MUZ
>
Pq Pz
 Last $ spent on medical care generates more U than
last $ spent on other goods
 Consumer could U by purchasing more medical care
(q), and less other goods (z).

 Then MUq would fall, MUz would rise, until the 2 ratios
• are equalized.

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 Consumer’s optimal Choice of health
• Assume a consumer is rational i.e
 chooses the best combination of a bundle of
health care and other goods, from among the
set of bundles that is affordable.
• This logic requires two elements:
The consumer ‘s preference ; described by a
set of indifference curves
The consumer’s budget constraint; described
by the straight budget line.
• Assume a two–gds model, where one
represents a composite of all other gds (O.G)
and the other i.e. health care good is the number
of visits to a physician in a year.
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 Consumer equilibrium analysis
• U1, U2, U3 are the individual’s ICs describing different
utility levels.
• The budget line is given by MN

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 Consumer’s Optimal Choice of Health
• Point M the amount of other gds consumed if no visits
occur.
• Point N the amount of visits if no other gds are
purchased.
• The slope of budget line MN is –Pv/pOG i.e. the
negative of the ratio of prices.
• The consumer equilibrium is at point E, i.e. a point of
tangency between the highest indifference curve
attainable , U2 and the budget line.
• All points on U3 are unattainable while points on IC U,
are inferior.
• At equilibrium point E, the slope of the IC equals the
slope of the budget line.

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 Consumer’s Optimal Choice of Health
• The slope of the IC, the marginal rate of
substitution (MRS), tells the rate at which the
consumer is willing to trade other gds for
physician visits.
• The slope of the budget line is negative, shows
the rate at which the consumer is able to trade
other gds for physician visits at current market
prices.
• At equilibrium MRS= -PV/POG i.e. a shilling
worth of O.G will yield the same extra utility as a
shilling worth of visits .

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 Consumer’s optimal choice of health
◦ Demand for health capital determines the optimal
amounts of other gds (OG), and health investment
capital, I

• PP=Production possibilities , U =U (OG, H) are utility (ICs)

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 Health status and demand: Illness

• Illness immediately drops the level of

health
• Health loss acts in the same way as direct
loss of income
• Leads to reduction of achievable
opportunities to consume other goods
(OG) and healthcare (H)

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 Effect of illness on consumer’s health

• PP=> Production possibilities , U =U (OG ,H) are utility

(ICs)
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 Effect of illness on consumer’s health
• With sickness the consumer’s equilibrium drops
from e1 to e2. However, e2 is not the best
achievable here .
• After the illness, the consumer can slide along
the PP' curve to e3, giving up some consumption
of other gds (O.G) to add health (H).Point e3 is
the best that a consumer can do.
• The illness initially drops the level of utility from
U1 to U2, and the purchase of medical care (at
the sacrifice of some(OG) raises it back to U3.

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 Effect of illness on dd for medical care

• ICs U1, U2 show the preference of a person before getting sick,

• U3, U4 show the same person’s preferences after the illness event.

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 Effect of illness on dd for medical care
• The ICs shift when the consumer gets sick. In
particular, the ICs change slopes i.e. the
marginal rate of substitution btn M and O.G
shifts.

• The decline in consumption from OG1to OG2

coupled with the increase in use of medical care
from M1to M2 , shows the effect of illness on
patterns of spending in the market. In addition, if
illness harms a person’s ability to earn Y, then
the budget constraint might also shift inward
because of illness.

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 Effect of illness on consumer’s income

• U1 = IC without illness, U2 = IC with illness, U3 = IC with illness that

affects Y

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 Effect of illness on consumer’s income…
• The additional reduction in consumption of both
M and OG reflects the loss of Y and confirms the
positive relationship between Y and good health.
Also more income allows the purchase of more
medical care.
• A decline in Y due to illness is shown by a shift
of budget line from I I to I' I'

• The pre-illness choice of OG and M are OG1and

M1 on budget line I I. The utility level U1 is the
highest attainable for the income I I. When
illness strikes ,ICs rotate and income falls to II'.
The best post-illness choice is the tangency of
the budget line II' and IC U3 , with OG3 and M3
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 Effect of illness on consumer’s income…

• Illness has caused 3 observable things:

• i) Y has fallen ,
• ii) Amount of OG has fallen, and
• iii) Amount of M has increased.
• Even if illness does not cause Y to fall (e.g. if the
person has good sick-loss insurance or sick
leave ), OG will still fall and M will still increase ,
compared with the no-illness choices .i.e. OG2
and M2.

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 Deriving a Demand Curve for Physician Visits
• Note : Now let q represent physician visits.
 Suppose Pq rises. This will lead to :
MUq MUz
<
Pq Pz
• Consumer can U by purchasing less q, and more z.
• Pq lower demand for q

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 Deriving a Demand Curve for Physician Visits…

• Downward sloping demand curve for physician visits.

Price represents the per-
unit out-of-pocket expense
the consumer incurs when
purchasing medical
services from the
physician.

• Price changes lead to movements along D curve

•
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 Deriving a Demand Curve for Physician Visits…
• Consumer’s purchase of medical care is a
“derived demand”.
• i.e., “no direct” utility from visiting the
doctor
• U derived from increased health
resulting from
• dr. visit: U = U(h,z) h = h(q,…)

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 Deriving a Demand Curve for Physician Visits…
 Is it logical to think that price plays a role in
healthcare decisions?
 Decisions to purchase health care take place at
either the intensive or the extensive margin.
 Intensive margin: As the price of a product
falls, consumers purchase more of I, or
consume it more intensively. E.g as the price of
physicians services falls, consumers visit their
physicians more frequently i.e. use their
services more intensively.

