Demand for Health Capital Chapter 7

Dr. Katie Sauer Health Economics

Overview: I. The Demand for Health II. LaborLeisure Trade-Offs III. The Investment/Consumption Aspects of Health IV. The Cost of Capital V. The Demand for Health Capital VI. Empirical Analyses ____________________________________________________________________ I. Demand for Health A. The Consumer as a Health Producer 1. People ultimately want health, they demand medical care inputs to produce it. 2. Consumers are active producers of their health. combine: -time devoted to health-improving efforts -purchased medical inputs 3. Health lasts for more than one period. - does not depreciate instantly (can analyze like a capital good) 4. Health can be treated both as a consumption good and an investment good. As a consumption good, health is desired because it makes people feel better. As an investment good, health is desired because it increases the number of healthy days available to work and to earn income.

B. A Model of Time Spent Producing Health

Suppose we divide your time into 3 categories: work leisure improving health The model: I = I(M,TH) Where I is investment in health M is market health inputs TH is time used in the production of health Total Time = + + + B = B(X,TB) Where B is leisure goods produced by the individual X is market purchased goods TB is time used producing leisure goods

time on improving health time producing leisure goods time lost to illness time working

T = TH + TB + TL + TW II. Labor-Leisure Trade-Off Model When you spend all your time working, Consumers have preferences regarding income your income is at its maximum and you and leisure. spend 0 hours on leisure. Consumers prefer to have both more income When you spend no time working, you can and more leisure. achieve your maximum leisure reduce Over time investments in healthtime: time III. The Investment and Consumption Aspects of Health - ,TL - 0 365 - T T lost to illness, H L and thereby increase The optimal income-leisure combination for A. The Production of Healthy Days leisure time. this consumer is Y*, B*. A higher level of utility can be achieved.

This illustrates the production of healthy days using a single input, health stock. If health stock falls below Hmin, it indicates death. The shape of the function indicates diminishing marginal returns.

B. Production of Home and Health Goods AECD represents production possibilities. If health is an investment good only, indifference curves look like U1. - no intrinsic value of health If health is a consumption good then indifference curves look like U2. - likes feeling good

IV. The Cost of Capital Suppose that an X-ray machine costs $200,000, and that its price does not change over time. Suppose that the annual income attributable to the use of the X-ray machine is $40,000. Is purchasing the machine a good investment? Consider the alternative: Instead of purchasing the X-ray machine, the clinic could have put the $200,000 in a savings account, at 5 percent interest, yielding the following: 200,000 x 1.05 = 210,000 at the end of Year 1 210,000 x 1.05 = 220,500 at the end of Year 2 220,500 x 1.05 = 231,525 at the end of Year 3 231,525 x 1.05 = 243,101 at the end of Year 4 243,101 x 1.05 = 255,256 at the end of Year 5

For the investment in an X-ray machine to be desirable by these criteria, it should provide at least $55,256 in incremental revenue over the five years. But capital goods depreciate over time. For the investment to be worthwhile, it must not only earn the competitive 5 percent return each year, but it also must provide enough return to cover depreciation. V. The Demand for Health Capital The cost of capital (in terms of forgone resources) is a supply concept. The marginal efficiency of investment is a demand concept that relates the return to investment to the amount of resources used. A. MEI is the marginal efficiency of investment The cost of capital is the foregone interest rate plus depreciation (r + ). As investmentat MEI: Looking in the stock of health increases, the rate of return on additional investmentcost of capital is r + 0, then If the declines. optimal investment is H0. If the cost of capital is r + 1, then optimal investment is H1.

B. Changes in Equilibrium 1. Age As we age, our health stock depreciates faster, that is, the depreciation rate rises from 0 to 1 to D. The result of aging in this model is a continuously falling optimal level of health stock. 2. Wage Rate As the wage rate rises, so does the return from healthy days. MEI curve shifts to the right It is now optimal to increase health stock from H0 to H2.

3. Education Education is seen as improving the efficiency of producing health. shifts the MEI curve to the right The optimal investment in health stock increases from H0 to H2. 4. Uncertainty Two effects can occur when we treat investment in health as a risky assts: a. Investment now can increase the efficiency of investment in the future (shift MEI to MEI) and increase optimal investment from H0 to H2. b. Investment now does not increase MEI in the future, which results in a return to investment below r + 0. VI. Empirical Analysis Sickles and Yazbeck (1998) - developed and estimated a structural model of health production - looks at the demand for leisure and the demand for consumption for elderly males - find that both health care and leisure consumption tend to improve health Gerdtham and Johannesson (1999) - estimate demand for health - results are consistent with the theoretical predictions - demand for health increases with income & education decreases with age, urbanization, being overweight, and being single Leibowitz (2004) - retrospective essay on research achievements and directions in the 30 years after Grossmans analysis - finds that increases in the parents valuations of time will also affect the relative costs of alternative inputs to childrens health Key Concepts: 1. People benefit from health in four ways: They feel better when well. They lose less time to illness, and can work more. They are more productive when they work and can earn more for each hour they work. They may live longer. 2. By analyzing the demand for health in this way, we recognize that the demands for health care inputs are demands that are derived from the demand for health itself.