HEALTH ECONOMICS

BISOGHO MUGHUSU EZEKIEL

ezekielbisoghomughusu@gmail.com

 Definition of public health care

economics and Introduction to public
health economics
Public health: The approach to medicine
that is concerned with the health of the
community as a whole.
Public health is community health.

Public Health Approach

Secondary Prevention:
Specialized Group
Interventions for Youth with AtRisk Behavior

Primary Prevention:
Interventions for
All

Tertiary
Prevention:
Specialized
Individualized
Intervention for
Youth with HighRisk Behavior

 "Health care is vital to all of us some

of the time, but public health is vital to
all of us all of the time."
Health can be defined as the state of
complete physical, mental and social
wellbeing and not merely the absence
of disease or infirmity (WHO 1948).

 Health care means goods and services

used as inputs to produce health.
(S. Witter et al 2000).
Economics is the systematic study of
resource allocation mechanism. It can be
applied to any social behaviour or
institution where scarcity exists and there
is consequently a need for making
choices (Wonderling.D et al 2005).

 Health economics is the study of the

value of health and how it can be
produced most efficiently and
distributed to maximize social welfare
(Witter.S et al 2000).
Or Health economics is a branch of
economics concerned with issues
related to scarcity in the allocation of
health and health care.

 Therefore, public health care

economics is the systematic study of
resource allocation mechanisms to
health care where scarcity exists and
there is consequently a need for
making choices so as to maintain and
promote health for all at all time.

 Introduction to public health economics

All around the world people fall ill resources
are used to try to make them better.
It important therefore to study the connection
between health and the resources which are
consumed in promoting it.
By resources we mean people , material and
time which could have been put to some other
use.

 The underlying problem is that people

have almost infinite needs- not just for
health, but also for food, shelter,
entertainment and other types of
consumption but finite (limited) resources
with which to satisfy them.
Choices have to be made to satisfy these
unlimited needs.

Basic four economic questions

1 What products are being produced and in

what quantities?
2. By what methods are products produced?
3. How is societys out put of goods and
services divided among its members? (Who has
access to these measures?)
4. How efficient is societys production and
distribution? (Can we get the same amount of
protection from malaria using fewer resources?

Evaluation of health interventions

This deal how much do the services cost and

what benefit do they bring?
This leads to a process of priority setting, in which
difficult choices are made.
this applies also to the organisation of the
provision of health services. They focus on issues
of technical efficiency in other words, getting the
most gain for resources which are invested in a
given activity and allocative efficiency that means
directing resources to their most productive use.

 In health care , it means to assess which

intervention will produce greatest health gains
for a given investment of resources, and
focusing on the activity.
it looks at the best way (or mix of ways) of
raising money for health care?
What are the advantages and disadvantages of
general taxation as opposed to payroll taxes,
social insurance and private insurance or user
fees?

 The implications of different financing systems

for efficiency and equity
Does it matter if fees are informal rather than
formal?
How much are patients spending on health as
a whole, including drugs?
How can problems of access for low income
groups be mitigated under these different
financing systems?

Is health achievable?
The word health is derived from the
old English word for heal which means
whole, signalling that health concerns
the whole person and his or her
integrity, soundness or well-being.
-ve absence of disease
+ve state of well-being

Predominant models of health

Biomedical model
Lay model of health
Social model of health

Medical model
The absence of disease and illness
Medical treatment can restore health

Lay concepts of health

Health is a positive concept
Differs depending on e.g. age, culture,
ethnicity
Example 1- .Older people - wholeness,
inner strength & ability to cope.
Example 2 - Young people fitness, energy
& strength
Example 3 - Middle class vs working class

Social Model of Health Dahlgren &

Whitehead 1991; social ecological theory

Importance of health economics

Importance of health economics
To aid health workers, decision makers,
government s and society at large to make choices
on how best to use resources;
Helps to determine the best way to finance health
care systems (eg public or private finance)
Helps to identify interventions that maximize
peoples welfare at minimum cost
Helps in prioritisation/ allocation of scarce
resources between various competing needs;

 Helps in the formulation of health policies and

deciding on policy choices;
Helps in rational distribution of resources
(equity)
Ensures efficiency with which resources are
allocated and used for health

Key concepts in health econ

1.The economy refers to all the

economic activities and institutions
within a geographically defined area.
2.Resources are every item within the
economy that can be used to produce
and distribute goods and services.
Resources are classified as labour,
capital and land.

