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Principles of health economics (including the notions of scarcity, supply and demand, marginal analysis, distinctions between need and demand, opportunity cost, margins, efficiency and equity)

Health Economics: 1 - Principles of Health Economics

From a Public Health point of view, health economics is just one of many disciplines that may be used to analyse issues of health and health care, in particular as one of the set of analytical methods labelled health services research. But from an economics point of view, health economics is simply one of many topics to which economic principles and methods can be applied. So, in describing the principles of health economics, we are really setting out the principles of economics and how they might be interpreted in the context of health and health care. As Morris, Devlin and Parkin (2007) put it: ‘Health economics is the application of economic theory, models and empirical techniques to the analysis of decision-making by individuals, health care providers and governments with respect to health and health care.’

There are many different definitions of economics, but a definition given in a popular introductory textbook (Begg, Fischer and Dornbusch, 2005) is instructive: ‘The study of how society decides what, how and for whom to produce’. In analysing these issues, health economics attempts to apply the same analytical methods that would be applied to any good or service that the economy produces. However, it also always asks if the issues are different in health care.

1.1 Production, resources, scarcity and opportunity cost

The definition of economics above includes the term ‘to produce’, emphasising that economics deals with both health and health care as a good or service that is manufactured, or produced. All production requires the use of resources such as raw materials and labour, and we can regard production as a process by which these resources are transformed into goods:

The inputs to this productive process are resources such as personnel (often referred to as labour), equipment and buildings (often referred to as capital), land and raw materials. The output of a process using health care inputs – for example health care professionals, therapeutic materials and a clinic - could be, for example, an amount of health care of a given quality that is provided. How inputs are converted into outputs may be affected by other mediating factors, for example the environment in which production takes place, such as whether the clinic is publicly or privately owned.

The key observation of economics is that resources are known to be limited in quantity, but there are no known bounds on the quantity of outputs that is desired. This both acts as the fundamental driving force for economic activity and explains why health and health care can and should be considered like other goods. This issue, known as the problem of scarcity of resources means that choices must be made about what goods are produced, how they are to be produced and who will consume them. Another way to view this is that we cannot have all of the goods that we want and in choosing the basket of goods that we will have, we have to trade off one good for another.

The term economic goods is sometimes used to describe goods and services for which economic analysis is deemed to be relevant. These are defined as goods or services that are scarce relative to our wants for them. Health care is such an economic good: first, because the resources used to provide it are finite and we can only use more of these resources to create health care if we divert them from other uses; and secondly, because society’s wants for health care, that is what society would consume in the absence of constraints on its ability to pay for it, have no known bounds. Nowhere in the world is there a health care system that devotes enough resources to health care to meet all of its citizens’ wants.

Of course, in a national health system, it is likely that the aim is to meet ‘needs’ rather than ‘wants’; this distinction is discussed below. But it is also the case that meeting one need may mean that another is not met and that no-one has discovered a limit to need.

To summarise: in the economy as a whole, there are not enough scarce resources to meet all of the wants that people have, so we have to choose which wants are met and which are not met; in the health care system there are not enough health care resources to meet all of the health needs that people have, so we have to choose which needs are met and which are not met.

Economics suggests that scarcity and the resulting necessity to choose are ubiquitous and unavoidable. This observation leads directly to an important and fundamental economics concept, which is opportunity cost. If scarce resources are used to produce a good or service, those resources cannot be used to produce other goods or services. Opportunity cost derives from the benefits that are forgone by not producing those other goods. Because there are many possible uses for resources, the opportunity cost of using resources in a particular way is defined as the benefits that would have resulted from their best alternative use.

When economists refer to costs, they usually mean opportunity costs. This is quite different to the more familiar concept of financial costs, the costs of goods and services and of scarce resources in terms of money. Very often, financial costs are used to measure opportunity costs, but this is not always the case. Opportunity cost and financial costs are different ways of thinking about costs, rather than separate elements of overall costs – it would make no sense to calculate them separately and add them together, for example.

1.2 Markets, Demand and Supply

1.2.1 Markets

Economics is a social science, as is emphasised in the definition of economics that refers to ‘how society decides …’. Although society does make collective decisions about what, how and for whom to produce, in most modern economies this is largely done through markets, by the interaction of those who wish to buy (buyers, or consumers) and those who wish to sell (sellers, or suppliers).

