Santerre Neun - Chapter 5

Chapter 5
The Demand for

Medical Care
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The Demand for Medical Care and the
Law of Demand
• Stock of health
– Durable good
– Generates utility
– Follows law of diminishing marginal utility
Law of Demand
• Production of health
– Input: medical services
– Follows law of diminishing marginal
productivity
• Utility
– Function of the quantity of medical care
Law of Demand
• Marginal utility decreases because
– Each successive unit of medical care
generates a smaller improvement in health
• Law of diminishing marginal productivity
– Each increase in health generates a smaller
increase in utility
• Law of diminishing marginal utility
Figure 5.1 - The Relationship between
Utility and Medical Care
Utility
Utility
Quantity of medical care (q)
The shape of the utility curve illustrates that total utility increases at
a decreasing rate with respect to the level of medical care
consumed.
The Utility Maximizing Rule
• Utility-maximizing rule
– Marginal utility gained from the last dollar spent
on each product is equal across all goods and
services purchased
– MUq/Pq = MUz/Pz
• MUq – marginal utility derived from the last unit of
medical care purchased, q
• Pq – price of physicians
• MUz – marginal utility derived from the last unit of all
other goods, z (composite good)
• Pz – price of composite good
The Law of Demand
• Initial condition
– Optimal mix of physician services and all
other goods; MUq/Pq = MUz/Pz
• If price of physician services increases
• MUq/Pq < MUz/Pz
– More satisfaction per dollar from consuming
all other goods
• Fewer units of physician services and more units
of all other goods are purchased
• MUq/Pq increases and MUz/Pz decreases, until
MUq/Pq = MUz/Pz
The Law of Demand
• Law of demand
– Inverse relation between price and quantity
demanded of physician services
• For its derivation, utility analysis, or the income and
substitution effects can be used
– Downward sloping demand curve
• Price
– Per-unit out-of-pocket expense
• After the impact of third-party payments has been
taken into account
Figure 5.2 - The Individual Demand
Curve for Physician Services
Price of physician
services
P0
P1
d
q0 q1 Quantity of physician
services (q)
The individual demand curve for physician services is downward
sloping, illustrating that quantity demanded increases as the price
of physician services drops.
Substitution effect
• Decrease in price of physician services
– Consumer substitutes away from the relatively
higher-priced medical goods like hospital
outpatient services
– Consumer purchases more physician services
• Quantity demanded for physician services
increases
Income effect
• Decrease in price of physician services
– Increases the real purchasing power of the
consumer (real income)
• As medical care is a normal good
– Quantity demanded of physician services
increases with the rise in purchasing power
The Law of Demand
• Law of demand
– Inverse relationship between quantity
demanded of physician services and the price
– The income and substitution effects can be
used to derive this relationship
• Demand for medical care = derived
demand
– It depends on the demand for good health
Other Economic Demand-Side
Factors
• Demand for medical services depends on
– Income
– Prices of other goods
– Time costs
Income
• Increase in income
– Increase in purchasing power
– Increase in demand medical services
• Considering medical care to be a normal good
– Demand curve shifts right
• Decrease in income
– Demand curve shifts left
Figure 5.3 - Shifts in Individual Demand
Curve for Physician Services
Price of physician
services
d1
d0
Quantity of physician
services (q)
Shift in the individual demand curve for physician services, from d0
to d1, due an increase in income. At each price, the consumer is now
willing and able to purchase more physician services.
Prices of other goods
• Complements in consumption
– Two or more goods jointly used for
consumption purposes
– An increase in the price of one good inversely
influences the demand for the other
• Demand for eyewear and services of an
optometrist
• Pediatric services and obstetric services
Prices of other goods
• Substitutes in consumption
– Two or more goods with similar characteristics
providing the same utility
– The demand for one good is directly related to
a change in the price of a substitute good
• Physician services and hospital outpatient services
• Generic and brand-name drugs
• Eyeglasses and contact lenses
Time costs
• Monetary cost of travel
– Opportunity cost of time
• Dollar value of the activities the person forgoes
while acquiring medical services
– Inversely related to the demand for a medical
service
– Examples of increasing time costs
• The farther an individual has to travel to see a
physician
• The longer the delay in getting an appointment
Health Insurance and the Demand for
Medical Care
• Growth of health insurance coverage
– Greatly influenced allocation of resources
• Impact on out-of-pocket payments for health care
– 1960: half of total expenditures
– 2010: one-eighth of total expenditures
• Impact on out-of-pocket payments for hospital care
– 1960: about 21%
– 2010: about 3%
Coinsurance
• The plan
– Consumer pays some fixed percentage of the
cost of health
– The insurance carrier picks up the remaining
portion
– Effectively lowers the out-of-pocket price of
health care
Coinsurance
• Demand curve for medical care
– Negatively sloped
• A consumer’s willingness to pay (marginal benefit)
for each unit of good falls as more of the good is
consumed
– Law of diminishing marginal utility
• Utility maximization
– Willingness to pay (marginal benefit) is equal
to the out-of-pocket price (marginal cost)
Coinsurance
• Effective demand (Refer to slide 23 and
25)
– Demand without insurance
– Consumer’s willingness to pay for medical
services without health insurance cover
– dWO
• Customer surplus
– Difference between willingness to pay and
market price paid
Coinsurance
• Nominal demand (Refer to slide 23 and
25)
– Demand with insurance, dWI
• Reflects total price paid for medical services
– Takes into account the coinsurance paid by the insured
• Insurance coverage is the gap between the
willingness to pay (effective demand) and the
actual price (nominal demand)
Coinsurance
• P = actual price
• C0 = fraction of P pay by consumer
• Pw = consumer’s willingness to pay
• Pw = C0P; P = Pw/C0
The Demand Curve for Medical Services
with Coinsurance
Per unit price
dWI
“Nominal”
demand
$250
dWO
“Effective”
demand
$100
Quantity of medical services (q)

