1. Define what we mean by the terms ‘derived demand’ and ‘agency relationship’ in health care. What are the challenges in deriving demand functions and plotting demand curves in health care?

Derived demand: The demand for health care derives from the demand for health.

Several assumptions are made in economics. For instance, people care about two life essentials in general – their level of health and getting their desired goods (final consumption goods). Health is viewed as human capital which possesses durability and limited number of periods. Health inevitably will depreciate as time passes but a person is assumed to be able to maintain good health for some time by contributing towards it.

In order to produce desired level of health one must invest in things such as; time, skills, education, healthcare, and etc. Similarly, in order to produce desired level of final consumption goods, one must invest in things such as; time, skills, and goods from the market. The act of purchasing healthcare and market goods is not due to an intrinsic care for them. Rather, it is due to the fact that it may contribute to the outcome of a desired level of health and final consumption goods.

To illustrate, if a home cooked meal is desired, then time, raw foods, cooking appliances, plates, cutlery, and etc may produce the meal. If a road trip is desired, then time, car, gas, map, and etc may produce a road trip. If good health is desired, then time and healthcare may produce good health. The notion that healthcare is a derived demand comes from this logic; that the demand for healthcare is derived from the demand for a certain level of health. It is important that an understanding of demand for health is first established before trying to understand the demand for healthcare.

In trying to understand the demand for health, a good place to start is to discuss the constraints that people run into when deciding their desired level of health and final consumption goods. There are mainly 3 types of constraints – time, income, and production. In regards to time, people can spend time working, producing health, producing final consumption goods, and/or in illness. In regards to income, people generally have a fixed amount of income. Thus, money spent on healthcare and market goods cannot exceed their fixed income. In regards to production constraints, there are 2 types. The first is the possible level of health that may be produced via various mixtures of healthcare plus time required. The second is the level of final consumption goods produced via market goods and time required. On a side note, education is assumed to be an important factor in producing health by making people more efficient. In other words, educated people are more efficient at producing health compared to non-educated people.

It is reasonable to say that people do not necessarily want to purchase health care. Going to the doctor’s office, going through treatment, going through surgery, and etc is not usually a pleasant experience. But people get sick and end up purchasing healthcare in order to improve health and ultimately well-being. Therefore, demand for healthcare is derived from the demand for health. This derived demand for healthcare can be represented in terms of utility:

U = u(H(Z,HC),HC,X)U = utilityH = health statusH( ) = the production function for healthZ = non-health-care goods, services, and activities that affect health statusHC = health care goods and servicesX = the set of all other goods, services, and activities that provide utility

Agency relationship: Established when a principal (patient) delegates authority to an agent (physician) to make crucial decisions on their behalf.

In order to make efficient healthcare decisions, two types of information requirements – first, the expected health impact from the intervention (physician strength) and second, the value to the individual of the health improvement (patient’s domain). Efficient decision-making requires integration of both of these information types, i.e. agency relationship.

Physicians are obligated to ethically practice as agents for their patients. Recommendations and treatments offered are assumed to be in the best interest of patients, which should be based on solid evidence. This agency relationship is very different in comparison to the consumer-supplier relationship in standard markets. In standard markets, suppliers are assumed to be completely self-interested profit-maximizers. Also, consumers are assumed to watch out for their own interests. However, in healthcare, agency relationship is assumed to be the norm where physicians’ self-interests are put aside in order to focus on the interest of the patients.

To better understand the agency relationship, it may be helpful to illustrate the two extremes – perfect agency relationship versus imperfect agency relationship. In a perfect agency relationship, the agent will provide all the information that the principal needs in order for the principal to make a final decision. Following this, the agent will implement the decision that the principal has made.

In an imperfect agency relationship, the principal will give all the information that the agent needs in order for the agent to make the final decision. Following this, the principal will implement the decision that the agent has made.

Supplier Induced Demand (SID) is one of the primary challenges in driving demand functions and plotting demand curves in healthcare. SID at its most general sense is demand for care that arises in part due to the influence of care provider. It occurs when asymmetry of information exists between supplier (physicians) and patients (consumers). It is generally accepted that physicians have much more knowledge and information than most patients. We visit doctors and often ask “what is wrong with me?” or “what should I do?” In other words, most patients lack medical information and knowledge required to make intelligent choices for themselves. This asymmetry of information and the associated agency relationship give physicians a lot of market power. Due to the fact that patients have less information/knowledge, physicians have the power to recommend unnecessary treatments to their

patients for their own financial benefits. Thus, physicians possess the ability to shift the demand curve, for better or for worse.

2. What factors drive physician labour supply decisions? Why might the labour supply curve for physicians be backward-bending? Does the empirical evidence support the backward-bending hypothesis?