Economics analyses markets mainly through what is called price theory. A market brings together the demand for goods from consumers and the supply of those goods from suppliers. Consumers and suppliers base their buying and selling on the price that they have to pay or will receive. Price therefore acts as a signal to both groups as to what they should do in the market. Consumers will want to buy more if the price is lower, but suppliers will want to sell more if the price is higher. If prices are too high, then suppliers will not be able to sell all that they want to and may lower the price. If prices are too low, there will be consumers who cannot buy all that they want. As a result, consumers may bid more, or suppliers may see the possibility that they can raise their price but still be able to sell all that they want. Simple observable indicators like these – the presence of excess demand or supply – determine how much of a good or service is sold and the price that it is sold for.

This simple model of a market for a single good shows one way in which society decides for whom to produce. Consumers can obtain goods if they are both willing and able to pay for them; the more willing and the more able that they are, the more that they can potentially consume. Also, a strong willingness and ability to pay is reflected in high demand even at high prices, which signals to suppliers that they should supply more. So, scarce resources are allocated to producing goods for which demand is high rather than other goods for which the willingness and ability of consumers to pay is less. The demand for such goods is lower and their prices are lower. This, therefore, also shows how markets decide what to produce as well as for whom.

If we also assume that suppliers aim to make as much income as possible from what they sell, then they will wish to keep down the costs of production by choosing the most efficient production methods. So, markets also help to determine how goods are produced as well as what and for whom.

Of course, the real economy is far more complex than this and no economist would pretend that this simple model is a precise description of reality. But the point is that markets do not result in a random allocation of scarce resources, but one that is the result of the incentives provided to economic actors – both consumers and producers – by prices.

1.2.2 Demand for health care, demand for health and need

If we are considering the market for health care, we will be interested in the demand for health care. However, in considering this demand, it is important to recognise that health care has special characteristics that may make it different from other goods. One factor is that health care is not usually demanded because it is in itself pleasurable; in fact it may be unpleasant. Instead, it is demanded mainly to improve health. So, even if health care is in itself unpleasant, it leads to more pleasure than would otherwise have been the case.

If health care is only demanded in order to improve health, then is there a demand for health improvements? Health can indeed be regarded as a good, in fact a ‘fundamental commodity’ that is essential to people’s well-being, leading to a demand for improvements in it. Health does have characteristics that more conventional goods have – it can be manufactured; it is wanted and people are willing to pay for improvements in it; and it is scarce relative to people’s wants for it. However, its relationship with the demand for health care is not one-to-one, because although health is affected by health care, it is also affected by many other things and it also affects other aspects of welfare, not just health care. As a good, health is even more peculiar than health care, because of its characteristics. It is less tangible than most other goods and cannot be traded – it cannot be passed from one person to another (although obviously some diseases can.)

In the context of ordinary goods and services, economics distinguishes between a want, which is the desire to consume something, and effective demand, which is a want backed up by the willingness and ability to pay for it. It is effective demand that is the determinant of resource allocation in market, rather than wants. But in the context of health care, the issue is more complicated than this, because many people believe that what matters in health care is not wants or demands, but needs. Health economists generally interpret a health care need as the capacity to benefit from it. Not all wants are needs and vice versa. For example, a person may want nutrition supplements, even though these will not produce any health improvements for them; or they may not want a visit to the dentist even if it would improve their oral health.

The conclusion from this is that the demand for health care can be analysed as if it were any good or service, but it has peculiarities that may mean that the usual assumptions about the resource allocation effects of markets do not hold. Moreover, it may well be that people wish resource allocation to be based on the demand for health or the need for health care, neither of which can be provided in a conventional market.

1.2.3 Supply

The supply side of the market is analysed in economics in two separate but related ways. One is related to the resource input / goods output model outlined above, looking at how resource use, costs and outputs are related to each other within a firm. Some of the issues that this illuminates concern efficiency in production, which will be discussed below. Others include issues such as economies of scale – are there any cost savings through having larger general practices, for example – productivity –how many more surgical operations can a hospital provide if it hires an extra nurse - and factor substitution – does allowing dental hygienists to replace dentists in undertaking certain tasks lower the costs of producing dental care?

