CHAPTER 3

DEMAND FOR HEALTH:

THE GROSSMAN MODEL
Intro
 Previously…
 Demand for health care is
downward sloping
 People choose amount of health care they receive
based on price
 People choose their health care, but do they
choose their own health?
 Is health something that happens to us? Or do we
choose it?
 We use the Grossman model to explore this question

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The 3 Roles of Health (H)

Health plays three roles in the Grossman

model:
1. A consumption good

2. An input into production

3. A form of stock/capital (an investment)

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Health as a consumption good
Health as a direct input into utility
 Health as a consumption good enters directly into utility
 Single-period Utility at time t
Ut= U(Ht, Zt)
 Ht = level of health
 Zt= “home good”
◼ Everything non-health that contributes to utility
◼ E.g. video games, time with friends, movie tickets
**Note: health ≠ health care
 Health care is not explicitly in the utility function
◼ i.e. Getting vaccines does not provide utility but staying
healthy does

Health as a consumption good Bhattacharya, Hyde and Tu – Health Economics

Time constraints in the Grossman model

 In a single period, there are only 24 hours in a day to

contribute to your utility. In any given period t, the
individual has Θ units of time at her disposal, and faces
the following time constraint:
Θ = 24 = TW + TZ + TH + TS
 Divide total time Θ between:
 Time spent Working TW
 Time spent Playing TZ
 Time spent Improving health TH
 Time spent Being Sick TS

Health as a consumption good Bhattacharya, Hyde and Tu – Health Economics

Time constraint means time tradeoffs

 Time working TW produces income

 Buy things that contribute to utility (H, Z) but need to spend time in
those activities (TH, TZ)
 Time sick TS does not increase utility
 Every hour spent sick takes away time to do other utility-increasing
activities (loss time)

Health as a consumption good Bhattacharya, Hyde and Tu – Health Economics

The labor-leisure tradeoff
 Given levels of TS and TH,
individual chooses how to
allocate time between work
TW and play TZ.
 Optimal point decides on
indifference curves
 When health improves,
more productive time is
available for use
 Pushes time constraint
outward (from U0 to U1)
 Can reach higher utilities

Health as a consumption good Bhattacharya, Hyde and Tu – Health Economics

Health as an input into production
The three roles of health (H)

Health plays three roles in the Grossman

model:
1. A consumption good
2. An input into production
 Of health (H)
 Of productive time (TP)
3. A form of stock/capital (an investment)

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 One important difference between H and Z: Z is a
flow that is created and consumed each period,
H is a stock that accumulates or deteriorates
from period to period. Decisions made about the
individual’s health ten years ago affect her today,
just as her decisions today will affect her ten
years from now. The level of H reflects the
complete history of past inputs and decisions
pertaining to health. But, enjoyment from
today’s home good is forgotten by tomorrow
and does not contribute to tomorrow’s Z.
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 In any given period t, before the individual has
allocated any time or Money, Zt starts out at 0. Ht
starts out at Ht-1 , but is modified by the health
decisions and purchases the individual makes
during period t. The individual treats Ht-1 as a
given during period t, since she can not go back
into the past, and change her history of health
decisions, which determined Ht-1 .

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Producing H and Z
 Both Health and Home good Z must be produced
with time and market inputs as in the following
production functions:

Ht = H (Ht-1, TtH, Mt)

Zt = Z (TtZ, Jt)

 Mt= market inputs for health H

 Ex: vaccines

 Jt= market inputs for home goods Z

 Ex: video games, opera tickets

 Today’s health Ht also depends on yesterday’s health Ht-1

 This is health’s third role as a stock which we discuss later
Health as an input into production Bhattacharya, Hyde and Tu – Health Economics
The market budget constraint
 In addition to the time constraint, the individual
faces a more traditional budget constraint: she can
not spend more than she earns.
 When the individual works, she earns a wage of w
dollars per unit of time. Her total time working in
period t is TtW , so her total income Yt for the
period t is: Yt = w. TtW .
 The Grossman Model does not specify how wages
w are determined, but presumably the indvidual’s
education and other factors determine the wages.