General formulation of the utility function for physician preferences:

U = U(C,L,E)C = consumptionL = LeisureE = Ethics

Consumption is the physician’s wish to purchase goods with the income earned from practice. Leisure is time spent not working. Leisure is assumed to be a normal good, meaning that other things being equal, high income equates to greater demand for leisure. Ethics is professional ethics that physicians abide by. In general, utility is maximized when a physician provides an appropriate level of service in accordance with the condition of the patient. Thus, utility declines when the care provided deviates from the appropriate level of care.

Physician labour supply decision is influenced by three factors – change in non-practice income, change in consumer prices, and change in fees or the price of inputs.

Change in non-practice income:

An increase in non-practice income will reduce physician supply (also medical service supply). A decrease in non-practice income will increase physician supply (also medical service supply).

Change in consumer prices:

A change in consumer prices changes real wage of physicians and it reduces the real value of non-practice income.

An increase in consumer prices reduces real wage, which creates substitution effect and income effect. Substitution effect refers to the fallen price of leisure, which leads physicians to work less. Income effect refers to the fallen income, which leads physicians to work more (considering leisure to be a normal good). In addition, an increase in consumer prices reduces real non-practice income, which increases labour supply. The net impact of these changes on labour supply is dependent on their relative sizes. Thus, actual figures are required to determine whether specific changes in prices will either increase or decrease physician labour supply.

Change in fees or the price of inputs:

Change in fees and in price of inputs affect physician labour supply and the optimal level of physician and non-physician mixture. Thus, it is useful to discuss two different cases – first, positively sloped physician labour supply and second, backward bending physician labour supply.

- Positively sloped labour supply curve:

An increase in physician fee will increase physician wages, which will cause physicians to work more. Increase in physician wages also increases the demand for non-physician inputs. These increases will lead to an increase in medical service supply.

An increase in the price of non-physician inputs will reduce physician wages, unless the physician fee also changes to counter the increase in non-physician inputs. The reduction in wages will cause reduction in physician labour supply. These decreases will lead to a decrease in medical service supply.

- Backward-bending labour supply curve:

When the physician labour supply curve is backward bending, however, change in physician fee in respect to the demand for non-physician inputs and ultimately on medical service supply is uncertain. There are three effects to physician fee increase in backward-bending curve: 1) reduction in physician labour supply, 2) increased ratio of non-physician to physician input desired, and 3) substitution of non-physician inputs for physician labour.

Why might the labour supply curve for physicians be backward-bending?

Backward-bending labour supply curve: A labour supply curve that, at high wages, bends backward, changing from a positive to a negative slope as the income effect associated with a wage increase dominates the substitution effect.

The physician labour supply curve shows two counter-acting effects – substitution and income effects. When observing the curve, it has a positive slope until it reaches its max. This is the substitution effect. Soon after it reaches its max, it starts backward bending. This is the income effect. When the curve has a positive slope, wage increase encourages physicians to work more and take less leisure. In other words, higher wages increase the opportunity cost of not working, thus wanting less leisure. However, higher wages mean higher income. Since we assume that leisure is a normal good, we also assume that as income increases so should leisure. This is the income effect – as income rises, take more leisure and work fewer hours. When the wage is very high, so is income. At higher wages, income effect dominates over substitution effect. Therefore, physicians seek more time for leisure, creating a backward-bending labour supply curve.

Does the empirical evidence support the backward bending hypothesis?

Studies from the 70s and 80s found empirical evidence supporting the backward bending hypothesis. However, more recent studies show mixed evidence.

3. Remunerating Canadian doctors solely on the basis of ‘Fee for Service’ results in Supplier-Induced Demand: blended payment mechanisms should be a policy priority. Discuss.

Fee-for-service:

Under fee-for-service payment system, physicians get reimbursement for all services provided to patients each time within the set of reimbursable services in a fee schedule. Although there are advantages to fee-for-service system, funders are trying to move away from this system because of the financial incentives it creates, i.e. supplier induced demand.

As explained in question 1, physicians already have power over patients. If physicians are only paid for each and every service that they provide within the fee schedule, then the system may create incentive for physicians to over provide services. In addition, patients may not receive best possible care or treatment because not all services are included in the fee schedule. Thus, service provision may become biased towards reimbursable services regardless of effectiveness. Furthermore, budget planning is difficult for fee-for-service system because total expenditure completely depends on the reimbursable services provided by physicians.

Blended funding:

Blended funding should be a policy priority. Under blended funding, physicians will receive a total funding that is comprised of a mixture of payment mechanisms that can potentially balance the contrasting incentives from various mechanisms. Below is an example of a blended funding mechanism in primary care (Rosser and Kasperski, 2002).

- Capitation:

Physicians are paid an annual fee per patient enrolled. Patients can choose physicians of their choice and when enrolled, the physician will provide coordination of care and health records. Billing data can be used to identify patients who visited the same physician two or three times in a year or two. This approach will avoid wasting time and administration costs to registering.

- Fee-for-service:

Services in fee schedule may include after-hour emergency services, obstetric services, and visits by non-enrolled patients.