5
The graph illustrates how a coinsurance health plan impacts the

individual demand curve for physician visits.
Coinsurance
• Reduction in coinsurance rate (C0)

– Nominal demand curve, dWI, rotate clockwise
and pivot
– dwi becomes steeper
• At zero willingness-to-pay price
– Insurance has no bearing on quantity
demanded
• Full coverage (C0 = 0)
– Nominal demand curve rotates out to its
fullest extent and becomes completely vertical
Demand Curve for Medical Services with
100% Coverage
Price per
visit dWI
Nominal
Effective demand
demand
dWO
q0 Office visits per year (q)
The graph illustrates the situation in which the individual has complete
medical coverage and the coinsurance rate is zero.
27
Copayment
• Copayment
– Fixed amount paid by the consumer
• Independent of the market price or actual costs of
medical care
– Does not automatically change with an
adjustment in costs of providing medical care
• Lower copayment
– Movement down the effective demand curve
– Greater quantity of care demanded
– No rotation of the nominal demand curve
Deductibles
• Deductible
– A fixed amount of health care costs per
calendar year paid by a consumer before
coverage begins
• Insurance carrier
– Pays all or some portion of the remaining
medical bills
• After the deductible is met
• Depends on the plan
Deductibles
• From the insurance carrier’s perspective

– Lower administrative costs
– Decrease demand for medical care
• Impact on demand for medical care
– Depends on
• Cost of the medical episode
• Point in time when the medical care is demanded
• Probability of needing additional medical care for
the remainder of the period
Moral Hazard
• Moral hazard
– Situation in which consumers alter their
behavior when provided with health insurance
• Insured consumers
– Take fewer precautions to prevent illnesses
– Shop very little for the best medical prices
– May purchase more medical care than they
would have without insurance coverage
Noneconomic Determinants of the
Demand for Medical Care
• Tastes and preferences
– Marital status
• A married individual demands less medical care
– Literacy
• Educated individuals tend to seek more medical
care (direct relationship)
• More use of home-produced health care services
(inverse relationship)
• Likely to recognize early symptoms
– Lifestyle (smoking, excess drinking)
• Increased demand for medical care
• Physical and mental profile
– Gender
• Females usually need more medical services than
males
– Childbearing
• Certain diseases are more prevalent in women
– Cardiovascular disease, osteoporosis, etc.
– Race/ethnicity
– Age
• Older individuals demand more for medical care
• State of health
– Sicker people demand more medical services
– Severity of illness
• Quality of care
– Assumed to be positively related to the
amount and types of inputs used to produce
medical care
– Higher demand for better quality of care
• Quantity demanded depends on

– Out-of-pocket price, income, time costs,
prices of substitutes and complements, tastes
and preferences, profile, state of health, and
quality of care
• Movement along the demand curve
– Change in out-of-pocket price
• Shift of the demand curve
– Change in all the other factors
Market Demand for Medical
Care
• Market demand
– Total demand by all consumers in a given
market
– Horizontal summation of the individual
demand curves
– Amount of medical services that the entire
market is willing and able to purchase at
every given price
– Downward sloping
Market Demand for Medical Care
• Intensive margin
– How much more or less of a product
consumers buy when its price changes
• Extensive margin
– How many more or fewer people buy a
product when its price changes
The Fuzzy Demand Curve
• Relation between price and quantity

