CLARE GATHOGA

KENYATTA UNIVERSITY
INSTITUTE OF OPEN, DISTANCE & e-LEARNING
IN COLLABORATION WITH

SCHOOL: ECONOMICS
DEPARTMENT: APPLIED ECONOMICS

UNIT CODE & NAME:

EAE 309 - HEALTH ECONOMICS

WRITTEN BY:
Peter K. Musyoka

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INTRODUCTION

The module introduces learners to health economics as a branch of economics in order to

develop an understanding of economic principles as applied to health and health care.
Emphasis is more on developing countries in general and Africa in particular.
Students taking this course ought to have passed 2nd year level microeconomics,
macroeconomics and quantitative methods or equivalents because some of the concepts that
are discussed here apply techniques of analysis that are covered in these levels of courses.

OBJECTIVES

The objective of the module is to acquaint learners with economic concepts and techniques to
analyze issues in health and health care; analyze health systems and health policy issues
within the African context. The learner should be able to:

i. Apply economic concepts and techniques to analyze issues in health and health care
ii. Demonstrate knowledge, understanding and application of a range of established
techniques of enquiry in Health Economics.
iii. Analyze health systems and health policy issues particularly within the African
context.

COURSE WORK

At least one exercise will be assigned at the end of every topic. These shall cover theoretical
as well as practical aspects of the course. Continuous assessment will comprise of a timed
test and a practical assignment. These will constitute 30% of the final mark, while the end of
semester examination will constitute 70%.

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REFERENCES
Core readings
1. Folland, S., Goodman, A. and Stano, M. (2008). The Economics of Health and Health
Care. FourthEdition. Prentice Hall. ISBN: 0-13-0122157

2. Folland, S., Goodman, A. and Stano, M. (2010). The Economics of Health and Health
Care. SixthEdition. Prentice Hall.

3. Witter, S., Ensor, T., Jowett, M. and Thompson, R. (2000). Health Economics for
DevelopingCountries: A Practical Guide. MacMillan Education, London, 2000. ISBN: 0-
333-75205-8

4. Santerre, R.E. and Neun, S.P. (2004). Health Economics: Theories, Insights and Industry
Studies.Thomson South-Western, Cengage Learning. Fifth Edition

5. Phelps, C.E. (2003). Health Economics. Third Edition, New York. Harper Collins

6. Phelps, C.E. (2010). Health Economics, Fourth Edition. Publisher: Prentice Hall, ISBN-
10:
7. 0321594576

8. Zweifel, P. and Breyer, F (1997). Health Economics, Oxford University Press.

9. Zweifel, P. and Breyer, F and Kifmann, M (2009). Health Economics, Third Edition.
Springer, ISBN:978-3-540-27804-7

Supplementary readings
1. Jack, W. (1999). Principles of Health Economics for Developing Countries. World Bank.
ISBN: 0-8213-4571-0 McGuire, A., Henderson, J. and Mooney, G. (1992). The
Economics of Health Care.Routledge. ISBN: 0-415-06586-0.

2. Donaldson, C. and Gerard, K. (1993). Economics of Health Care Financing. Macmillan.

EconomicsIssues in Health Care Series. ISBN: 0-333-53870-6. #1

3. Jacobs, P. (1991). The Economics of Health and Medical Care. Third Edition, An Aspen
Publication.

4. Feldstein, P.J. (1993) Health Care Economics, 4th Edition, Delmar Publishers Inc.

5. Rice, T. (1998). The Economics of Health Reconsidered. Chicago: Health Administration

Press

6. Clewar, A and Perkens, D. (1998). Economics of Health Care Management. London:

Prentice Hall.

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7. Drummond M.F, Sculpher, M.J., Torrance, G.W, O'Brien B.J. and Stoddart, G.L. (2005).
Methods for the Economic Evaluation of Health Care Programmes. Third Edition,
Oxford University Press

8. Foxrushby J. and Cairns J. (2005) Economic Evaluation. Open University Press.

ISBN:9780335218479

9. Culyer, A.J and Newhouse, J.P. (2000). Handbook of Health Economics, North Holland,
Volumes 1A&1B

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TABLE OF CONTENTS

TOPIC TITLE page

Topic One: Introduction to Health Economics 7 - 19
The scope and relevance of health economics; health and health care; health as a
public good and the role of government in health care; health care as a
commodity; the nature of health care-need versus demand; summary, activities
and further reading

Topic Two: Demand and Supply of Health 20 - 46

Demand for health and health care: Determinants of demand for health care
(price of medical care, education, lifestyle, other behavioural aspects, insurance,
nature of sickness, and quality of health care); the Grossman model; empirical
measurement-RAND Health Insurance Experiment and Household income and
expenditure surveys
Supply and cost functions for health care providers: Production functions of
health and health care; Cost functions including hospital cost analysis; supply of
health care

Topic Three: Markets and Market Failure in Health and Health Care 47-62
Markets for physicians; market failures and government intervention; asymmetric
information and agency relationship

Topic Four: Health Insurance, Moral Hazard and Adverse Selection 63-77
The demand for and supply of health insurance; moral hazard and adverse
selection; managed care

Topic Five: Health and Development 78-99

Measures of health and development; disease profiles of rich and poor countries;
health and growth; health expenditure and health; linkage between poverty and
health; social, political and regional dimensions of health; Country case-studies

Topic Six: Health System and Financing 100-122

Economic Objectives of Health Care Systems; Organization and Structure; Public
Sources of Health Finance; Private Sources of Health Finance;

Topic Seven: Economic Evaluation of Health Interventions and Epidemiology 123-149

Methods of Economic Evaluation of Health Care interventions: Cost analysis,
cost effectiveness analysis, cost utility analysis, cost benefit analysis;
Applications to Economic Evaluation of Health Care interventions; Impact
Analysis of HIV/AIDS, Malaria and TB

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Topic Eight: Health System Decentralization 150-157
Objectives of decentralization; Different types of decentralization; Impact of
decentralization

REFERENCES

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 TOPIC ONE

INTRODUCTION TO HEALTH ECONOMICS

1.1 INTRODUCTION

This topic introduces the student to the scope and relevance of health economics. The topic
discusses foundations of health economics, areas normally covered in health economics and
also its importance and characteristics.

1.2 TOPIC OBJECTIVE

At the end of this lecture the learner should be able to:

(i) Define health and healthcare
(ii) Discuss the importance of health economics
(iii) Explain the characteristics of healthcare as a commodity

1.3 The scope and relevance of health economics

In this sub-topic, we define Economics, Health Economics and explain the scope and
relevance of health economics.

Definition of Economics
- The best starting point for consideration of the contribution of health economics to health
planning is a definition of economics. Economics is defined as:
"the study of how people and society end up choosing, with or without the use of
money, to employ scarce productive resources that could have alternative uses, to

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 produce various commodities and distribute them for consumption, now or in the
future, among various persons and groups in society. It analyses the costs and
benefits of improving patterns of resource allocation."
- This definition does not restrict economics to any one kind of human activity: it applies
to all activities where scarcity exists and there is thus a need for making choices.
- Indeed, economics is often described as the study of scarcity and choice.
- The emphasis of the above quotation is on describing and analysing decisions to do with
scarcity and choice.
- This area of economics is called positive economics and it is concerned with 'what is', or
'was', or 'will be'.
- In addition, normative economics attempts to determine what 'should be', not merely
'what is'.
- Normative economics thus has to make judgements about the norms, or standards to be
applied and disagreement over normative statements cannot easily be settled by empirical
observation.
- For instance debate over the desirability of a private market for health care is often as
much concerned with issues of normative economics (such as the value to be placed on
freedom of consumer choice) as it is with issues of positive economics (such as how a
private market behaves in practice).
- Although positive economics may not state what 'should be', it is still relevant to policy-
making.
- For instance, positive economics cannot decide what health objectives ought to be
achieved but it can explore the implications of adopting different objectives and different
policy options.

Definition of Health Economics

- Health economics can be defined broadly as the application of the theories, concepts and
techniques of economics to the health sector. It is thus concerned with such matters as:

o the allocation of resources between various health-promoting activities

o the quantity of resources used in health delivery
o the organization and funding of health institutions
o the efficiency with which resources are allocated and used for health purposes
o the effects of preventive, curative and rehabilitative health services on individuals and
society.
- Although health economics has only recently developed as a sub-discipline of economics, it has
established an interest in many of the main theoretical areas of economics. Figure 1 attempts to
indicate the intellectual span of health economics and the main fields studied within health
economics. The concerns of the different fields are as follows:

- Box A: what determines health? What is the relative contribution of health services, income
levels, education, environmental factors etc?

- Box B: what value is placed on health and how can it be quantified?

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- Box C: what influences the demand for health services (demand derived from the demand for
health)? What is the influence of price, income, travel time, behaviour of health care providers
etc?

- Box D: what are the characteristics of the supply of health services? What are the costs of
production, mix of inputs, nature of the markets supplying health care inputs such as labour,
drugs, equipment? What are the payment systems for health service suppliers and how do these
influence their behaviour?

Figure 1: The Framework of Health Economics A

B WHAT INFLUENCES
HEALTH?
WHAT IS HEALTH? WHAT IS Occupational Hazards:
ITS VALUE? Consumption Patterns:
Perceived attributes of health Education:
Health status indexes: Value of Income: etc
life:
Utility scaling of health:

E C

MICRO-ECONOMIC DEMAND FOR

F
EVALUATION HEALTHCARE
MARKET
Cost Effectiveness & Influences of A+B on Health
EQUILIBRIUM
Cost Benefit Analysis of Care Seeking Behaviour.
Alternative Ways of Barriers to Access (Price, Time, Money prices; Time
improving health (e.g. Psychological; Formal); Agency prices, Waiting lists &
Non price Rationing
choice of programme, Relationship; Need.
systems as Equilibrating
delivery method,
Mechanisms and their
treatment method, etc)
D Differential Effects
SUPPLY OF HEALTH
CARE
Costs of Production;
Alternative Production
H Techniques; Input
Substitution; Markets
PLANNING, BUDGETING, & for inputs (Manpower,
MONITORING MECHANISMS Equipment, Drugs, etc);
Evaluation of Effectiveness of Remuneration Methods
Instruments available for and Incentives
optimizing the system; including
the interplay of Budgeting,
Manpower Allocations; Norms;
Regulation, etc and the Incentive
G
Structure they generate. EVALUATION AT WHOLE SYSTEM
LEVEL
Equity & Allocation Efficiency Criteria
brought to bear on E+F; Inter-regional &
International Comparisons of Performance
Source: Adapted from Centre for Health Economics, University of York.

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- Box E: what are the costs and consequences of alternative ways of improving health/delivering a
health programme?

- Box F: what are the results of the interplay of supply and demand for health services in terms of
money or time price paid, rationing systems, who does/does not get health care?

- Box G: what are the effects of different ways of financing and organizing the health sector in
terms of efficiency and equity criteria?

- Box H: what means are available to maximize the achievement of the objectives of the health
sector (e.g. budgeting systems, planning methods) and how effective are they?

- Theoretical and applied work has been done in all these areas, though in many cases the body of
knowledge is still small relative to other sub- disciplines of economics.

So, why is this economic perspective useful in the context of health care?
- Health economics examines the problem of scarcity as it arises with respect to health and health
care.
- It examines how we as individuals and societies confront the fact that while the resources
available to us are limited, the alternative uses for these resources are unlimited. Thus, health
economists are interested in some very important questions. How is health produced? What role
does health care play in its production? What is the value of health? How do we go about
measuring health status? What influences demand for health and health care? What influences the
supply of health care? How can equilibrium between demand and supply be achieved? The
discipline of health economics is the study of these questions and the answers to them that
individuals and societies have put forward.
- Health economics draws its theoretical inspiration (foundations of health economics) mainly
from four traditional areas, namely:
i) Finance and insurance,

ii) Industrial organization,

iii) Labour, and

iv) Public finance

- Health Economics also requires detailed knowledge of health technology and institutions-what
are the institutional arrangements that are there to ensure that health care is provided?

Scope of health economics

- A, B, C, and D are the disciplinary “engine room” of health economics

- E, F, G, and H are the main empirical fields of application for which A to D exist.
Looking at this coverage then we conclude that: There is something in health
economics for almost every conceivable kind of economist, namely:
o Powerful defenders of conventional methods and aggressive challengers;

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 o Pure theorists and applied economists;
o Those who undertake academic research for its own sake and those who see it
as an instrument for the improvement of societies;
o Those who love to engage in the cut and thrust debate on important topics and
those who prefer to observe and comment on it;
o Those whose main objective is to do research as well as those who want an
exciting subject to teach; and
o Those who want to be active participants in policy formation processes.

Why study health economics

1. Contribution of the health sector to the overall economy.

- Health sector‟s contribution to GDP can no longer be ignored. The share of GDP is
increasing because of overall increase in consumption; people willingness to pay for
improved quality health care).
- Personal spending on health relative to household total income and spending is also very
important.
- It is crucial to understand the importance of health to the labour force (number of health
workers employed) which affects the overall economy.
- Increased capital investment in health sector also affects the economy.
- increase in other resources used in the health sector (e.g. patients‟ and other support
workers‟ time to produce and maintain health); transport cost and fees paid also affects
the economy
- In developing countries, most well equipped hospitals are located in cities and people
take much time to access this-hence more time is wasted affecting productivity and the
economy as a whole.
2. Growing importance attached to economic problems of health care delivery

- There are many economic problems that affect delivery of healthcare services such as:
o Increasing cost (both time and price costs);
o equity problems (both vertical and horizontal);
o problems related to quality of services (do we have the necessary drugs,
technology, etc);
o sustainability (can the services be provided continuously or the system will
collapse?), and

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 o Customer satisfaction.
3. Many health issues have substantial elements of economics

- Most health issues have substantial elements of economics and hence the need to study
them. They include:
o Alternative health interventions
o Choice of provider (health seeking behaviour)
o The role of government in health
o Commodities that people consume and carry health hazards (e.g. tobacco,
alcohol) etc.
o Allocation of resources-how do we determine costs and benefits of
different health interventions? How do we set our priorities in provision of
health care?
o Delivery of health care services- How do we deliver health care services
efficiently? For instance do we use public mechanism or public/private
mixture? Do we need to decentralize?etc.

1.7 General features of the health Care

- There are different understandings of health – each with different implications for the roles
of government.
- It is important to recognize, first, the difference between health and „health care‟.
- The term health refers to a state either of an individual or of a community.
- A number of factors including „health care‟ may influence this state of health.
- However, other factors that affect health are poverty, level of education, food intake, access
to clean water and sanitary and housing conditions.
- The narrowest concept of health sees it as a measure of the state of the physical body
organs.
- An individual is unhealthy if there is a malfunctioning of part of the body.

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- A broader, but related, definition sees health just in terms of the mechanics of the different
bodily organs, but in the ability of the body as a whole to function.
- In contrast, the WHO definition of health as “a state of physical, mental and social well-
being and not merely the absence of disease or infirmity” indicates a clear shift away from
earlier narrow organic or functionally-based definitions of health to a more holistic view, it
sees the health of an individual or community as being concerned not only with physical
(and mental) status, but also with social and economic relationships.
- How one views health will affect the type of intervention and planning that is possible.
- The narrowest definitions are closely associated with a medical model of health in which the
role of health services is seen as paramount in restoring the functioning of the unhealthy
body.
- Wider primary health care concepts suggest that broader interventions, including
community empowerment and anti-poverty measures, are necessary to promote health.
- Health Care is demanded to contribute to achieving health.
- What is health care then? It is the prevention, treatment, and management of illness and the
preservation of mental and physical well-being through the services offered by the medical
and allied health professions. Health care has value in use (to restore health status), value in
exchange (it is tradable) and is scarce as well. Therefore health care is an economic
commodity.
- We now turn to different perspectives on the importance of health and on to possible roles
of the state in promoting it.

Perspectives of Health
- Three perspectives can be distinguished:
a) Health as a right
- Health is viewed by some as a right analogous to justice or political freedom.
- Indeed, the WHO constitution states that „… the enjoyment of the highest attainable
standard of health is one of the fundamental rights of every human being without distinction
of race, religion, political belief, economic or social condition‟.

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- Although it is difficult to believe that equal health status is attainable in the same way that
equal political freedom may be, health is seen as so fundamental that constraints to its full
attainment must be minimized.
- In part, this involves ensuring access to health care. The government is seen as having a
responsibility to ensure this, comparable with its role in ensuring equal justice.
- According to such a view, a government will be particularly concerned with issues of equity
in health and health care.
b) Health as consumption good
- For others, health is seen as an important individual objective that is not comparable with
justice, but rather with material aspects of life.
- Such a view often refers to health as consumption good.
- The government here has no special responsibilities in the promotion of health, but leaves
decisions as to its comparative importance to individual consumers.
- The role of the state under such a view might be limited to ensuring that the health care
provided is of an adequate quality (such as ensuring professional standards in the same way
that it would monitor the quality of any good or service, such as food).

c) Health as an investment
- A third view of health is that it is important, but largely it affects the productive ability of
the workforce.
- Illness may affect overall production, either through absenteeism or by lowering
productivity through its debilitating effects.

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Health as a public good
- A public good is one whose consumption benefits more than one person or firm.
- Some of these goods are non-rival, in the sense that providing the good to one person
necessarily allows the good to be provided to every other person at no additional cost.
- Public goods are NOT goods provided by the state (e.g. NOT public health systems!)
Examples of public goods:
- Defence
 Given size of armed forces may protect population of 10, 20, 50 or 100 million
people
- Law & order
 Foreign visitor benefits from crime-free streets as much as local residents
- Information
 Discovery of food additive that causes cancer – cost borne once, then cost of
dissemination so that all can benefit is (virtually) zero
 Infectious disease surveillance (prevent epidemics)
The question is therefore whether health is a public good? The response to this question is
that, Health per se is NOT a public good: This is because
 one person‟s health status primarily benefits them
 goods and services necessary to provide and sustain health are predominantly
rival and excludable
BUT: are aspects that have public good aspects (e.g. communicable disease control like through
immunization of individuals)

1.8 Distinctive characteristics of the health Care services from other commodities

There are certain features that can be found with the health care needs and health care delivery
systems in almost every country. This section presents the main characteristics of health care as a
commodity which together, differentiate health care from other commodities.

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 a. Huge governmental involvement: Firstly, health care can be very expensive, particularly
in the case of hospital treatment, accidents and long-term illnesses. Hence, a common
feature of health care is the substantial government involvement in ensuring access,
regulating health professionals, and in public and private health care insurance. In most
countries, health care resources are not allocated wholly or even primarily through
private markets. Government involvement in the health care sector is very significant to
ensure widespread access to health care services for all citizens in order to produce a
healthy population. Thus, the government is a dominant player in providing and financing
health services (Ensor et al., 2001). In Ghana, government is the main provider and the
major financier of health care delivery. In the year 2000, 53.5% of the total expenditure
on health in Ghana was borne by the government(WHO)1

b. Uncertainty: Another important characteristics of many types of health care needs [if not
all] is uncertainty making them and their concomitant costs unpredictable because one‟s
future consumption of health care is uncertain[Drummond and Mooney, 1982]. Also,
there is uncertainty regarding the effects of health care. It must be noted that, although
trial based evaluation can establish whether or not an intervention is effective on the
average its [the intervention‟s] effectiveness for any single individual [i.e. the marginal
effect] may be uncertain. That is, uncertainty is an inherent characteristic of many types
of illnesses and accidents – they [and their associated costs] are unpredictable. As a
consequence of this unpredictability, health and health care decisions need to be made in
the context of risk. This most often poses a problem for low-income people especially
those in countries where health care delivery is market based. Since this group of people
are those who usually need health care most, there is need to find alternative means of
financing health care such as social health insurance so as to make it accessible and
affordable to everyone. Health insurance cannot eradicate [or even influence] the
uncertainty of illness, however, health insurance can reduce an individual‟s financial
risks and encourage them to use health care at the appropriate times instead of waiting
until their health deteriorate, which will make it more expensive to treat or even lead to
death.

1
http://www3.who.int/whosis/country/indicators.cfm?country=gha

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c. Information asymmetry: As far as health care is concerned, patients [consumers] very
often lack both the knowledge and information to know what is wrong with them and
what can be done to restore their health. Meanwhile, health care professionals have the
expertise and may direct the patients as to what health care services can be used to restore
their health. This creates information asymmetry between the patients and the health care
providers, thereby causing the concept of consumer sovereignty to collapse. Thus
because the providers often tell patients what services they need and then provide those
services, informational asymmetry creates interdependence between the supply and
demand sides of health care markets, thereby violating the basic condition for efficient,
well-functioning markets. Information asymmetries are therefore noted to be significant
sources of market failure in the health care sector because they give the providers
considerable power, which they can use to exploit patients. To this end, Evans [1974]
suggest that „the type and amount of care provided is not solely a function of patient need
but also relates to the physician‟s desire to achieve a target income‟‟. Thus demand for
health care is often supplier-induced due to information asymmetries. This usually occurs
when health care providers are paid on fee-for-service basis, thereby creating supply-side
moral hazard, However, licensure, professional regulation, and professional ethics are
usually used by regulatory authorities to ensure minimum quality standards in health care
so as to encourage providers to act as agents for their patients‟ interests instead of
exploiting the informational asymmetry for their [providers‟] own economic advantage

d. Derived demand: Health care has a derived demand -i.e. health care is not demanded for
its own sake but rather, it is demanded as a „result of a more fundamental demand for
health itself‟‟ (Drummond and Mooney 1982). For example, bypass surgery is demanded
because of its long-term effects on health although its direct and immediate effects on
well-being could be negative-pain and suffering. Thus individuals do not make positive
choice to consume health care, but rather they consume it because they have to in order to
get good health. Health care is only valued to the extent that it improves individuals‟
health and/or its potential to improve productivity (Jack, 1999). Hence, the demand for
health care must usually be placed in the context of all other health-influencing activities
because health care is only one of many possible ways to maintain or improve health.

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 Things like diet, lifestyle, and education may also be important in maintaining and
improving health.

e. Externality: Health care often creates external effects beyond those which accrue to the
recipients of care that result in inefficient resource allocation in private markets. As noted
by Drummond and Mooney (1982), “all of us have an interest in other people‟s health
and hence their consumption of health services.‟‟ For example, others may care about
your health because they want you to continue working and hence create wealth for the
community. They may also like you to be vaccinated against communicable diseases
since this reduces their chances of catching the disease. The above characteristics are
present at varying degrees in different health care services.

It must be noted that these features of health care as a commodity-uncertainty, asymmetry of

information, derived demand, externalities and huge governmental involvement-are not
individually unique to health care because each on its own, can be found in other
commodities. However, these characteristics are generally prevalent in the health care sector
and their combined effect makes health care “different‟‟ from other goods. Most importantly,
these characteristics of health care as a commodity may lead to market failure and make
resource allocation in health care through private, unregulated markets inefficient,
inequitable and cost-increasing thereby requiring substantial governmental involvement to
allocate health care as a merit commodity (Goods that the government compels individuals to
consume, such as health care, seat belts, primary education are called merit goods) or on
equity grounds. As a result of these characteristics of health care, there is the need for every
country to have a well- thought out system of financing health care, which should be efficient
and sustainable.
Most importantly, these characteristics lead to market failure and make resource allocation in
health care through private, unregulated markets inefficient, inequitable and cost-increasing.
Therefore, there is the need for substantial governmental involvement to allocate health care
and how it is financed.

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1.9 SUMMARY

This lecture has defined health and health care and has given the distinction that exists
between the two. It has also given key features that makes healthcare different from any
other commodity. Further the lecture has explained why we need to study health economics.
It has also explained the main features of health care and the various perspectives of health
and government‟s role as dictated by various perspectives in the provision of health care
services.

1.10 ACTIVITIES

1) Do we need health or healthcare?

2) What makes health care different from any other good?

3) In relation to health, what is the distinction between need and demand?