 Labour refers to human resources both

manual and non- manual, skilled and
unskilled
Capital refers to goods that are used to
produce other goods or services for example
machinery, buildings and tools
Land refers to all natural resources. It also
refers to manufactured consumables (ie
almost everything else that does not fall
under labour or capital

 3.Most resources are not, in themselves, useful to

us as individuals but they can be combined to make
something that is useful. This process is called
production.
4. Commodities (or production out puts) are the
result of combining resources in the production
process.
5.In economics the term utility (for individuals) or
welfare (for populations) are used to describe the
satisfaction or happiness provided by commodities.

 Commodities are either goods that you can

hold or touch (for example a drug) or else
they are services that happen to you (for
example a consultation).

What can be done with

commodities or resources

Consumption
Investment
Exchange.
Consumption describes people using up a
commodity in order to increase utility
(happiness or satisfaction gained).

 People invest because they expect the

utility they gain from the final product to be
greater than the utility they gain from
directly consuming these resources.

Recourse or
commodity
Production

Exchange

Other
commoditie
s

Other
commodities
Consumption

Increased Utility

Key concepts

6. Scarcity
How we deal with not having enough of stuff
By graduating from high school, how much
more money will you make than someone who
doesnt graduate over your lifetime?
$283,500, or about $9,500 a year
A limited amount of resources to meet
unlimited wants and needs.
EVERYTHING is scarce!

Why do we have scarcity?

We have Unlimited Wants and Needs
But
Limited Resources
Create Scarcity
So we need to make Choices
What to produce, How to Produce, For
Whom to produce

Causes of scarcity
Personal Perspective: your own feelings of
what is needed or wanted.
Im starving! Im broke!
Poor Distribution of Resources: not using your
resources to their potential.
I never have any time- yet I watch 6 hours of Tv
I dont have enough money for college, but I have
to have a pair of $200 sneakers!

Rapid Increase in Demand: A sudden rush to

use resources can cause a shortage.

How to deal with scarcity

Doing without something
Shut up kid- youll get nothing and like it
Ill go to the prom, but not on the senior trip
Instead of driving to the theater, lets watch
a movie on cable and save gas money
Creating more resources Ill get a second job
Making better use of our resources
While I watch television, Ill grade papers

Needs and Wants

Needs are the things that a person has to
have to survive.
Food, Water, Shelter
The BARE NECESSITIES!
Wants
Are those things that you would like, but do
not need to survive.
Car, I-Pad, Concert Tickets

Real costs

Def. All of the resources used to produce a

good or service.
Most resources can be used for only one
thing at a time.
Real costs of building a bridge instead of a
building
Construction workers (cannot work on
building a new building), A crane (cannot
be used to build a new building),Steel
(used in the bridge, cannot be used in a
new building)

Trade offs
Def. When you choose between two
possible uses for a resource, giving up
one alternative for another.
Ex. Bridge vs. Building
I can either buy this book or pizza, but
not both.

Opportunity cost
When you make a trade off, there are costs.
The value of time, money, goods, and
services given up in an economic choice.
The #1 alternative is the Opportunity cost.
By doing this, I give up the opportunity to do
that.
If we build the bridge, we cant build the
building.
If I buy the pizza, I cant buy the book.

What is the opportunity cost

of going to college

Benefits Higher Income ,

More Job opportunities
Job opportunities in a career I enjoy
Job opportunities in more places
Opportunity Costs Costs a LOT of money
Student loans for years ,4 (or more) years of
school, No guarantee of a job when I get out
What if I change my mind?