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In any given period, the individual can spend her
income on two items: market inputs into health, Mt
and the home good, Jt .
 Let pm and pj represent the prices of these two
goods. She thus faces the following budget constraint:
pm * Mt + pj * Jt ≤ w * TtW = Yt

 To simplify, we assume that the individual can not

save leftover income to spend in future periods:
pm * Mt + pj * Jt = w * TtW = Yt

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Health affects production by lowering T S

 The relationship between health levels H and sick

time Ts : The intuition is simple; the healthier the
individual is the less time she spends sick in a
given period and the more productive time Tp
she has available.

 Productive time Tp is simply the complement of Ts and is

the sum of time spent on the other three useful activities
of working, playing and improving health:
TP= Θ – TS = TW + TZ + TH

Health as an input into production Bhattacharya, Hyde and Tu – Health Economics

 Healthier you are, the less time you spend sick
 TP is productive time spent on useful activities
 Increased productive time can be reinvested into health
(TH) or other useful endeavors (TW, TZ)
 Only way to reduce sick time (TS) is to improve health
 In the Grossman Model, there are diminishing marginal
returns to productive time from health. If a person is
already healthy enough to have very little sick time, then
additional improvements in health yield little additional
productive time. If a person is very unhealthy, even small
improvements in health can yield substantial decreases in
sick time.
Bhattacharya, Hyde and Tu – Health Economics
 This is the second role of health in the
Grossman Model: In addition to its role as a
consumption good, health is an input to the
production of productive time.

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TS falls as health H improves, but the effect of
better health on TS also shrinks as health
improves.
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There is a point labeled Hmin on the H-axis, such that the individual’s TS equals Θ.
This means she is sick for the entire period, with no time left to work, play, and
seek medical care. In this way, a model provides an economic definition of death.
The individual has no productive time left, and can not generate any more health.
Thus, she remains at Hmin for all remaining periods is effectively dead.
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 Let’s go back to the case where the individual is
still alive, with H > Hmin : The only way to reduce
sick time Ts is to improve health. Any market
inputs or personal time dedicated to improving
health create extra productive time. This new-
found productive time can be re-invested in
health-improving activities (TH), but it can also be
put to use as time spent working TW or playing
TZ. The main goal of reducing sick time is to have
more productive time for producing more H and
Z.
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Three roles of health in the Grossman
Model
 1. Health is a consumption good. It contributes
directly to the individual’s utility function each
period. Being healthy is valuable in and of itself.
 2. Health is an input into production. It generates
productive time TP which is useful for producing
more H and Z.
 Health is a form of capital. Unlike the home
good, it endures from period to period. It can
accumulate (or depreciate) over time, so
improvements in health today can lead to better
health tomorrow. Bhattacharya, Hyde and Tu – Health Economics
 Production Possibility Frontier
 Production Possibility Frontier An INCORRECT PPF
(PPF): the possible
combinations of H and Z
attainable, given an individual’s
Problem point
budget and time constraints

 Standard economic PPF shows

H and Z as substitutes
 Wrong! Why?

 Maximum Z is minimum H
 If individual is at minimum H,
they are dead and cannot
produce any Z

Health as an input into production Bhattacharya, Hyde and Tu – Health Economics

PPF in the Grossman model
 Point A A CORRECT PPF
Hmin: no productive time
for work, play, or
improvement of health
 Point B
 “free-lunch zone”
 Small improvements in
health yield large
increases in productive
time; can increase Z
without giving up H

Health as an input into production Bhattacharya, Hyde and Tu – Health Economics

PPF in the Grossman model

 Point C A CORRECT PPF

 Maximum Z possible
 Can’t improve health
without taking away Z
 If try to increase Z by
shifting resources, sick
time will increase and
outweigh gain in
resources for Z
 Increases in health will
not produce extra time to
offset time spent
improving health

Health as an input into production Bhattacharya, Hyde and Tu – Health Economics

PPF in the Grossman model
 Point D A CORRECT PPF
 “tradeoff zone”
 Increases in H only yield
small decreases in sick
time
 Increases in H, takes
away from Z