1.11 FURTHER READING

1) Feldstein, P.J. (1993) Health Care Economics, 4th Edition, Delmar Publishers Inc.
2) Rice, T. (1998). The Economics of Health Reconsidered. Chicago: Health Administration
Press

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 TOPIC TWO
DEMAND AND SUPPLY OF HEALTH
2.1 INTRODUCTION

This topic introduces learners to demand and supply for health and healthcare. It also discusses
determinants for demand for health care. Further, Grossman Model; Human Capital Model and
effects of changes in medical care are discussed and how they relate to healthcare.

2.2 TOPIC OBJECTIVES

At the end of this lecture the learner should be able to:

(i) Discuss the specific nature of the health care service
(ii) Explain the effect of some economic factors on health status of society.
(iii) Explain determinants of demand for health care
(iv) Discuss Grossman‟s model of health care

2.3 Demand, Supply and Equilibrium

In this sub-topic, we discuss the demand function, price elasticity of demand, income
elasticity of demand, and cross-elasticity of demand; supply function, elasticity of supply,
and supply curve.

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 a) Demand
- In order to use scarce resources as efficiently as possible, an efficient information system is
required to bring together the values of the alternative uses of resources (products) with their
production cost, and to co-ordinate the many decisions of consumers and producers.
- The price system, although imperfect, attempts this difficult task and plays a central role in
economic analysis.
- It influences many health and health care programmes either directly or indirectly (e.g.
through markets for personnel, drugs etc.).
- It is thus important to consider the workings of the price system, through an examination of
demand and supply.
- In economics, the quantity of a particular good demanded is seen as a variable determined
by a range of factors.
- The demand function summarizes this relationship:
Qd = f (P, RP, Y, T, ...)

- The quantity demanded (Qd) is a function of the price of the good (P); the prices of other
related goods (RP); income (Y); and the organizational and institutional structure of society
and preferences and tastes of individuals (T) which will depend on many socioeconomic and
cultural factors.
- Of these, prices and incomes are the most useful for theoretical analysis.
- The demand function can represent the demand of an individual, or of all individuals
demanding a particular good - in which case it is simply the sum of individual demands.
- The relationship between demand and price is often portrayed as a demand curve (Figure 2).
- It illustrates how much would be demanded at each price.
- For most goods, more is bought as the price falls and so the demand `curve will slope
downwards.
- In using a two-dimensional drawing of the demand curve it is assumed that the other factors
(RP, Y,T) remain constant. This helps to clarify different aspects of demand, but modern
econometric techniques allow more sophisticated estimation of the impact of the different
variables on demand.

Figure 2: Demand Curve

P

0
Quantity

21
- It is also important to know about the responsiveness of demand to changes in any of the
variables.
- Responsiveness is measured by economists and referred to as the elasticity of demand; it is
reflected in the shape of the demand curve.
- Price elasticity of demand is measured by expressing the percentage change in quantity
demanded (Qd) as a proportion of the percentage change in price (P).

% Change in Qd
d 
% Change in P
- If the percentage change in Qd is greater than the percentage change in price the demand for
a good is elastic, Ed > 1.
- If the percentage change in quantity demanded changes by less than the percentage change
in price (Ed < 1) the demand is inelastic.
- If the percentage change in price evokes a similar change in percentage quantity demanded
then the demand is unitary elastic, (Ed = 1).
- Elasticity will depend upon the ease with which goods can be substituted for one another.
- Income elasticity of demand measures the response in quantity demanded (Qd) which arises
from changes in income (Y).
-
% Change in Qd
d 
% Change in Y
- Cross-elasticity of demand measures the response in quantity demanded of good A (Qda) which
arises from changes in the prices of other goods or services (Pb).
% Change in Qda
 AB 
% Change in Pb
- It measures the degree of association amongst goods, i.e. whether they substitute or
complement (need to be used with) each other.

b) Supply
- In economics, supply is used in a sense symmetrical with demand.
- The quantity of a good that producers offer for consumption is seen as determined by certain
economic variables, of which the most important is the price at which the good can be
offered.
- The supply function relates the quantity supplied to the variables likely to affect it.
Qs = (P, RP, C, RC, T, .......)

- The quantity supplied (Qs) is some function of the price of the good (P), relative prices (RP),
costs (C), relative costs (RC), and tastes (T) which will include socioeconomic and cultural
factors.
- The supply curve (Figure 3) shows the relationship between price and the quantity supplied.
- It will normally slope upwards indicating that more will be supplied if prices rise.

22
Figure 3: Supply Curve
P

0 Q

- The ease with which quantity supplied will respond to changes in price is measured by the
elasticity of supply, and it is reflected in the shape of the supply curve.
- The elasticity of supply is roughly measured by expressing the percentage change in quantity
supplied (Qs) as a proportion of the percentage change in price (P).
% Change in s
s 
% Change in P

- Like the elasticity of demand, it is described as elastic where (Es > 1) and inelastic where Es <
1.
- Elasticity will depend upon the ease with which quantities of goods or services can be produced.
- In some cases over an appreciable time span it may be difficult to obtain any more goods,
irrespective of the price offered, e.g. agricultural crops or production where the scale of
activities is fixed in the short term.

c) Equilibrium
- Equilibrium in a market is achieved when supply equals demand (Figure 4). Price and quantity
will adjust until the point is reached where buyers and sellers are content to exchange a given
quantity (q1) at a given price (p1).
Figure 4
P

P2 S

P1 E

P3
0 D
Q1 Q

23
- At p2 suppliers will be willing to supply more than buyers are willing to purchase at that price.
- There will be excess supply and pressure to reduce prices.
- At p3 buyers will be willing to buy more than suppliers are willing to offer and there will be
pressure on prices to rise - excess demand.
- If factors in the equation other than price change, the supply/demand curve will shift.

2.3 Demand for Health Care

In this sub-topic, we discuss the demand for health care. Specifically we ask whether there is
demand for health care. To answer the question, we look at the need, utilization and
demand.

Nature of Health care

Need, utilization and demand
- It can be argued that the demand for health care is fundamentally different from the demand
for 'supermarket' type goods.
- There are a variety of characteristics that distinguish health care from other goods and there
are a number of failures specific to the health care market.
One of the most significant of these is that supply and demand do not interact in the conventional
manner.
- For example, because of uncertainty and information gaps, the supplier is directly involved
in the decision whether or not to consume health care.
- Traditional demand analysis has, thus, been amended to allow for this difference by
considering, for example, the existence of an agency relationship between doctor and
patient and of supplier-induced demand.
- In particular, the concept of need has been used to gain a better understanding of decisions
in the health care sector, and it is introduced here in order to show some of the complexities
of the theoretical debate about whether or not there is a demand for health care.
- Need can be defined in a variety of ways.

24
- A common definition is that of normative need, which is assessed by an expert on the basis
of a comparison of the actual situation with a technically determined standard.
- Alternatively, need can be defined as felt need i.e. assessed by the individual.
- These needs can conflict if the consumer is not the best judge of his/her own needs, as may
be the case with respect to health.
- Normative need and demand differ in principle.
- Demand reflects individuals' wants, backed by a willingness to pay for them, and so health
care may be (normatively) 'needed' but not 'demanded' (e.g. early treatment for
hypertension); or it may be 'demanded' but not (normatively) 'needed' (e.g. cosmetic
surgery).
- In contrast, it can be argued that demands are the expression of felt needs - expressed
through a willingness and ability to pay.
- Market for health care must involve two groups: the buyers and the sellers, who interact to
trade health care.
- Who would the buyers and sellers be in such a market?
- We all want good health and so most of us would be prepared, if necessary, to purchase
medical treatment to cure an illness.
- This suggests that everybody is potentially a buyer (or consumer) of health care.
- More precisely, at any moment, a buyer would be anybody who was ill or who wanted
preventative medical treatment such as vaccination or who wanted guidance about their
health.
- The sellers would be those people who could provide medical and health care services, such
as doctors, nurses, physiotherapists, and dentists among others.
- The decision to use health care reflects a combination of normative and felt need, because
for consumption decisions in the health sector consumers often rely on information provided
by the supplier in addition to/supplemented by their own preferences.
- Relatively few studies of demand for health care have been done but it is also possible to
glimpse the demand curve for health care through a study of utilization data.
- From the limited evidence on the demand for and utilization of health care in developing
countries, a number of tentative conclusions can be drawn which are not surprising given
the economic theory of demand. The main findings are that:

25
 o higher income status is associated with greater demand for health care and, in
particular, for modern health services
o price helps to determine health care demand and price rises may reduce the
demand of lower income groups more than that of upper income groups
o poor physical access (increasing the time costs of seeking care) reduces demand
o the perceived efficacy and quality of care are important influences over the
decision to demand care from any particular provider.
- The relative importance of some of the factors influencing demand may differ from theory.
- For example, where beliefs about illness causation imply certain treatment options, price
and income are much less important in health care utilization decisions.
- These beliefs might be incorporated in item T of the demand function ('the organizational
and institutional structure of society, preferences and tastes'). In practice, however, it is
difficult to account for them and adequately to include them in health care demand analysis.
- The links between the variables of the health care demand function also make it difficult to
isolate the impact of any one.
- Illness causation beliefs may well be linked to income level (a proxy for socioeconomic
status and education); income level is itself linked to ill-health and so both directly and
indirectly influences the demand for health care.
- Most observers agree that consumers demand are affected by various factors such as more
ignorant, taste and uncertain in their role as consumers of health services than as purchasers
of most other commodities.
- They cannot assess the quality and character of the health services they consume and are
generally unaware of the variety of health care alternatives available for treating a given
illness.
- Ethical standards adopted by the health professions preclude advertising, so consumers are
denied access to this form of information concerning the relative merits and costs of various
forms of care and treatment.
- Moreover, the reluctance of some physicians to discuss illness in non-ethical terms also
tends to keep consumers ignorant of feasible treatment alternatives and makes it nearly
impossible for them to exercise rational choice.

26
- While individuals can choose their physicians, doctors usually determine the kind and
quantity of health services individuals consume.
- While doctors may have some knowledge of the individual‟s financial resources, these
considerations are unlikely to have much influence on the type of care prescribed.
- Consumers also generally lack knowledge concerning their actual need for care. Thus, the
overall benefit of health services is generally uncertain from the consumer‟s point of view
and the demand for a significant portion of health services is based on the doctor‟s
judgment.
- The demand and need for medical care is not always the same. For instance, an individual
may demand more care than is required medically.
- Conversely, he may need medical care, but may not be aware of its value.
- Need is generated by the incidence of illness, while demand is generated by the
interrelationship of illness with other factors.
- To plan for future use of facilities and personnel, demand rather than need for such
resources must be projected.
- Demand analysis can be applied with appropriate modifications to explain variations in
expenditures on medical care services.
- From the patient‟s viewpoint, the need for medical care is not always clear-cut. For
example, the distinction between a severe cold and pneumonia may not be noticeable to the
consumer. Chest pains may indicate either bronchitis or a serious heart condition.
- In such instances, a high-income family would be expected to take greater precautions and
thus incur higher medical care expenditures than a low-income family.
- Moreover, even after treatment is begun economic factors may influence its duration.
- A poor family may decide to forego the possible benefit from an extra day in hospital or an
additional visit to the physician.
- Medical care is characterized by a low degree of substitutability, most medical needs are
highly specific and alternative goods are not able to supply the same level of satisfaction.
- Moreover, medical care is generally wanted for its own sake, most medical care and
treatment are unpleasant and generally are not wanted until it becomes a preferable
alternative to the pain and other consequences of illness. This implies that the price
elasticity of demand for medical care would tend to be low.

27
- Grover C. Wirick has identified five fundamental factors that can have an impact on the
demand for health care services.
i. The need, when a person suffers from a condition that requires attention, or
he/she has some other reason for seeking medical care or examination.
ii. There must be a realization of the need. Either the individual or someone
acting in his/her behalf must know that the need exists. A number of
psychological processes may be involved including awareness of the existence
and availability of medical skills as well as the benefit likely to be gained
through health services. In addition to these, the hopes, fears and beliefs of the
individual, as well as the other personal factors such as his/ her previous
experiences, customers and religion play a significant role. For example, a
person with a strong religious conviction against a particular kind of medical
treatment may have a different realization of need for care from that of
someone with other religious beliefs.
iii. Financial resources must be available to implement the care. This capability
may take many forms, including the income and assets possessed by the
individual or his/her family, insurance coverage, eligibility for free care under
a group or government program and availability of care through welfare
programs.
iv. There must be a specific motivation to obtain the needed care even with the
availability of the other forces such as need, realization and resources,
something must initiate the action.
v. Availability of service.

- The first three forces are characteristics of the patient, while the fifth is a phenomenon of his
environment. The fourth force is somewhat indistinct and could be characteristic of either or
both.
- In short…
Determinants of demand for health care are:
1. Ill-health: Because the demand for health care derives from a demand for health, a primary
determinant of the demand for health care is ill-health.

28
2. Total cost an individual faces for the service (including the price of the service to the
consumer, travel costs, lost income while receiving the service, and non-money costs such as
the time).

3. The prices of compliments or substitutes to the health care services

4. Income of the individual

5. Tastes, values and attitudes of the individual

6. Education (Grossman and Fuchs hypotheses).

7. Demographic factors such as age, sex,

- Although insurance (public or private) often lowers the financial price a consumer pays for a
service, other costs can be significant factor in the decision to seek health care.
- Once an individual visits a heath care provider, these demand-side factors interact with
supply-side influence to determine the care actually utilized.
- Acting as agent for the patient, the provider assesses and recommends what care is needed
to restore health.
- In this sense, the provider plays an active, indeed often a leading role in treatment decisions,
“inducing” patients to consume certain services.
- When done in the interest of patients, this inducement is beneficial.
- Providers, however, do not always act as perfect agents for their patients.
- Their recommendations are sometimes influenced by self-interest, or the interest of the
organization for which they work (supplier-induced demand).
- Though the potential for such self-interested supplier-induced demand is widely
acknowledged given the informational asymmetry between patient and provider, its policy
importance remains an ongoing area of controversy among health economists.
NOTE:
- A doctor‟s ability to induce demand is enhanced when patients have a difficult time
gathering and processing information.
- Given this unique position, doctors can serve as imperfect agents, serving their own interests
over those of their patients.
- In other words, they have the ability to influence the demand for the services they personally
provide.

29
 - When faced with two alternative treatments that are equally effective, the physician can
choose the cheaper alternative and save the patient money, or the more expensive alternative
and buy a new flat screen plasma TV for the den.

2.4 Grossman‟s theory of the demand for healthcare

In this sub-topic, we give an insight into Grossman‟s model; provide guidance on the technical
concepts and graphical representation of the model. We also show the implications of the model
and highlight some of the criticisms of the model.

2.4.0 General Background

Health is determined by many factors among which medical care is only one. These factors
include social class, work environment, employment status, income, housing conditions, heating,
education, diet and lifestyle (how do these factors link to our health, resources, and how we
behave). The relative importance of inequalities in these types of resources cannot be
determined unless there is an understanding of the links between resources, behaviour and
health.

2.4.1 Background to Grossman

- Grossman (1972a, 1972b) used the theory of human capital to explain the demand for health
and health care.
- According to human capital theory, individuals invest in themselves through education,
training, and health to increase their earnings.
- Grossman was concerned with how individuals allocate their resources to produce health.
- The model goes beyond traditional demand analysis and has been extremely influential in
health economics.
- It utilises the idea of the individual as a producer of health (not simply a consumer) by
removing the artificial separation of consumption and production.
- It also introduces the idea of investing in human capital (health and education) to improve
outcomes in both the market (work) and non-market (household) sectors.

30
2.4.2. Key concepts in the model
- Grossman shows the way in which many important aspects of health demand differ from the
traditional approach to demand:
i. It is not medical/health care as such that the consumer wants, but rather health.
Medical care is a derived demand for an input to produce health. People want health;
they demand inputs to produce it. Thus, demand for health care is derived from a
demand for health (few people want health care for its own sake)
ii. The consumer does not merely purchase health passively from the market. Instead,
the consumer produces it, spending time on health-improving efforts in addition to
purchasing medical inputs. This means that individuals are not passive consumers of
health but active producers who spend time and money on the production of health
iii. Health lasts for more than one period. It does not depreciate instantly, and thus can
be analyzed like the capital good that it is. Health depreciates (perhaps at a non-
constant rate) and can therefore be analyzed as a capital good
iv. 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 also is desired because it increases the number of healthy
days available to work, and thus to earn income. Thus, demand for health is derived
from the demand for utility (e.g. healthy days in which to participate in leisure and
work)

2.4.3. Key assumptions

The model is based on the following key assumptions:
- Individuals value health but do not value it above all else (if they did, they would not over-
eat, smoke, drink too much, or drive too fast)
- Individuals have limited incomes with which to finance health and other activities, and
neither is costless
- Individuals exert a relatively high degree of control over their health by virtue of the fact that
they can influence their health-affecting consumption patterns, their health care utilization
and their environment
2.4.5. The demand for health

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Grossman model shows that demand for health consists of two elements: (the main arguments
Grossman made)

(1) Consumption effects: health yields direct utility i.e. you feel better when you are healthier
(2) Investment effects: Health is a productive good that produces healthy days. This
production function relationship can be illustrated by the below.
Healthy days
The figures shows Relationship of
Healthy Days to Health Stock
365

0
Hmin Health Stock

- The horizontal axis measures health stock in a given period.

- The greater one‟s stock of health, the greater is the number of healthy days, up to natural
maximum days.
- The bowed shape of the curve illustrates the law of diminishing marginal returns (additional
resources have decreasing marginal impacts on the output).
- Also note the concept of a health stock minimum shown as Hmin. At this point, production of
healthy days drops to zero, indicating death.
- Health increases the number of days available to participate in market and non-market
activities –the novel bit of the model

2.4.6 Health as a capital good

- Because health is a capital good, it is necessary to understand the cost of capital as well as
the capital good demand process.
- H Stockt = H Stockt-1 – depreciation () + investment in H (I)

32
- This equation implies that, health stock at period t equals health stock in the previous period
(t-1) less depreciation plus the amount of investment in health.
- A person is born with initial endowment of H, which they add to by investing in health.
- The rate of Health production will depend on the efficiency (are the returns more or less in
the investment you make?) of investment in H.
- Grossman assumes that an increase in knowledge capital raises the efficiency of the
production process in the non-market (household sector), just as an increase in technology
raises efficiency of the production process in the market sector.
- There will be depreciation () in the value of the stock of H through age, accident,
carelessness, sudden disease (actually these are causes of depreciation in health stock).

- As we are considering utility (U) over a life-time we also need to be aware of the issue of
time-preference

- In the human capital model, individual is a producer of H (amongst other things): they buy
market inputs (medical care, food, clothing), and combine them with their own time to
produce services that increase their utility
- The analysis is based on human capital theory which shows how individuals invest in
themselves e.g. through training or education, to increase their productivity
- The optimal amount of investment in human capital is determined by the relative Costs and
Benefits: usually the Costs occur in the short-term whilst the Benefits accrue in the future in
the form of enhanced job opportunities.
- Because of the depreciation, it is necessary to restore health stock through investing in health.
- This brings us to the supply side of health care.
2.4.7 Production of Health Care
- Three peculiarities of the supply of health care complicate its analysis:

o complexity of product: health care is not a simple product, but a related bundle of
goods and services directed towards the same objective of improving health. In
many cases these goods and services are joint products and the supply and costs
of one are not independent of the others. They also have a quality dimension that
is difficult to measure objectively

33
 o complexity of organization: commercial, private non-profit and public institutions
are found side by side supplying health care to the same, or overlapping, markets.
Little is known of the determinants of the behaviour of non-commercial institutions
o specialized input markets: the key inputs of the health care industry are produced
in 'dedicated markets', of which the most important (professional labour) is often
tightly controlled by the professionals.

- Because of its special features, measuring and modelling supply can be as difficult as
measuring and modelling demand.
- Very little is known about how different types of supplier behave. More attention has been
devoted to measuring costs within the health care market and inputs into health care
production.
- Even so, only limited cost data is currently available for developing countries, particularly
for hospitals and for immunization services.
- However, the potential value of cost analyses for planning and management purposes is
increasingly recognized. For example, cost data can be used:
o in the assessment of operational efficiency
o to determine the resource requirements for alternative planning options
(especially recurrent resource requirements)
o to fuel the debate about alternative financing mechanisms and the necessity of
cost-recovery.

2.4.8 The Production Function and the Health Sector

- In order to understand better the process of evaluation, it is important to identify three
interrelated, although conceptually distinct, components common to all productive activities.
These are : input, process, output.
- Inputs are the various resources such as manpower and equipment that are available for use
in a productive activity.
- Process describes the transformation or productive technique which changes inputs into the
desired outputs. Output refers to the end result of production.

34
- In economics these relationships are usually explored within the framework of the production
function.
- Production functions are merely a way of representing, both qualitatively and quantitatively,
the relationship that exists between inputs and outputs.
- Within this framework the quantity of a particular type of output (Q) is represented as being
determined by the various inputs that go into its production such as labour (L), and capital (K).
- The way that these inputs are combined is represented by thefactor (T), which assumes a given
(fixed) state of technology, or the use of a particular type of production process.
- The relationship between input and output is often represented by a production function of
the type:
Q = f (L,K,T)
- which is simply mathematical shorthand for saying that output (Q) is a function of (or
dependent upon) combinations of labour (L) and capital (K), and the way in which they are
combined (T).
- Although this conceptual distinction seems clear, in practice, analysis is not quite so
straightforward.
- In the social services in general and in the health sector in particular, a number of factors
make the study of productive relationships extremely problematical.
- In large part these are due to the complexity of the health sector itself. Health care systems
are not simple productive units.
- They are highly complex, dynamic mechanisms, using a wide range of different resources, in
a multiplicity of ways.
- They produce many different types of output simultaneously, and sometimes even
unintentionally.
- The way in which these outputs are produced is often poorly understood and it is often
difficult to relate a particular output to any one intervention or activity.
- These are not the only difficulties. A large number of different types of resources are used in
health activities.
- Because of poor information systems it can be difficult to identify, measure or value these
inputs. Even greater problems exist on the output side of the equation. For example, a major
problem relates to the confusion surrounding the true output of health services.

35
- If it is 'health', then it is necessary to define what one means by that term. Even if this were
done satisfactorily, the concept still has to be measured and valued.
- These problems relating to the output of the health sector have been explored by many
researchers and from many different perspectives.
- The work remains largely at the conceptual stage and only recently have attempts been made
to develop and use measures of health outcome in health services planning and evaluation.
- There is, however, growing support for the development of such measures and the near future
may see their practical use increase.

Figure: Investing in Health

INPUTS PRODUCTION PROCESS OUTPUT

 Health care
 Diet HEALTHY
 Exercise HEALTH DAYS
 Environment STOCK
 Income
 Time

And to quote …

“The only way to keep your health is to eat what you don’t want, drink what you don’t like and
do what you’d rather not.” Mark Twain (1835-1910).

- So how do individuals/ households make decisions to invest in their health?

- Consumers produce gross investment in health and the other commodities in the utility
function according to a set of household production functions:
Health production I = f(M,TH;E)
Consumption goods Z =f(X,TC;E)
Where;
I = investment in health; M = market health care inputs ; TH= time spent on improving health; Z
= composite consumption good; X = market produced goods; TC = time spent on composite
consumption good; E = education
- An increment to capital stock such as health is called an investment.

36
- Health investment (I), is produced by time spent improving health (TH), and market health
inputs (provider‟s services, drugs), M. Likewise, composite good (Z) is produced with time
(Tc) and market purchased goods, X.
- Analogy with a firm using inputs to produce goods: decisions made according to production
functions –relationship between inputs and outputs.
- Education plays a crucial role in determining the efficiency of health capital and also in other
production functions, and therefore influences consumption patterns of households (in the
model, education was measured by number of years spent in schooling).
- Assuming that:
 individuals want to maximise their lifetime utility

 they have perfect knowledge and

 able to allocate time between different activities.