Trade off; Sleep vs Study

Options

Benefit

Opportunity
Cost

1 hour of
extra study
time

Grade of C on 1 hour of
test
sleep

2nd hour of
extra study
time

Grade of B on 2 hours of
test
sleep

3rd hour of
extra study
time

Grade of B+
on test

3 hours of
sleep

Costs
When economist talk about cost, they mean
all the costs, resources, implications of the
quantity and not just the money costs
One looks at hidden costs opportunity costs
and all other unquantified costs
When you analyse costs you should recognise
that there costs incurred by providers,
consumers and health providers

Reasons for studying costs

1.resources are scarce and our wants are

unsociable therefore we study costs/ resources
to make choice
2.Health sector consumes a lot of resources
from the national gross domestic product GDP
3. Evaluation of health service by being able to
identify the alternative resources and costs
We can evaluate how effectively and efficiently
the resources have been used

Reasons for studying costs

Knowledge of cost can assist in planning
of future budgets
The study of costs is of value to managers
in ensuring that costs do not eceed the
available revenue

Classification of costs

Cost into the service

These include cost of drugs, equipment,
building-These are the inputs
Cost to the service- These are social costs
They include transporting themselves, waiting
time.
They are rarely thought about during planning
They influence health , for they affect the
ultimate user

Cost concepts

Opportunity cost
Total cost
Fixed cost
Variable cost
Average cost
Marginal cost

Opportunity cost

This is a key concept in health economics.

It explains the consequences of choosing
between two alternatives.
The benefits of choosing one alternative are
compared with the cost of foregoing the other
alternative
Opportunity cost is the value of the best
alternative which is foregone in order to get or
produce more of the commodity under
consideration.

Opportunity cost is what you forgo.

Example: Your opportunity cost for taking this

class includes:
Whatever else you could have bought with your
tuition and fee money
Plus the work, family participation, and recreation
that you are not doing because you are here.

The health gain that would have got from

service Y is the opportunity cost of our decision
to provide service X. Economists try to ensure
that the opportunity of providing X does not
exceed the health gain from X.

Opportunity cost is not resources used

Strictly speaking, the cost of something is
not the resources used up to get it.
Instead, the cost is what else you could
have done with those resources.
Resources have value only because you
can use them to make goods and services
that have value.

Using prices for costs

Opportunity cost can be hard to use in
practice.
Dollar costs (prices) are
easier to determine
and

easier to add up.

Nevertheless, we should not

lose sight of opportunity cost.
For example:
saving medical institutional costs by
discharging patients early
adds opportunity costs for family members
drafted into being home caregivers
(one of the ways that the percentage of national
health expenditure in the GDP understates the
cost of our health care system)

Opportunity cost = price?

Prices can reflect society's opportunity cost
"Reflect" here means that the ratio of prices of
any two goods or services is the opportunity
cost of the one in terms of the other.
If the market system works properly then the
price ratio of any two goods or services tells
you what the social tradeoff actually is, how
many of good X you give up to get each unit
of good Y.

 For this to work properly, you have to have

strong competition and savvy consumers.
Competition will then force the sellers to
be efficient, and provide goods and
services at prices in line with costs.

Total cost
... is a function of quantity
function in the mathematical sense

Total cost = TC(Q)

TC(Q) = the total cost per unit of time of
producing Q units of output per unit of time

Costs are flows, not stocks

Total cost, fixed cost, variable cost, marginal
cost, average cost
All have a time dimension. They are
denominated in units of currency per unit of
time.
For example, a U.S. firm presenting annual
budget numbers would use "dollars per year"
as its cost units. For a monthly budget, the cost
units would be dollars per month.

Total cost example

Here was the total cost per month of providing
different numbers of screening mammograms per
day. This whole table is the total cost
Output rate

Mammograms/day

10

15

20

30

40

50

Total cost per month $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167

 Source: Physician Payment Review

Commission, The Costs of Providing
Screening Mammography, 1989. This
study was done just after Medicare started
paying for screening mammograms.

Fixed cost
Fixed cost is the cost of producing 0
output in a given time period.
Fixed costs are costs that can't be avoided
in the "short run"
"Short run" means a time period in which
fixed costs can't be avoided.
(Circular?)

Fixed cost is a function of Quantity per unit of

time in the trivial sense that it's a constant
function. Fixed costs line goes straight across.

Variable Cost
Variable cost equals total cost minus fixed
cost.
The variable cost is extra cost of producing Q,
above the cost of producing 0.
In the "long run," all costs are variable.

