 Consumer theory: Utility and Demand [see Weeks 1-3]

 Producer theory: Factors of production, costs and Supply [see Week 4]

 Competitive market equilibrium and efficiency [see Week 5]
 The assumptions required for perfect markets, and common types of market failure [see
Weeks 6 and 8-10]
 The role of government and government intervention [see Weeks 7-10]

Consumer theory: Utility and Demand [see Weeks 1-3]

Opportunity cost shows us the consequence of any choice. Economic assumptions: rational agents in
economics will aim to maximise their utility with given resources.

Utility
two assumptions: (1) consumer sovereignty (consumer is best judge of own utility) and (2) utility is the
objective for individual behaviour.

Total utility

The total happiness a consumer gets from combination of goods and services

Ui=f(Xi,Yi,Zi,...n)

(U=level of utility received from goods & services, X, Y, Z etc. represents various good & services)

Assumption: utility is ordinal, can be ranked, so different combinations can generate more or less utility

Utility from health care

Utility from health care is a derived demand - we get utility from being healthy rather than unhealthy,
and because health care makes us healthier then we have a “derived demand” (as in, we would actually
demand “health” - but that isn’t a good that we can trade, so we instead demand the things that make
us healthy)

But some aspects of health care do give direct utility from consumption (consumption benefits) - we
directly enjoy consuming them (massage, exercise) - but many aspects of health care may actually give
us negative direct utility, we just do them for the derived benefit (vaccination, exercise) (where does
exercise sit for you?)

Investment benefit: Utility function

 Upward sloping curve ⟹ total utility increases as more of the good is consumed.
 Utility obtained from consumption of one more unit of the good is its marginal* utility = slope of
the Total Utility (TU) function
 Concave function ⟹ we prefer more of a good to less of it, but additional units of a good bring
less utility than previous unit = diminishing marginal utility.
Marginal utility (MU)
 Note that, mathematically, marginal utility is the same thing as the slope of the utility function
(slope=Δy/Δx, Δy is the change in units of utility, Δx is the change in the number of
goods/services consumed)
 With small units of consumption, the slope is often steep; and, as more units are consumed the
slope gets flatter (Diagram 1(b), diminishing marginal utility).

Indifference Curves

IC depict a consumer’s preferences over two or more goods.

An IC represents different combinations of the goods that give the same utility or benefit (such that a
consumer is indifferent to all points on one IC, such as U1 in Diagram 2).

IC further out from 0 represent higher utility (so in Diagram 2, U3 > U2 > U1).
Maing inferences about consumer behaviour from ICs =

Consumer equilibrium: maximizing utility

Consumer equilibrium is the combination of goods the consumer will choose to buy in the market given
his/her income and given prices of goods. This is the combination that maximises utility subject to
budget constraint. We can illustrate this by combining the indifference curves and budget constraint in
the same diagram.

 The goal is to maximise utility ⟹ find the highest indifference curve possible for the given
budget
 If indifference curves are curved and the budget constraint is a straight line, this will be a single
point
 This occurs at the point of tangency, i.e. where the slope of the indifference curve equals the
slope of the budget line
 The slope of the budget constraint is equal to the ratio of the price per unit of the two (or any #)
goods.
Price changes = Income changes =

Pareto Efficiency and Edgeworth Box

Edgeworth box = Allocation of a fixed number of two goods between two consumers

The defining feature of a Pareto efficient point is that, at this point, it is impossible to improve the utility
of any one person without reducing the utility of someone else

The Edgeworth Box diagram shows how, from any starting point (endowment), any society will trade
(whether through barter or by inventing a currency/money system) until all avenues for mutual gain
from trade are exhausted - in this way it will be (Pareto) efficient.