- The implied choices are:

o Inter-related time choices: Labour time (income) vs. leisure time vs. ill time.
Allocation of time either to produce health or the composite good will depend on
the utility derived by the individuals. Individuals have to make choices on how to
allocate time for different activities including income generating ones, leisure, and
so on.
o Within leisure time choice: health producing time (gym) vs. non-health producing
time. Time allocated for leisure can be used in production of health. For instance,
individuals may be exercising as part of leisure but these exercises may contribute
in improving health. Leisure time may also be used in non-health producing
activities like consuming alcohol or engaging in promiscuous activities.
o Resource choices: Health care inputs vs. other consumption subject to budget
constraint. Individuals have to make decisions bearing in mind that resources are
scarce. There exists constraints and so making choices best on priorities is very
important.

2.4.9 The demand for Health Capital

Optimal choice of investment

37
- Conventional economic analysis provides a powerful conceptual apparatus by which to
analyze the demand for a capital good.
- The cost of capital, in terms of foregone resources (for health capital, both time and money),
is a supply concept. The other needed tool is the concept of the marginal efficiency of
investment, the MEI, a demand concept that relates the return to investment to the amount of
resources invested.
- At Equilibrium, the Marginal Efficiency of Investment, (MEI curve describes the pattern of
rates of return, declining as the amount of investment increases) equals the Cost of Capital
(that is the interest rate, r, plus the depreciation rate, )
- This means that Marginal cost (of investing in H) = Marginal benefits
- Marginal cost = r + ,
Where; r = rate of interest on other investments; = rate of depreciation of health
i.e. the opportunity cost
- Both r and  are exogenous to the model
- Marginal benefit = rate of return = (W*G)/C
Where;
W = wage rate, G = marginal product (rate of return) of health investment which
is subject to diminishing MR (stop smoking through to Michael Jackson‟s oxygen tent),
C = direct cost of investment in health
This is the „marginal efficiency of capital‟ (MEC)

38
- The optimal Health Stock can be presented as:
Cost of Capital MEI MEI1

B
r+D

r+1

r+0 A C

0
Hmin H1 H0 H2 Health Stock

Figure: Optimal Health Stock

- The MEI curve describes the pattern of rates of return, declining as the amount of investment
(measured on the horizontal axis) increases. In the figure, the cost of capital is shown as the
horizontal line labeled r+0.
- The optimum amount of capital demanded is thus H0, which represents the amount of capital
at which the marginal efficiency of investment just equals the cost of capital. This
equilibrium occurs at point A.
- The MEI curve for health is downward sloping. This occurs because the production function
for healthy days exhibits diminishing marginal returns. The cost of capital for health would
similarly reflect the interest rate plus the rate of depreciation in health.
- Understand that a person‟s health like any capital good, also will depreciate over time. Thus
the optimal demand for health is likewise given at the intersection of the MEI curve and the
cost of capital curve.

2.4.10 Changes in Equilibrium: Age, Wage, Education

Here we want to understand how does investment in health change in response to changes in age,
wage, and education?

39
 a. The Effect of Ageing
- Depreciation increases ( to 1) over the life cycle (not a constant rate), therefore marginal
cost (MC) rises, and hence demand for health capital falls-but demand for health care may
rise due to inelastic demand curve for health.

Cost of capital

r+1

r+ X

MEI

H1 H* Health Stock
- Part of this is offset by increasing investment in health (H) so health care demand rises.

And to quote…
“Biological factors associated with ageing raise the price of human capital and cause
individuals to substitute away from future health until death is chosen” (Grossman, 1972)

b. Changes in the Wage Rate

- An increase in W raises the returns on healthy days. The optimal level of H is thus higher.
But investment in HC also requires an input of time which increases the costs of such
investment.

40
Cost of capital

r+

MEI2
MEI1

H1 H2 Health stock

c. Changes in Education
- Education increases the efficiency of non-market production-it increases the marginal
productivity of health inputs thereby raising the optimal health stock. Also better educated
may enjoy exercise among other activities more and may be more able to follow treatments.

Cost of capital

r+

MEI2
MEI1

H 1 H2 Health stock

MEC-Marginal efficiency capital

Implications/ Significance
- Raise education amongst the poorly educated i.e Increase literacy levels among the illiterate

41
- Ageing can‟t be controlled but we can control interest rates. So use policies to affect
depreciation.

- Reduce price of health care especially to the poor so that they can demand it

- Use policies to make sure that the elderly are looked after

Change in prices
- A fall in the price of a unit of health inputs results in the budget line swivelling outwards
from the intercept on the consumption axis

- Assuming that the individual did not devote all of her income to consumption before the
price change, she will employ more health inputs and consequently will be able to achieve
better health.

- This suggests that subsidising the price of health inputs (for example, milk and heating) will
result in improved health for those receiving such subsidies. (But these subsidies may not be
effective unless its targeted subsidies)

Note: To shift possibility frontier:- 1) Adopt technology and 2) Improve efficiency.

This will ensure fair redistribution of income to the society.

Technical knowledge/ education

- Advances in medical science or education will cause an upward shift in the health production
function

- This means that the individual can reach a higher level of health for the same level of health
inputs

- This suggests that a health education programme may bring about improved health without
any increase in the demand placed on health services and other health inputs

2.4.11 Application to choice behaviour

- If other capital stocks are low, an individual will choose to deplete her health stocks in order
to replenish other stocks e.g a high wage occupation that causes the stock of health to decline
may be chosen if the stock of wealth is low

42
- A similar kind of argument might be applied to the type of recreation activities which are
chosen e.g. an individual with low stocks of wealth relative to health may smoke since it is a
relatively cheap in terms of wealth and expensive in terms of health

2.4.12 Policy implications

- The model can be used to predict the likely (and opposite than intended) effects of policy
changes e.g the government may attempt to reduce queuing time in order to encourage
greater utilisation of health care by the poor.

- This will increase the marginal efficiency of capital (MEC) of both rich and poor but since
the value of extra time is greater for the rich, the MEC will shift up further for this group,
thus increasing the inequality.

2.4.13 Criticisms of the model

- The model assume health care is a constant life time investment

- It ignores insurance markets

- It assumes perfect information on the part of consumers about the MEC of health care,
interest rates, depreciation, etc. – for now and the future.

- It is deterministic including the choice of when to die!

2.4.14 Empirical measurement of demand for healthcare: The RAND Health Insurance
Experiment (R-HIE) city campus 21/3/2017
- The experiment was done in South Africa. It sought to answer these key questions

i. Does the cost of medical care determine the use of medical resources? (health
care demand and utilization)
ii. Does the cost of medical care determine the health outcome in the population?
(i.e., lower cost may lead to more utilization, but does 10 as opposed to 100 visits
to the doctor lead to better health for individuals?)
- Starting in 1975 and lasting for 15 years (up to 1982), the experiment selected a random
sample of families from the USA population

43
- Selected families remained in the experiment for 3 to 5 years at most. All wealth stratums in
the population were present throughout the 15 years

- In total, some 2,770 families (amounting to approximately 8,000 people took place in the
experiment, so far the most expensive health experiment ever performed

- Selected families were all pre-retirement age to control for old age effect in health care
demand and the effects of health at old age

- Selected families were randomized among health plans that differ among the regarding the
share paid for the plan among 4 possible co-insurance payment:

0% Co-insurance (Free plan)

25% co-insurance
50% co-insurance
95% co-insurance
- The experiment aims is to understand how the DEMAND for health and the HEALTH
STOCK (health outcome or health effect) varied in the population conditional on type of
health plan

- The results were astonishing!

- In terms of “health care utilization”, the evidence point out that individuals who had to make
co-insurance payments made 1 to 2 fewer physicians visits (annually) than those with free
health care plans and demanded (agreed to) 20% fewer hospitalizations.

- The result controls for confounders (education, wealth, and other characteristics of the
families and individuals), while the results were found to be equally true for either adults or
children in the selected households

- The observed reduced demand for health controls for health care need, that is, the results
refer to health care demand conditional on participant decision to initiate the consultation.

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2.8 SUMMARY

 Consumers want health not health care per se

 Consumers produce health

 Health does not depreciate instantly

 Demand for health has pure consumption and pure investment aspects

 The cost of holding health is the opportunity costs of capital plus the depreciation rate

 The MEC curve is downward sloping due to decrease in marginal returns (MR)

 Rewards of being healthy are greater for high income

 Health can be generated at less cost by educated

2.9 ACTIVITIES

1. Describe the features that make health an investment good and a consumption
good.

2. Do you think the typical person becomes more or less healthy upon retirement?
What does the Grossman model predict?

45
2.10 FURTHER READING

1. Mills,Anne and et.al. (1992), Health Economics for developing countries: A Survival
KitLondon.
2. Drummond, M., Stoddart, G. , O‟Brien, B. , and Torrance, G. (1997) Methods for the
Economic Evaluation of Health Care Programmes, second edition, Oxford Medical
Publications; Oxford.

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 TOPIC THREE

MARKETS AND MARKET FAILURE IN HEALTH AND HEALTH CARE

3.1 INTRODUCTION

In this topic, we discuss market and price mechanism, theory of perfect competition, market
failure, main types of market failure, causes of market failure, and the role of government in
provision of health care.

3.2 TOPIC OBJECTIVE

At the end of this lecture you should be able to:

(i) Define market and market failure
(ii) Discuss the main types of market failure
(iii) Explain the role of government in provision of health care.

3.3 Background

In this sub-topic, we look at the general background of the markets for health care. We explore
the various questions considered in analyzing health care markets.

- "Is health care in some way fundamentally different from food, clothes or any other
commodity which is distributed through the market? Are there special characteristics

47
 distinguishing medical care from these other goods? Why should society's objectives be
better achieved by non-market provision?" (Le Grand and Robinson 1976 pp. 32-33).

- These questions are typical of those that are frequently raised in the debate on the nature of
the commodity 'health' and the most appropriate organizational context for its optimal
production, allocation and delivery.

- They reflect the two aspects of the debate:

o First, technical arguments about the functioning of the health care market; and

o Second, more fundamental arguments about the nature of society's objectives.

- The second concern more basic issues because only when society's objectives are established
can 'optimal production, allocation and delivery' be defined and understood.

- However, the current debate focuses around the technical issues. For example, there are those
who argue that health care is not different and can be allocated via market mechanisms in the
same way as other goods and services.

- On the other hand, there are those who argue that health care is in some ways different, and
requires the modification or replacement of market mechanisms.

- This focus reflects the establishment of efficiency as the central societal objective and the
understanding of 'optimal' as 'most efficient'.

- However, a second important objective is that of equity, which is still a central policy
objective within many government health care systems.

- It remains important for practical policy-making, therefore, to consider whether, and to what
extent, the operation of the health care market achieves equity.

- The changing balance between equity and efficiency as policy goals helps to explain why the
extent to which governments have intervened in the free operation of the health care market
varies from country to country and has changed over time within countries.

- In considering these issues three groups of questions will be addressed in this topic.

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 o First, technical issues: what is the rationale for the market and the price
mechanism? What are the requirements for the market and the price mechanism
to function? What are the economic characteristics of health care? Is health care
different? Are the conditions of perfect competition satisfied in the case of health
care?

o Second, what are society's objectives? Are they considered or realised through the
functioning of the market?

o Third, what do the answers to these questions imply for the organisation of health
care services?

3.4 Markets and the Price Mechanism

In this sub-topic, we look at the general background of the markets for health care. We explore
the various questions considered in analyzing health care markets.

- What is a market? What do markets do? How do they work? The features of markets are
usually described in relation to consumer choice and producer competition:

"A market economy may be defined as an economic system in which the

mechanism of variable prices functions freely to signal consumer preferences and,
through its effect of profitability, to encourage the allocation of resources -
manpower, capital and raw materials - so as to satisfy those preferences. The
consumer exercises choice by voting with his purse. It is an impersonal system
which permits decentralised initiative in the use of resources; this in turn
promotes competition and efficiency while maximising the range of consumer
choice." (Centre for Policy Studies, Why Britain needs a social market economy,
Barry Rose, Chichester 1975.)

- A central feature of the market is the price mechanism.

49
- On the demand side, price is a measure of how much income must be sacrificed in order to
obtain a commodity.

- The more something is valued, the more consumers will be willing to give you to obtain it.

- On the supply side, prices indicate to producers the strength of these consumer values.

- The price at which a producer can offer a commodity for sale reflects both his efficiency, and
(to the extent that the prices of the resources used in production measure their scarcity value)
the opportunity cost of the commodity as well.

- Within the context of the market it is argued that the price mechanism, if allowed to operate
free of constraints, will result in an optimal pattern of allocation, distribution and exchange.
This is because:

o it transmits information about consumer preferences and the strength of those

preferences; and also information about resource costs, about scarcity, about the
efficiency and opportunity costs of production

o it provides incentives both to produce what is most highly valued in society, and
to produce it in the most efficient manner

o given an initial distribution of resources or of income, prices determine who in

society gets what goods and services.

- In other words, prices signal what society wants, how much it wants it, what this costs in
terms of resources or alternative options sacrificed and how efficiently producers are able to
satisfy these wants.

- 'Optimal' allocation in this sense is efficient: i.e. a situation where no reallocation can make
one individual better off without making at least one worse off (allocative efficiency).

- The price mechanism, in this argument, also has the advantage of securing efficiency in
resource use: i.e. achieving maximum output at given cost or a given output at minimum cost
(operational efficiency).

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- This type of structure stands in contrast to non-market systems which require conscious
decision-making about what will be produced, how, when, where, in which ways, and for
whom.

- Some writers have argued that the very complexity of a modern industrial economy makes it
more difficult for a central planner to comprehend all the knowledge and information
necessary for efficient management than in smaller and simpler economic systems.

- The claimed advantage of the price mechanism as a rationing system is that it allows the
decentralized coordination of a large number of separate activities.

- All of this happens automatically without the need for conscious planning or centralized
decision-making. Or does it? What are the requirements for markets to function in this
manner? Do markets operate this way in practice?

- The theoretical analysis and rationale for markets are usually explored using an idealized
model of the real world known as perfect competition.

- For the price mechanism to operate in the way described above, a number of conditions must
be simultaneously satisfied.

- These conditions are known as the conditions of perfect competition.

3.5 The model of perfect competition

In this sub-topic, give an overview of an ideal market or what is commonly referred to as free
market and the conditions necessary for such a market which if violated, then market failure
occurs.

- The conditions of perfect competition are as follows:

o a large number of buyers and sellers, each small in relation to the total number so
that they are unable to control price or output. With only a few sellers, competition
may not operate

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 o no barriers to entry: producers are free to enter or leave the market, while factors of
production are mobile

o no significant economies of scale which would give a price advantage to large-scale

producers and imply a tendency towards monopoly. A natural monopoly describes
the situation where it is more efficient in terms of production at least cost to have
just one large producer, but this eliminates the competitive controls on price,
quantity and quality

o no product differentiation or brand names; products are homogeneous, without

quality differences etc.

o assumption of self interest: producers aim to maximize profits and consumers aim
to maximize utility (i.e. benefits)

o no externalities or spillover effects in production or consumption. An activity

creates an externality if people who are not involved in the decision to
produce/consume are affected by it

o no risk or uncertainty: there exists perfect knowledge of prices, of products, of the

implications of consuming or not consuming a product etc.

- Market failure refers to the situation in which these conditions (necessary to achieve the
market-efficient solution) are absent, or are contravened in one way or another.

3.6 Is Health Care Different?

In this sub-topic, we discuss what makes health care different from other commodities, and
various types of market failures.

- Health care is not different from other goods in the sense that like other commodities it is
scarce, and therefore requires allocation and institutions to organize its allocation.

52
- A number of characteristics (as discussed in Topic One) are, however, often mentioned as
distinguishing health care from many other goods and services:

i. health care has both a consumption and an investment element (i.e. good
health yields direct consumption benefits from being healthy, and
contributes to greater production and investment)

ii. the costs of health care can be high in relation to income, and ill-health may
also affect earning capacity

iii. patients have a direct involvement in the production as well as in the

consumption of health care

iv. consumption or non-consumption decisions may well be irreversible (i.e.

decisions may lead to death or permanent disability).

- Although these characteristics are unusual they do not in themselves mean that health care
cannot be treated in the same ways as other commodities, nor do they necessarily imply a
particular form of organization. For example, insurance schemes have developed in order to
minimize the adverse effects of high health care costs and the effects of illness upon earning
capacity.

- However, the health care market does not, in practice, function according to the theory of
perfect competition.

The main market failures are discussed below:

3.6.1 Consumer rationality and consumer sovereignty

- Rationality implies consistency and in particular that decisions are consistent with the
principle of utility maximization (i.e. that consumers use their economic resources in order to
maximize their utility or benefit).

- In a few instances in health care, rationality would appear to be absent or impossible.

53
- Those who are mentally ill, and who reject or who do not recognize their need for treatment,
are incapable of pursuing rational ends.

- Others, such as those who are unconscious, are temporarily unable to exercise rational
choice.

- Health care may, therefore, in some circumstances be a merit good which must be distributed
by the government because it will be under-consumed if left to the willingness-to-pay of
individuals (who are not always rational in their demand for health care).

3.6.2. Risk and uncertainty

- The need for health care is difficult to predict. If the cost of health care was small in relation
to income this would not be important but it is not. Costs associated with illness are uncertain
and often large.

- Insurance is of course the mechanism that has developed in order to cope with the problems
of risk and uncertainty, and in many countries insurance systems exist to cover the
expenditures arising from ill- health.

- Insurance systems do not necessarily imply state involvement, although many existing
schemes operate with varying degrees of government support or control.

- The chief problem with the operation of insurance in a market system is in the way risks are
treated.

- Private insurance systems must at least cover their costs. To do this they set a premium based
on the observable characteristics of those applying for insurance, and the estimated costs of
treating certain conditions.

- Some individuals have characteristics that make them bad risks (such as the very young or
very old, those with existing chronic conditions, and smokers); some conditions imply high
treatment costs as a result of expensive procedures or long periods of treatment (such as the
problems arising from chronic illness, haemophilia, or old age).

- A private insurance system is unlikely to cover these individuals.

54
- Some form of state intervention is therefore essential to ensure that all individuals secure
access to health care, irrespective of their age, initial state of health, or ability to pay.

3.6.3Information
- For many commodities the consumer has some understanding of the product, or can acquire
such information by experience.

- With medical care, patients have little idea of the effectiveness, of the quality, or of the
consequences of having or not having treatment.

- Individuals may not even realize that they are ill.

- Furthermore, consumer entry into the market is infrequent, knowledge acquired from past
experiences becomes rapidly outdated, while the urgency of some conditions precludes time
consuming and often costly information gathering.

- There is little incentive for producers to provide information, and although patients may try
to obtain more information through 'second opinions', doctors are traditionally reluctant to
provide conflicting information or to disagree with colleagues.

- The irreversibility of much medical care emphasizes the importance of making the right
decisions based on adequate information.

- Many professional groups and agencies have developed to provide information but for ethical
reasons there are often controls imposed on the advertising of services.

- These problems have in part contributed to the unusual relationship between producers and
consumers in health care.

- The doctor is consulted and acts as an agent on behalf of the patient.

- The consumer chooses to delegate decisions about consumption to the doctor, thus demand
for health care is often initiated by the supplier (demand may even be supplier-induced).

- An obvious danger of this is that consumers may be exploited: depending on the price of
health care, and the method used to pay for it, doctors may stand to benefit from generating
demand for their own services.

55
3.6.4Externalities and public goods
- There are numerous instances in health care where the consumption or production behaviour
of one party spills-over to affect another party.

- Inoculation against infectious diseases, and public health measures such as sewerage and
drainage are the most frequently quoted examples of these physical external effects.

- There may also be a caring externality underlying the provision of health care - this is
discussed later.

- A particular type of externality is known as a public good.

- The two distinguishing characteristics of this type of commodity are non- rivalness in
consumption, and non-excludability.

- In simple terms this means that once the good is provided, it is possible for additional
individuals to consume it without reducing the consumption of others, and that at the same
time, it is impossible, or at least prohibitively difficult, to exclude others from consumption.

- The classic example of a pure public good is the clean air.

- The practical implications of such goods are that individuals have an incentive to understate
their valuation of such commodities, and/or once they are provided, not to pay for them.

- Certain health care services are characterized by the problems associated with public goods.

- Malaria control through environmental management (e.g. cleaning ponds) is an often-used

example where one person's consumption does not impede another's, and where it would not
be practical (or would be prohibitively expensive) to exclude non-payers from the benefits.

- Such services, if they are to be provided at all, will require some form of collective action.

- The practical significance resulting from the presence of externalities and public goods is that
left to market mechanisms alone some commodities will not be produced at all, whereas
others will be produced in inappropriate amounts.

3.6.5Competition and barriers to market entry

56
- The medical care market is not conducive to free competition.

- A number of professional groups have developed to control entry of suppliers to the health
care market. The arguments in favour of this control are that it is important to maintain
standards of practice, and to reduce the uncertainty regarding professional competence.

- The disadvantages are that such controls, by reducing supply, tend to increase costs.

- A number of barriers to entry exist - professional licensure, licensing of drugs and

pharmaceuticals, controls on the establishment of new facilities and/or services.

- Professionalization may have increased the numbers of highly trained personnel and reduced
uncertainty about competence, but it is essentially anti-competitive.

3.6.6 Economies of scale and monopoly

- There are some instances of economies of scale and tendency to natural monopoly in health
care. Examples include pharmaceutical firms, and hospitals.

- More often, the market will be characterized by a limited degree of competition between a
few large producers (i.e. oligopoly).

- Price competition may be reduced in these circumstances by collusion, and competition

limited instead to, for instance, advertising of brand names.

Is Equity Achieved Through the Market?

- From an equity perspective, there are two theoretical arguments against the market-based
allocation of goods:

o First, while the market does not require any particular pattern of income distribution
to function, it will reinforce the pattern in existence. This pattern is generally
inequitable and is based on accidents of birth, property and education. The market
exacerbates income inequalities by allocating goods according to the individual's
ability to pay for them, and so, in theory, allocation via the market will undermine
the health of those who are both least able to afford health care and are most
vulnerable to ill-health (the low-income groups). The pursuit of equity involves
allocating goods such as health care in a way that counterbalances income

57
 inequalities (i.e. favouring the low-income groups), together with a pattern of
taxation that falls more heavily on high- than low-income groups. In practice, health
care must be allocated in accordance with the objective of achieving a net subsidy
for low-income groups and a net contribution from high-income groups.

o Second, the market assumes that individuals are basically self- interested in their
behaviour and seek to maximize their own utility. A concern for equity, however,
reflects less selfish behaviour; it represents a concern for the well-being of others.

- These theoretical arguments are supported by the practical realities that there is often an
inverse relationship between income and ill-health, that ill-health may further limit income
earning capacity and that the cost of health care is often high in relation to income.

- Consequently, at a minimum, intervention in the market is required to protect those who are
both most likely to be sick and least able to afford health care.

The Role of Government Intervention

- Government intervention in the health care market may be promoted on either efficiency or
equity grounds.

- It can attempt to restore the conditions necessary for the market to work or to limit the
undesirable effects of markets and market failure.

- For example, allocative measures are designed to restore the conditions of perfect
competition; and distributive measures are designed to correct an undesirable distribution of
economic resources, and then to allow markets to work.

- Distributive measures may work through the tax system via transfer payments to the poor or
negative income taxes; or through price regulation via price support (e.g. minimum wages) or
tariffs.

- Moreover, government intervention can be minimal, limited to that of referee, information

provider or regulator of market fixing by vested interests.

58
- Or government can have a more extensive role ranging from the regulation and control of the
health care system to the provision of the finance for services to the direct provision of
services for all.

- A fully socialized health care system - meaning, in this instance, a system in which health
care is provided without charge to the consumer and financed from general revenue - carries
the remedial measures to their logical conclusion.

- For example, with free service (equivalent to a 100% subsidy) there is little distortion of
demand through differences in income.

- Recognition of such advantages of government production is not denied in orthodox Western

economics; in the applied field of public finance it has always been recognized that there
might be merit goods which the state might choose to provide independently of the market,
with education and health care as conspicuous examples.