Variable costs per month (20 working days per month)

Tests per day

Cost category
Radiological
technologist
Film
Medical Records

Unit
cost

15
20
30
40
50
$4,83 $4,83
$7,24
$2,415 $2,415
0
0 $7,245 $7,245
5
$1,20
$3,00
$3.00 $300
$600 $900
0 $1,800 $2,400
0
$2,00
$2.00 $200
$400 $600 $800 $1,200 $1,600
0

Supplies and
miscellaneous

$2.00

$200

Postage

$1.00

$100

Forms
Total monthly
variable cost

$0.75

$75

10

$2,00
$400 $600 $800 $1,200 $1,600
0
$1,00
$200 $300 $400 $600 $800
0
$150 $225 $300

$450

$600 $750

$7,45 $8,33 $12,49 $14,24 $15,9

Marginal cost- incremental cost

Marginal cost is
Total cost at output Q
minus
total cost at output Q-1.
Marginal cost is the additional cost of
producing one more.
Or the reduction in cost from producing one
less.

Calculating marginal cost

is a bit tricky, because the radiological
technologist is "lumpy."
"Lumpy" means not continuously variable.
The technologist is somewhat of a fixed cost
over some mall changes in output rate,

Apparently, you can only hire full-time

technologists, not part-time, which would
reduce the lumpiness.

Marginal cost is the concept to

use when considering changes.
Compare the costs with the change
to the cost without the change.
The difference is the marginal cost of the
change.
Compare that with the marginal benefit of
the change to decide whether the change
is advantageous.

Average cost
Average cost is
Total cost at output = Q, divided by Q.
Average cost is sometimes mistakenly used
in place of marginal cost.
The upcoming Stool Kato smear test article
shows an example of that confusion.

Average cost
Marginal cost is what to use to decide
whether to do something.
Average cost is good for telling you
whether you're making money overall.
Profit = Revenue minus cost.
Average profit per unit =
Revenue Units Average Cost per unit.

If you charge all customers the same price

(in health care, you generally don't. But, suppose you

did.)

Revenue is the total amount you take in.

Revenue = Price times Quantity.
Therefore Price equals Revenue divided by Quantity.
Profit = Revenue minus Cost,
so profit per unit = Price minus Average Cost.
If Price exceeds Average Cost then your unit profit is
positive.
If the price is less than the average cost, your
average profit per unit is negative.

Average cost
Tests per
day
Tests per
month
Total cost

10

15

20

30

40

50

100

200

300

400

600

800

1000

$6,17
$13,62 $14,50 $18,66
$22,16
2 $9,462 $10,337
7
2
7 $20,417
7
(Can't
divide

Average cost by 0.) $94.62 $51.69 $45.42 $36.26 $31.11

$25.52 $22.17

Economies of scale. AC falls as Q rises.

Thats because the fixed cost gets spread
over more tests.

Average cost and marginal cost

Tests per day
Tests per
month
Total cost

10

15

20

30

100

200

300

400

600

40

50

800 1000
$20,41 $22,16
$6,172 $9,462 $10,337 $13,627 $14,502 $18,667
7
7
Can't
divide

Average cost by 0

$94.62 $51.69 $45.42 $36.26 $31.11 $25.52 $22.17

Marginal cost Not

from previous applicoutput level
able
$3,290
Corresponding
Not
marginal cost applic-

$875 $3,290

$875 $4,165 $1,750 $1,750

In the 40 column:
The marginal cost per test is $8.75,
but the average cost is $25.52.
Can we really provide extra tests at a price just
over $8.75 each and make money?
Yes, if we don't have to charge all our
customers that price.
Offering a group a price just above its marginal
cost will let us make money on that group.
But if we offer all customers prices just above
their marginal costs, we won't cover our fixed
costs, so we'll lose money overall.

Price discrimination
Jargon term for charging different customers
different prices.
Not illegal.
In health care, often encouraged.
Sliding scale fees for doctors
Payment plans and write-offs for hospitals
Drug samples
Negotiated contracts with insurers

Long-run and short-run

In the short run, it pays to sell to any customer
who'll pay marginal cost.
Even if youre losing money overall, you're
losing less than if you had turned down the
sale.
In the long run, when you can get out of your
fixed cost, you shut down if your average price
is not more than average cost.

