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Lecture 2:
Economics & Efficiency
Jan Abel OlsenUniversity of Tromsø, Norway
www.janabelolsen.org
Teaching programmes: Master of Public Health, University of Tromsø, NorwayHEL-3007 Health Economics and Policy
Master of Public Health, Monash University, AustraliaECC-5979 Health Economics
Master of Health Administration, Monash UniversityECC-5970 Introduction to Health Economics
Main text: Olsen JA (2009): Principles in Health Economics and Policy, Oxford University Press, Oxford
Micro economics
• Producers (firms, sellers)
– Profit-maximizers
• We’re only in it for the money
• Consumers (households, buyers)
– Utility-maximizers
• We’re only here to get satisfaction
The subject of Economics
‘How scarce resources are used to produce and distribute goods and services to meet human wants’
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1: Production
Input output
X
Labour
Capital
Raw materials
The typical relationship between one input factor and output
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Average vs marginal
• Average productivity: X/L
– Total output / Total input
• Marginal productivity: ∆X/∆L
– Changed output / Changed input
– Or, what is the change in output following a one unit increased input?
Production function
• X = f(L, K)
– L = Labour
– K = Capital
• Substitution of input factors
– If less L, more K is required to maintain a given X0
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Substitution of input factors
Isoquant
Cost-effective combination
Isoquant
Budget line
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Producing more than one good
• Scarcity
– Society has a fixed amount of production factors
• The more production factors used for producing X, the less become available for producing Y
– The ‘opportunity costs’ of producing 1 extra X is measured in terms of how many Y the same production factors alternatively could have produced.
• The production possibility curve:
– Impossible to increase X without reducing Y
Production possibility frontier (PPF)
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2: Consumer behaviour
The ‘law’ of diminishing marginal utility
‘satiation point’
Many ways to get some satisfaction
Indifference curve
Utility function: U = u(X, Y)
Substitution of consumption goods
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The cheapest way to get some satisfaction
Indifference curve
Budget line
Robinson Crusoe’s optimum(a one-person-economy)
Marginal costs of producing one extra X in terms of reduced number of Y (marginal rate of transformation, MRTXY)
=Marginal value of X in terms of how many units of Y one is willing to sacrifice (marginal rate of substitution, MRSXY)
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Distributing goods across individuals
• Scarcity
– Society has a fixed amount of goods
• The more goods to Anne, the less become available for Betty
• The utility possibility curve:
– Impossible to increase Ann’s utility without reducing Betty’s utility
Utility possibility frontier(a two-persons economy)
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3: Production of health care
HC
Doctors, nurses
Buildings,machinery
Drugs
Production function in health care and health
• Two separate production relationships
Input factors HC H
• HC = f(doctors, nurses, drugs …)
• H = f(HC)
• H = f[HC(doctors, nurses, drugs …)]
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The opportunity cost of health care
• More money for health care
less for consumption goods
• More money for the public health sector
less for other public sectors
• More money for hospitals
less for primary care
• More money for hospital ward A
less for ward B
• More GP-time for patient X
less for patient Y
Health possibility frontier
HA
HB
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4: The wealth-health spaceIt is certainly better to be rich&healthy than poor&sick!,
but is it better to be rich&sick than poor&healthy???
Health
Wealth
rich
poor
sick healthy
?
?
Trade-offs in the wealth-health space
Health
Wealth
rich
poor
sick healthy
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5: The concept of efficiency I
• Technical efficiency– All points on the isoquant, i.e.
• No waste of input factors
• Cost efficiency – Where the isoquant is tangential to the budget line, i.e.
• The maximum quantity produced with the given budget, OR• The cheapest way of producing a given quantity
The concept of efficiency II
• Pareto-efficiency in production – all points on the production possibility frontier (PPF), i.e.
• Impossible to increase the production of X without reducing the production of Y
• Pareto-efficiency in consumption – all points on the utility possibility frontier (UPF), i.e.
• Impossible to increase Ann’s utility without reducing Betty’s utility
• Pareto-efficiency in the production of health – all points on the health possibility frontier (HPF), i.e.
• Impossible to increase Ann’s health without reducing Betty’s health
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The concept of efficiency III
• Allocative efficiency – in theoretical welfare economics– the allocation of scarce resources that maximize social welfare
• the marginal costs of producing one additional X in terms of reduced number of Y (the marginal rate of transformation, MRTXY) =
• the marginal value of X in terms of how many units of Y one is willing to sacrifice (the marginal rate of substitution MRSXY)
• Allocative efficiency – in applied health economics– the allocation of health care that maximizes policy objectives,
• Allocative efficiency crucially depends on the policy objective
6: Supply and demand
• Supply curve reflects marginal costs
– Technical reason: Diminishing marginal productivity
– Input price reason: Increasing unit costs
• Demand curve reflects marginal benefits
– The ‘law’ of diminishing marginal utility
– Income effect: The more we’ve already bought, the less money we have left for buying more
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Market equilibrium: Supply = Demand
Q*
P*
Elasticities of demand: DX = f(px, pY, I)
• The own price elasticity of demand is the relative change in quantity, X, following a relative change in its own price: ε = (ΔX/X) / (ΔpX/pX)
• The cross price elasticity of demand is the relative change in quantity of good X following a relative change in the price of a related good Y: εC = (ΔX/X) / (ΔpY/pY)
• The income elasticity is the relative increased demand following a relative income increase: εI = (ΔX/X) / (ΔI/I)
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Health policy relevance: DX = f(px)
• The own price elasticity of demand is the relative change in quantity, X, following a relative change in its own price: ε = (ΔX/X) / (ΔpX/pX)
• If we aim to increase the consumption of healthy goods through subsidies, it is important to know how sensitive demand is to lower prices. – To which extent will people demand more?
• If we aim to decrease the consumption of unhealthy goods through indirect taxes, it is important to know how sensitive demand is to higher prices. – To which extent will people demand less?
Health policy relevance: DX = f(pY)
• The cross price elasticity of demand is the relative change in quantity of good X following a relative change in the price of a related good Y: εC = (ΔX/X) / (ΔpY/pY)
• If we increase the price of a certain good, Y, that may lead to some ‘indirect effects’ on the demand for a different good, X. – If X is a substitute to Y, people will consume more X when
Y gets more expensive.• E.g. taxing tobacco may increase the demand for e-cigarettes
– If X and Y are complementary goods, people will consume less X, when they consume less Y.
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Health policy relevance: DX = f(I)
• The income elasticity is the relative increased demand following a relative income increase: εI = (ΔX/X) / (ΔI/I)
• When income increases, the relative increase in the demand for goods differ– Health care appears to be income-elastic, i.e. the relative
increase in the demand for health care is higher than the relative increase in income.
Lessons
• The dismal science
– Scarce resources opportunity costs
• Technology
– Production function; Substitution of input factors
• Preferences
– Choices and trade-offs
• Objectives
– Maximize social welfare, or a given policy objective
• Application to health and health care
Recommended