- However, like the competitive market, the socialized health care system does not exist in its
ideal form in the real world. Among the qualifications are:

o even with zero price and wide geographical dispersion of services, there will
persist some non-price impediments to access that make complete equality hard to
achieve

o a socialized system of health care in a non-socialized economy will be exposed to

some residual market pressures, for example in the supply and price of inputs it
purchases from the rest of the economy

o the degree of equity attained in a socialized health care system depends partly on
the nature of the tax system from which it is financed (and on the nature of other
sources of finance such as foreign aid). If it is regressive (bearing more heavily on
the poor than the rich) a zero price is not enough to achieve overall equality in the
health care system

59
 o as a socialized system does not rely on market forces for resource allocation, it
must be planned. Its properties therefore depend on the efficiency and cost of the
planning system

o at a lower level, the allocation of services is likely to be left largely in the hands of
health professionals. In any conflict between consumer needs and demands the
result is likely to be biased towards professionally assessed needs, especially when
the consumer does not pay and therefore may have less influence

o a socialized health care system, like any other large organisation, is always in
danger of bureaucratization, with all this implies in terms of inertia and emphasis
of the interest of the producer above those of the consumer.

- Just like the market fails to allocate resources optimally, the government may fail also. This
is due to:

o Asymmetric information: Government is less specialized in some areas and same

information problems as in market are faced too.

o Incentives: If there are no profit motives, then there is no incentive to reduce the
costs. In the absence of price mechanism, what would be the incentive to produce or
consume at optimal levels?

o Assumption of benevolent government: People may be excluded in economic,

social and political “markets”. This may be an incentive for politicians to exploit
such groups during electoral cycles which are short term. They will do for their own
interests and not those of the people they represent.

- Thus, in practice, neither ideal form of health care organization, the market or a socialized
health care system, functions according to theory.

- Mixed systems exist in reality, involving different degrees of government intervention and
reflecting different balances between the two central aims of society, equity and efficiency.

- Practice tempers theory in policy-making and the realities both of scarce resources and of
unequal distribution (of income, of ill-health) are recognized.

60
- There is a great need for examination of the specific form that is appropriate for a particular
country and period, in order to minimize its side-effects.

3.7 SUMMARY

- Market is where demand and supply adjust through price mechanism to allocate
resources in the society.

- Market failure is where a free market produces a Pareto inefficient result.

- The main of market failures are: Consumer rationality and consumer sovereignty; Risk
and uncertainty; Information; Externalities and public goods; Competition and barriers to
market entry; and Economies of scale and monopoly.

- Government intervention in the health care market may be promoted on either efficiency or
equity grounds.

- The government intervenes through: Legislation, regulation, subsidizing/taxation, funding,

provision, social protection etc.

3.8 ACTIVITIES

i. Analyze to what extent the various types of market failures are evident in the Kenya
Health Care sector.

ii. How has the Kenyan government tried to address different types of market failures in
the health sector?

61
3.9 FURTHER READING

1. BARR N (1987). The Economics of the Welfare State. Wiedenfeld and Nicolson
2. LEES D (1976). Economics and Non-Economics of Health Services. The Three
Banks Review 110 pp
3-20
3. Le GRAND J and ROBINSON R (1976) Chapters 1 and 2. In: The Economics of
Social Problems . Macmillan
4. ROEMER MI (1982). Market Failure and Health Care Policy. Journal of Public
Health Policy
December 1982
5. ROEMER MI and ROEMER JE (1982). The Social Consequences of Free Trade in
Health Care: A Public Health Response to Orthodox Economics International Journal
of Health Services vol 12 no 1
6. WORLD BANK (1987). Financing Health Services in Developing Countries: An
Agenda for Reform.
World Bank, Washington

62
 TOPIC FOUR
HEALTH INSURANCE

4.1 INTRODUCTION

The topic introduces students to concepts of insurance and their application to Health care.
Further students and introduced to demand and supply concepts for health insurance and
factors that determine demand for health insurance and problems associated with demand for
health insurance.

4.2 TOPIC OBJECTIVES

At the end of this lecture you should be able to:

(i) Define health insurance
(ii) Explain factors determining demand for health insurance
(iii) Explain key terminologies used in health insurance
(iv) Discuss main problems associated with demand for health insurance.

4.3 Definition of Insurance, Health Insurance and its desireable characteristics

This sub-topic, introduces the learner to the concepts of insurance. What is insurance and what
are the desireable characteristics of insurance?

- Insurance is a private or public system of protection against the losses that are uncertain.

63
- The aim of insurance is to reduce the variability in one‟s income by pooling risks with a large
number of people
4.3.1 Desirable characteristics for insurance:
o The number of insured should be large, and they should be independently exposed
to potential risk

o Losses covered should be definite in time, place, and amount

o The chance of loss should be measurable

o The loss should be accidental from view point of person who is insured

- Thus the principle of insurance is based on probabilities, not one of payment for known
future events; though in practice, a prepayment element for health care exists since certain
types of utilization are highly predictable.

- Premiums are paid to an insurance institution which compensates any insured victim of the
event for any financial loss resulting from the event.

- Insurance therefore, helps to lessen and spread risks, and it relies on the fact that what is
unpredictable for an individual is highly predictable for a large number of individuals.

- Health insurance is a private or public system of protection against the losses owing to
medical expenses.
- It can also be defined as a method of providing members of a defined group or community
with protection against the cost of medical care (Atim et al., 1998; Bennett, 2004).
- It is based on the principle of pooling of risks, and therefore, the redistribution of financial
resources from that segment of a community that does not incur high health care costs to
those segments of the community that do.
- Risk pooling occurs when transactors each facing possible large losses agree to contribute a
small premium payment to a common pool, to be used to compensate whichever of them
actually suffers the loss. Contributions must cover losses plus administration costs (adapted
from Evans, 1994).
4.3.2 Terminologies used in Insurance:
- Premium- the periodic payment made on an insurance policy for a given amount of
insurance coverage. Thus an insurance premium is the actual amount of money charged by
insurance companies for active coverage.

64
- Coinsurance- this is the percentage of costs that are paid by the beneficiary of health
insurance policy.
- Deductibles- this is the amount health care expenditure a beneficiary must pay before the
insurer begins payment.
- Copayment- this is the amount paid by a beneficiary of health policy as a result of
coinsurance and/ or deductibles.
- Actuarially fair- Insurance policy where there exists equality between expected benefit
payout and premium paid.
- Cream-skimming- a process whereby an insurer tries to select the most favourable
individuals with expected losses below the premium charged (or the capitation payment
received) in order to increase profits. Cream-skimming can make it difficult or impossible for
individuals with high expected losses to purchase private insurance.
- Adverse selection- is a process that occurs when individuals with different expected losses
are charged the same premium, whereby those with low expected losses drop out of the
insurance pool, leaving only individuals with high expected losses. Adverse selection can
make it difficult to sustain private insurance markets.
- Moral hazard- is the situation whereby people may take advantage of free health care or
their membership in a health insurance plan by using services more frequently than if they
were paying for health care directly from their pocket or had they not been members of an
insurance plan.
- Loading costs- this is the administrative and other costs associated with underwriting an
insurance policy. This may include salaries, rental fee, opportunity costs, and inflation,
among others.
4.4 Demand for Insurance

This sub-topic, examines individual‟s demand for insurance cover, problem of choice,
determinants of demand for health insurance, the model for demand and problems associated
with demand for health insurance.

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- Uncertainty in health status and medical expenditures impose the following risks on
individuals:

o Loss of health itself

o Incurring large financial costs

o Reduced ability to work/productivity

o Inability to enjoy other forms of consumption

- Because an individual is uncertain about above risks he/she is faced with a problem of
whether or not to insure himself/herself.

- Basic theory of demand for insurance presents a systematic view of some underlying
assumptions or variables that can influence decision to buy insurance.
4.4.1 Determinants of demand for health insurance
- An individual‟s demand for private health insurance will be determined by factors such as:

o Consumer tastes/ preferences (risk lover, averse or neutral)-the degree of risk

aversion.

o Level of wealth- A pauper doesn‟t care much about death. But a wealthy person
cares much and will tend to go for insurance policy.

o The likely magnitude of loss- A person who incurs high medical costs will often go
for insurance.

o Likelihood of illness-Higher risk will demand more insurance

o Price of insurance (premium)- Higher price reduces likelihood that an individual

will insure against a given event

- Existing evidence shows that the likelihood of illness:

1. Increases with age - This is also affected by availability of public health insurance
programs (Public and private health insurance)

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 - Differs by gender -Women are more likely to fall sick as they are responsible for
child birth. They are also affected by availability of public health insurance program
targeting pregnant women

- Differs by type of care needed- Chronic vs. Acute vs. preventive and thus elasticity
of demand will differ.

- In analyzing demand for insurance, the main model used is the Expected Utility theory.

- The model states that the demand for insurance is a demand for certainty i.e. buyers of
insurance prefer certain losses to actuarially equivalent uncertain losses.

- Insurance companies do not take risks, but rather they spread the risks among many
consumers.
- But one of the determinants of demand for health insurance is consumer tastes/preference
which depends on the level of risk aversion.
- To understand what risk aversion is, we conduct a simple test to see if you are “risk aversion”
- Given:
o Your pay cheque, OR
o Doubling your pay cheque for correctly picking one coin flip.
- Which would you select?
- Most of us are risk averse. We would select the option which has certainty. Since we do not
want to lose, we will definitely choose our pay cheques rather than doubling it with
uncertainty.
- Risk aversion: - is the degree to which a certain income is preferred to a risky alternative
with the same expected income.
- Actuarially fair gamble: is one in which the amount you pay for the gamble is equal to the
expected value of the gamble. e.g. paying Shs.1 to play, and the expected value of the game
is Shs. 1.
- Risk aversion is reflected by diminishing marginal utility of income/wealth as indicated in
the diagram below where A>B. Utility lost when you lose Shs.1 is larger than utility gained
by winning Shs.1.

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- Presence of aversion makes consumers willing to pay to spread risk with others.

- Insurance companies specialize in pricing risks, and not in taking risks.

- It is clear from the theory of insurance that the losses that are insured are: large, infrequent,
random, and not associated with a large moral hazard.

4.5 Problems in demand for insurance

This sub-topic, discuses the major problems associated with demand for health insurance.
These are Moral Hazard and Adverse selection and possible solutions for the problems.

- There are two main problems associated with demand for insurance. These are Moral Hazard
and Adverse Selection. We now look at these problems in details.

1) Moral hazard:

- It is the situation whereby people may take advantage of free health care or their membership
in a health insurance plan by using services more frequently than if they were paying for
health care directly from their pocket or had they not been members of an insurance plan.

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- Moral Hazard can also be said to be the disincentives created by insurance for individuals to
take measures that would reduce the amount of care demanded. OR, additional quantity of
health care demanded, resulting from a decrease in the net price of health care attributable to
insurance

- It refers to the increased usage of services when the pooling of risks lead to decreased
marginal costs for services (i.e. the price is reduced).

- It is also used to refer to how one changes behavior when they are insured.

Effects of the new price system (with insurance) on demand for insurance
- Buying insurance lowers the price per unit of health care service at time it is bought.
- Person with health insurance is more likely to go to the doctor for a small problem than
someone without health insurance
- This is likely to affect good with higher elasticity of demand such as preventive care.
- Moral Hazard is also used to refer to how one changes behavior when they are insured.
- We may take more risks, which could have health care implications when insured rather than
when we are not insured .e.g. Learning snowboarding (many people break their arms). Many
people may not take risk to learn the snowboarding if they don‟t have health insurance.
Sources of Moral Hazard

1) Quantity demanded of medical care is greater than amount consumer would purchase
if he/she paid full cost
2) Individual is less likely to engage in preventive behavior and/or more likely to engage
in unhealthy behavior
3) Individual demands higher quality/more costly types of care than he/she would in the
absence of insurance
4) Individual‟s incentives to monitor health care providers is lower than in absence of
insurance
5) Individual‟s incentive to search for lower prices is lower than in the absence of
insurance

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- How presence of insurance affects demand through price of health care services is illustrated
using graphs below.

- Quantity demand at the price without insurance is Q0 and with the presence of insurance,
more is demand and quantity increase to Q1.
- The Difference between the quantities demanded in the absence of insurance and with the
presence of insurance shows the moral hazard increase due to the presence of insurance.
- The idea is clearly illustrated in the next graph which shows the movements of the demand
curves.

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- For services that are not very price sensitive, insurance will not cause individuals to purchase
more services. e.g. purchase of insulin for diabetics.

- For those that are price sensitive (cosmetic surgery –not from accidents), insurance may
encourage one to buy more.

Typical solutions to the moral hazard

- Increase cost sharing.

o This could be done through copayments or deductibles

o Reduces the quantity demanded by increasing price consumer faces. By increasing
the prices, this may encourage the consumers to:
 Increases preventive behavior/reduces unhealthy behavior since consumer
faces part of “costs” from these behaviors
 Increases the likelihood of consumer choosing less expensive types of
medical care
 Raises the likelihood that consumer better monitors provider behavior
 Increases likelihood that consumer “shops around” for less expensive
sources of care

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- Offer less generous insurance for specific services with more elastic demand (e.g., mental
health coverage, preventive care)

Problems with solutions

- Assumes individuals will decrease unnecessary care. However people due to informational
asymmetry do not know which care is unnecessary so may decrease necessary and
unnecessary care

- Some health services which are elastic have long-term health gains which may not be
realized by consumer

o There are arguments related to presence of externalities

o Preventive care and chronic disease management will lead to better health in the
future and can lead to lower health costs in the future

o These models don‟t take the long-term effects of not receiving care into
consideration.

o Increasing price may decrease demand in the short-run but increase it in the long-
run

Other solutions to moral hazard

- Instead of rationing on price, ration on need

o Don‟t use price mechanism to say how much care you should or should not get

- Managed Care: Under this we can have Gatekeepers, provider guidelines and provider
networks such that usage can be minimized.

Moral Hazard Criticisms

- It is assumed that consumer preferences must hold for demand to represent willingness to
pay. For this to happen:

o Consumers must be rational.

 This means they know consumption of more of a good always makes them
better off.

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  Preferences must exhibit transitivity
 If there are 3 bundles A, B, C ranked in order of priority
 A preferred to B, and B preferred to C
 Then A must be preferred to C and not the other way round.
 Consumers must be able to rank any bundle, and so know which good is
preferred to which.
o They must have sufficient information to make good choices.
o They must know what the result of their consumption decisions will be
- If these assumptions hold the demand curve shows the willingness to pay for an additional
unit of health services
But the concern is:
- Do we meet these assumptions?
1. Are consumers rational?
o Consumers do not have information on prices and quality to be able to rank/choose
different health bundles.
o You can pay a lower price for a health plan but it is not the same product. Do we
really know all the differences?
o Do people understand the difference between fee-for-service and managed care and
how the type of payment system might affect care?
o Are consumers just picking the least costs without recognizing the potential quality
or service differences?
- We have to choose health plans, this is very hard to do when you can‟t get information on
quality and pricing.
- How much you are reimbursed if you have to seek healthcare outside the network when
traveling.
- Is more health care better? Or are you going to get more services because quality is poor and
they can‟t figure out the problem
2. Do consumers know what is best for them?
o People can make wrong tradeoffs. This can be due to need to “show-off” or due to
time preferences. e.g. young people tend to think they are unbeatable persons
3.Do consumers know the result of their consumption decision?

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 o Do we know what would have happened if we had not been treated? We look at the
counterfactual.
o Would the result have been the same if I saw a different doctor?
o We often do not know if we made the right decision. e.g. after head injury begin a
series of acupuncture. It takes a number of sessions for acupuncture to work and so
it takes time. Time also helps your head heal. So after a month and a half of
acupuncture you feel better. So the question is, was it the acupuncture or was it time
that healed you?
o Who said the prices reflect the cost of making the good
 With monopolies that prices may be too high so we are under consuming
care e.g. prices of the drug for cancer going to go from $20,000 to $100,000
2) Adverse selection:

- Is a process that occurs when individuals with different expected losses are charged the same
premium, whereby those with low expected losses drop out of the insurance pool, leaving
only individuals with high expected losses.

- Adverse selection can make it difficult to sustain private insurance markets.

- This situation often result from asymmetric information in which individuals are able to
purchase insurance at rates that are below actuarially fair rates plus loading costs
-alternatively:
- Occurs when high-risk consumers, who know more about their own health status than
insurers do, subscribe to an insured group composed of lower-risk individuals to secure low
premiums.
- This theoretical idea risk adverse comes from Arrow‟s 1963 article.

- Risk pooling works because everyone in the group is at risk and therefore has an interest in
making sure that solid insurance benefits are provided.

- Suppose the risk was not random, you knew (you are certain):

o You had a higher chance of lung cancer because you have smoked all your life.
Then you would want to be insured.

o You never smoked, you eat well, you do exercises, so you think there is a low
chance of getting sick. Then you would not want to pay a lot for health insurance.

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- Adverse selection occurs when some factors are known to the insured (i.e. you) but not to the
insurer. i.e. there is asymmetric information

- As a result of asymmetric information, we can have:

o Two types of consumers:

 relatively healthy, with low risk of illness (pL)

 relatively unhealthy, with high risk of illness (pH)

- Insurance company observes overall risk in the market and not the actual risk for each
individual.

- The company then sets premium based on observed average risk.

- Individuals decide to take up health care or not based on their actual risk.

- Those individuals who are healthier or less risk adverse are more likely to under insure or not
insure and those who are sicker and risk adverse will insure

- People enroll into insurance based on their own risk of sickness

- Adverse selection into the health insurance market will be a problem if insurance companies
only know the average risk of the population.

- To try to mitigate the problem of adverse selection, insurance companies need to figure out
each person‟s actual probability of illness

Possible solution to adverse selection

- Waiting periods –Insurance companies enforce some waiting period once an individual
purchases a policy such that they cannot enjoy the benefits immediately. This can bar
individuals from purchasing policy when they are already sick or are in danger.

- Pre-existing condition exclusions-insurance companies try to determine some existing

conditions for them to determine whether to insure an individual or not.

- Risk rating (underwriting)

o If the high risks are something the insurance company can observe in advance, they
can adjust premiums up or down to account for varying risk.

o Adjust insurance based on age, gender, behaviors (how much you smoke or drink),
Body Mass Index (BMI), your cholesterol, blood pressure

- Insurance that precludes individual selection according to subscribers‟ perceptions of their

own risk

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- It can be made mandate that everyone must purchase health insurance

- Provision of universal health insurance can also limit adverse selection problem

4.5 SUMMARY

- Health insurance is a private or public system of protection against the losses owing to
medical expenses
- It is based on pooling of resources.
- In theory, individual health insurance trades off a guaranteed reduction in wealth (the
insurance premium) for a reduction in uncertainty due to ill health through the pooling of
risk.
- The organization and cost conditions in some health insurance markets, however,
suggest that some contingencies may not be insurable.
- There are two main problems related to health insurance-Moral Hazard and Adverse
Selection
- The main model used in analysis of demand for health insurance is the Expected Utility
Theory

4.6 ACTIVITIES

1) Discuss the main determinants of demand for health insurance and to what extent are
they applicable to Kenya.
2) What are the major problems of health insurance facing the Kenyan market?

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4.7 FURTHER READING

1. Rothschild and Stiglitz (1976). Equilibrium in competitive insurance Markets: An

essay on the economics of imperfect information. The Quarterly Journal of
Economics, Vol. 90, No. 4 pp. 629-649.
2. Folland, S., Goodman, A. and Stano, M. (2010). The Economics of Health and Health
Care. SixthEdition. Prentice Hall.

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 TOPIC FIVE
HEALTH AND DEVELOPMENT

5.1: INTRODUCTION

In this topic, we discuss the measures of health and development. We also look at the disease
profiles for rich and poor countries and discuss how health and growth are related. We
further discuss how health and poverty are linked focusing on social, political and regional
dimensions of health.

5.2: TOPIC OBJECTIVES

At the end of this lecture the learner should be able to:

(i) Explain how health and poverty are linked.
(ii) Describes effects of growth on health and vice versa
(iii) Explain the role of health in development

- Development is the concern of all developing countries. The health planner, manager, etc., is
equally charged with that concern and must be knowledgeable about what development
implies and the role health should play in the development of a given country.

- The following questions are of paramount importance for the health worker in a developing
country such as Kenya:

o what is development?

o How does it differ from economic growth?

o How can development be measured?

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 o What role does health play in development?

o What role should the health worker play in facilitating development?

o This subsection will be attempting to provide some answers and insights to these
questions.

5.3 Economic Development

- Development has been variously defined. The modern view of development perceives it as
both a physical reality and state of mind in which society has, through some combination of
social, economic and institutional processes, secured the means for obtaining a better life.

- The definition of “a better life” may vary from one society to another.

- Development in all societies, however, must consist of at least the following three objectives:

o To increase the availability, distribution and accessibility of life-sustaining goods

such as food, shelter, health, security and protection to all members of society;

o To raise standards of living, including higher incomes, the provision of more jobs,
better education and better health, and more attention to cultural and humanistic
values so as to enhance not only material well-being, but also to generate greater
individual community and national esteem.

o To expand the range of economic and social opportunities and services to

individuals and communities by freeing them from servitude and dependence on
other people and communities and from ignorance and human misery.

5.3.1 The process of economic development

- The idea of economic development is currently used in two ways:

o to arrange nations and communities on a scale from poor (less developed) to rich
(developed)

o to refer to the process by which poor nations become richer.

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- There tends to be a systematic relation between income and other differences which include:

o pattern of production (eg. agriculture is more important in poor countries)

o pattern of trade (eg. poor countries tend to import manufactured goods, export
primary products)

o energy use (eg. poor countries use less non-human energy per head)

o consumption patterns (eg. poor countries spend relatively more on food, little on
consumer durables)

o degree of urbanisation (in poor countries a smaller proportion of the population

lives in towns)

o demography

o health levels and health inputs.

- Many of these differences between countries correspond to changes over time in the history
of present 'developed' countries. Hence economists have built up a model of development as
a process accounting both for the historical experience of developed countries and for present
comparative data (the present rich countries are assumed to have started the process early, the
poor ones late). This process is sometimes seen in terms of 'stages of growth'.

- In the 1950s the driving force for this economic process was seen as investment (growth of
physical capital such as roads, dams and factories).

- This leads to increased output, which in turn makes resources available for further investment
- provided they are not swallowed up by population growth or increased consumption.

- The model was common to 'capitalist' and 'socialist' theories of development.

- The essence of development policy, following this view, is to invest more while holding
down the rate of increase of population and consumption.

- However, events in the 1960s and 1970s made this view of development seem oversimplified
because 'investment' involves not only physical capital but also finance, technology and

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 social organisation, each of which has special problems; and external trade and finance
impose important constraints on development.

- Economic development is, therefore, no longer seen simply as a process of injecting capital
into the economy with automatic benefits in terms of production and human welfare.

- It is recognized that it may even have negative side-effects.

- Because capital is not a 'magic bullet', planning for development becomes much more
complicated; it must take into account all aspects of the economy including health.

- Although economic development has its own momentum, there has been agreement since the
1950s that it can at least be stimulated and its effects controlled, and that this involves some
form of planning. There is a theoretical distinction between three approaches:

o 'laisser faire' where intervention is limited to providing favourable conditions for

private industry, the benefits of which 'trickle down' to the whole population

o 'democratic socialist' where state intervention is more active and much attention is
given to distributing the benefits of development through social services

o 'Marxist' where the crucial step is the transfer of power from a ruling class
(capitalist) to the party representing the people; distributing benefits then becomes
merely a technical planning problem.

- In practice, whatever the approach adopted, most poor countries succeeded between 1950
and the mid-1970s in expanding national production, slowing population growth (so that
average income rose in almost all countries), and improving the conditions of life sufficiently
to produce a general increase in the expectation of life.

- On the other hand, these successes were not inconsistent with an increasing absolute income
gap between the richest and poorest countries, an increasing absolute number of poor and
illiterate in the world, and a recognition that the groups and classes involved in development
continually used their political power to protect and further their interests.