The other way in which supply is analysed is so called market structure – how many firms are there supplying to a market and how do they behave with respect to setting prices and output and making profits. There are two well-known theoretical extremes of market structure. Perfect competition has very many firms in the market so that none has any real economic power, none makes any profits, prices are as low as they can be and output is as high as can be. A monopoly has only one firm, which has great market power, makes as large profits as can be had and has higher prices and lower output. Other models are somewhere in between. The behaviour of some health care organisations, such as pharmaceutical companies, providers of services like dentistry, ophthalmic services and pharmaceutical dispensing and for-profit insurance companies can relatively easily be analysed using these models. It may be more difficult for other organisations. However, they may provide relevant insights – for example regulation of the UK provider sector is increasingly guided by the use of market forces involving ’contestability’ to provide some competitive pressures for efficiency.

1.3 The principle of the margin

Economics analyses many economic activities according to ‘marginal’ principles. Marginal does not mean small or unimportant; instead it means at the margins of an existing state of affairs, for example the cost or benefit that will be incurred or gained by changing the allocation of resources slightly. There are two reasons for this. First, looking at marginal values of economic variables often gives a better view of the issues faced in decision making. Secondly, an influential economic theory suggests that people do, at least implicitly, make decisions using marginal principles.

The definition of a marginal change is that it is a change in an economic variable that is caused by the smallest possible change in another variable. For example, the marginal cost of a good is most widely defined as the extra cost incurred in producing one more unit of it. That cost could actually be rather large, even though the change in the amount of the good is small. As an extreme example, suppose that the good is a particular surgical operation and the surgical unit carrying it out has reached full capacity for its operating theatre. An extra operation could only be carried out if a new theatre was built, so its marginal cost would be very high. By contrast, the marginal cost of the last operation performed within the existing capacity may have been quite small, simply the cost of theatre staff, disposables and subsequent care. This demonstrates an important point. Marginal cost may vary considerably with respect to the same size of change in the other variable, depending on the level of that other variable – in this case the number of operations.

A classic example of the importance of looking at marginal costs is the impact of schemes designed to lower hospital inpatient surgical costs by reducing length of stay through earlier discharge. Hospitals may have information on the average cost of an inpatient stay, which can be used to calculate an average cost per day. However, the costs of an inpatient day are not constant. In particular, they may be much smaller than the average towards the end of the stay, because the average includes a share of the costs of treatment and perhaps of high dependency care that took place towards the beginning of an inpatient stay. So, reducing the number of low dependency days at the end of the stay will save far fewer costs than expected. Marginal costs calculated with respect to an increase or decrease in the number of days would give a correct estimate of the likely savings.

Similarly marginal benefit might be the extra benefit gained by the consumption of one more unit of a good. A classic example of the importance of looking at marginal rather than average benefits is a screening programme which can be carried out with different numbers of sequential tests. The more tests, the more cases are detected. A programme that used two tests might yield 11 cases per 1,000 people tested rather than the 10 cases that a one test programme would produce. But if instead of analysing these as a one test screen and a two test screen, the two tests are analysed as one test followed by another, the marginal benefit is only 1 case, which does not look so good.

Further use of the concept of the margin is discussed in section 6, and a specific application of this in health care is discussed in section 8.

1.4 Efficiency and equity

Economic analysis usually judges the way in which scarce resources are employed according to two main criteria: efficiency and equity. These two concepts have technical definitions, which will be described below, but in very broad terms efficiency refers to obtaining the greatest output for a given set of resources and equity refers to a fair distribution of that output amongst the population.

1.4.1 Efficiency

Before discussing efficiency in detail, it is useful to give a warning. Although economists are specialists in the analysis of efficiency and largely agree about what it means and about definitions of different types of efficiency, the labels given to those types vary. The same concept may be given different names and the same name may be given to different concepts. Here we will use the labels given in Morris, Devlin and Parkin (2007). If other texts are consulted, it may be wise to check what is meant if efficiency is referred to, especially if the terms ‘technical’ or ‘allocative’ efficiency are used. They are not necessarily wrong, just different.

A very broad definition of efficiency has been given by Knapp (1984): ‘The allocation of scarce resources that maximises the achievement of aims’. This is a useful start, because it suggests the very benign nature of the desire to achieve efficiency. If we have scarce resources and competing uses for them, our aim will be to obtain the best set of uses, with ‘best’ defined in whatever way we want. If we decide that the aim of the health system is to improve the health of the population and we have a fixed health care budget, we will obtain the biggest health gain if the allocation of scarce health care resources is efficient.