Fixed costs

Remain the same from one year to another

Eg electricity bills, drug budgets, salaries and
water bills
Salaries and maintenance can only apply in
established units
But this is not because these vary according to
the system
Inflation is an outcome of instability of the
country and leads to changes in government
budgets

Utility
This an economic jargon fo statisfaction
The assumption is the greater utilty
obtained to visiting particular specialist the
greater will be the price that anyone will
be prepared to pay for it
The satisfaction one attaches to a
particular food or service indicates the
attempt to maximise the utility for it

Markets
In economics, the term market is used to
describe any situation where people who
demand a good or service can come into
contact with the suppliers of that good.
For it to be a market, the buyers and
sellers do not have to physically meet.
The amount of money that is exchanged
for a commodity is the price.

The price is influenced by;

The number of buyers in the market
The amount of money they are able to pay.
These influences are described as the market
forces of supply and demand.
This essentially describes free market that
involve only firms and individuals buying and
selling commodities and resources.
In reality, most markets have some kind of
government interventions.

 Such interventions in the market

might involve levying taxes, fixing
prices, licensing suppliers or
regulating quality.
Government might decide to take
control of demand for commodity and
prohibit private demand, or it may
decide to take over supply entirely
and prohibit private supply.

 Government makes laws that are

intended to free up market forces and
make markets more easily accessible.
In some economies, the government
plays such a large role that markets
scarcely exist at all. Such systems are
referred to as command or centrally
planned economies.
These have diminished due to failure to
motivate workers

 Almost every country in the world today

has a mixed economy, a system in which
market forces and central planning both
play a role.

Demand

The willingness to purchase a good or

service and the ability to pay for it
To demand something you must:
Want it ,Be able to afford it
Have a definite plan to buy it
Wants are the unlimited desires or wishes
that people have for goods and services
Demand reflects which wants to satisfy.

Determinants of demand

The price of the good

The price of the related goods
Income
Population
Tastes and Preferences
The households amount of
accumulated wealth.
Expectations about future income,
wealth, and prices.

Quantity demanded
The amount (number of units) of a product
that a household would buy in a given time
period if it could buy all it wanted at the
current market price.

The Demand Curve

Zakarias demand for

telephone calls

The demand
curve is a graph
illustrating how
much of a given
product a
household would
be willing to buy
at different prices

The Law of Demand

The law of demand
states that there is a
negative, or inverse,
relationship between
price and the quantity
of a good demanded
and its price.
This means that
demand curves slope
downward.

The law of demand

Other things remaining the same, the
higher the price of a good, the smaller
is the quantity demanded.

Demand curve

 Willingness and ability to pay

Another way of looking at demand curve is the
willingness and ability to pay
It tells us the highest price that someone is
willing and able to pay for the last unit bought.
A change in demand
When any factor that influence buying plans
changes, other than the price of the good, there
is a change in demand.

 Movement along versus a shift of the

demand curve
Changes in the factors that influence
buyers plans cause either a movement
along the demand curve or shift of the
demand curve.
If the price of a good changes but
everything else remains the same, there
is movement along the demand curve.

 A change in demand is
not the same as a change
in quantity demanded
In this example, a higher
price causes lower
quantity demanded.
Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve,
from DA to DB.

Income and wealth

Income is the sum of all households

wages, salaries, profits, interest payments,
rents, and other forms of earnings in a
given period of time. It is a flow measure.
Wealth, or net worth, is the total value of
what a household owns minus what it
owes. It is a stock measure

Related Goods and Services

Normal Goods are goods for which
demand goes up when income is higher
and for which demand goes down when
income is lower.
Inferior Goods are goods for which
demand falls when income rises.

Related Goods and Services

Substitutes are goods that can serve as
replacements for one another; when the price
of one increases, demand for the other goes
up. Perfect substitutes are identical
products.
Complements are goods that go together; a
decrease in the price of one results in an
increase in demand for the other, and vice
versa.

 A shift of the demand curve

If the price of a good remains constant but
some other influence on buyers plans
changes, there is a change in demand
A change in demand versus a change in
quantity demanded
A point on the demand curve shows the
quantity at a given price. A movement along
the demand curve shows a change in the
quantity demanded.