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- For example: developed countries try to preserve existing patterns of trade and finance, so
that gains flow from the 'periphery' to the 'centre'; elites in developing countries try to corner
the gains on development and multinational corporations use their bargaining power for the
same purpose.

- Further, development has been a highly uneven process.

- Other countries appear to be economically static (e.g. Ethiopia) and international 'poverty
belts' exist in sub-Saharan Africa.

5.3.2 Growth and Development

- For a long time, Development and Economic growth were used interchangeably. Although
the two are closely related they are, however, different.

- Economic growth can be defined as an increase in a country‟s productive capacity,

identifiable by a sustained rise in real national income over a period of years.

- The main differences between growth and development can be outlined as follows:

1. Development encompasses the total well-being of the individual, a community or a

nation, while economic growth is concerned with the increase in per capital
earnings of the people making up the nation.

2. Economic growth is one characteristic of development, yet development must not

be measured by the rate of economic growth. It is possible for a country to
experience economic growth without becoming developed. A country, for example,
may acquire a great wealth from its mineral deposits, but have a low level of health
services. This is due to the fact that the wealth goes into the hands of a very small
minority who might squander it on luxury goods instead of establishing a viable
infrastructure.

3. Development is concerned with the total person, his economic, social, political,
physiological, psychic and environmental requirements. If one of these is not fully
catered for, development has not been achieved.

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 5.3.3 Measurement of Economic Development

- The measurement of development has presented social scientists with a problem of finding
the suitable tools and techniques to do so and of interpreting the results of such
measurements.

- Several suggestions have been presented for measuring development.

- One line of research has suggested the use of so-called social indicators. The purpose of these
is to measure the well-being of the population by examining factors such as health and
nutritional status, level of education, housing conditions and so forth.

- However, it is easier to calculate GNP, per capita incomes and growth rates.

- As a result, in most reports these variables are used as indicators of Development.

- Economic Development, in addition to a rise in per-capita income, implies fundamental

changes in the structure of the economy characterized by:

1. Rising share of industry, along with the failing share of agriculture in GNP and
increasing percentage of people who live in cities rather than the countryside

2. Passing through periods of accelerating, then decelerating population growth,

during which the age structure of the country changes dramatically.

3. Changes in consumption patterns as people no longer spend all their income on

necessities, but instead move on to consume durables and eventually to leisure-time
products and services.

4. Meeting the needs of the present without compromising the ability of future
generations to meets their own needs (sustainability)

5. Participation (mainly) by the citizens of the country in the process as well as the
benefit, While economic development and modern economic growth involve much
more than arise in per capita income, there can be no development without
economic growth

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 5.3.4 Demographic development

- Economic development is paralleled by a process of change sometimes called the

'demographic transition'. For much of human history populations have grown very slowly
because high birth rates (40-50 per thousand) have been offset by almost equally high death
rates. At present the richest countries are again in a situation of slow population growth (less
than 1% per year) but with much lower birth and death rates (10-20 per thousand).

- In the transition from one situation to the other, birth and death rates do not generally move
in step. Death rates fall first, and in combination with high birth rates produce a period of
very rapid population growth (currently 3-4% per year in sub-Saharan Africa).

- Only when birth rates fall does the population begin to stabilize. This may not happen for a
period of decades, giving time for the population to grow to several times its original level.

- The demographic transition, like economic development, is believed to have its own logic
and momentum, but is also partly controllable.

- The crucial factor, the speed at which birth rates follow the fall in death rates, is believed to
depend partly on the fact that greater child survival causes parents to desire less children, but
also on deliberate policies of population control.

- This is the justification for the huge annual expenditure on national and international
population control programmes.

5.3.5 Health development

- Health increases human potentialities of all kinds. Everyone can benefit from better health in
the present, and improved health for the young will lead to healthier population in the future

- Better child health and nutrition promotes future productivity growth directly by helping
children develop into stronger and healthier adults

- 'Health development' is a convenient name for the process by which populations move from a
low level to a high level of health.

- The nature of these changes shows most clearly in the case of infant deaths.

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- At low levels of health (Infant Mortality Rate of, say, 150 per thousand births), most infant
deaths are associated with communicable diseases, particularly diarrhoeal and respiratory
conditions.

- At intermediate levels the common infectious diseases (many of which have a nutritional and
environmental element) begin to give way to a range of (mostly perinatal) conditions which
require institutional care.

- At high levels of health, infant deaths are reduced to a core of congenital conditions and
expensively institutionalizable diseases.

- For children and young adults the same basic pattern is found, although at lower absolute
levels of mortality.

- Among the infectious conditions, diarrhoeal diseases fall in importance relative to the classic
diseases of poverty (such as Tuberculosis) and of the tropics (such as malaria).

- Maternal mortality becomes important as the counterpart to perinatal conditions, and falls
very sharply with the improvement of general health.

- Accidents are also significant causes of death. Although they have much the same incidence
at all levels, in poor countries they tend to be agricultural and in rich ones, industrial or
mechanical.

- At older ages the gap between countries with low and high general levels of health tends to
narrow.

- The difference in mortality rates for infectious diseases is much the same as at younger ages,
but infectious diseases are much less important relative to chronic and degenerative diseases,
which show few consistent differences between countries.

- Hence in all countries the typical diseases of old age are cancer, heart disease, stroke,
diabetes, arthritis and mental conditions.

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 5.3.6 Common Health Indicators and Measurement of Health

- World Health Organization (WHO) defines health as “a state of complete physical, mental
and social well-being and not simply the absence of disease or infirmity”

- Health statistics generally measure morbidity (Sickness) and mortality (Deaths)

- Health is different from other measures of human capital like education. Thus due to its
nature, a multidimensional approach is needed. In measuring health, there are measurement
error problems and systematic error problems that are related to the demand for health

- Generally, one of the measurements of health status is measured the self perceived level of
health. However, this measurement can suffer from perception bias. In collection information
on self-reported morbidity, illness and normal activity, information about the illness or
specific symptoms during a given period are sought. This may lead to recall problems.

- Sometimes individuals are asked whether any days of normal activity were lost due to ill
health in trying to get the self reported level of health.

- Information about self-reported physical function can also be sought. Activities of daily
living (ADL) are used to capture only physical health problems such as shortness of breath,
joint problems, or back problems. Thus, issues of nutrition and state of the mind are ignored.

- Another measurement is the nutrient based indicators such as calorie intake and
anthropometrics. Calorie availability is computed by converting food quantities into nutrient
intakes using standard composition tables. This method suffers from systematic bias. There is
problem of wastage and leakage.

- In relation to anthropometrics, adult stature can be used as an indicator of well-being. Height

is predetermined by adulthood and weight provides more current indicator of nutritional
status. Height and weight ratio is express in terms of Body Mass Index (BMI).

- The relationship between BMI and mortality (the so called Waaler Curve) is U-Shaped. The
method is not expensive and random error can be minimized by good field procedures.

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- Some common indicators of health includes: Crude death rate; Life expectancy; Infant
mortality; Under Five Mortality; Height and weight; Height for age and weight for age;
Anemia; Protein Calorie Malnutrition

5.3.7 Health Implications of Economic Development

- The associations between health and national development are complex. The interaction is a
two-way phenomenon with health being both influenced by and influencing economic
development.

- Improved health has been considered solely a result of economic growth, a part of the
product of growth rather than one of its causes.

- This is because economic development provides the extra resources for better nutrition,
better housing and sanitation, health services and technology. These lead to lower mortality
which triggers off demographic development.

- But this is a very simple causality effect. First, some of the relationships involved are
circular. For example, unless the demographic transition is completed many of the gains from
economic growth will be absorbed by a high rate of population increase.

- Economic development promotes better health, but better health, by reducing the burden of
sickness and uncertainty, facilitates economic development (although this has proved very
difficult to demonstrate). The relationship between economic, demographic and health
development is a complicated system of interacting variables.

- Second, in this system some of the arrows between variables point both ways. For example,
some nutritional differences between poor and rich countries make for better health; others, it
has been argued, lead to specific 'Western' diseases (such as cancer, heart disease).

5.3.7.1 Production and Health

- Economic development is usually accompanied by changes in patterns of production which

interact with the health of the population. These production changes include:

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 o a shift in the balance between manufacturing industry and agriculture

o agricultural production for cash sale rather than subsistence

o rising levels of energy use, associated with new, more capital-intensive

technologies.

- The most obvious examples of interaction are unfavourable to health, possibly because:

o capital-intensive production shifts the balance of power in favour of employers,

who exploit their position

o social controls break down and are not replaced by effective political controls
(planning, safety)

o workers are not trained to handle new technologies safely.

- Sometimes the damage to health is direct and concrete e.g. Bhopal in 1984 when a release of
fumes from a chemical factory killed 2000 people, Chernobyl in 1986 when a partial meltdown
of a nuclear reactor spread detectable radiation over most of Europe.

- In other cases the effect is more indirect (and disputable). For example, irrigation leads to
increased agricultural output but creates a suitable environment for the spread of waterborne
diseases such as schistosomiasis (as occurred with the Aswan High Dam); the use of insecticides
in agriculture encourages the emergence of resistant strains of malarial mosquito, making malaria
more difficult to control.

- Possible countermeasures at the national level include more careful impact assessment of new
investments, and greater social responsibility among, and control of, individual producers. The
cost of these countermeasures also has to be borne in mind.

- However, from the economist's point of view development is always potentially favourable to
health.

- It makes resources available that can be used for all the intersectoral actions which can contribute
to better health, and also to more and better health services.

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- Yet, for development in a particular case actually to be favourable to health it clearly must not
generate any of the dangerous side-effects discussed above.

- Two more general questions must also be asked:

o how is the income from production distributed among persons and groups?

o how is that income spent (by individuals or society)?

- Finally, it should be remembered that the health care industry is itself a form of production. It
changes in the same direction as the rest of the economy. That is, it becomes more productive but
also more capital- intensive with development, and can generate dangerous side-effects through
the ignorance of clients, indifference and exploitation by producers and the failure of effective
social control over its activities.

5.3.7.2 Distribution and Health

- The proceeds of economic development (resources for health services, other kinds of goods and
supplies favourable to health, income in general) are not necessarily equally distributed between
persons and groups.

- Strict equality (equal shares for all) is probably not possible for health services or in general;
what is sought is equity, fair shares for all obtained through the avoidance of inequalities which
are not necessary or socially acceptable.

- The goal of equity is supported on two grounds: as a matter of general social policy, or because it
is believed that equitable distribution produces better health results for a given input of resources.

- This belief is justified because health services, like many forms of production, are subject to
diminishing returns.

- That is, the more resources that are applied to a given population, the less the increase in output
(health) obtained from adding one more unit of input.

- It is conceivable that development may increase the available resources but may increase
inequality to such an extent that large groups of the population are worse off than before, so that
there is no improvement in overall health levels or other aspects of welfare.

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- Hence there is a debate between those who believe in the 'trickle down effect' (benefits from
development spread themselves naturally throughout the population) and those who believe that
special measures are needed to preserve equity during development.

- Through an examination of the main aspects of inequality in developing countries some general
relationships between development and equity can be seen. (It must be remembered that the
degree of equity always varies in pre-industrial countries, depending in particular on the amount
of free land available.)START HERE NEXT LESSON….21/6/2016

o Urbanization- in developing countries towns are usually richer and have better social
services and health indicators than rural areas. Development may increase the
differential because new industries, high- technology services and administration are
located in the towns. On the other hand, larger urban markets often mean high food
prices and thus increased farm incomes - an example of the 'trickle down effect'.
Development is also accompanied by a growing urban proportion of the population. On
balance, the effect of development may be to reduce urban-rural differences, but only
after a long period and with great variations between countries.

o Sex differentials - in many developing countries, women have less access to formal
employment, cash income and public services than men; these differentials are much
narrower in developed countries. Health indicators often show the results of women's
disadvantages, and in extreme cases women have a lower expectation of life than men
(although the opposite is true for most countries). These disadvantages may also
impede general health development - for example, the health of children is linked with
the level of education of women. As fertility is also linked with female education,
sexual inequality may impede demographic development as well. Finally, sexual
inequality tends to limit the supply of nurses and some other types of health workers.
The broad conclusion is that if development reduces sexual inequalities it is favourable
to health.

o Factor incomes - one way of looking at people's incomes is in terms of the kind of
factor of production that they control (i.e. land, labour or capital), the amount of the
factor that they have and its price (rents, wages, interest rates). In market economies,
and indirectly even in planned economies, the scarcer the factor, the higher its relative

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 price. Development involves changes in the balance between factors and so far as it
results from investment (i.e. an increasing stock of capital), the price of capital should
fall and income inequality be diminished. On the other hand, if a technological advance
is made which needs capital to put it into effect, it is the existing capitalists who are
best placed to take advantage of it, and so push up the rate of profit. Which tendency
prevails in the long run? The evidence is hard to evaluate, but two broad indicators
suggest that on the whole development evens out factor incomes: the share of the
national income going to labour is higher in developed countries, and real interest rates
(net of inflation) are lower.

- Overall, therefore, economic and social inequalities and hence health differentials (measured, for
example, by mortality rates) are probably less in developed than in developing countries.

5.3.7.3 Consumption and Health

a) Private consumption patterns

- Patterns of consumption tend to vary in a predictable way with income, whether differences are
considered between national averages or between income groups in the same country.

- A useful way of summarizing these income/consumption relationships is through the economic

concept of elasticity of demand.

- The income elasticity for a particular category of consumption, say food, can be defined roughly
as the percentage change in expenditure on that item associated with a 1% change in the
consumer's income.

- An income elasticity of more than 1 means an item of consumption takes an increasing share of
total expenditure as incomes increase (termed a 'luxury' good).

- Medical care typically has an income elasticity of more than 1 (say, 1.3), although measurement
is complicated by the role of the public sector in the provision of health care.

- A typical poor country will spend 2-3% of national income on health care (public and private),
whereas the richest countries spend up to 10%.

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- Such statistics raise the question of what share of national income a poor country should devote
to health care.

- World Health Organization (WHO) has suggested a minimum of 5%; but applying this in
practice raises further questions:

o if countries can hold down the price of health service inputs, they can get more health
care (in real terms) from a given expenditure. Attention recently has been given to
reducing the price of drugs (e.g. through essential drug policies), but the most important
input price to health care is the wages and salaries of professional and other health
workers. These vary widely between poor countries, being influenced not only by the
level of economic development but also by local demand and supply and by
competition in the international market

o if expenditure on health care is increased, what other kinds of consumption will be

reduced to make this possible, bearing in mind that many of these other categories
contribute to health?

- From a health perspective, levels and patterns of food consumption are obviously important.

- Food as a whole tends to have a rather low income elasticity (about 0.7), accounting for perhaps
75% of income in the poorest countries and 15% in the richest.

- With increasing incomes, there are shifts in the balance between categories of food; basic cereals
tend to have the lowest elasticity, while oils and fats and meat have high ones.

- Further, at higher incomes, food consumption includes an increasing element of refined and pre-
cooked foods.

- What is the significance of this for health? From one point of view, these trends are positive:
starting from a diet which is largely carbohydrate, it seems that with increasing incomes
consumers naturally move to one with a better balance in terms of proteins and vitamins. It has
been argued that nutritional improvement (in quantity and quality) explains much of the
improvement in health in industrial countries in the 18th and 19th centuries.

- On the other hand, it can be argued that the changes in diet that are favourable to health at low
levels of income may become harmful at higher levels.

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- Among the factors blamed for various health problems in rich countries are excessive fats, salt
and additives, and too little fibre.

- Further, it can be argued that considerations of prestige and imitation of foreign patterns
encourage the spread of 'rich country' dietary patterns to countries at quite low levels of income.
Hence the concept of 'Western' diseases.

b) Public consumption patterns

- All countries have a public sector - i.e. some services are provided by agencies of government,
central or local, rather than by private suppliers - and only the most extreme market economists
argue that public provision of some functions is unnecessary.

- Nevertheless the share of the public sector in the economy varies widely.

- Has this any connection with levels of development on the one hand and with health on the
other?

- It might appear that regardless of level of development, countries are free to make a political
choice between a 'socialist' pattern (in which all production, or at least the commanding heights,
is under public control), a 'market' pattern ( in which public production is minimal), or any
intermediate stage of 'mixed economy'.

- But the actual situation reflects two conflicting trends.

- On the one hand, poor countries which aim at economic development see great advantages in a
socialist approach – the possibility of coherent planning, equitable sharing of the results of
development and continuity of policy.

- On the other hand, it is more difficult in the poorest countries for government actually to control
the economy.

- Much of the economy may consist of small-scale agriculture and industry, which is always hard
to control; tax systems have to be kept simple; communication difficulties limit government
effectiveness and so on.

- Many of the poorest countries are nominally socialist, but typically only 15-20% of the national
income comes under government control, against 40% in even non-socialist developed countries.

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- Hence in many nominally socialist countries government does not in practice control all
production, but concentrates on industries crucial to the development plan, plus provision of
basic social services (e.g. India).

- Alternatively, or in addition, functions are pushed down to the local level for administration and
financing (e.g. China).

- This pattern of ownership applies to health services as much as other forms of consumption: in
most developing countries, a substantial share of health care is provided privately, or at a local
level. Is this bad?

- It is very hard to show statistically any consistent difference in health indicators between
countries with 'socialist' and 'private' systems of health care provision.

- Perhaps we need to distinguish between the many kinds of preventive and promotive work,
which are unlikely to be provided effectively on a private basis, and other services where the
difference in efficiency between public and private may not be great.

5.3.8 Major determinants of poor health

- The following are some of the main determinants of poor health which have direct or indirect
interdependence with Economic Development:

o Population growth: rapid population growth implies an increased need for medical and
other social services

o Malnutrition

o Sanitary conditions and inadequate shelter

o Education

- There remains a debate on the relation between health status improvements and economic
growth. It is argued that health status improvements are attained at the expense of fixed capital
entailing a smaller economic growth. That is, the investment funds that could have been used for
the growth of the economy at large are to be used for investments in the health service sector
which has in part a consumption character.

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- Some argue, however, that investment in basic needs, such as in the health service sector, are
investments in the health service sector which has in part a consumption character.

- Some argue, however, that investment in basic needs, such as in the health service sector, are
investments in human capital which in turn is growth promoting.

- Although some tend to conclude that there is a positive relationship between health and economic
development, this does not prove that improvement of the health service sector is a sufficient
condition for economic development.

- On the other hand, a better health status does not guarantee a faster economic growth.

5.4 Poverty and Health

- Poverty and Ill-health are intertwined.

- Poverty breeds ill-health (due to diet, education, transportation, etc).

- Ill health keeps poor people poor

Figure below shows a downward spiral that ends in death

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- Malnutrition is the single most important risk factor for disease. When poverty is added to the
picture, it produces a downward spiral that may end in death. At the personal level:

o Poor people may eat and absorb too little nutritious food, making them more disease-
prone.

o Inadequate or inappropriate food leads to stunted development and/or premature death.

o Nutrient-deficient diets provoke health problems; malnutrition increases susceptibility

to disease.

o Disease decreases people‟s ability to cultivate or purchase nutritious foods.

o The downward spiral of poverty and illness can end in death.

The tide of malnutrition can be changed

- This need not be so. Better nutrition is a prime entry point to ending the malnutrition problem.

- Better health means stronger immune systems which means less illnesses.

- Healthy people feel stronger, can work better and may have more earning opportunities to
gradually lift them out of both poverty and malnutrition.

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- Healthier, more productive societies are a potential outcome.

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5.5 SUMMARY

- Economic growth can be defined as an increase in a country‟s productive capacity,

identifiable by a sustained rise in real national income over a period of years.
- Economic development is economic growth plus improvement in social welfare.
- Measures of economic growth includes: GNP, per capita incomes and growth rates
- WHO defines Health as “a state of complete physical, mental and social well-being and
not simply the absence of disease or infirmity”
- Common indicators of health includes: Crude death rate; Life expectancy; Infant
mortality; Under Five Mortality; Height and weight; Height for age and weight for age;
Anemia; Protein Calorie Malnutrition

- The associations between health and national development are complex

- The main determinants of poor health which have direct or indirect interdependence
with Economic Development: Population growth; Malnutrition; Sanitary conditions and
inadequate shelter; Education.

5.6 ACTIVITIES

i. Economic development is a process, what are the necessary situations for a given
country to be considered that it is in this process?
ii. Outline the major determinants of poor health in a developing country.
iii. Improved health can be considered as a precondition for economic development –
how? Discuss.
iv. Economic development as a complex process is affected and manifested by factors
such as – what?
v. Show the policy implications of the WHO definition of health as a concept.
vi. Health and poverty are intertwined. Discuss.

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5.7 FURTHER READING

1. Folland, Goodman Stano, the Economic of Health and health Care, third edition, 2001.
2. Bowling, A. (1997) Measuring Health: A review of quality of life measurement scales,
second edition, Open University Press, Buckingham.
3. Mills,Anne and et.al. (1992), Health Economics for developing countries: A Survival
KitLondon.
4. CUMPER G (1984). Determinants of Health Levels in Developing Countries. Research
Studies Press Ltd.John Wiley & Sons Inc.

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 TOPIC SIX
HEALTH SYSTEM AND FINANCING

6.1 INTRODCUTION

This topic introduces the learner to the concepts of health systems, the importance and
rationale of health financing, definitions for health care financing and different mechanism of
financing health care.

6.2 TOPIC OBJECTIVES

At the end of this lecture you should be able to:

(i) Differentiate between health systems and health care systems
(ii) Identify the factors that influence the choice of a financing system
(iii) Explore the different sources of financing the health service sector
(iv) Understand the strong and weak points of different financing mechanisms.

6.3 Health Systems of Health care systems

In this sub-topic, we define health systems and health care systems and show which one
is more practical to use.

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6.3.1 Definition of the health system and Health care system
- The precise definition of what services and activities comprise of the health sector is
necessary to guide data collection and, especially, to make comparisons of health systems
across countries or at different times. The following pairs of items show the difficulty of
drawing a line between aspects of the health sector/non-health sector. Which should be
included within the definition of the health sector?

o Heath services Environmental services (e.g. water, sanitation, Environmental

pollution control, occupation safety etc.)

o Hospitals, social welfare institutions

o Education and training, pure medical research

o Medical social work; social work

o Formally trained medical practitioners; traditional medical practitioners

- In practice, the boundaries of the health sector vary considerably between countries and
different definitions have been developed for different purposes.

- In developing countries, the definition tends to be broader than in developed countries due to
greater deficiencies in certain areas (e.g. environmental health) and extensive use of the
traditional health sector.

- A useful rule of thumb is to include all finance/ expenditure whose primary intention
(regardless of effect) is to improve health.

- Thus health systems include all the activities whose primary purpose is to promote, restore or
maintain health.
- Formal health services including the professional delivery of personal medical attention are
clearly within these boundaries, tradition healers and all use of medication, whether
prescribed by a provider or not, home care (self treatment).
- Public health activities as health promotion and disease prevention, and other health
enhancing activities like road and environmental safety improvement are also part of the
system.