For practical purposes, it is useful to have more precise and technical definitions of efficiency. However, it is useful first to understand a slightly abstract idea, called Pareto efficiency, which is also (though not consistently) called allocative efficiency. This arises from an attempt to create a criterion for judging different allocations of resources to different ends which might be widely acceptable. (Whether it is or not is in fact debated, but that debate is beyond our aims here.) The suggestion is that we would be able to say that one allocation is better than another if at least one person is better off under the first allocation and no-one is worse off. This is called the Pareto criterion. If we change from one allocation of resources to another, for example if it were possible to make changes to the health care system in terms of the kind of care that is made available, and this means that some people benefit and no-one is made worse off, then this is described as a Pareto improvement. If it is not possible to make any such changes, then we have achieved a Pareto optimum. Another way to view the Pareto optimum is that it is a position where it is not possible to make anyone better off without making someone else worse off.

If our aim is to make people as well off as possible and we are not concerned about whether some people are better off than others, then a Pareto optimum is efficient. We cannot further improve the achievement of our aim because even if we can make someone, or even many people, better off, we do not know if this is outweighed by those who are made worse off. Of course, there are many allocations of resources that would be Pareto optimal, some of which would imply great inequalities between different people. If our aims also took account of this, then we might not view all Pareto optimums as efficient. Nevertheless, ideas of efficiency in economics do derive from this concept of Pareto efficiency Three types are defined below:

  • Technical efficiency
  • Economic efficiency
  • Social efficiency

Technical efficiency is a concept that is used in considering the production of health and health care. Recall from section 1.1 that this is a relationship between resource inputs and outputs. Technically efficient production is achieved if we are producing most output from a set of inputs, or producing a set amount of output using the fewest inputs. For example, the number of patients that can be treated in an out-patient clinic depends on the number of medical and nursing staff that are available and other inputs. If the most that can be provided by one doctor and two nurses is 20 treatments each day, then it is technically inefficient to provide 19 treatments with that number of staff or to provide 20 treatments with more staff.

Another way of viewing technical efficiency, which is consistent with Pareto efficiency, is that the clinic cannot undertake more treatments without employing at least one more member of staff. More generally, production is technically efficient for a given set of inputs if it is only possible to produce more by employing more of at least one input.

Economic efficiency has a number of different labels, including cost-effectiveness, though that term should be used carefully, as will be explained in the section on economic evaluation. Technical efficiency is defined with respect to the physical numbers of inputs, but economic efficiency is interested in the cost of those inputs. Economic efficiency is achieved if we are producing most output for a given cost, or producing a set amount of output at the lowest possible cost. Using the example above, some aspects of the treatment provided in a clinic could be undertaken either by doctors or nurses. It might be technically efficient for 20 treatments to be provided each day by using one doctor and two nurses or two doctors and one nurse. But if we assume that doctors are more expensive to employ than nurses, then it will be economically efficient to use the first of these staff mixes. So, although achieving technical efficiency is necessary to achieve economic efficiency, not all technically efficient ways of producing are economically efficient.

Another way of viewing economic efficiency, which is consistent with Pareto efficiency, is that given the costs of employing staff, the clinic cannot undertake more treatments without them costing more to provide. More generally, production is economically efficient for a given set of input prices if it is only possible to produce more by incurring greater costs.

Social efficiency is a much broader concept than technical and economic efficiency. Both technical efficiency and economic efficiency concern production, and if the supply side of the market achieves economic efficiency in every market, there is allocative efficiency in production for the economy as a whole. There is an equivalent concept for the demand side of the market called allocative efficiency in consumption where, given prices of goods, consumers maximise their utility. If both of these are achieved, then there is allocative efficiency in the economy as a whole, which is also known as social efficiency. This is the same as the Pareto efficiency described earlier.

Obviously, this is not a concept likely to be of practical use in health economics, but it is an important idea for debates about whether markets should be used in health care. It can be shown that if markets work perfectly, then they will produce a socially efficient economy. To some, this gives a presumption in favour of market provision. However, if markets do not work perfectly they will not produce a socially efficient economy. The questions are then how imperfect markets are and whether or not there are alternatives, such as government provision, that are better.

1.4.2 Equity

Equity is an important criterion for allocation of resources, and it is particularly important in health care because it is observable that people attach more importance to equity in health and health care than to many other goods and services. Almost every health care system in the world has equity as an important policy objective. However, economic analysis of equity is less clear than that of efficiency, except in the ways in which equity is measured, and there is lower consensus amongst economists about it.

