QR 24 Economics Review Session

1. QR 24 Economics Review Session 12/3/2009

2. Agenda • Demand curves • Supply curves • Equilibrium • Market failures • Moral hazard • Adverse selection • Net Present Value

3. Demand Curves • y-axis: price • x-axis: quantity of (something) consumed • Slope: usually negative • Why?  decreasing marginal benefits • Marginal benefit: if I already have 100 (or 1000, or 10,000) of something, how much would I get out of having 1 more?

4. Demand Curve for Medical Care • An odd thing about demand equations is that they usually express quantity (x-axis) as a function of price (y-axis): • For example, Qd = 100 – 4P • This is the opposite of how you usually see this relationship expressed: y = a + bx Price $100 Demand $50 Quantity of medical care

5. Demand Curves (cont.) • Health care example: Physician visits • Patient willing to pay a lot for that first visit • Perhaps the initial diagnosis is the most important piece of information needed • Patient willing to pay less for each additional visit • Perhaps 2nd, 3rd, 4th, …, opinions don’t add much new information • This is decreasing marginal benefits

6. What Shapes Demand Curves? • Personal Income • For most goods, demand increases with income • People who make more money buy more stuff • Other prices • If substitute goods become cheaper, demand will decrease • During a sale at CVS’s in-store medical clinics, demand for routine care (e.g., vaccinations) would decrease at local doctors’ offices • Tastes/Need • People choose to spend their money in different ways • Sicker people demand more health care than healthier people

7. sick healthy Medical Care Demand by Society Price $100 $50 Quantity of medical care

8. Price-Responsiveness (Elasticity) • The responsiveness of the quantity demanded of a good or service to a change in its price • “Elastic demand” : |Ed|>1 • If the price goes up a little, demand goes down a lot • “Inelastic demand”: |Ed|<1 • If the price goes up a little, demand doesn’t change much

9. sick healthy Price Elasticity of Demand Price Less elastic $100 More elastic *technical note: While elasticity is related to the slope of the demand curve, it is not exactly the same thing $50 Quantity of medical care

10. Supply Curves • y-axis: price • x-axis: quantity of (something) produced • Slope: usually positive • Why?  higher prices give suppliers incentive to produce more • With constant marginal costs and perfect competition, supply curve is horizontal • Marginal cost: if we’re already making 100 (or 1000, or 10,000) of something, how much would it cost to make 1 more?

11. Supply Curve for Medical Care Price Supply $100 Sample equation: Qs = 3P $50 Quantity of medical care

12. Market Equilibrium • The price-quantity pair where the quantity demanded is equal to the quantity supplied • Set demand and supply equations equal (Qd = Qs) to solve for P, then plug in P to find Qd or Qs. • Represented by the intersection of the demand and supply curves • Economists call this the “optimal point” • Why?  It’s efficient since the value of the last unit consumed (marginal benefit) is equal to the cost of producing it (marginal cost) • Optimal points are usually noted with a “*”

13. Market Equilibrium Price Supply $100 Demand $50 P* Q* Quantity of medical care

14. First Fundamental Theorem of Welfare Economics • If we assume • Rational individuals • Price-taking behavior (no monopolies) • Complete markets • Complete information • Then market exchange leads to a socially optimal (Pareto) outcome.

15. Market Failures in Health • Incomplete information -> • adverse selection • moral hazard • The quantity consumed (and produced) is not efficient (i.e., is not at the “optimal point”) • Other market failures in health: • Consumers not well-informed • Consumers not rational • Monopolies

16. Demand for Health Care • Demand for health differs from standard demand because (Grossman model, 1972) • Health not health care produces utility • Consumers can purchase health care or produce it through time inputs / behaviors / decisions • Demand for health care both raises utility (you feel better) and also can increase your ability to work, gain income, increase utility from additional consumption. • BUT… this model account for uncertainty in health outcomes.

17. Demand for Insurance and Moral Hazard • The real world involves significant uncertainty • Insurance smoothes income shocks (raising overall utility), but produces moral hazard. • Optimal insurance: trade-off cost of moral hazard which induces unnecessary care with the welfare benefit of reduced uncertainty.

18. Moral Hazard • Consumers who are insulated from risk behave differently than they would if they were exposed to full risks • Health insurance insulates patients from full financial risks • Good because we are risk averse • (So we’re willing to pay a “risk premium” for insurance) • Bad because of moral hazard

19. Deadweight Loss • The loss of economic efficiency that occurs when the quantity consumed (and produced) is not optimal • When patients are insured, they face a lower price for any amount of medical care • Because they are insulated from the full price, they will consume more care (moral hazard)

20. Moral Hazard Price Supply $100 Demand Quantity consumed (Qins) > Optimal quantity (Q*) $50 P* Pins Q* Qins Quantity of medical care

21. Deadweight Loss Deadweight loss here = all the money that is spent on health care above what it is worth to patients (area of the yellow triangle) Price Supply $100 Demand Price received by providers PMD Providers are supplying more than they would at the efficient point, and patients are demanding more $50 P* Price faced by patients Pins Q* Qins Quantity of medical care

22. Evidence for Moral Hazard • RAND Health Insurance Experiment: • Families enrolled over 3 or 5 years with levels of cost-sharing that vary 0%- 95%. • Spending at 25% cost-sharing at 81% of spending level with no cost-sharing and 69% with cost-sharing at 95%. • Estimated price elasticity of -0.2 • Little measured impact on health outcomes

23. Adverse Selection • One of the two fundamental problems with the market for health insurance • Four conditions necessary for adverse selection: • Heterogeneity in health status of patients • Competing health plans • Premiums do not account for heterogeneity in health status of patients • KEY CONDITION: **Information asymmetry (insurers don’t know health status of patients)**

24. Adverse Selection – Death Spiral • Sicker patients are attracted to the more generous plans • These plans will have to increase premiums to make up for the higher costs • Healthier individuals move out of generous plans because the premiums have increased • These plans will have to increase premiums again to make up for the higher costs…

25. Adverse Selection • Potential solutions: • Single-payer • Risk-adjusted premiums • Reinsurance to compensate plans that experience higher-than expected usage

26. Net Present Value • Asks how much a gain or a loss in the future is valued in today’s dollars. • Why? If I get $100 three years from now, this is equivalent to putting $x in the bank now and receiving interest on it. I only need to put x = 100 * (1 / (1 + r) )t in the bank (t = time, r = interest rate). • Discount factor: (1 / (1 + r) )t = (1/(1.03))^3 =.91 • If r = 0.03 and t = 3, then $x = 91.