Endowment shows how all the goods in the market are allocated between these only 2 consumers

See week 3.2 for more detail

Demand
Law of demand: for most of goods, the quantify demanded will be negatively related to price (quantity
demanded will decrease as price increases and increase as price decreases)

Demand Curve

The demand curve expresses how price is related to the quantity demanded of a single good at the level
of the whole market

Definition: a graph showing the relationship between the price of a certain good (on the y-axis) and the
quantity of that good which is demanded at that price (on the x-axis) for a market.
Factors affecting Demand

- Price of good
- Substitutes
- Consumer income
- Consumer tastes
 A change in price (P) will result in a movement along the same (pink) demand curve, with a
change in both the quantity demanded and the price. In the diagram below, this is shown as a
move from A to B.
 Change in any other (exogenous) factor will result in a shift of the whole demand curve. The
price of the good (P) stays the same, but other things have changed for each individual
consumer (a change in relative prices caused by an increase in the price of substitute goods like
physiotherapist visits, or a market-wide increase in incomes such as from a national income tax
cut). This causes a change in quantity demanded at every level of price (P) and this is shown as a
shift or move of the whole demand curve to the right or left. In the diagram below, this is shown
as a move from A (on the original, pink demand curve) to C (on the new, orange demand curve).

Price elasticity of demand (PεD or Ep)

Price elasticity of demand is a mathematical formula which describes the relationship between price and
quantity demanded:
Where Ep is price elasticity of demand, P is price, Qd is quantity demanded and Δ is "the change in"
(expressed as a percentage, %)

X = price, Y = demand

Calculate the proportional change in price (ΔQd) bottom part of Ep

 Price increase from $5 to $6 = (6-5)/(0.5*(6+5)) = 0.181818

 Price decrease from $6 to $5 = (5-6)/(0.5*(5+6)) = -0.181818

Calculate the change in quantity demand (%ΔQd) top part of Ep

So, if the quantity demanded increases from 10 to 15, the proportional change in quantity demanded is:

(15-10)/[0.5*(10+15)] = 0.4

And if the quantity demanded decreases from 15 to 10, the proportional change in quantity demanded
is: (10-15)/[0.5*(15+10)] = -0.4

So again, the absolute size of the proportional change is the same regardless of the direction of change,
but the sign is negative for a reduction in quantity demanded and positive for an increase in quantity
demanded.

Calculate Price elasticity of demand

We have calculated the denominator (bottom part) of this formula in Step 1 and the numerator (top
part) in Step 2.

So if a price rise from $5 to $6 is associated with a decrease in quantity demanded from 15 to 10 units:

Ep = -0.4 / 0.181818 = -2.2

Producer theory: Factors of production, costs and
Supply [see Week 4]
Production
maximize profit, where profit is defined as the value (in monetary terms) between what they sell their
goods for (revenue) and what it costs them to produce those goods (costs).

Revenue is simply the amount produced (Q) multiplied by the market price (P

Increasing inputs increases total product (quantity produces) increases, and marginal product (change in
output) decreases

Isoquants (for two inputs, one producer)

Each isoquant curve represents the technically efficient combinations of labour and capital that can be
employed to produce the same number of a product. (like the Edgeworth box and utility for two
consumers)
Isocost curve (the producer's budget constraint)
Like how scarcity of recourses restricts consumer choice, scarcity of resources and cost to produce
retrict a producer’s output
 the price of labour is known as wages (w), typically applied per hour or week of labour input
 the price of capital is known as capital rent or interest (r), typically applied per $ of capital input
 the price of land is known as land rent (n), typically applied per square metre, acre or hectare of land
input

Producer equilibrium
Producer equilibrium refers to the state where the combination of price and output gives maximum profit to the
producer. At point A, it is not possible to produce any more of the good - if the producer changed the mix of labour
and capital employed, their total production would decline. Any decline in quantity produced would mean lower
profit (because profit = P x Q).

choices between any two different outputs: the production possibility frontier (PPF). The slope of the
PPF indicates the opportunity cost of producing one good versus the other good

The PPF captures the concepts of scarcity, choice, and trade-offs.

 The shape of the PPF depends on whether there are increasing, decreasing, or constant changes
in output as we switch resources from producing good X to good Y.
 Points that lie on the PPF illustrate combinations of output that are technically efficient - this is
the best (most technically efficient) way we can produce goods X and Y, with no waste of
resources. We cannot determine which points are allocatively efficient without knowing more
about what utility people derive from consuming X and Y
 All points on the PPF curve are technically efficient
Competitive market equilibrium and efficiency [see
Week 5]
1. Technical efficiency is concerned with achieving maximum outputs with the least input or cost
(most benefit for a given cost, or lowest cost for a given level of benefit).
2. Allocative efficiency refers to how different resource inputs are combined to produce a mix of
different outputs and what combination of these different outputs will maximise benefits (for an
individual, or for society).