 Point E
 Spend all time and
money on health
 Ignores all home goods

Health as an input into production Bhattacharya, Hyde and Tu – Health Economics

Choosing optimal H* and Z*
 Someone who values
both H and Z chooses a A key prediction of the Grossman Model:
point between C and E In maximizing their utility, people make
in order to maximize tradeoffs that lead to less than maximal health.
their utility
 Chooses point F
 U2 is unattainable given
PPF constraints
 At U0, an individual can
attain more utility
 At F: U1 and PPF are
tangent
 H* and Z* are optimal
levels of health and home
goods
Health as an input into production Bhattacharya, Hyde and Tu – Health Economics
Exotic preferences and indifference curves

Cares only about Health H Cares only about home good Z

 If individual only cares about  If individual only cares about

Health home goods (Z)
 Horizontal indifference
 Vertical indifference curves
curves
 H* and Z* at point E
 H* and Z* at point C

Health as an input into production Bhattacharya, Hyde and Tu – Health Economics

 Extending Grossman:
The multi-period utility function
 Let’s present the full range of our individual’s preferences. He values
health and home goods in every single period of his life:
U=U(H0,Z0,H1,Z1,…,HΩ-1,ZΩ-1,HΩ,ZΩ)
Where:
Ht is the level of health in period t=0,….,Ω,
Zt is the amount of the home good in period t, and
Ω is the length of the lifespan in periods.
* Ω is actually chosen by the individual.

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Health as an investment
The three roles of health (H)

Health plays three roles in the Grossman

Model:
1. A consumption good
2. An input into production
3. A form of stock/capital (an investment)

Bhattacharya, Hyde and Tu – Health Economics

Lifetime of utility

 On any day, an individual considers not only

today’s utility U(H0,Z0) but all future utility as well!

 Health is a stock; some of it carries over each new period

 Home good Z is a flow (it lasts for only 1 period)
 δ = individual’s discount rate, δ ε (0,1)
 The individual values the current utility flow more than he
values the same amount of utility flow in any future period.
 Ω = individual’s lifespan (total number of periods)
Health as an investment Bhattacharya, Hyde and Tu – Health Economics
Health as an investment good
 Health is a form of human capital akin to
knowledge or education.
 Health stores value from investments in previous
periods, but also depreciates in value over time.
 Let ɣ be the rate of depreciation, this measures
how fast health H dissipates from period to period.
 Our revised production function for health reflects
the depreciation of health over time as following:

Bhattacharya, Hyde and Tu – Health Economics

Health depreciates over time

Some of yesterday’s health lasts to today but not

all of it
Ht = H ( (1- γ)Ht-1, TtH, Mt )
 γ = rate of depreciation

 Recall:

 Ht = health at time period t

 Ht-1 = health from previous period

 TtH = time spent on health in period t

 Mt = market inputs for health (like checkups and

prescription pills)
Health as an investment Bhattacharya, Hyde and Tu – Health Economics
Return to health capital
 Health is a capital good which means that it is an
investment with its own rate of return.
 On the other hand, health has a particular
feature: at low levels of health, small
investments have enormous returns to
productive time.
 What happens to an individual’s lifetime utility
when her health in any one period is magically
increased by a small amount?

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 This increase in health has reflections on her
health and utility level in each period for the rest
of her life span. The total increase in lifetime
utility, which is the return to this increase in
health, depends on her starting level of H. The
marginal lifetime returns to health are high at
low levels of health and low at high levels of
health because of the diminishing marginal
returns to health.