 When demand
shifts to the right,
demand increases.
This causes
quantity
demanded to be
greater than it was
prior to the shift,
for each and
every price level

 Higher income decreases the

demand for an inferior good

Higher income increases the

demand for a normal good

The demand for health care

Demand requires that a person desires the
service, that they can afford to pay for that
service and that they are willing to pay for it.
The normative need for health care is the care
that practitioners believe is necessary for a
person to remain or become healthy. On some
occasions the patient decides that they require
health care (felt need) but their doctor decides
that they could not benefit from such care.

 On other occasions, the doctor would

have considered there to be a medical
need but the patient does not consult their
doctor because they prefer not to have
treatment or do not recognize the need.
Even if the patients are as well informed
as their doctor, it quite possible that their
demand is different from the need.
Health economists distinguish a need,
want and demand.

Need
What is objectively best suited to their
medical condition. This is commonly judged
by a doctor, but doctors are only as good at
judging need as their training, equipment
and abilities allow, they may be influenced
by factors other than need, such as fee
schedules or the views of their patients.

 Wants
What the patient believes to be best
for them-what they would like (for
example a fast- acting drug).
Demand
What they actually purchase (S.
Witter et al 2000).

Use of service
It depends on the availability of service
(the supply side) as well as the demand.
When a market is in equilibrium then
demand equals use.

Factors influencing demand

for health care

Need (by patient);Patient preferences; Income;

Price/user charge;Travel cost and waiting time;
Quality of care (as perceived by the patient).
Use depends on demand and accessibility. If
planners allocate resources on the basis of
need instead of demand then they may find that
some services are underused while others
services are oversubscribed.

 Health service demand must be devoted to the

subject of equity (fairness).
Health care provision is fundamentally
important in many cultures.
Many health systems emphasize the need to
supply health care regardless of peoples
income and ability to pay.
Equity plays an important part in health
planning. The ability of health systems to be
equitable is inevitably restrained by the need to
finance health services and achieve efficiency.

Patient factors:
1 Consumers must decide among the available
alternatives designed to satisfy their desires for
health care.
2 Weigh benefits against costs of a good or
service.
Effective demand:
Consumer must have the money to pay for
alternative goods or services.
Consumer must be able to rank alternative
goods and services.

Health status:
The acute care model of medical treatment
follows an expected pattern a patient
develops a medical condition (illness,
injury, pregnancy, etc.),
seeks out a physician,
seeks treatment,
and either dies or recovers.

Health status: Chronic illness, defined as a condition

where a complete cure is not possible, has become a
major factor in health care spending. The condition
does not go away.
Some conditions are more likely as we age (Parkinsons
disease, CHD, Alzheimers disease, arthritis, diabetes,
asthma, and emphysema are growing problems among
the aged.)
Not all chronic conditions are age related: e.g. HIV
infections as well as other sexually transmitted diseases
such as Chlamydia; and respiratory diseases such as
tuberculosis and pneumonia, are increasingly resistant
to traditional methods of treatment.

Demographic xters

A growing population
An ageing population
Sex male or female (especially females
during child bearing years)
Men suffer more frequent health losses due to
life style choices such as drinking, smoking
and over eating.
As more women enter the labor force and
pattern themselves after men, these
differences are narrowing.

Economic standing
Income, Education and Expenditures on
Medical Care are positively correlated.
Education is associated with higher levels of
income.
Education makes one a more informed
consumer.
Studies show that health status and income
are closely related.
The same holds for Education and health
status.

Physician factors
Docs prescribe drugs, admit patients into
hospitals, and order tests.
Principal Agent relationship
An agency exists when an individual (the
patient, and in our case the principal) gives
someone else (the physician, the agent) the
authority to make decisions on his or her behalf.
Problems arise when the interests of the
principal and the agent diverge

 In medicine patients are relatively

uninformed concerning alternative
diagnoses and treatments.
Patients trust Docs to make choices for
them because of the difficulty in gathering
and understanding medical information.
The Docs role as a supplier can create a
conflict of interest. (i.e. Patients are their
source of income)
Key idea: Docs can influence the demand
for medical care.

Principal agent problem

Traditional economics: Increase supply
and the price falls and the quantity
increases. Price falls from P0 to P2.
Supply induced demand would have
supply increasing from S0 to S1 but as a
result of the physician induced demand,
demand would shift to D1.