Market Equilibrium - the state where supply and demand reach a balance.
A producer won’t enter a market if the price of a good doesn’t cover average variable cost (labor cost to
produce good)

As price rises quantity produced increases

For consumers, demand lowers and they exit the market

Consumer surplus uses the demand curve to show the increased utility of consumers from trade
Producer surplus is the total amount that producers benefit from producing and selling a quantity of a
good at the market price (P*), uses the supply curve to show the increased revenue of producers from
trade
The assumptions required for perfect markets, and
common types of market failure [see Weeks 6 and 8-10]
Perfect information problems in healthcare

Assumption: consumers are rational

 Non-rational behaviour might be particularly relevant for certain groups in society, such as:
children, elderly, seriously ill, mentally ill

Are consumers sovereign in health care markets?

For consumers to be able to place a value on health care they require the following information:

 expected benefits of the particular treatment

 alternatives available
 implications of not having treatment

What do economists mean by ‘perfect information’?

 Suppliers have knowledge of the production process and costs of production

 Consumers can compare the value of goods on the basis of price => this means that consumers
understand the relationship between consumption and utility (to be able to place a value on
goods/services)
 Consumers are as well-informed about the good as the producer

Information problems in health care: uncertainty , incomplete information (Imperfect or incomplete

information applies where no single party to the transaction has perfect (full) information), information
asymetry (one know more than other)

Info asymytry introduces agent to make decisions on behalf of consumer. Agent is usually the supplier of
the service => this immediately means that demand & supply are not completely separable, ie supply
and demand are no longer independent, which is a failure of the conditions for a perfectly competitive
market

The complete market assumption is that all costs & benefits of a transaction are internalised or private,
which means that the decisions of consumers and producers are based on all relevant costs and
consequences from purchase/consumption and production of that good.
An externality is an unintended cost or benefit (which is often called a spillover effect) of a market
transaction (consumption or production) which impacts on a party not immediately involved in the
transaction.

An externality (- or+) creates a difference between the private & social costs or benefits of economic
activity

 Production externality - although price (P) may be equal to marginal (private) cost (MPC) it may
differ from marginal social cost (MSC), P=MPC≠MSC
 Consumption externality – although price (P) may be equal to marginal (private) benefit (MPB)
it may differ from marginal social benefit (MSB), P=MPB ≠MSB

Major problem is that the externality is not fully reflected in the market price (used by consumers and
producers to make decisions about quantity to consume/produce), therefore leading to the following
impact of externalities on market equilibrium quantity:

 Negative production externality: MSC > MPC, therefore over-provision

 Positive production externality: MSC < MPC, therefore under-provision
 Positive consumption externality: MSB > MPB, therefore under-provision
 Negative consumption externality: MSB < MPB, therefore over-provision

Summary: Health insurance

 Health insurance protects individuals against the cost of illness (price), especially when prices
can be large and/or income may be reduced due to accident or illness
 Health insurance provides financial protection against the cost of illness => it is the “market”
solution to uncertainty concerning the timing and magnitude of an expense
 Overall, health insurance protects individuals against the cost of being sick. It cannot technically
prevent people becoming sick, but it reduces the financial impact of an event
 Insurance is especially relevant for low-probability but high-cost events, e.g., a heart attack or a
serious accident, something that's unlikely to happen, but if it does happen, it has a large
financial impact

But any time you have any insurance markets there are two problems, which have been always been
associated with insurance:

3. Moral hazard: where the act of consumption of insurance as a good, in itself changes the
behaviour of the consumer To address moral hazard, insurers introduce co-payments to
increase the price signal to consumers, but this in turn has equity implications.
4. Adverse selection: where information failure (specifically, information asymmetry where the
consumer has more information than the producer) can lead to the collapse of the insurance
market The solution to adverse selection is risk-pooling by insuring large groups (if not the entire
population) in a market, so that costs (payouts) more predictable from insurer’s perspective.