It is important to distinguish equity from equality. Equity is a synonym for fairness and in the context of health care this means fairness in the distribution of health and health care between people and in the burden of financing health care. Equality means an equal distribution and the difference between the equity and equality is that it may not always be fair to be equal. For example, it might be thought to be unfair if both healthy and sick people are given the same amount of health care. However, equity is often defined with respect to equality and inequality. For example, it may be considered to be equitable that people who have an equal need for health care should have equal access to it. This is a very common definition of equity. However, there could be others, for example:

  • equal use of health services for equal needs for health care
  • equal use of health services for equal willingness to pay for that use
  • equal health outcomes for equal merit
  • equal health care payments by people for equal ability to pay for that health care
  • equal expenditure on people for equal health deficit

There are some equity principles that do not take this form. For example, the utilitarian principle is that the most desirable states of the world are those that maximise society’s welfare, even if that involves inequalities. The maximin principle is if there are inequalities in the distribution of resources, these must benefit the least well off. The free market principle is that any distribution of resources, even if it produces very large inequalities, is fair as long as it results from fair trading with a fair starting point for trade.

We might notice that it is likely that all of these equity principles will conflict with each other. But economics does not really have anything to say about which of these, or others, is the fairest. That is a normative question, based on individual or collective value judgements and may be best analysed using philosophical and political analysis. Economics may be able to describe inequalities, but normative analyses is needed to make judgements of these are inequitable; for example, whether or not inequalities in health care use across income groups are inequitable.

Economics is useful in considering equity in a systematic way and in measuring inequality. A useful distinction, which also has roots in philosophy, is between horizontal and vertical equity. Horizontal equity means the equal treatment of equals – for example, do those who are have equal levels of health need have equal access to health care. Vertical equity means the unequal treatment of unequals – for example, do those who have worse levels of health have greater access to health care.

It is necessary to consider what it is that we wish to be equitable about. Three areas in which equity may be considered are the finance of health care, the distribution of health care and the distribution of health.

Analysis of equity in the finance of health care mainly concentrates on vertical equity. A particular emphasis is whether or not health care is financed according to people’s ability to pay, in other words whether or not people who have different incomes make appropriately different payments. This is encapsulated in the progressivity of the health care financing system. It is to be expected that rich people will pay more for health care than poor people; in itself this does not mean that the finance system has any bias towards rich or poor. However, in a progressive financing system, the proportion of a person’s income that is used to pay for health care rises as income rises. Regressive systems can and do exist, where even though rich people spend more money on health care than poor people, the proportion of their income that the rich spend is lower.

Horizontal equity in financing considers whether or not people who have the same income, and therefore the same ability to pay for health care, make the same payments. Inequities could arise because of the financing system itself, for example if health care financed by local taxation varies across regions or if payments are for use of services and the incidence of ill health varies across people who have the same income.

Horizontal equity in the distribution of health care mainly examines whether or not people with the same need for health care make the same use of health care services. It is difficult to assess in practice what equal need means and how it might be measured. For example, if we look at ethnicity or socioeconomic status, we might agree that these should not in themselves affect the use of health services and are ‘non-need’ factors. Of course, different socioeconomic and ethnic groups might have different use of health services because they have different levels of ill-health, for example, which should affect such use and are ‘need’ factors. But if we control for need factors and find that the use of health care services is affected by non-need factors, there is evidence of horizontal inequity, because people with the same need consume different amounts of care. Vertical equity in the distribution of health care is usually interpreted to mean whether individuals with different levels of ill-health have different levels of use that are appropriate to that difference.

Finally, there is the issue of equity in the distribution of health, which is almost always expressed in terms of inequalities in health. Health inequalities, particularly those that demonstrate that health levels vary systematically and inversely with socioeconomic status, are always of some importance in health policy debates and a major concern of some governments, depending on their political preferences. It may be argued that this is in fact the only real equity concern, since a concern for equity in health care derives solely from a concern about the distribution of health.

Although inequalities in health are important to health economists, and derive to some extent from economic factors, the specifically economic contribution to the analysis of health inequalities is relatively small compared with that from many other disciplines (McIntyre and Mooney, 2007). The main contribution of economics is to analyse inequalities in health with respect to individual people rather than social groupings of various kinds (O'Donnell et al, 2007)

© David Parkin 2009