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- This way of defining a system does not imply any particular degree of integration, nor that
anyone is in overall charge of the activities that compose it.
- In this sense every country has a health system, no matter how fragmented it may be among
different organizations or however unsystematic it may seem to operate.
- Integration and oversight do not determine a system but they may greatly influence how well
it performs.
6.3.2 Goals of health systems
- Improving the health of the population they serve
- Responding to peoples‟ expectations
- Providing financial protection against the costs of ill-health.
These objectives are not always met, resulting to public dissatisfaction with the way services
are run or financed, with account of errors, delays, rudeness etc.
6.3.3 Health care systems
- All the information available about health systems refer only to the provision of, and
investment in health services:

That is the health „care‟ system including preventive, curative and palliative interventions
whether directed to individuals or to populations.
- Thus our focus will be on the health care system and not health system.
6.3.4 Economic objectives of health care/ health care systems
- Health care systems have two key objectives:
1) Efficiency: Given the limited resources available for health in developing countries,
it is essential to raise and use resources as efficiently as possible.
This include:-
a. Allocative efficiency
b. Exchange efficiency
c. Technical efficiency
2) Equity:
- Most governments explicitly identify equity as a policy objective - and, in particular, as one
of the objectives of their health care system. While the precise definition of equity that is
adopted is often not clear it generally reflects a concern to distribute health care fairly, in

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 recognition of differences in health need. The question "who gains?" must, therefore, be
asked in assessing the equity impact of health systems. Equity include:-

a. Horizontal equity-only those who benefit from/use health care (i.e. the sick or
potentially sick) should pay for it
b. Vertical equity-that the distribution of the burden of paying for health care
should reflect differences in ability to pay

6.3.5 Key concepts used in Health care financing

o Financial protection- Ensuring that no household is impoverished because of a need to
use health services. This implies that by using health care services, no one should be
made worse off but remains on the same financial status.
o Universal coverage- A health system that provides all citizens with adequate health care
at an affordable cost.
o Equitable financing -Contribution according to ability-to-pay and benefit according to
need (capacity to benefit). Here, three systems can be adopted. Either:
 Progressive system:- Implies that the rich pay more than the poor
 Regressive system:- Poor tend to pay more than the rich in proportion
 Proportionate system:- Everybody pays the same proportion
o Cross-subsidies- In this case, we can have two types of cross-subsidies
 Income cross- subsidies (in this case, money is taken from the rich to
subsidize the poor)
 Risk cross-subsidies (in this case, money is taken from the healthy
population to cater for the ill population)
6.3.6 Definitions of financing:
- Raising revenue to pay for a good or services.

- Function of a health system concerned with the mobilization, accumulation and allocation of
money to cover the health needs of the people, individually and collectively, in the health
systems.

- The whole processes of health care finance involves:

o where the money came from

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 o How it was:

 collected

 Pooled

 Redistributed to the third party payers

 Finally used to pay the providers for their services

- The purpose of health financing is to make funding available and to set right financial
incentives to providers, to ensure that all individuals have access to effective health care.

- Thus health system financing has got THREE interrelated functions to ensure individual
have access to health services:

o Revenue collection
o Pooling resources
o Purchasing
- These are summarized in what is called Kutzin framework.

6.3.6.1 Revenue collection

- This is the process by which health systems receive money from households, organizations,
donors etc.
- There are various ways of collecting revenue. They include:
o General taxation, health insurance (mandatory & voluntary), out-of-pocket (OOP).
o Balance between external and domestic sources
o Balance between companies and organizations
- Contribution mechanisms:
o General taxes:
 Direct taxes
 Indirect taxes
o Health insurance
 Private voluntary health insurance

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  Mandatory health insurance

6.3.6.2 Pooling of resources

- It refers to the accumulation and management of revenues in such a way to ensure risk of
having to pay is borne by all members of the pool and not by each contributor individually.
- Main purpose is to share the financial risk associated with health interventions for which
need is uncertain.
- This is because it is difficult to predict risk of an individual falling ill, but easier for a larger
group (pooling or spreading risk)
- Some key issues related to pooling include:

o Coverage and composition of risk pool: size of the population and socio-economic
status of groups covered, demographic, illness conditions etc…
o Mechanisms of allocating resources from pooling to purchasing organizations
o Out-of-pocket and medical savings accounts allow to pooling (outside households)
o Single universal pre-payment funding mechanism maximizes risk pool.
o Fragmented pools (e.g. Community Based Health Insurance (CBHI)).
o Sustainability and equity problems (ill tends to join these schemes more than
healthy???)
6.3.6.2 Purchasing
- This is the process by which pooled funds are paid to providers in order to deliver a specified
or unspecified set of health interventions.
- Choice of benefit package: Some issues are considered in choosing benefit package. These
includes:
o Which services (inpatient, outpatient, comprehensive)
o Type of service provider: public, NGO, private-for-profit
o Route for accessing services: referral routes, Primary health care (PHC),
gatekeepers
o Affordability and sustainability
6.4 How to choose a financing system
- Choices of financing can have impact on how fairly burden of payment is distributed e.g. can
the rich and healthy subsidize the poor and the sick?

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- The success of countries in carrying out the three main functions has important implications
for:
o Funds available (now and in the future)
o Equity (fairness) of revenue collection mechanism
o Economic efficiency (both technical and allocative)
o Levels of pooling and prepayment (and implications for risk and equity
subsidization)
o Numbers and types of services consumed and purchased
o Financial and physical access to services.
6.5 Factors influencing health care Financing
- The form and level of health care financing are now major policy issues for most developing
countries and it is essential that decision makers have a clear understanding of the
implication of alternative approaches to financing health care.
- There is an increasing interest in how health services are funded, both in industrialized and
developing countries.
- The following factors, among others, influence the health services sector and should be given
due attention in health care financing.

a) Demographic changes

- These have major effects on health care provision; firstly demographic change may lead to
variations in the health coverage of the population. Rapid population growth rates can cause
tremendous strains on the provision of social services including health care.
- Secondly, the age structure of the population has an important significance to the provision
of health care. There are higher health service unit costs associated with the young and the
old. The antenatal, obstetric and under five age groups are all relatively heavy users of health
care, as are the elderly with their higher incidence rate of chronic illness.
- Third, demographic factor relates to the relationship between economic producers and
dependants of a country. High dependent ratio means an increased burden on the productive
population for providing health care.
b) Economic recession

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- This can be expressed by low or even negative growth rates, increasing debt burdens and
high inflation rates.
- This has severe implications for the ability of governments to maintain, let alone expand,
expenditure on health care.
- Such effects on the supply of health care are exacerbated by the increased need for health
care brought about by the recession itself through the links between poverty and ill health.

c) Rising expectation
- Expectation of health care consumers specially, the middle classes, to receive high-
technology medical care similar to that available in the industrialized world.

d) Concerns about equity

- Governments committed to the principles of primary health care have a major responsibility
to improve levels and depths of coverage.
- The concerns for equity may influence the choice and system of financing health care.
- To extend and improve basic health care at a time when there is such strong middle class
pressure may only be available by providing substantial additional resources to the health
sector.
e) Disease-pattern changes
- Disease-pattern change may result due to changes in average income levels or due to changes
in social development.
- Thus, as standards of living rise and morbidity patterns change, these changes are likely to
have an effect on health care financing.
- In addition to shifts in disease patterns, the advances of medical technology have led to the
possibility of treatment for health problems previously accepted as untreatable. This again
places further pressures on health-care providers.

f) Efficiency
- Given the limited resources available for health in developing countries, it is essential to taste
and use resources as efficiently as possible.
g) Displacement effects

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- Rather than generating additional resources for the health sector, new or expanded financing
mechanisms may merely displace funding from other sources.
- Displacement is not necessarily an undesirable consequence if the new or expanded source of
finance is more efficient or more equitable than the one it partially displaces.
- Examples of displacement effects include foreign assistance which may displace government
support for health care; counter-funding often a precondition for foreign assistance, which
may divert funds away from existing priority projects; health insurance schemes, which may
in some instances displace earth than additional to the total of resources being allocated to
health care (e.g. displacing direct payments); charitable contributions which may be
withdrawn when other sources are developed; and government allocations which may be
reduced when other sources of finance (such as user fees) are developed.
h) Wider effects of the health sector
- Health sectors may account for a sizeable share of national resources and are often major
employers.
- Consequently, the activities of the health sector may have spill-over effects on the economy
as a whole.
- These include external effects on costs (e.g. inflation through the repercussions of high
increases in stag pay); foreign exchange problems through heavy foreign borrowing for
development projects or for development project or for payments for imports such as
pharmaceutical or equipment opportunity costs such as the attraction of scarce manpower
into the health sector at the expense of other professions, and disincentives to investment and
employment (e.g. as a result of financing health services through high taxes on certain
economic activities, enterprises or sectors).
- These external effects may also be positive as in the case or improved productivity resulting
from reduced death and disability in the work force.

6.6 Criteria for choosing a Financing system

- In selecting a system of financing health care some criteria should be used. The first three
criteria outlined below are general, while the last two have particular importance within the
context of primary health care:
a) Viability and ease of using the system

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- This implies bureaucratic and cost simplicity, social acceptability and technical feasibility
- The system should be made to work e.g. user fees failed due to practical application of
waivers and exemption procedures- otherwise it can work but it is very complex.

b) Revenue generating ability

- Ability to actually generate funds. This should be assessed in terms of net revenue-earning-
ability. i.e the difference between total revenue generated and costs of administering the
system.
- The administration of user-charges for example, may include the costs of billing, accounting
and the safe storage and collection of funds. Even where additional staff is not employed and
existing staff are used, it implies an opportunity cost to the health service in terms of
alternative activities which the staff could have been engaged in had they not been involved
in the revenue generating scheme.
c) Effects on service – provision
- Systems of financing, for example which involve three parties– the patient the provider and
an insurance company – may lead to over-provision of certain services

d) Effects on equity
- That is equal access to care for those in equal need.
e) Participation in decision-making
- This is a concept that stresses community participation which creates an opportunity for a
direct relationship between the consumer and the provider; an example of a financing system
suitable of such participation is user charges.
- Stakeholders should be happy with the system. (think of the Kenyan Social Health Insurance
which was been pushed for implementation but failed due to resistance from various
stakeholders).

6.7 Criteria of choosing health care financing

a) Effects on health care supply:
- Effects in terms of effectiveness and efficiency. Some systems may have (dis)incentives on
pattern of service provision, making it less cost effective e.g. system of financing which

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 involve 3 parties, government, patient, and insurance may lead to over provision of services,
which may not be the most appropriate response to health a problem.
b) Demand side effects including equity:
- Impact on health seeking behaviour/ access to services. If the financing mechanism is going
to have negative effects, then it is not good. For instance user fees can promote inequities.
c) Participating in decision making:
- The concern here is who is involved in decision making? And who is accountable to service
users?
d) Sustainability:
- Long-term stability and potential for generating revenue
o If revenue generated is subject to frequent fluctuations, it cannot be regarded as
reliable
o Ability of financing mechanism to maintain its level of funding in the long-term and
expand its level of funding over time as the need for health care grows.
What kind of financing system is appropriate for a country?
Countries have different systems depending on:
- Historical reasons- history plays important role in financing, financing systems are not
easily changed.
- Economic basis-High Income Countries (HIC) may be more likely to have developed
systems like Social Health Insurance (SHI) which are difficult to implement in Low Income
Countries (LIC).
- Ideology- different ideologies may be attuned to different financing mechanisms e.g. neo-
liberal ideologies are likely to favor individual systems such as out-of-pocket.
- International pressures: World Bank and IMF may advocate for particular financing
systems (e.g. user fees & Community Based Health Insurance or Social Health Insurance)
6.8 Sources of National Health care Financing systems
- Health care Financing is a broad term used to define alternative arrangements for paying,
allocating, organizing and managing health resources.
- It includes:
o Defining a level/ quality of care preferably a minimum basic health services
packages to be provided, in an accessible and equitable manner.

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 o Identifying different modalities of financing to establish a financially sustainable
system.
o Institute different mechanisms for mobilizing funds and rationalizing the use of
available resources including cost and risk –sharing mechanisms/ insurances plans.
Strategies
- The financing mechanisms envisaged are grouped into broad and complementary strategies.
- It includes improving government health sectors efficiency, generating additional and new
sources of revenue, encouraging private and non-governmental organizations participations,
development of social and private health insurance, promotion of community participation,
encouraging bilateral and multilateral agencies participation, and organizational mechanisms
for implementation of the health care and financing strategies.
- National Health care financing systems has Plurastic nature in funding: therefore, it has
different sources of health care funding:
1) Public sources:
o Direct government budgeting
o National health services and public services health systems
o Social health insurances sponsored or mandated by the government
o Community financing
2) Private sources
o Direct payment by households
o Private voluntary health insurance
o Employers based health insurances
o Payments by community and other local organizations
3) External financing
o Foreign aid or
o development loans

6.8.1 Government financing

6.8.1.1 Public and quasi public sources of finance
a) General tax revenues

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- General tax revenue is used in almost every country of the world to finance certain
components of health care and, in developing countries; it is often the most important source
of financing.
- The taxes can either be direct or indirect
- However, low tax ratios (the proportion of national income collected as tax) in these
countries mean that it is often insufficient by itself to support health care.
- Although tax ratios tend to increase in line with development, this depends in larger part on a
country‟s political will to increase the tax burden.
- In developing countries general tax revenue is composed largely of duties on imports and
exports and sales taxes. Taxes on business transactions, profits and incomes are all of lesser
importance.
- General tax revenue is currently not the most reliable source of finance for the health sector
in developing countries.
- This results from factors such as:
o the low political priority frequently given to the health sector in national budget
decisions;
o the instability of government finance in countries heavily dependent upon taxes on
imports and exports;
o the frequent use of public expenditure as a tool of macro-economic policy; and
o frequent disparities between budgeted funds and their actual availability or
disbursement. The net yield is usually high unless bureaucratic overheads are high.

- The equity impact of tax systems is dependent on both the proportional burden of taxation
and on the use which is made of the revenue raised.
- Tax systems can be progressive, falling more heavily on the rich than the poor and, therefore,
equitable; but they may also be regressive falling more heavily on the poor than the rich, and
inequitable.
- Developing countries are assumed to have regressive financing systems because they tend to
rely on indirect taxation.

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- But in practice their tax systems may be progressive because the poorest sections of society
fall outside the formal economy and indirect taxes may be levied primarily on luxury items
consumed predominantly by the wealthier population groups.
- Available evidence on the burden of taxation is in-adequate to permit firm conclusions about
its incidence to be drawn. However, it is clear that tax revenue is often used inequitably in
health systems: health systems are dominated by high-technology urban- based care and so
the rural populations (and the urban poor) have in-adequate access to any form of care.
- There is a limit to what can be collected in tax revenue and how much can be allocated to the
health sector without conflict with wider primary health care objectives.
- Taxes that make the poor poorer could seriously damage their health status and undermine
their productivity; there are also many other fields of socioeconomic development that
compete with the health sector for funds and yet give substantial support to primary health
care (e.g. agriculture).
b) Deficit financing
- General tax revenue may be supplemented by deficit financing- that is the decision to borrow
and spend funds in the present and repay them over some period of time.
- Deficit finance may be raised nationally or internationally, through mechanisms such as the
issuing of bonds or certificates or long-term low-interest loans.
- The cost of enjoying the use of these funds in the present rather than the future is the interest
that needs to be paid on the loan.
- In developing countries high inflation rates (affecting the real rate of interest on loans) and
lack of confidence in the government's abilities to honour eventual redemption of the bond
may make it difficult to use deficit financing as a source of support for health systems.
- When it is used, deficit financing is typically for specific construction projects (e.g. hospitals
and water and sewerage systems).
- Unless such projects sell their services or contribute directly to increased output that can be
taxed to service the debt, the deficit must be repaid from general tax revenue.
- Thus the agency doing the deficit financing must be endowed with the authority to impose
additional taxes or fees, or be given a claim on general tax revenue in order to service the
debt.

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- Deficit finance may also be raised from abroad in the form of bilateral or multilateral aid
loans, typically given for a project life of between three and five years, and thereby
constituting only a short-term source of support.
- Although useful for many developing countries in helping to develop and expand health care
infrastructure, foreign aid is often limited to supporting import components.
- Past reliance on deficit financing in the economy as a whole is now burdening many
countries with excessive debt repayment problems.

c) Earmarked taxes
- Most tax revenues are paid into a national pool and then shared out between different areas of
government expenditure. Some governments, however, may 'earmark' a particular tax for a
particular purpose. For example, taxes on the sale of particular products may be earmarked
for health services at either national or local level. The problem with such taxes is that they
are often difficult to administer, may be politically unpopular, and are also often unpopular
with tax administrators because they limit their freedom of action. They can be regressive if,
as is of-ten the case, taxes are levied on items such as beer, cigarettes, recreational events, or
foodstuffs; but they can be progressive if they are imposed on luxury products purchased
primarily by the more affluent sections of society.
- A clear advantage of this source of finance is that a tax is visibly assigned to priority funding
of certain activities or programmes. Although not a major source of health sector finance in
most countries, they may constitute an important source of finance for specific projects or
programmes.

d) Social insurance
- Social insurance can finance health care, as well as other needs such as invalidity and old age
support, for either the whole population or a part of it.
- It is conventionally financed by imposing mandatory insurance payments on employed
workers as a percentage of their wages, and by imposing a similar or somewhat higher
payroll tax on their employers.
- Governments may in some instances also contribute to the schemes.
- Beneficiaries (workers and their dependents) may have to pay a user fee (termed copayment)
in addition to their wage deduction.

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- In order to include those workers outside the modern employment sector insurance payments
may also be calculated on measures of income or wealth other than wages, such as the value
of crops produced.
- Allowance will then have to be made for the fact that cash income is only available
seasonally, when crops are sold.
- In their capacity as employers, governments may either run their own social insurance
scheme or contract such schemes to private insurance companies.
- The total financial contribution to social insurance schemes is (in theory) determined
actuarially on the basis of the incidence of illness, the conditions of eligibility for benefit, and
the value of those benefits.
- Individual contributions are not determined, however, on the basis of expected risks or
claims, but in some proportion to income. As risks are pooled, there is an unequal benefit
distribution in favour of high-risk (high-need) workers.
- The main problems of social insurance are related to issues of equity.
- It is easiest to cover those in regular employment, who may be as little as 5 to 15% of the
population in developing countries; and there are often marked inequalities in the quantity
and quality of services available to those covered by insurance relative to those who are not.
- Overall, it is argued that social insurance reinforces the mal-distribution of resources between
rural and urban areas in developing countries.
- It provides extra funds for largely urban, employed workers and leaves the large rural
populations and the informally employed urban population even further handicapped than
before its introduction.
- Critics of social insurance also argue that it undermines both public and private health care
by competing with these sectors for limited supplies of real medical resources (e.g.
personnel).
- Finally, it tends to promote or reinforce high-cost, hospital-based, doctor-centred, curative
health care.
- More positively, social insurance can be the means of channelling extra funds into organized
health services.
- By relieving the pressure on ministries of health to devote resources to urban health services,
it may even, indirectly, make more resources available to those in rural areas.

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- Governments have in many instances an increasingly favourable attitude to the development
of social insurance.

e) Lotteries and betting

- These may be used as sources of earmarked income for health and social services in
developing countries.
- Often administered by quasi-public bodies under national or local government regulation,
these typically non-profit schemes rarely constitute an important component of overall health
sector finance.
- Largely supported by the incomes of the poor and thereby constituting a form of regressive
taxation, they typically have low net yields because of the payment of prizes and high
administrative costs.
- The typical net yield from lotteries is between 10-30% of gross receipts.

6.8.1.2 Private Sources of Finance

- Private financing for health care can be direct or indirect:
a) Direct payment:
- This is personal payments made directly to a wide range of providers, including private
practitioners, traditional healers and private pharmacists.
- User fees, whether for government-provided or for privately provided health services, are an
out-of-pocket payment and are therefore considered here as health finance from a private
source.
- Similarly, charges to contributions or prepayments by members of community financing
schemes are also considered as coming from private (non-government) sources.
b) Indirect payment:
- This is payments for health care services by employers (e.g. payment by large and privately
owned industrial complexes in developing countries or sharing of health care costs by
employers in industrialized countries) and health financing by other non-government bodies
such as local charity fund-raising for health causes.

6.8.2 Health Insurance

6.8.2.1 Private Health Insurance

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- Private health insurance differs from social insurance in two main ways.
- First, private health insurance typically does not include pensions for invalidity or old age.
- Second, the price (or‟ premium‟) charged for private health insurance is not based on the
pooled risks of a large population, but on personal risk characteristics and the likelihood of
illness in the individual or group covered.
- As a result, premiums are likely to vary for different individuals or groups.
- Schemes may be profit or non-profit making and may be organized for individuals or groups,
the letter often benefiting from lower premiums (resulting from lower per capita
administration costs as well as a degree of risk-sharing).
- In many countries the larger employers act as an organizing body for health insurance, and
may pay part of the premium as a fringe benefit.
- However, in order to control the level of utilization of services, individuals are often required
to pay for part of the cost of medical care on a direct fee-for-service basis.
- In countries where demand is sufficiently high, commercial insurance companies may be
active.
- Private insurance is not subject to the political allocation process and may channel extra
funds into the health sector.
- However, it suffers from problems of two coverages because of its cost and the exclusion of
bad risks, or enhancing inequity and promoting the growth of high-technology health care,
inappropriate to developing countries.

6.8.2.2 Employer-Financed schemes

- In some instances employers may directly finance health care for their employees.
- They may, for instance, pay for private sector health services, employ medical personnel
directly, or provide necessary facilities and equipment.
- Oil companies, mining and mineral industries, and large-scale export-centered agricultural
enterprises usually provide for the health needs of their workforce.
- Benefits are seldom extended to families as employers are primarily concerned with
maintaining the productivity of the work force.
- In developed countries the primary focus is on accident prevention and occupational health,
and in developing countries also, employers may have a legal obligation to provide first aid

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 or occupational health services (e.g. sugar and coffee plantations in Latin America, tea and
rubber estates in Asia and Cocoa farms and mines in Africa).
- Problems with employer-financed schemes relate to the quality of care provided, the possible
fragmentation of services, difficulties enforcing employer liabilities, and the fact that
viability depends upon the performance of the employing agency.
- Nowhere is employer finance a predominant source of support for health, although employer
schemes are often a precursor to national social insurance schemes.
6.8.2.3 Charity and voluntary contributions
- It can take the form of financial support or in-kind donations (e.g. personal services, physical
facilities, equipment and supplies), and may originate from business enterprises, wealthy
families, religious organizations or private individuals.
- Often these resources are channeled through foundations or religious bodies.
- The problems with this source of finance are often indirect. For example, donors may have
different priorities from the recipient nation and may not recognize their most urgent health
needs.
- Donors may prefer to finance visible evidence of their support such as physical facilities and
equipment, and thereby commit the recipient country or organization to the recurrent costs of
those facilities in the future.
- Charitable contributions may also take the place of, or reduce, other sources of finance. For
example, contributions may be eligible for tax relief, reducing general tax revenues for use
elsewhere (although the effects in this instance are likely to be minor).
- Charitable contributions have played an important role in health service provision in the past,
and in some African countries are still major sources of health care finance, channelled
through religious agencies.
- The general trend, however, is for governments to support or take over mission health
services.
- Thus the role of charitable and voluntary contributions is decreasing, although it may still be
important in times of emergency or disaster and can be a useful supplement to other forms of
health finance.
6.8.2.4 Community financing and self-help

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- Current primary health care initiatives in developing countries stress the importance of
national self-reliance and community participation in health care delivery.
- By mobilizing under-utilized national and local resources (e.g. organisational skills,
manpower and cash) and by developing affordable and culturally appropriate delivery
systems, it is hoped that basic health care will become universally accessible.
- Consequently some governments and many non-governmental agencies are turning to
communities for organization, participation and financial support, and communal self-help is
increasingly thought of as an important source of financial support for health services in
developing countries.
- The challenge is to develop new types of local institution that can coordinate and
systematically utilize the community resources.
- Self-help can take many forms such as labour, local insurance, support for volunteer health
workers, and drug cooperatives.
- Opponents of community financing mechanisms argue that it puts the burden of financing on
those least able to afford it (often the poorer rural communities).
- It is also seen as a diversion for governments lacking the political will to generate new
sources of revenue, or to reallocate existing ones.
- Although in some instances it can make a substantial contribution, community finance is
unlikely to generate sufficient resources by itself to meet country health needs, and should be
seen as complementary to, rather than as a substitute for, other sources of finance.

6.8.2.5 Direct household expenditure

- Household income is ultimately the source of most health care finance, but direct expenditure
constitutes a specific category of financing that should be considered separately. Included in
this category are any payments a consumer may make directly to health care providers such
as fees for services, or prices paid for goods and supplies.
- Direct household expenditure is not independent of other sources of finance.
- Government services may charge user fees (often nominal) for certain services.
- Even with insurance coverage, there is often a requirement for some degree of copayment,
which tends to increase the amount that would otherwise have been spent on health.