Moral Hazard - inefficeincy

 if moral hazard occurs, then once insured against something (“X”), then “X” is more likely to
occur
 full insurance means that the money cost (price) for health care goods are reduced to zero (if
"X" occurs, the insurer pays all costs)
 moral hazard results in excess demand for the insured good, which generates market
inefficiency (benefits from resources used for providing health care are less than the benefits
foregone from an alternative use)
Adverse Selection
Adverse selection arises from the combination of differences in individual risk and information
asymmetry:
  different potential consumers of insurance have different risk or probability of need for a health
care good; and
 insurance producers have less information about individual risk than the individual

Actuarial: an estimate of an uncertain variable input into a financial model, normally for the purposes of
calculating premiums or benefits. Eg, smoking and life insurance

Adverse selection:

 Occurs when consumers know more about their risk level (i.e. their expected demand for health
services) than the insurer
 Is more of an issue when there are high costs to producers overcoming the information
asymmetry by increasing their information about potential consumers - for example when there
are barriers (e.g. privacy laws) to insurers acquiring additional information except by asking
consumers directly for the information
 Is only an issue when there is voluntary insurance
 Describes a situation where insurers attract a higher than expected proportion of high risk
consumers - such that insurance consumers are more high risk than low risk individuals
 Results in excessive consumption and costs to the producer compared to the predicted level,
meaning that the insurance producer will lose money (negative profit)

=> Potentially a much greater problem than moral hazard to the insurer (from a profit perspective)

Monopoly - failure of the "many sellers"

assumption of many buyers and sellers is required so that no single agent can affect market price
through their behaviour in the market. This means (if the assumption holds) that all actors in the market
are what we call ‘price takers'.

"Deadweight loss" is the term applied to the lost consumer/producer surplus (compared to the perfect
competition ideal)

The role of government and government intervention [see

Weeks 7-10]
All the policy objectives are around trying to minimize the risk of health damage and prevent harm.

the general principle, from an economist’s perspective, would be the government should intervene to
the point where the marginal gain of intervening is just greater than the marginal cost of intervening.
Why we need government interventions in health care markets
Efficiency: think of perfect market however, if it does not happen (market failure due to monopoly, imperfect
information, asymmetric information, externality, etc.) then we will have inefficient allocation of resources
(demand and supply do not achieve equilibrium).

Inequity: the concern about the inequitable distribution of health outcome and health resources. Market do fail
(perfect market is theoretical), so reasons for government intervention are to ensure optimal level of production
and consumption of public goods (and goods with significant externalities, private marginal benefit < social
marginal benefit).

Economic Rationale for intervention

 Market failure and the inefficient allocation of health care resources, especially

o Monopoly power (leading to the price exceeding marginal social cost, representing
inefficient allocation of resource)
o Imperfect Information (the provider or consumer does not know the long-term
consequences associated with a health good)
o Information asymmetry between providers and consumers (providers have more
knowledge about the benefits/harms of a health service than that for the consumer, so
consumer’s demand for such health service may be affected by the information
obtained from providers)
o Externalities (costs or benefits are borne or enjoyed by those who are not producing or
consuming the good/service directly lead to inappropriate allocation of resource. E.g.
restriction needs to be applied for the production of good with negative externality)
 Inequitable distribution of health outcomes and health care resources (this is not about
efficiency, but to ensure equitable access to health goods/services at affordable prices to
patients when they need)

What governments should NOT do…

 Use taxation system to make poor subsidise health care of rich

 But well-off generally use more publicly funded services than less well off (accessibility of
services) notes: in any society, well-off tend to use generally more publicly funded services than
the less well-off, which is around the poor accessibility of services that many of us are working
to improve.