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 Deriving a Demand Curve for Physician
Visits…
• Extensive margin: To explain the “one-shot”
purchases that take place on an either-or basis
in health care, economists rely on the notion of
the extensive demand for a product.
– Although each individual consumer can
choose to purchase certain types of health
care only once, taken together more
consumers may choose to purchase that
particular type of health care if its price falls.

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 Deriving a Demand Curve for Physician
Visits…
E.g., an individual can have a tooth extraction once.
This is a one-off purchase that either happens or
does not happen. If the price of tooth extractions
falls however, we may still observe an inverse
relationship between the price and number of teeth
extracted. This is because at the extensive margin,
more consumers choose to purchase this one-time
form of dental service as price falls.

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 Other Economic Factors Affecting Demand
 The demand curve illustrates the effect
of changes in the price of the good on
quantity demanded holding all other
factors (income, prices of other goods)
constant.

 Changes in factors other than the price

of the good itself lead to shifts in the
demand curve.

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 Other Economic Factors Affecting Demand
• 1. Income
• If income increases, then at any given price, consumer is
willing and able to purchase more q.

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 Other Economic Factors Affecting Demand

• 2. Complements - 2 or more goods

which are consumed together
• e.g. left shoes and right shoes.
• e.g. laser printers and toner cartridges.
• e.g. alcohol and cigarettes?
• e.g. contact lenses and optometrist visits.

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Other Economic Factors Affecting Demand…
• 2. Complements: 2 or more goods which are
consumed together
• e.g. contact lenses and optometrist visits.
• If contact lenses become cheaper, demand for
optometrist visits ___.

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 Other Economic Factors Affecting Demand

• 3. Substitutes - other goods which

satisfy the same wants, or provide same
characteristics.
• e.g. Coke and Pepsi
• e.g. Physicians and Nurse practitioners?
• e.g. generic and brand name drugs.

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 Other Economic Factors Affecting Demand

• 3. Substitutes - other goods which

satisfy the same wants, or provide same
characteristics
• e.g. generic and brand name drugs.
• If generic drugs decrease in price, D for
brand name ___.

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 Other Economic Factors Affecting Demand

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 Elasticities
• A relatively flat demand curve implies that a small
increase in price leads to a large fall in # visits
demanded.

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 Elasticities
• In this case demand is considered to be relatively
“elastic” with respect to a change in price.

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 Elasticities
• A relatively steep demand curve implies that a small
increase in price leads to a small fall in # visits
demanded.

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 Elasticities
• In this case demand is considered to be relatively
“inelastic” relative to a change in price.

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 Elasticities (cont.)

% QD % change in quantity demanded

ED  
% P % change in price

• Example: If the elasticity of demand for physician visits is

-.6, a 10% increase in price leads to a 6% decrease in
the number of visits demanded.

• Elasticities are scale-free

– We can compare the ED for physician visits vs.
nursing home days, even though they are consumed
in different units.

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 Elasticities (cont.)
• ED is expected to be negative. Thus, own-price
elasticities of demand are often quoted in terms of
absolute value.

• The demand curve is inelastic if

• 0<|ED|<1

• The demand curve is elastic if

1<|ED|<

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 Elasticities (cont.)

Q
% QD Q Q P
  
% P P P Q
P
• If you are given a formula for a demand curve, you can
compute the elasticity of demand for any combination of
price and quantity along that demand curve.

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 Except in special cases, the ED is different
on different points of the demand curve.

• Demand curve: Q = 8 – 2P
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 Elasticities (cont.)
• Income elasticity of demand:

% QD % change in quantity demanded

EY  
% Y % change in income

• Example: If the elasticity of demand for physician visits is

.1, a 10% increase in income leads to a 1% increase in
the number of visits demanded.
• For most types of medical care, EY should be positive.

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 Elasticities (cont.)
• Cross-price elasticity of demand:

%QX % change in quantity demanded of good X

EC  
%PY % change in price of good Y

• Example: If the elasticity of demand for Tylenol

with respect to the price of Advil is 1.5, a 10%
increase in the price of Advil leads to a 15%
increase in the quantity of Tylenol demanded.
– EC is negative for complements.
– EC is positive for substitutes.

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 Elasticities
• Own price elasticity of demand critical for determining
a health care manager’s total revenue.

TR = PQ D
Demand theory tells us that P QD
If demand for physician services is inelastic, and the price
is raised, then I %QD I < I %P I
Implies that:
Total revenue will increase if price is raised when demand
is inelastic.

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 Insurance
The above demand analysis assumed that the
patient pays for care out-of-pocket.
• 1. Coinsurance - Patient pays only a fixed % of
the cost of each visit (often C = .20)
• e.g. If the visit costs $100 :
• patient pays $20, insurance pays $80

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 Insurance

• No insurance : consumer faces price P, makes q visits.

• W/ coinsurance : consumer faces price cP, wants to
• make qc visits.

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 Insurance (cont.)
• Coinsurance leads to a demand of qc visits at price P,
• shared by consumer and insurance company.
• Demand curve rotates clock wise

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 What if the consumer has full coverage?
• i.e., copayment = 0.

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 Indemnity Insurance
Insurer pays a fixed amount for each purchased service.
Insurer pays $150 for each overnight hospital stay, and
patient pays the rest.

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• Deductibles - Consumer must pay a fixed amount out of
pocket per year before coverage begins.
– e.g. The initial $100 per year in health care expenditures must be
paid by the customer.

– Lowers administrative costs, because fewer small claims are

filed each year.
– Lowers demand for relatively inexpensive medical services near
start of the year.
– Has much less impact on demand if relatively expensive medical
services are required.

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