Principal agent problem

Fee splitting and self referrals (especially
with imaging and lab work)
Capitation and DRGs limit this practice
(DRGs diagnosis related groups)

Supply
Like demand supply is subjected to
various factors and these are;
The price of goods to be supplied
The cost of production
The price of substitutes
The taste of the consumers
objectives of the producer

The law of supply

The law of supply holds that other things
equal, as the price of a good rises, its quantity
supplied will rise, and vice versa.
Why do producers produce more output when
prices rise?
They seek higher profits
They can cover higher marginal costs of
production

Supply Curve

The supply curve has a positive slope, consistent

with the law of supply.

Equilibrium
In economics, an equilibrium is a situation
in which:
there is no inherent tendency to change,
quantity demanded equals quantity supplied,
and
the market just clears.

Equilibrium

Equilibrium occurs at a price of $3 and a quantity of

30 units.

Shortages and Surpluses

A shortage occurs when quantity
demanded exceeds quantity supplied.
A shortage implies the market price is
too low.
A surplus occurs when quantity supplied
exceeds quantity demanded.
A surplus implies the market price is too
high.

Shift in demand curve

A change in any variable other than price that

influences quantity demanded produces a
shift in the demand curve or a change in
demand.
Factors that shift the demand curve include:
Change in consumer incomes
Population change, Consumer preferences
Prices of related goods:
Substitutes: goods consumed in place of
one another
Complements: goods consumed jointly

Shift in the Demand Curve

This demand curve has shifted to the right. Quantity

demanded is now higher at any given price.

Equilibrium After a Demand Shift

The shift in the demand curve moves the market equilibrium

from point A to point B, resulting in a higher price and higher
quantity.

Shift in the Supply Curve

A change in any variable other than price that
influences quantity supplied produces a shift in
the supply curve or a change in supply.
Factors that shift the supply curve include:
Change in input costs
Increase in technology
Change in size of the industry

For any given rental price, quantity supplied

is now lower than before.

The shift in the supply curve moves the market

equilibrium from point A to point B, resulting in a
higher price and lower quantity.

Price Ceilings & Floors

A price ceiling is a legal maximum that can be

charged for a good.
Results in a shortage of a product
Common examples include apartment
rentals and credit cards interest rates.
A price floor is a legal minimum that can be
charged for a good.
Results in a surplus of a product
Common examples include soybeans, milk,
minimum wage

A price ceiling is set at $2 resulting in a shortage of 20 units.

A price floor is set at $4 resulting in a surplus of 20

units.

Elasticity

Elasticity:
the responsiveness of quantity to a change
in another variable
Price Elasticity of Demand:
The responsiveness of quantity demanded to
a change in price
Price Elasticity of Supply:
The responsiveness of quantity supplied to a
change in price

Price Elasticity of Demand:

Price Elasticity of Demand When price
changes how much does the quantity
demanded change?
Price elasticity of demand measures
responsiveness of quantity demanded to
change in price, holding constant the other
variables that affect price = % change in Q
% change in P

 Elasticity varies among products because

some products may be more essential to
the consumer.
Products that are necessities are more
insensitive to price changes because
consumers would continue buying these
products despite price increases.
Elastic goods show shows a sharp in QD if
a slight change in price occurs. (not
needed in daily life)

 An inelastic good or service is one in

which changes in price witness only modest
changes in the quantity demanded or
supplied, if any at all.(needed in daily life.
If elasticity is greater than or equal to one,
the curve is considered to be elastic.
If it is less than one, the curve is said to be
inelastic.

Price Elasticity of Demand

It relates demand to price
ED= D1-DO/DO/P1-PO/PO
Price of H/care

Demand for HC

N/position 1

$200

120

O/position=0

$100

160

Calculate price elasticity of demand

From ED=D1-DO/DO/P1-PO

E= Elasticity, D= Demand at 2 diff, points

P= price at 2 different points
Then E= 200-100/100/120-160/160
= -0.25
When elasticity is negative it means an
increase in price will lead to a decrease in
demand

 Income Elasticity of Demand:

The responsiveness of quantity demanded to
a change in income
Cross Price Elasticity of Demand:
The responsiveness of quantity demanded of
one good to a change in the price of another
good

The Mathematical Representation

of Elasticity
Elasticity =

%Q
%P

Q
Q

P
P

Because the demand curve is downward sloping and

the supply curve is upward sloping the elasticity of
demand is negative and the elasticity of supply is
positive. Often these signs are implicit and ignored.