demanded is fuzzy
– Lack of medical knowledge
• Providers disagree about the treatment
– Consumers lack the information to make
informed choices
• Rely heavily on the advice of their physicians
– Physicians, rather than consumers, choose medical
services
– Inability to accurately measure medical care
Figure 5.6 - The Fuzzy Demand Curve for
Medical Care
Price per
visit
D
Quantity of medical care
The gray band represents the possible fuzziness of the demand for
medical care given uncertainty and the role of the physician.
The Fuzzy Demand Curve
• Implications
– For a given price
• Some variation in the quantity or types of medical
services rendered
– For a given quantity or type of medical service
• Price differences can exist
Elasticities
• Elasticity of demand
– Responsiveness of quantity demanded to a
change in an independent factor
– Own-price elasticity
– Income elasticity
– Cross price elasticity
Own-Price Elasticity of Demand
• Amount of change in consumption of a

good or a service when its price changes
• ED = %ΔQD / %ΔP
– ED – price elasticity of demand
– % ΔQD – percentage change in quantity
demanded
– % ΔP – percentage change in price
• ED < 0
– Shows inverse relationship between price and
quantity demanded
• |ED| > 0
– Absolute value of the price elasticity of
demand is positive
• |ED| > 1
– Price elastic demand: |%ΔP| < |%ΔQD|
• |ED| < 1
– Price inelastic demand: |%ΔP| > |%ΔQD|
• |ED| = 1
– Unit elastic demand: |%ΔP| = |%ΔQD|
• |ED| = 0
– Perfectly inelastic demand: |%ΔQD| = 0
• Vertical demand curve
• |ED| = ∞
– Perfectly elastic demand: |%ΔP| = 0
• Horizontal demand curve
• Greater elasticity means

– Quantity demanded is more sensitive to a
change in price
– Flatter demand curve at any given price
• Elasticity of demand varies with
– Portion of the consumer’s budget allocated to
the good
– Decision-making time frame
– Extent to which the good is a necessity
– Availability of substitutes
Figure 5.7 - Elasticity of Demand and
the Slope of the Demand Curve
Per unit price
P1
P0
Da (Relatively elastic)
Db (Relatively inelastic)
Qa Qb Q 0 Quantity of medical services(q)
The figure illustrates the changes in quantity demanded for a

relatively inelastic and a relatively elastic demand curves, when the
Price changes from P0 P1.
• Own-price elasticity of demand for medical

services
– Inelastic with respect to price
• Because the consumer typically pays a small
portion of the cost of medical services
• Because medical services are sometimes of an
urgent nature
• Medical services are necessities
– More elastic
• For elective medical care (luxury)
• If more substitutes available
• Total revenue, TR = P*QD

• Effect on an increase in price
– Elastic demand: TR decreases
– Inelastic demand: TR increases
– Unit elastic demand: no change in TR
Income Elasticity of Demand
• Income elasticity of demand, EY

– Percentage change in quantity demanded
(%ΔQD) divided by the percentage change in
income (%ΔY)
– EY = %ΔQD / %ΔY
– The amount of change in demand for a
product with change in real income
Income Elasticity of Demand
• If EY > 0 , normal good

– Any increase in income leads to an increase
in quantity demanded
• If EY < 0, inferior good
– An increase in income leads to a decrease in
the amount consumed
• Most types of medical care: EY > 0
Cross Price Elasticity of
Demand
• Cross-price elasticity, EC
– Extent to which the demand for a product
changes when price of another good is
altered
– EC = %ΔQX / %ΔPZ
– %ΔQX: percentage change in demand for
good X
– %ΔPZ: percentage change in price of good Z
Cross Price Elasticity of Demand
• If EC < 0, complements in consumption

• If EC > 0, substitutes in consumption
• If EC = 0, unrelated goods
Empirical Estimation
• Data unavailability
• Dependent variable
– Quantity of medical care consumed
• Such as number of physician visits
• Independent variables
– Need to include variables for:
• Health insurance
• Consumer’s income
• Time cost
• Prices of complements and substitutes
Own-Price, Income, Cross-Price,
and Time-Cost Elasticity Estimates
• Demand for primary health care
– Relatively inelastic
• Total expenditures on hospital and physician
services increase with a greater out-of-pocket price
• Demand for other types of medical care
– Slightly more price elastic than the demand
for primary care
• Percentage of out-of-pocket payments tend to be
the lowest for hospital and physician services
Table 5.2 - Price Elasticity of Demand for
Health Care: Selected Studies
Dependent variable Study Elasticity Country
Medical expenditures Eichner (1998) -0.62 to -0.75 United States
Newhouse and the Insurance
Experiment Group (1993) -0.17 to -0.22 United States
Phelps and Newhouse (1974) -0.04 to -0.12 United States
Rosett and Huang (1973) -0.35 to -1.5 United States
Van Vliet (2001) -0.079 Netherlands
Hospital Care
Admissions Manning et al. (1987) -0.1 to -0.2 United States
Hospital Inpatient Davis and Russell (1972) -0.32 to -0.46 United States
Hospital Outpatient Davis and Russell (1972) -1.0 United States
Bhattacharya et al. (1996) -0.12 to -0.54 Japan
Patient Days Feldman and Dowd (1986) -0.74 to -0.80 United States
Physician Visits Cockx and Brasseur (2003) -0.13 to -0.03 Belgium
Total and Elective Cromwell and Mitchell (1986) -0.14 and -0.17 United States
surgery
Table 5.2 - Price Elasticity of Demand for
Health Care: Selected Studies
Dependent variable Study Elasticity Country