Bhattacharya, Hyde and Tu – Health Economics

The labor-leisure graph

Bhattacharya, Hyde and Tu – Health Economics

MEC curve and investments in health

 Marginal Efficiency of
Capital (MEC) curve:
indicates how efficient
each unit of health capital
is in increasing lifetime
utility
 When level of H is
low, small
investments have high
returns to productive
time
Health as an investment Bhattacharya, Hyde and Tu – Health Economics
 Costs to investing in health
 Opportunity cost
 Forgoes putting money into
other investments
 r = interest rate of alternative
market investment
 Depreciation due to aging (γ)
 Health must pay a return of at
least r + γ
 If return is less than
r + γ, depreciation lowers the
effective return to health
below r, then market return
beats health investment
return. Thus, r + γ is the
effective price of health
capital.
 H* = optimal amount of health
 Marginal cost balances with
marginal benefit of health
Health as an investment Bhattacharya, Hyde and Tu – Health Economics
 The MEC curve determines the
optimal amount of health H* for
the individual. On a traditional
demand curve for a given good,
the quantity associated with a
particular price is the optimal
demand for the good at that price.
 Similarly, the MEC curve shows the
optimal health level associated
with the market price of health
investment, r+γ. At this price level,
the individual optimally chooses
H*. And at H*, the marginal cost of
health investment r+γ balances the
marginal benefit of health
invesment.

Bhattacharya, Hyde and Tu – Health Economics

Predictions of the Grossman model
The Grossman model helps explain why we
observe:

1. Better health among the educated

2. Declining health among the aging

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Health and education

 Well-educated individuals are more efficient

producers of health
 College grads benefits more than a high
school dropout.
 Explanations?

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MEC and efficiency of health investment

Better educated are

more efficient at each
level of health
investment
 MECC > MECH
 H*C is higher than H*H

 MECC = college graduate

 MECH = high school
dropout
Bhattacharya, Hyde and Tu – Health Economics
Predictions of the Grossman model
The Grossman model helps explain why we
observe:

1. Better health among the educated

2. Declining health among the aging

Bhattacharya, Hyde and Tu – Health Economics

 Depreciation of health
 Recall:
Ht = H ( (1- γ)Ht-1, TtH, Mt )
 Depreciation γ is not
constant
 γ increases with age
 As γ increases, costs
(r + γ) increase and it takes
more resources to maintain
same level of health

As a result of increasing depreciation γ over time,

optimal health H* also declines over time!

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Optimal death in the Grossman model

 Because of rising
depreciation, there are
better investments in the
market than the individual’s
health
 H* eventually reaches Hmin
 Why would anyone choose
Hmin?
 How is Hmin utility-
maximizing?

Bhattacharya, Hyde and Tu – Health Economics

Unifiying the Grossman Model
We have studied four different graphs, each
representing a different tradeoff or constraint in
the Grossman Model:
 The PPF

 The Health Production Schedule

 The Labor-Leisure Graph

 The Marginal Efficiency of Capital (MEC) Curve

Bhattacharya, Hyde and Tu – Health Economics

 All the diagrams are snapshots of an
optimization problem.
 Simultaneously solving for the optimum in each
diagram results in the bundle of Ht, Zt, TtH, TtZ, TtW
TtS, Mt, Jt that maximizes the individual’s lifetime
utility.
 To better see how the diagrams interrelate, let’s
work on the effect of an increase in age.
 It depicts the decisions of the same individual at
two different stages of his life: the young period
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Bhattacharya, Hyde and Tu – Health Economics

• Recall that the direct result of the aging process is

an increase in depreciation rate ɣ as shown in part
a. As a result of the higher depreciation, the
optimal level of H decreases as the aging individual
shifts investments away from health. Accordingly,
the optimal level of health of the individual in the
old period is less than the one in the young period.
Bhattacharya, Hyde and Tu – Health Economics

This lower level of health inevitably results in lower productive time,

as the individual suffers more sick time in the old period as shown in part b.
The decline in productive time in turn limits the available time
for work and play as shown in part c.
Bhattacharya, Hyde and Tu – Health Economics

Having less productive time also reduces the time and Money available to the
individual for production of H and Z. This shrinks inward the individual’s PPF
and results in a lower level of overall utility as shown in part d.
Conclusion

 Is health something that happens to us or is

chosen?
 Grossman model says it is chosen
 In fact, we even choose when we die

 While that may seem far-fetched, Grossman model a

useful tool for understanding the roles and tradeoffs
of health

Bhattacharya, Hyde and Tu – Health Economics