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- Health insurance benefits, moreover, may have an upper ceiling, with households required to
pay directly for their health care requirements in excess of this level.
- Until recently, comparatively little was known about the extent or the characteristics of direct
household expenditure on health care, but a range of recent studies have shown that this form
of financing is far more common and considerably more important than was hitherto thought.
- The extent to which these payments represent a real ability and willingness to pay for health
care is, however, unclear.
- Willingness to pay does not necessarily reflect ability to pay.
- Current levels of household expenditure partly result from the existing pattern of government
health care provision, and the limited access to free/cheap government health care
(particularly in rural areas).
- People may use and buy non-government (e.g. mission, private, traditional) health care partly
because they have no cheap or good quality government alternative.
- Low- income groups tend to delay use of health services until illness is severe, presumably in
part to avoid payment, but such delay generally only increases the necessary expenditure.
- High health care bills may sufficiently undermine their economic position to push them
further into poverty.
- Health care payments also sometimes displace expenditure for other basic necessities of life
(e.g. food), because there is only limited ability to pay for the range of household needs.
- Utilization of, and payment for, health services is, moreover, likely to depend heavily on the
perception of their relevance to a specific health need and the extent to which they provide a
service that people value.
- Use of traditional healers, for example, may reflect a belief in the relevance of their
treatments for certain diseases rather than a general willingness to pay for any type of health
care.
- Perceptions of poor quality in government services certainly undermine their use and,
therefore, willingness to pay for them.
- Private services may be more oriented to the preferences and circumstances of households,
for in-stance providing for payment in kind or payment related to ability to pay.

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- Raising the level of direct household expenditure for health care, for example by user fees,
will clearly have a negative impact on equity (by influencing both the distribution of the
payment burden and the benefits gained).
- It may be mitigated by the introduction of an exemption mechanism for the poor, although
such a mechanism may itself reduce the demand for health care made by low-income groups
because they may not wish to be identified as 'poor'.
- Moreover, such willingness to pay as exists is attached primarily to curative services, and so
can only ex-tend the provision of preventive care if it is possible to re-allocate resources
within the health sector.
- Finally, the potential yield from user fees is unclear. It is dependent on the level and type of
fees, the bureaucratic structure required to implement them, the existence of ex-emption
mechanisms, the impact of fee systems on the demand for care and the rates of collection.
- The administrative difficulties of implementing a fee system (e.g. how is ability to pay
assessed? who assesses it? who collects the fees? how is abuse of the system restricted?) may
cause less revenue to be collected than theoretically is possible.
6.9 SUMMARY

- Health systems includes all the activities whose primary purpose is to promote, restore
or maintain health
- Health system is very wide and so only health care system can be handled adequately.
- Economic objectives of Health care/health care systems are: Efficiency and Equity
- Economic efficiency dictates that resources are allocated and used in a manner which
obtains the best outcome at the least cost.
- Two central features of economic efficiency are allocative efficiency (doing the right
thing) and technical or operational efficiency (doing the thing right).
- Equity in health sector by definition means fairness. This can be considered in terms of
horizontal or vertical equity.

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6.10 ACTIVITIES

1. Write down the factors that influence the choice of a financing system.
2. Describe the different systems of financing the health service sector.
3. Show how demographic conditions can affect the choice of health care financing systems.
4. Outline the problems of health insurance as a system of health care financing.
5. What are the drawbacks of private financing?
6. Discuss the weaknesses of government financing.
7. Are communities financing schemes applicable to Kenya? Explain.

6.11 FURTHER READING

1. Black, D.(1980) Inequalities in health: report of a research working group. Department

of health and social security and social security, London.
2. Cullis, J,G, and West P.A. (1979). The economics of health Martin Robertson, London
3. DUNLOP D W (1983). Health Care Financing: Recent Experience in Africa. Social
Science and Medicine vol 17 no 24 pp 2017-2025
4. Blanpain, J. (1978) National Health insurance and health resources. Harvard university
press.
5. HOARE G and MILLS A (1986). Paying for the Health Sector. EPC publication No. 12,
London School of Hygiene and Tropical Medicine
6. WORLD BANK (1987). Financing Health Services in Developing Countries: An
Agenda for Reform. World Bank, Washington
7. ZSCHOCK D K (1979). Health Care Financing in Developing Countries. APHA
Monograph No 1

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 TOPIC SEVEN
ECONOMIC EVALUATION OF HEALTH INTERVENTIONS

7.1 INTRODUCTION

The topic introduces to the student the cost concept and how they concept is used in
economic evaluation of healthcare programmes. Governments provide many goods and
services to public. In Kenya the government is the main player in the provision of health care
services and evaluation of alternative programmes/interventions need to be evaluated. Such
projects involve expenditures of large amount of money provided. The study of economic
evaluation equips students with necessary skills used in evaluating different
programmes/interventions and how effective they are in relation to their benefits and costs.

7.2 TOPIC OBJECTIVE

At the end of this lecture you should be able to:

(i) Understand the meaning and basis of cost as a concept
(ii) Be aware of the possibility of using cost concepts to undertake economic evaluation
(iii) Be introduced to the possibilities of using cost benefit analysis and cost effectiveness
analysis in assessing the performance of health care activities
(iv) To explain the effects of scope and viewpoint of an economic evaluation.
(vi) To describe direct, indirect and intangible costs
(vii)To outline the methods needed for costing in an economic evaluation and to give
examples of costing methods and cost data types.

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7.3 Definition of Cost

- Economists define a cost as the value of resources used to produce a good or services.
However, the way these resources are measured can differ. There are two main alternatives
with respect to measurement of these resources: financial and economic costing.
- Financial cost represents actual expenditure on goods and services purchased. Costs are thus
described in terms of how much money has been paid for the resources used in the project or
services. In order to ascertain the financial costs of a project, we need to know the price and
quantity of all the resources used or, alternatively, the level of expenditure on these goods
and services.
- Economists conceptualize costs in broader way. They define costs in terms of the alternative
uses that have been forgone by using resources in a particular way. These economic or
opportunity costs recognize the cost of using resources as these resources are then
unavailable for productive use elsewhere.
- The basic ideas are that is that things have a value that might not be fully captured in their
prices. It is not difficult in many health programmes to identify resources inputs for which
little or no money is paid: volunteers working without payment; health messages broadcasts
without charge; vaccines or other suppliers donated or provided at large discount by
organizations or individuals. Thus, the values of these resources to society, regardless of who
pays for them, are measured by opportunity cost.
- Economic cost then include the estimated value of goods or services for which there were no
financial transaction or when the price of a specific good did not reflect the cost of using it
productivity elsewhere. The main ways that financial and economic costs differ is in the way
they treat:
o Donated goods and services
o Others inputs whose prices and incorrect or distorted.
o Valuation of capital items.

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- The theory and the concept of cost arise from the fact that economic resources are scarce by
nature. Had it not been for the scarcity of resources, the concept and theory of cost may not
exist as such.
o Scarcity has two sides:
 The infinite nature of human wants
 The finite or limited nature of resources available to produce goods and
services.
7.4 Types of costs
“What is a cynic? A man who knows the price of everything and the value of nothing‟ (Oscar
Wilde)
- Costs can be defined in many ways, but generally can be considered as direct, indirect and
intangible.
o Direct costs are those immediately associated with an intervention such as staff
time, consumables etc.
o Indirect costs might include a patient‟s work loss due to treatment.
o Intangible costs may be things like pain, anxiety, quality etc.
- Benefits, however, can be analyzed in three different ways reflecting the different types of
economic analysis used in evaluation.
o First, benefits can be examined in terms of the immediate (direct) effects on health.
These are usually clinically defined units appropriate to the area of study, such as
„lives saved‟, „reduction in tumor size‟, „change in blood pressure‟ etc.
o Second, benefits from an intervention can be considered in more generic terms such
as the impact on general well-being/ happiness/ satisfaction, these are more
generally labeled as „utilities‟. The utility of an intervention to an individual is its
benefit. Measures such as the Quality Adjusted Life Year (QALY) are used to
quantify this.
o Third, benefits might be considered in the same terms as costs, which means that
benefits must be valued in monetary terms by some means.

- Whatever kind of economic evaluation may be applied, the costs must be assessed.

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 o These are divided into costs borne by the ministry of health (like drug and
equipment),
o By patients and their relatives (like transport and food) and
o By the rest of society (like health education).
- Next the costs have to be valued in monetary terms;
o Direct costs, like wages, pose little problem,
o But indirect costs (like time spent in hospital) have to have values imputed to them.
o Costs must also be further subdivided in to average, marginal and joint costs, which
help decisions on how much of a service, should be provided.
o Capital costs (investment in plant, buildings, and machinery) are also important to
need due consideration, as discounting and inflation.

7.4.1 Which costs should be included?

- If the evaluation is being made from the widest perspective the viewpoint of society as a
whole-then three main categories of costs must be considered:
o Health service costs
o Costs borne by patients and their families
o External costs borne by the rest of society
1. Health Service Costs
- These will include staff time, medical supplies (including drugs), bed and food services in the
case of inpatients, use of capital equipment, and overheads such as water, heating and
lighting.
- These items may be divided into variable costs, which vary according to the level of activity
(for example, staff time) and fixed costs, which are, incurred whatever the level of activity
(for example, heating and lighting).
- In the long run, practically all costs become variable since those that are fixed in the short run
may be varied-for example, by opening and closing wards, and by building new hospitals.

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- In economic evaluation all such health service costs-both fixed and variable-are referred to as
direct costs.
2. Costs Borne By Patients and Their Families
- These will include out of pocket expenses such as travel, and any cost resulting from caring
activities undertaken by the family.
- These are both direct cost items. In addition, there may also be indirect costs (productivity
costs) such as income lost because of absence from work (which is a production loss to
society) and any psychological stress experienced by patients, or their families or both.

3. External costs
- These occur when people not directly involved in a programme experience increased costs
because of it.
- In most cases these effects are too small and diffuse to merit inclusion in the analysis, but
there may be some occasions when they are large enough to require attention. For example,
public health legislation enforcing antipollution standards or specifying water purification
levels may lead to increase in manufacturing costs and consumer prices (as well as providing
health benefits).

Why economic evaluation?

- In economics, we are faced with the problem of scarce resources and so the necessity of
choice
- The concern is that markets may not allocate resources to health care efficiently or fairly
- As a result to a lesser or greater extent governments intervene in health care markets & many
decisions about what & how much to provide, how to provide & for whom must be taken
- Economic evaluation is undertaken to inform such decision making

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7.5 Economic evaluation (EE)

- It is important to determine at the outset from whose viewpoint an economic evaluation is to

be carried out.
- It may be based on the viewpoint of an individual patient, the hospital, the government, or
society at large.
- The broadest viewpoint is that of society in general, as this will include all the costs and
benefits, no matter to whom they accrue. For this reason, it is the preferred approach.
- Adopting this approach has two main implications that distinguish it from approaches with
more limited perspectives.
o Firstly, it usually involves measuring and valuing items that do not have market
prices attached to them, such as the time costs that patients incur when undergoing
treatment and recuperating.
o Secondly, it means that certain costs, or cost savings, or both, should not be
included in the evaluation because they are transfers from one sector to another
rather than a net cost to society. E.g. free health care.
- Economic evaluation involves the identification, measurement and valuation and then
comparison of costs (inputs) and benefits (outcomes) of two or more alternative treatments or
activities.
- In economic evaluation (EE), the costs and consequences of alternative interventions or
scenarios are compared to examine the best use of the scarce resources.
- EE basically sets to answer two main questions:
o Is this procedure worth doing compared with other things we could do with the
same resources?

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 o Are we satisfied that the health care resources should be spent this way rather than
in another way?
- EE is dependent on the quality of underlying medical evidence; because of this clinical trials
are viewed as a natural vehicle for economic analysis
7.6 Features that characterize an Economic Evaluation/ Analysis

- First, it deals with both the inputs (costs) and outputs (consequences), It is the linkage of
costs and consequences, which allows us to reach our decision.
- Second, Economic analysis concerns itself with choices. Resource scarcity, and our
consequent inability to produce all desired outputs, necessitates that choices must, and will,
be made in all areas of human activity. These choices are made on the basis of many criteria,
sometimes explicit, but often implicit.
- Economic analysis seeks to identify and to make explicit set of criteria, which may be useful
in deciding among different uses of scarce resources.
- Economics evaluations:
o Always compares any health care programme with an alternative, for example, no
treatment or routine care.
o Always measure the benefits produced by all alternatives compared.
o Always measures the cost of any programme.
- The above characteristics of economic evaluation/analysis lead us to define economic
evaluation as the comparative analysis of alternative courses of action in terms of both their
costs and consequences.
- Therefore, the basic tasks of any economic evaluation are;
o Identify (costs and benefits)
o Measure
o Value
o Compare the costs and consequences of alternatives

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- “The pursuit of efficient practice is not merely about reducing costs. If it were the most
efficient procedure would be to do nothing, as that pushes costs to zero.” (Professor Alan
Maynard4).
- Economic evaluation of health care programmes aims to aid decision- making with their
difficult choices in allocating health care resources, setting priorities and moulding health
policy.
- But it might be argued that this is only an intermediate objective.
- The real purpose of doing economic evaluation is to improve efficiency: the way inputs
(money, labour, capital etc) can be converted into outputs (saving life, health gain, improving
quality of life, etc).
- The choice of what health care to provide is about what economists call allocative efficiency.
- This means that we strive for the maximization of benefits (however we decide to measure
this) subject to given available resources.
- So, from a fixed resource we aim to get as much out of a range of health care programmes as
possible.
- This will mean that we will need to compare very different interventions, say health
promotion advice to quit smoking versus prescribing Relenza versus a procedure on an
ingrown toenail.
- Thus, allocative efficiency is about finding the optimal mix of services that deliver the
maximum possible benefit in total.
- Resources will be directed to interventions that are relatively good (i.e. efficient) at
converting inputs into health benefits and away from those that require larger input for
relatively low health gain.
- This approach may of course be constrained by certain equity considerations, to ensure that
certain groups do receive health care.
- The choice of how to provide health care is about what economists call technical efficiency.
- This means that we might strive for minimum input for a given output. For example, if we
have decided that performing tonsillectomies on children is worthwhile, part of an allocative
efficient allocation of resources, then we may need to examine the efficiency of how we do
this.

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- So, if the output we wish to achieve is to successfully remove a child‟s tonsils then we might
choose between, say, a day case procedure or an inpatient stay.
- This is an issue of technical efficiency since the output or „outcome‟ is fixed, but the inputs
will differ depending on which policy we adopt.
- The day case approach may perhaps require more intensive staff input and more follow-up
outpatient visits.
- If this was the case, then inpatient tonsillectomy may be the more technically efficient
strategy.

- Thus, with any given health care programme an economic evaluation is aiming to make
explicit the total resources consumed specifically by that programme (i.e. attributable to it)
and the total benefit generated specifically by that programme.
- Drummond et al (1997) defines economic evaluation as “the comparative analysis of
alternative courses of action in terms of both their costs and consequences.” It differs from
other forms of analysis since it considers both costs and consequences and is comparative.

- Evaluation needs to be comparative as an intervention can only be labeled as good or bad

relative to some benchmark or alternative even if this alternative is a „do nothing‟ strategy.
- If an evaluation is not comparative and does not consider both costs and consequences, then
it is only a partial evaluation.
- It is a description of either just the costs or just the benefits of one intervention in isolation.
This is most uninformative since it is one-dimensional and without a context by which to
judge relative performance (efficiency).
- If both costs and consequences are considered, but no comparator is provided, then the study
is again only a partial evaluation, described as a cost-outcome study. It lacks context and is of
limited use.
- If alternatives are compared, but only in terms of costs or benefits and not both then again
the study only provides a partial evaluation and can be labeled an effectiveness study or a
cost analysis. It would be comparative, but only across one dimension.
- Hence, an economic approach can be considered a full evaluation technique. Whatever the
approach, the same three-stage process for the assessment of all costs and benefits can be

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 applied. All relevant cost and benefit variables must be i) identified, ii) quantified and iii)
valued.

- At the start of an evaluation, it must be determined which costs and benefits are sufficiently
important to merit inclusion in the study.
- This should be separate from the measurement stage so as to avoid the study being entirely
data driven (i.e. the more intangible consequences of an intervention might be considered
equally important). The identification of relevant benefits and costs will define the variables
in the study.
- These can be broadly classified into changes in resource use, changes in productive output
and changes in health state.

- The next stage is to measure changes in these variables brought about by the intervention in
question.
- Often it is important that this is done before valuation, as it is necessary to know the
magnitude of gains or losses before values can be attached.
- Presenting variables in terms of „natural‟ quantities or frequencies (i.e. hour‟s worked or
clinical units) can also be very useful in terms of generalisability.
- Others can use these data and apply values relevant to their own setting (i.e. different cost
structures or health values).
- The differential timing of costs and benefits must also be considered in an evaluation.
- The effects of health treatments do not always occur at the same point in time.
- Costs may be incurred today, but the benefit may not arrive until next year (i.e. preventative
treatments, health promotion), part of this future benefit might be that future costs will be
avoided. 100 shillings spent today may not have the same value as 100 shillings spent next
year because of inflation; interest on savings and not least a positive rate of time preference.
- People may just prefer to have 100 shillings in their pocket today rather than 100 shillings in
a week or a month or a year, because it offers them more choices.
- This can be incorporated into economic evaluation by the notion of discounting future costs
and benefits to their present day value.

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- A simple formula can be applied to do this for any chosen discount rate, normally within the
range of 0-10%. Material covered so far in this pack has been very much at a conceptual
level.
Spotting economic evaluation
- Is there a comparison of two or more alternatives?
- Are both costs and consequences examined?
- If not- the study is not an economic evaluation but may be:
o Description of costs or outcomes
o Evaluation of efficacy or effectiveness
o Cost analysis

Treatment
Consequences
A
Cost
s
CHOICE

Cost Treatment
Consequences
s B

7.7 Types of Economic Evaluation

- The different ways of looking at benefits combined with cost analysis represent the different
techniques of economic evaluation: cost effectiveness analysis (CEA), cost utility (CUA) and
cost benefit analysis (CBA).
- When to see each of the above techniques will depend on the nature of the question to be
addressed, which may be a choice between alternative clinical strategies for a condition:

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 timing of an intervention; settings for care; types and skill-mix of personnel providing care;
programmes for different conditions; scale or size of a programme; or other ways to improve
health.

7.7.1. Cost-Effectiveness Analysis (CEA)

- When different health care interventions are not expected to produce the same outcomes both
the costs and consequences of the options need to be assessed.
- This can be done by cost-effectiveness analysis, whereby the costs are compared with
outcomes measured in natural units-for example, per life saved, per life year gained, and pain
or symptom free day.
- Many cost-effective analyses rely on existing published studies for effectiveness data, as it is
often too costly or time consuming to collect data on costs and effectiveness during a clinical
trial. Where there is uncertainty about the costs and effectiveness of procedures sensitivity
analysis can be used, which examines the sensitivity of the results to alternative assumptions
about key variables.
- In what follows these methods of analysis are described and the possibilities how the benefits
of alternative interventions should be valued are discussed.

- CEA is concerned with technical efficiency issues, such as: what is the best way of achieving
a given goal or what is the best way of spending a given budget.
- Comparisons can be made between different health programmes in terms of their cost
effectiveness ratios: cost per unit of effect.
- Under CEA effects are measured in terms of the most appropriate unidimensional natural
unit. So, if the question to be addressed was: what is the best way of treating renal failure?
Then the most appropriate ratio with which to compare programmes might be „cost per life
saved‟. Similarly, if we wanted to compare the cost-effectiveness of programmes of
screening for Down‟s syndrome the most appropriate ratio might be „cost per Down‟s

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 syndrome fetus detected‟. In deciding whether long-term care for the elderly should be
provided in nursing homes or the community the „cost per disability day avoided‟ might be
the most appropriate measure.
o The advantage of the CEA approach is that it is relatively straightforward to carry
out
o It is often sufficient for addressing many questions in health care. However, it is not
comprehensive. The outcome is uni-dimensional under this analysis, but often
health programmes generate multiple outcomes.
o For example, in Downs‟ syndrome screening, foetus detected is one outcome, but
miscarriages avoided might be another very relevant outcome measure, especially
if, say, blood testing is being compared to amniocentesis. But this cannot be
incorporated into this form of analysis. So, CEA not only assumes that the outcome
of the health programme is worthwhile per se, but also that it is the most
appropriate measure. A further problem with CEA is comparability between very
different health programmes. Cost per foetus detected may be a useful way to
compare the efficiency of blood testing versus amniocentesis, but how would these
be compared to, say, drugs aimed at reducing cholesterol. Health programmes with
different aims cannot be compared with one another using CEA: cost per unit
reduction in cholesterol cannot meaningfully be compared with foetus detected.
Hence, CEA is useful when comparing programmes within like areas, where
common „currencies‟ can be used.
- If the outcomes of alternative procedures or programmes under review are the same, or very
similar, then attention can focus upon the costs in order to identify the least cost optionthe
method of evaluation will be cost-minimisation analysis.
- If, however, the outcomes are not expected to be the same, then both the costs and
consequences of alternative options need to be considered.
- Cost-effectiveness analysis is one method of economic evaluation that allows this to be done.
1. Measures of Effectiveness
- In order to carry out a cost effectiveness analysis it is necessary to have suitable measures of
effectiveness.
- These will depend on the objectives of the particular interventions under review.

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- In all cost effectiveness analysis, however, measures of effectiveness should be defined in
appropriate natural units and, ideally, expressed in a single dimension.
- Common measures used in several studies have been “lives saved” and “life years gained”.
- Thus, Boyle and colleagues, in their study of neonatal intensive care of very low birth weight
babies, measured effectiveness in terms of mortality rates at the time of discharge of newborn
infants from hospital.
- Their study compared two periods-one before the introduction of neonatal intensive care, and
another after its introduction-and measured cost effectiveness in terms of additional costs per
life saved.
- Several other measures of effectiveness have been used by different researchers (see the box
below), these have included the number of pain or symptom free days resulting from
alternative drug regimens in the treatment of duodenal ulcers; and the number of episodes of
fever cured and deaths prevented in the treatment of chloroquine resistant malaria in African
children.
- Most of the above mentioned studies express effectiveness in terms of a single dimension and
thereby permit direct comparison between alternative procedures in terms of their marginal
cost per unit of outcome.
- Sometimes, however, the alternatives under examination have multiple outcomes.
- Nonetheless, many of these choices can be dealt within the cost-effectiveness analysis
framework.
- Thus, if one procedure emerges as less costly and of equal or greater effectiveness than all
the other options on each dimension of effectiveness, it is clearly the most cost effective
option.
- For example, The comparison of day surgery with overnight inpatient care for cataract
surgery, measured outcomes in terms of the number of both operative and postoperative
complications, and in terms of visual acuity of patients three to six days and 10 weeks to six
months after surgery. Patient satisfaction was also elicited through a questionnaire. As day
surgery emerged as the more effective option on practically all of these effectiveness
measures, and was subsequently less costly, the evidence suggests that it is the preferred
option.

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- One argument for carrying out analysis in this way-that is, not always seeking to combine
outcome measures into a single unit, is that the variations across a number of dimensions are
made clear to decision makers rather than being concealed within an aggregate measure.
- This can sometimes permit more informed decision-making, although it can also result in
tortuous attempts to compare apples and oranges.