- Special-case-based-funding:

Physicians are compensated for special cases that require extraordinary levels of care due to complex medical needs. Because of the complexity of care/needs, compensation will take into consideration physician’s experience, seniority, and extra training required.

- Bonus payments:

Physicians are compensated for achieving positive outcomes in various areas of care, i.e. chronic disease management, preventative programs, and/or health promotion programs.

This blended funding mechanism will have several advantages. Through capitation, supplier induced demand and issues regarding quality versus quantity in fee-for-service will be addressed. Through fee-for-service, special-case-based-funding, and bonus payments, issues regarding under-provision of certain care/services will be addressed. This type of funding mechanism will help in defragmentation of care and broaden the scope of physician practice to a more comprehensive care.

4. Priority setting can be extremely challenging in the ‘real world’. Outline what you see to be the major steps within a priority setting exercise and discuss key strategies to mitigate both organizational and non-organizational challenges that might arise in framework implementation as well as in acting on recommendations.

Outline what you see to be the major steps within a priority setting exercise

Program Budgeting and Marginal Analysis (PBMA) – an approach to priority setting which is based on economic principles but is pragmatic enough for use in practice.

PBMA is based on the following economic principles for priority setting – need to consider opportunity costs, need for marginal analysis of costs and benefits, and existence of a fixed budget. There are 7 stages in PBMA.

First stage is in determining the aim and scope of the priority setting process. It is important to identify right off the bat what the program structure for the priority setting process is. Additionally, the program structure identified should reflect health service objectives and context, such as; organizational context and study setting, policy context and strategic plan, service outputs and outcomes. In the first stage, study design is also decided upon. The choice depends on whether I decide to conduct a micro marginal analysis and look at a single program (studying efficiency within the program) or to conduct a macro marginal analysis and look at multiple programs (studying efficiency between programs).

Second stage is looking at program budget. The aim of the program budgeting is to provide a summary of financial information under investigation. The way to do this is by tracking expenditures to services and sub-programs. This task may be difficult due to lack of accurate information, especially for large organizations and multi-site providers.

Third stage is to form a priority setting advisory panel. The panel should consist of service providers, collaborating service providers, decision-makers/policy-makers, finance/information personnel, consumer/community representatives, and range of clinical and non-clinical people involved. The panel will review initial program structure and study design and make corrections as needed. The panel will

also identify service investments and disinvestments, followed by analysis of costs and benefits. Finally, the panel will establish locally relevant decision-making criteria, which leads to the fourth stage.

Fourth stage is determining locally relevant decision making criteria. This is the corner stone of the priority setting process. Identified criteria need to be explicit and clearly defined. Some examples include program effectiveness, equity, and capacity building. When identifying criteria, different players’ values will need to be reflected. The last step in stage four is criteria weighting and it involves identifying relative importance of criteria. Some methods include; discussion/group consensus and/or decision analysis.

Fifth stage is identifying options for investment or disinvestment. In service investments, new services may be looked at and/or expansion of existing service may be considered. In service disinvestments, ceasing existing services and/or scaling down existing services may be possibilities. In generating options for investment or disinvestments, the advisory panel will make the decisions. The panel will determine how much budget is releasable. They may carry out anonymous proposals, surveys, or interviews to generate options. The process must be evidence based, i.e. published outcomes/effectiveness studies, clinical pathways models, and/or expert opinions.

Sixth stage is evaluating the options. Options should be evaluated in terms of benefits for patients under each of the identified criteria.

Seventh stage is validating results and reallocating resources. Resources should be allocated to services with higher benefits per dollar spent. The benefits should be based on health outcomes and other decision-making criteria identified earlier on. In terms of validating results, it is important to take the options to various stakeholders prior to making the final decisions. In fact, engagement of all key stakeholders is critical as it enables shared understanding of cultures and challenges.

Discuss key strategies to mitigate both organizational and non-organizational challenges that might arise in framework implementation as well as in acting on recommendations.

There are four factors for success in PBMA – objectives, readiness, representation, and feasibility. Having a clear understanding of these four areas throughout the process and not deviating from the plan may be an overall strategy to face challenges. For instance, establishing clear organizational objectives, ensuring organizational readiness for change, establishing appropriate advisory panel, and ensuring feasibility of implementation will inevitably lead to success.Ensuring accountability for reasonableness (A4R) may also help face challenges. There are five components to A4R – relevance, publicity, revision, empowerment, and enforcement. Relevant principles, reasons, and evidence under circumstances should be agreed upon every step of the way. Processes, decisions, and rationales should be transparent to all stakeholders and the public. If necessary, need to be flexible enough to make revisions in challenging decisions. Power differences should be minimized and optimal participation should be promoted. Finally, there should be voluntary

or public regulation mechanisms. When all of the above are taken into consideration in all the stages of PBMA, challenges that might arise in framework implementation as well as in acting on recommendations may be much reduced.