Nursing home care
Probability of entering a Headen (1993) -0.7 United States
nursing home
Number of patients Nyman (1989) -1.7 United States
Patient days Lamberton et al. (1986) -0.76 United States
Number of patients Chiswick (1976) -2.3 United States
Dental Services Manning and Phelps (1979) -0.5 to -0.7 United States
Mueller and Monheit (1988) -0.18 United States
Prescription Drugs
Number Smith (1993) -.10 United States
Expenditures Contoyannis et al. (2005) -0.12 to -0.16 Canada
Own-Price, Income, Cross-Price,
and Time-Cost Elasticity Estimates
• Income elasticity of demand
– Household data
• Health care: normal good, with income elasticity <
1
– Country-level data
• Aggregate income elasticity is slightly >1
• Health care: luxury good
• Travel time elasticity of demand
– Approximately equals to own-price elasticity
The Impact of Insurance on the
• RAND Health Insurance Study (HIS)
(Manning et al., 1987)
– Families were randomly assigned
– 14 different fee-for-service health insurance
plans
– Test: impact of differences in insurance
coverage on the demand for medical care
The Impact of Insurance on the
• Results
– As the level of coinsurance rises
• Consumers demand less medical care
– Consumers cut back on the number of visits to health
care providers and not on the amount spent on each visit
• The probability of using any medical services,
along with total medical expenditures diminishes
• Own-price elasticity of demand is sensitive to the
level of insurance
– Consumers become more sensitive to price changes
– Negative impact of deductibles on the
consumption of medical care
Table 5.3 - Sample Means for Annual Use
of Medical Care per Capita
The Impact of Noneconomic Factors
on the Demand for Medical Services
• Age and severity of illness
– Directly influence the demand for medical
care
• Overall health of the individual
– Inversely affects the demand for medical care
• Education
– No consensus
– Direct impact: greater willingness to seek care
• Offset by the inverse effect (a greater ability to
produce health care at home
• Effect of medical knowledge on the
demand for medical care
– Positive relationship
• Consumers with a more extensive background in
medicine tend to consume more medical services
• Consumers with a lack of medical knowledge tend
to underestimate the impact of medical care on
overall health
– Often fail to consume an appropriate amount
• Effect of medical knowledge on the
demand for medical care
– Years of schooling, whether the individual
worked in the health care field, medical
insurance, and income
• Positively influenced the level of health information
acquired
– Age and whether the individual drank or
smoked
• Inversely affected the quantity of health information
collected
Patient Protection and Affordable
Care Act (PPACA) of 2010
• Objective
– to extend health insurance coverage to
millions of uninsured Americans
• Approach
– Medicaid to cover all non-Medicaid under the
age of 65 with incomes up to 133 percent of
the federal poverty level
– All individuals mandated to have health
insurance coverage by 2014
• Those elect not to acquire insurance will face a
penalty
Patient Protection and Affordable
Care Act (PPACA) of 2010
• Approach
– States required to design and create
American Health Benefit Exchanges
• Providing individuals and small businesses access
to affordable health insurance
• Offering health plans with an established set of
minimum benefits
• Providing subsidies to those who cannot afford the
premium payments
– A number of insurance market regulations

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Chapter 5

The Demand for

Quantity of medical care (q)

Quantity of medical services (q)

The graph illustrates how a coinsurance health plan impacts the

• Reduction in coinsurance rate (C0)

q0 Office visits per year (q)

• From the insurance carrier’s perspective

• Quantity demanded depends on

• Relation between price and quantity

• Amount of change in consumption of a

• Greater elasticity means

The figure illustrates the changes in quantity demanded for a

• Own-price elasticity of demand for medical

• Total revenue, TR = P*QD

• Income elasticity of demand, EY

• If EY > 0 , normal good

• If EC < 0, complements in consumption

Dependent variable Study Elasticity Country

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