Elasticity Labels
Elastic : the condition of demand when the
percentage change in quantity is larger than the
percentage change in price
Inelastic: the condition of demand when the
percentage change in quantity is smaller than
the percentage change in price
Unitary Elastic: the condition of demand when
the percentage change in quantity is equal to
the percentage change in price

The Relationship Between

Slope and Elasticity
Elasticity and the slope of the demand curve
are not the same but they are related.
At a given price level, elasticity is greater with
a flatter demand curve.
With a linear demand curve (meaning a
demand curve that has a single value for the
slope) elasticity is greater at higher prices

Figure 1
P 13
12
11
10
9
8
7
6
5
4
3
2
1
0

12.5% change (9-8)/8

25% change (4-3)/4

D1
1 2 3 4 5 6 7 8 9 10 11 12 13

Q/t

Figure 2
P

13
12
11
10
9
8
7
6
5
4
3
2
1
0

50% change (12-8)/8

D2

25% change (4-3)/4

1 2 3 4 5 6 7 8 9 10 11 12 13

Q/t

Figure 3
Higher Prices Means Greater Elasticity
P 13
12
11
10
9
8
7
6
5
4
3
2
1
0

12.5% change (9-8)/8

50% change (3-2)/2
A
B
Demand
C

25% change (4-3)/4

D

1 2 3 4 5 6 7 8 9 10 11 12 13

9.1% change (11-10)/11

Q/t

Explanation
A good for which there are no good substitutes
is likely to be one for which you must pay
whatever price is charged.
It is also likely to be one for which a lower price
will not induce substantially greater
consumption.
Thus, as price changes there is very little
change in consumption, i.e. demand is inelastic
and the demand curve is steep.

Explanation
Inexpensive goods that take up little of
your income can change in price and your
consumption will not change dramatically.
Thus, at low prices, demand is inelastic.

Seeing Elasticity Through

Total Expenditures
Total Expenditure Rule: if the price and
the amount you spend both go in the
same direction then demand is inelastic
while if they go in opposite directions
demand is elastic.

Determinants of Elasticity
Number of and Closeness of Substitutes
The more alternatives you have the less
likely you are to pay high prices for a
good and the more likely you are to settle
for something that will do.
Time
The longer you have to come up with
alternatives to paying high prices the
more likely it is you will shift to those
alternatives.

Extremes of Elasticity
Perfectly Inelastic:
The condition of demand when price
changes have no effect on quantity
Perfectly Elastic:
The condition of demand when price
cannot change

Elasticity and the Demand Curve

How the Elasticity of Demand
Affects Reactions to Price Changes

3-143
3-143

Figure 4 Perfectly Inelastic Demand

P
S2

S1

P1
D
Q1=Q2

Q/t

Figure 5 Perfectly Elastic Demand

P
S2
S1

P1=
P2

Q/t

Q2

Q1

Figure 6 Inelastic Demand

(at moderate prices)

S2
S1

P2
P
1

D
Q/t
Q2

Q1

Figure 7 Elastic Demand

P

(at moderate prices)

S2
S1

P2
P

Q/t

Q2

Q1

Elasticity
Examples
Inelastic Goods
Price Elasticity
Eggs

0.06

Food

0.21

Health Care Services

0.18

Gasoline (short-run)

0.08

Gasoline (long-run)

0.24

Highway and Bridge Tolls

0.10

Unit Elastic Good (or close to it)

Shellfish

0.89

Cars

1.14

Elastic Goods
Luxury Car

3.70

Foreign Air Travel

1.77

3-148
3-148

 Elasticity of supply works similarly. If a

change in price results in a big change in
the amount supplied, the supply curve
appears flatter and is considered elastic.
Elasticity in this case would be greater
than or equal to one.

 On the other hand, if a big change in price

only results in a minor change in the
quantity supplied, the supply curve is
steeper and its elasticity would be less
than one.