FFS fee-for-service payment

Demand side & Supply side interventions

 Demand side

o Consumer preferences (choice)

 o Co-payments send a price signal to reduce demand (moral hazard)
 Supply side

o Contracting with providers at price where price reflects desired goal, eg cost
effectiveness (PBAC)

There are a range of possible government interventions to counteract information problems in

health care (and other) markets:

 barriers to entry, including licensure, certification, accreditation to ensure quality of health care
goods where there are information problems related to assessing provider/good quality
 restrictions on advertising and fees to restrict information bias
 threats of malpractice and effective legal system
 ethical constraints - relying on professional standards of providers
 producing, distributing and promoting guidelines for practice, evidence-based clinical practice
guidelines
 consumer advocacy, presence of some informed consumers; consumer information provision;
consumer interest groups

Overall, information/knowledge may be under-produced in private markets. Governments can directly

intervene through:


o Dissemination of information through direct provision or subsidy
o Expand stock of knowledge through funding support for research
o Patent protection where stock of knowledge ↑

Monopoly and Government Intervention

 "Deadweight loss" is the term applied to the lost consumer/producer surplus (compared to the
perfect competition ideal)
 Government intervention aims to regain (some) of this deadweight loss (e.g. through price
controls/caps)

Government/insurer interventions to address moral hazard

All interventions to address moral hazard attempt to reduce the over-consumption of the insured good.
Most interventions focus on the demand side of the market, acting to push demand back towards the
competitive market equilibrium level through:
 Use of co-payments or user charges (where insurance only covers a proportion of the cost, e.g., co-
payment for PBS-listed medications)
  Use of non-price rationing (such as waiting lists, as in the triage system used in the ED of Australian public
hospitals, where consumers face a "price" to consume insured health care goods in terms of time costs,
but no money cost)

Additional interventions act on the supply side of the market to indirectly reduce demand or to reduce
the cost to the insurer:
 Use of primary care as “gateway” to multiple insured health care goods, such that consumers cannot
access specialist care or allied health without GP referral. GPs serving as gatekeepers for health care is a
common intervention to reduce health care demand in social insurance systems (like Medicare)
 Place direct limits on the quantity of services that will be covered by insurance, such as restricting the
number of dental check-ups covered by private health insurance per year to 2, or the number of allied
health visits that can be covered by Medicare to 5 per year
 Incentives to demand care from selected low-cost providers (Preferred Provider Organisations - PPOs), for
example Australian private insurance companies have a list of preferred service providers that come with
a higher reimbursement rate than other (non-listed) providers
 Combining insurer and provider roles, for example in a Health Maintenance Organisations (HMO) - this is
aimed at reducing demand and costs borne by the insurers, but it does generate dependance between
supply and demand so can create additional market imperfections

Government/insurer interventions to address adverse selection

 Universal insurance is the ultimate solution to adverse selection - by making insurance apply to
the whole population (universal), all individuals are included and population-level risk prediction
will accurately predict events in the insured risk pool. Publicly financed health care systems
typically use this solution, with health insurance mandated for all individuals in the population
(or in a subset of the population, such as all individuals who pay tax)
 In a voluntary insurance market, producers can seek to sell to whole groups of consumers rather
than to individual consumers. In countries such as the US, insurance is often purchased by whole
firms (and then offered as part of the employment package to all the workers employed by that
firm). In other countries, insurance is marketed to a whole village or community, with all
members of that community then included as consumers. Both cases illustrate ways that
producers can increase the risk variation in the risk pool and improve the accuracy of risk
prediction (thereby improving producer efficiency)
 Any type of insurance market may also apply exclusions and benefit ceilings to place absolute
limits on the potential costs of an individual consumer (for example, excluding mental health
care from goods insured, or not insuring people with extremely high risk, and/or restricting the
number of allied health sessions that can be claimed to 10 per year).
 Experience rating allows the producer to tailor premiums to the individual (or group) history of
consumers - such that as well as using observable factors, the insurance price is based also on
data on previous use of health care goods and medical history. The opposite to experience
rating is community rating, where all consumers (or all consumers within broad observable
factor groups such as age/sex) must be offered the same price.
 Governments may need to regulate in voluntary insurance markets to prevent "cream-
skimming" - which are actions by producers to select lower-risk consumers through incentives.
Attempts to attract lower-risk consumers are obvious and efficient marketing strategies for
producers (for example, offering gym memberships and preventive health as included goods
 under insurance policies), but regulation may be required to prevent exclusion of higher-risk
groups from the market.
 Many of the above solutions are combined with subsidised insurance for disadvantaged groups
and/or safety nets to ensure that people consuming beyond benefit ceilings or excluded
groups/goods do not face extremely high out-of-pocket costs (catastrophic expenditure) - which
is the whole point of insurance in the first place!

Five instruments of government intervention