Examples of measures of effectiveness

o Cases treated appropriately

o Lives saved
o Life years gained
o Pain or symptom free days
o Cases successfully diagnosed
o Complications avoided

2. Costs-Minimisation Analysis (CMA)

- Cost-minimisation analysis is an appropriate evaluation method to use when the case for an
intervention has been established and the programmes and procedures under consideration
are expected to have the same or similar outcomes.
- In these circumstances, attention may focus on the cost side of the equation to identify the
least costly option.
Cost –Minimisation
o Is concerned only with technical efficiency
o Can be regarded as a narrow form of cost effectiveness analysis
o Evidence is given on the equivalence of the outcomes of different interventions
o As outcomes are considered to be equivalent no different decisions can be made on
the basis of costs
Advantages
o Simple to carry out, requires costs to be measured, but only that outcomes can be
shown to be equivalent
o Avoids needlessly quantifying data
Disadvantages
o Can only be used in narrow range of situations.
o Requires that outcomes be equivalent

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Example 1. Cost-Minimization Analysis

Suppose we are comparing two programmes involving minor surgery for adults. Both
accomplish the outcome of interest, and from an examination of effectiveness data differ in no
other significant respects except that one requires hospital admission for at least one night, while
the other (a day surgery programme) does not. If we identified the common outcome of interest –
operations successfully completed – we would find that it could be achieved to the same degree
(i.e. identical number of surgeries) in either programme, though presumably at different costs.
The economic evaluation is then essentially a search for the least cost alternative. Analysis such
as this is often called cost-minimization analysis. We might also be interested in the distribution
of costs (e.g. in this case to what extent does the day-surgery programme shift costs to the
patient), but our principal efficiency comparison will be made on the basis of cost per surgical
procedure.

- CMA is really a special form of cost-effectiveness analysis, where the consequences of the
alternative treatments being compared turn out to be equivalent.
- It can be seen from the box below that there are nine possible outcomes when one therapy is
being compared with another. In three of the nine cases the analysis reduces to a CMA.

- In general Cost-effectiveness analysis (CEA) is:

- Concerned with technical efficiency.
- What is the best way of achieving a given goal with least resources?
- What is the best way of spending a given budget?
- Used when the interventions being compared can be analyzed with common measures.

Advantages
- Relatively simple to carry out
- Often able to use outcome measures which are meaningful in a particular field

Disadvantages
- Since outcome is uni-dimensional, cannot incorporate other aspects of outcome into the cost-
effectiveness ratio.

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- Interventions with different aims/goals cannot be compared with one another in a meaningful
way.
- Meanings of outcome measure not always clear, i.e. what is value of a case detected in a
screening programme.
- May have situations when the option with the highest cost effectiveness ratio should be
chosen

Example 2. Cost-Effectiveness Analysis

Suppose that our interest is now the prolongation of life after renal failure and that we are
comparing the costs and consequences of hospital dialysis versus kidney transplantation. In this
case, the outcome of interest – lifeyears gained – is common to both programmes; however, the
programmes may have differential success in achieving this outcome, as well as differential
costs. Consequently, we would not automatically lean toward the least cost programme unless, of
course, it also resulted in a greater prolongation of life. In comparing these alternatives we would
normally calculate this prolongation and compare cost per unit of effect (i.e. cost per life-year
gained). Such analyses, in which costs are related to a single, common effect, which may differ
in magnitude between the alternative programmes, are usually referred to as cost-effectiveness
analysis. Note that the results of such comparisons may be stated either in terms of cost per unit
of effect, as in this example, or in terms of effects per unit of cost (life-years gained per dollar
spent). The latter is a particularly useful approach when working within a given budget
constraint, as long as the alternatives under consideration are not of radically different scale.
Furthermore, although the alternatives used in this example are similar in that both could be
considered variants of an overall renal programme, it should be noted that cost effectiveness
analysis could be performed on any alternatives, which have a common effect. Thus, kidney
transplantation could be compared to heart surgery if the common effect of interest was life-
years saved. Similarly, an influenza immunization programme could be compared to a home care
programme if a common effect of interest, perhaps disability days avoided, could be identified.

3. Discounting Benefits (in cost-effectiveness analysis)

- Costs incurred at different points in time need to be “weighted” or discounted to reflect the
fact that those that occur in the immediate future are of more importance than those that
accrue in the distant future.

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- This raises the question: should the benefits or effects of alternative procedures also be
discounted? (For details about discounting refer to section three of this material)
- In answering this issue there is a difference among economists. If a zero discounting (no
discounting applied) were adopted, the main consequence would be to change the relative
cost effectiveness of different procedures.
- Using a positive discount rate means that projects with long lasting effects receive lower
priority. If a positive rate is replaced by a zero rate, procedures such as neonatal care-which
lead to benefits over the recipient‟s entire future lifetime-will, become relatively more cost
effective.
- In practical terms, it is probably true to say that while the case for using a zero discount rate
for benefits has powerful intellectual and may gain empirical support in the future, it will be
too hasty to recommend that positive rates be discarded in economic evaluations.
- In general:
o Cost-effectiveness analysis is a form of economic evaluation in which the costs of
alternative procedures or programmes are compared with outcomes measured in
natural units-for example, cost per life year saved, cost per case cured, cost per
symptom free day.
o Effectiveness data are ideally collected from economic evaluations built in
alongside clinical trials. In the absence of dedicated trials researchers need to draw
on the existing published work.
o Sensitivity analysis should be applied when there is uncertainty about the costs and
effectiveness of different procedures. This investigates the extent to which results
are sensitive to alternative assumptions about key variables.
o There is debate among economists about whether benefit measures should be “time
discounted” in the same way as costs. If they are not, projects with long lasting
effects will become relatively more cost effective-for example, maternity services
and health promotion. But it will be probably wrong to recommend this as a
standard practice.

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7.7. 2. Cost-Utility Analysis (CUA)

- CUA is concerned with technical efficiency and allocative efficiency (within the health care
sector).
- It can be thought of as a sophisticated form of CEA, since it also makes comparisons
between health programmes in terms of cost effect ratios.
- However, CUA differs in the way it considers effects. These are multidimensional under this
form of analysis.
- CUA tends to be used when quality of life is an important factor involved in the health
programmes being evaluated.
- This is because CUA combines life years (quantity of life) gained as a result of a health
programme with some judgment on the quality of those life years.
- It is this judgment element that is labeled utility. Utility is simply a measure of preference,
where values can be assigned to different states of health (relevant to the programme) that
represent individual preferences.
- This is normally done by assigning values between 1.0 and 0.0, where 1.0 is the best
imaginable state of health (completely healthy) and 0.0 is the worst imaginable (perhaps
death). States of health may be described using many different instruments which provide a
profile of scores in different health domains. EuroQol EQ-5D for example, simplifies health
into just five domains (such as mobility, selfcare, usual activities, pain/discomfort and
anxiety/depression).
o Each domain is given a score from 1 to 3,
o So the health profile would read 11111 for the best scores in all domains
o 33333 for the worst. EuroQol EQ-5D has 243 possible health profiles, all of which
have been assigned a utility value by general population surveys.

- This approach of using utility is not restricted to similar clinical areas, but can be used to
compare very different health programmes in the same terms.

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- As a result, „cost per QALY gained‟ league tables are often produced to compare the relative
efficiency with which different interventions can turn resources invested into QALYs gained.
- It is possible to compare surgical, medical, pharmaceutical and health promotion
interventions with each other.
- Comparability then is the key advantage of this type of economic evaluation. For a decision-
maker faced with allocating scare resources between competing claims, CUA can potentially
be very informative.
- However, the key problem with CUA is the difficulty of deriving health benefits. Can a state
of health in fact be collapsed into a single value? If it can then, whose values should be
considered in these analyses? For these reasons, CUA remains a relatively little used form of
economic evaluation.

1. When should CUA be used?

- The following are a number of situations where you might wish to use CUA:
(1) When health-related quality of life is the important outcome. For example, in comparing
alternative programmes for the treatment of arthritis, no programme is expected to have
any impact on mortality, and the interest is focused on how well the different
programmes will be improving the patient‟s physical function, social function, and
psychological well being;
(2) When the programme affects both morbidity and mortality and we wish to have a
common unit of outcome that combines both effects. For example, treatments for many
cancers improve longevity and improve long-term quality of life, but decrease quality of
life during the treatment process itself.
(3) When the programmes are being compared have a wide range of different kinds of
outcomes and we wish to have a common unit of output for comparison. For example, if
you are a health planner who must compare several disparate programmes applying for
funding, such as expansion of neonatal intensive care, a programme to locate and treat
hypertension, and a programme to expand the rehabilitative services provided to post-
myocardial infarction patients;
(4) When we wish to compare a programme to others that have already been evaluated using
cost-utility analysis.

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2. When CUA should not be used?
(1) When only intermediate outcome data can be obtained. For example, in a study to screen
employees for hypertension and treat them for one year, intermediate outcomes of this
type cannot be readily converted into QALYs for use in CUA.
(2) When the effectiveness data show that the alternatives are equally effective in all respects
of importance to consumers (e.g. including side-effects). In this case, cost-minimization
analysis is sufficient; CUA is not needed;
(3) When the effectiveness data show that the new programme is dominant; that is, the new
programme is both more effective and less costly (win-win). In this case, no further
analysis is needed;
(4) When the extra cost of obtaining and using utility values is judged to be in itself not cost
effective. This is the case above in points 2 and 3. It would also be the case even when
the new programme is more costly than the old, if effectiveness data show such an
enormous superiority for the new programme that the incorporation of utility values
could almost certainly not change the result. It might even be the case with a programme
that is more costly and only somewhat more effective, if it can be credibly argued that the
incorporation of any reasonable utility values will show the programme to be
overwhelmingly cost-effective.

3. Measuring Quality
- Measuring a person‟s quality of life is difficult. Nonetheless, it is important to have some
means to have for doing so since many health care programmes are concerned primarily with
improving the quality of a patient‟s life rather than extending its length.
- For this reason, various quality of life scales have been developed in recent years.
- The Nottingham health profile is one quality of life scale that has been used quite widely in
Britain. This comprises of two parts:
o The first measures health status by asking for yes or no responses from patients to a
set of 36 statements related to six dimensions of social functioning:
 Energy,
 Pain,
 Emotional reactions,

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  Sleep,
 Social isolation,
o Physical mobility. These responses are then “weighted” and a score of between 0
and 100 is assigned to each dimension.
o The second part asks about seven areas of performance that can be expected to be
affected by health:
 Employment,
 Looking after the home,
 Social life,
 Home life,
 Sex life,
 Hobbies,
 Holidays. The Nottingham health profile has been applied, for example, in
studies of heart
 transplantation, rheumatoid arthritis and migraine, and renal lithotripsy.

- Other quite widely used measures include the sickness impact profile and the quality of
wellbeing scale.
- Recently, a new outcome measure, the Sf-36 health survey questionnaire, has been gaining
popularity.
- After testing it on 1980 patients in two general practices it was considered to be a promising
measure which is “easy to use, acceptable to patients, and fulfils stringent criteria of
reliability and validity”.
- Although all of these scales embody some form of scoring scheme, they do not usually
generate a single quality of life score.
- This means that, although they are of considerable value in assessing the outcomes of
interventions in the case of particular diseases or disabilities, they cannot be used to compare
outcomes between different programmes.
- To do this, generalisable measure of quality is necessary.
- One of the earliest measures to be developed-and one which has subsequently been used
widely to calculate QALYs –is the Rosser index.

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4. Rosser Index
- Rosser and her colleagues described health status in terms of two dimensions: disability and
distress.
- The states of illness are classified into eight categories of disability and four categories of
distress.
- By combining these categories of disability and distress 32 (8 times 4), different states of
health were obtained. Rosser then interviewed 70 respondents (a mixture of doctors, nurses,
patients and healthy volunteers) and, by using psychometric techniques sought to establish
their views about the severity of each state relative to other states.
- The final results of this exercise were expressed in terms of a numeric scale extending from 0
= dead to 1 = perfect health.
- With this classification system it becomes possible to assign a quality of life score to any
state of health as long as it is placed in an appropriate disability or distress category.
- Although actual scores generated through the Rosser study have been the source of some
criticisms, Gudex and Kind reported that a single training session on the approach was
sufficient to obtain a high level of agreement between doctors on rating patients and that
these descriptions could be used to categories patients reliably, accurately, and quickly.

5. Quality – Adjusted Life – Years (QALY)

- One of the features of conventional CUA is its use of the QALY concept; results are reported
in terms of cost per QALY gained
QALYs: - combine life years gained with a measure of the quality of those years.
o Quality is measured on a scale of 0 to 1. With 0 equated to being dead and 1
equated to the best imaginable state of health.
o Combine all dimensions of health & survival into a single index.
Cost A  Cost B
 Cu ratio 
QALY A  QALY B

6. What is the QALY concept?

- The advantage of the QALY as a measure of health outcome is that it can simultaneously
capture gains from reduced morbidity (quality gains) and reduced mortality (quantity gains),

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 and combine these into a single measure. Moreover, the combination is based on the relative
desirability of the different outcomes.
- The QALY approach, which forms a key part of most cost utility analyses, has been the
subject of some criticism.
- It has been accused of discriminating against elderly people, making illegitimate
interpersonal comparisons, disregarding equity considerations, and introducing bias into
quality of life scores.
- Rival measures that are claimed to be sound theoretically, such as “healthy years
equivalents” (HYEs), have also been put forward. It has, however, recently been claimed that
under most assumptions QALYs and HYEs will lead to identical project rankings.
- Amid all this debate it is as well to bear in mind that decisions have to be made about the
allocation of resources and cost utility analysis is probably the most sophisticated form of
economic evaluation available at present.
- However, sensible use of the technique and interpretation of research findings based on the
approach should recognise that cost utility analysis is still at a fairly early development stage
and treat it accordingly.
- That is, decision makers should exercise appropriate care, caution, and intelligence.
DALY: The Disability-Adjusted Life Year, a measure akin to the QALY in aggregating survival
and quality of life effects, but normally advanced as a method of estimating the burden of illness
associated with a disease, rather than the cost effectiveness of health care interventions.

7.7. 3. Cost-Benefit Analysis

- Cost benefit analysis is the most comprehensive and theoretically sound form of economic
evaluation and it has been used as an aid to decision making in many different areas of
economic and social policy in the public sector for more than fifty years.
- Cost-Benefit analysis (CBA) estimates and totals up the equivalent money value of the
benefits and costs to the community of projects to establish whether they are worthwhile.

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 These projects may be dams and highways or can be training programmes and health care
systems.
- The main difference between cost-benefit analysis and other methods of economic evaluation
that were discussed earlier in this series is that it seeks to place monetary values on both the
inputs (costs) and outcomes (benefits) of health care.
- Among other things, this enables the monetary returns on investments in health to be
compared with the returns obtainable from investments in other areas of the economy.
- Within the health sector itself; the attachment of monetary values to outcomes makes it
possible to say whether a particular procedure or program offers an overall net gain to society
in the sense that its total benefits exceed its total costs.
- Cost-effectiveness and cost-utility analysis do not do this because they measure costs and
benefits in different units.
- CBA requires programme consequences to be valued in monetary units, thus, enabling the
analyst to make a direct comparison of the programmes incremental cost with its incremental
consequences in commensurate units of measurement, be they Birr, dollars, or pounds.
- CBA compares the discounted future streams of incremental programme benefits with
incremental programmes costs; the difference between these two streams being the net social
benefit of the programme.
- In simple terms, the goal of analysis is to identify whether a programme‟s benefits exceed its
costs, a positive net social benefit indicating that a programme is worthwhile.
- CBA is a full economic evaluation because programme outputs must be measured and
valued.
- In many respects CBA is broader in scope than CEA/CUA. Because CBA converts all costs
and benefits to money, it is not restricted to comparing programmes within health care, but
can be used (although not without problems) to inform resource allocation decisions both
within and between sectors of the economy.
- CBA is broader in scope and able to inform questions of allocative efficiency, because it
assigns relative values to health and non-health related goals to determine which goals are
worth achieving, given the alternative uses of resources, and thereby determining which
programmes are worthwhile.

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 o Both costs and benefits are assigned a monetary value. The benefits of any
intervention can then be compared directly with any costs incurred.
o If the value of benefits exceeds the costs of any intervention, then it is potentially
worthwhile to carry that intervention out.
o If society funds projects for a given budget, then it can maximise the benefits
generated by social spending.
o It is concerned with allocative efficiency.
o It is concerned with the question, is a particular goal worthwhile. Potentially it can
answer questions such as should extra money be used for heart transplants or
improving housing.
o Method requires that all resources and benefit generated by an intervention need to
be assigned a monetary value. Therefore, needs to cost things which have no market
value, i.e, changes in health, quality of life, length of life, pain, etc.
o Methods of valuing
 Willingness to pay (WTP)
 Human Capital Approach

7.9 SUMMARY

- Economic evaluation is the comparative analysis of costs and consequences of

alternative sources of action.
- Economic evaluation basically sets to answer two main questions: 1)Is this procedure
worth doing compared with other things we could do with the same resources? 2) Are
we satisfied that the health care resources should be spent this way rather than in another
way?
- Two main characteristics of economic evaluation are: 1) It deals with both the inputs
(costs) and outputs (consequences); 2) It concerns itself with choices
- Four tasks of economic evaluation are: Identify; Measure; Value; and Compare costs and
consequences of alternatives.
- Types of economic evaluation are: Cost minimization; Cost effectiveness; Cost utility;
and Cost benefit.

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7.9 ACTIVITIES

1. Costs are incurred in all economic activities-why?

2. Explain the cost implications of ill health
3. Define cost benefit analysis and explain its difference from cost effectiveness
analysis.

7.10 FURTHER READING

Bowling, A. (1997) Measuring Health: A review of quality of life measurement scales,

second edition, Open University Press, Buckingham.

Briggs, AH. , Gray, AM. Handling Uncertainty When Performing economic evaluation of
health care interventions: Health Technology Assessment 1999;3(2).

Drummond, M., Stoddart, G. , O‟Brien, B. , and Torrance, G. (1997) Methods for the
Economic Evaluation of Health Care Programmes, second edition, Oxford Medical
Publications; Oxford.

Kobelt, G. (2002) Health Economics: An Introduction to Economic Evaluation, second

edition, Office of Health Economics; London.

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 TOPIC EIGHT
HEALTH SYSTEM DECENTRALIZATION
8.1 INTRODUCTION

The topic introduces the student to the health sector reforms and more specifically to
decentralization. Overtime, health sector has undergone various reforms driven by various
motives which could be political, economic, international ideologies and so on. Kenya has
not been left behind. The Kenyan health system has undergone different reforms including
the recent devolvement of the health services. This topic will look at the decentralization and
its various categories and the objectives for each.

8.2 TOPIC OBJECTIVES

At the end of this lecture you should be able to:

(i) Understand the meaning and basis health sector decentralization
(ii) Explain definitions of decentralization
(iii) Discuss objectives of health sector decentralization
(iv) Differentiate different types of decentralization

8.3 BACKGROUND

In this sub-topic, we define decentralization; discuss the objectives and various types of
decentralization.

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- Decentralization is regarded as the transfer of public authority, resources, and personnel from
the national level to sub-national jurisdictions.
- Decentralization is based on the simple concept of getting resources to where they are
needed.
- It is rooted in administrative science; it has been promoted widely because of its perceived
technical, political and fiscal benefits in the development.
- Decentralization is also perceived as part of the democratization process, thus the
characterization as an administrative and political tool for reform
- The most and commonly used definition of decentralization is the transfer of decision-
making power and administrative responsibility from the central government to the
periphery.
- Though there are different definitions of decentralization the widely accepted on is:
o “The transfer of responsibility for planning, management and the raising and
allocation of resources from central government and its agencies to field units or
levels of government, semi-autonomous public authorities or corporations, area-
wide, regional or functional authorities, or non-governmental private or voluntary
organizations”
8.3.1 Dimensions of decentralization
- Scholars have identified four typologies of decentralization as described below.
1) Political decentralization involves horizontal sharing of political power between the three
arms of government as well as vertical sharing of power between the national and sub-
national governments.
2) Fiscal decentralization involves the transfer of financial resources from the central
government to autonomous local agencies. This entails direct transfers from the national
level to the local agencies or assignment of taxation powers to the sub-national units.
3) Administrative decentralization refers to the transfer of responsibility for the planning,
financing and management of certain public functions.
4) Divestment or Economic/Market decentralization is where the national or sub-national
government assigns responsibilities to private entities which offer the services and levy
user charges for the same. In this regard the private entity works for and on behalf of the
government. However the government still bears the legal responsibility to ensure that

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 the service is delivered. In certain cases the government may have shares in the private
entity and thus sits in the decision making bodies. Such services would include water
supply, electricity supply, garbage collection, toll services fees collection among others.

8.3.2 „Political‟ objectives of decentralization

- To ensure reduced role of the state in social affairs- It is argued that governments are not
responsive to consumer rights as they don‟t know what people want
- To disperse and defuse social and political conflict
- To reinforce locally dominant groups‟ access to decision-making and resources. This is
meant to strengthen power of dominant groups. However, this does not necessarily happen
because it will depend on who controls decentralization
- To expand central control over the periphery-this reinforces central control
- Decentralization is a political process; it is about power- Difficult to give away power to
lower levels.
- Note: Stated objectives are not real objectives!!! There could be other hidden interests.

8.4 Broad categories of decentralization

- Decentralization can either be described as functional or geographical:
o Functional decentralization: achieved when authority for performing particular
functions, such as health care, is transferred to a specialized local office-as in the
development of district (counties) bodies within the health sector, such as District
Health Management Teams (DHMTs)
o Geographical decentralization: Requires that broad responsibilities for public
functions be transferred to local organizations that have well defined geographical
boundaries (e.g. the development of county or sub-county government levels of
governments at perhaps regional or provincial levels)
- Although decentralization is often seen as a technical matter, intended perhaps to improve
efficiency of health care delivery, it also often has explicit political dimensions.
- The establishment of local governments thus represents the creation of a new layer of
government and might perhaps be aimed at consolidating the national political system,
broadening the pattern of political participation within a country or strengthening local
accountability.

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Political decentralization

- Four forms of political decentralization:

o Strengthening existing mechanisms of local representative democracy, most clearly
structures of local government.
o Extending representative democracy to lower levels (local government)
o Extending direct democracy to „user groups‟ or the „neighborhood‟ e.g. (creation of
institutional or area governance bodies which are comprised of representative of
local authority e.g. DHMT)
o Infusing representative democracy with direct democracy to involve ethnic
minorities, women, disabled and the elderly (i.e. disadvantaged groups). Could
include creating governance bodies for health care institutions.
- Aims to give citizens or their elected representatives more power in public decision- making.
- Advocates assume that decisions made with greater participation will be better informed and
more relevant to diverse interests in society than those made only by national political
authorities.

Administrative Decentralization
- Seeks to redistribute authority and financial resources among different levels of government.
- The 3 forms are:
o Deconcentration is the transfer of decision-making authority to a lower
administrative level
o Delegation is when duties are allocated to a lower level (semi)-autonomous
organization.
o Devolution refers to transferring decision-making to a lower political level.
Fiscal Decentralization
- Giving local governments and private organizations revenues to carry out service effectively.
- Forms of fiscal decentralization include:
o self-financing;
o expansion of local revenues;
o intergovernmental transfers;
o authorization of municipal (county) borrowing

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Privatization
- While administrative decentralization relate to the allocation of power between different
levels of government, privatization occurs with transfer of ownership into private hands.
- Government and private sector cooperate to provide services or infrastructure
Deregulation
- Reduces legal constraints on private participation or allows competition among private
suppliers for services that in the past were provided by the government or regulated
monopolies

8.4 Key Objectives and Benefits of Decentralization In HealthCare Sector

- Increase service delivery effectiveness through adaptation to local conditions and targeting to
local needs.
- Improve efficiency of resource utilization by incorporating local preferences into
determination of service mix and expenditures
- Increase health worker motivation through local supervision and involvement of service
users in oversight, performance assessment etc.
- Improve accountability, transparency, and legitimacy by embedding health service delivery
in local administrative systems.
- Increase equity of service delivery by enabling marginalized and poor groups to access health
care providers and to influence decisions on service mix and expenditures.
- Increase the role of the private sector in health service delivery by separating financing of
health care from service provision.
- Decentralization can nurture dynamism in the delivery system allowing for a mix of private-
public providers and services.
- It can enhance localized innovations and adaptations for resource mobilization and cost-
consciousness in tackling local health problems.
- Cutting across these pillars is the assumption that decentralization can promote equity and
efficiency.

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8.5 WHO Five Streams of Decentralization
- WHO describes patterns of decentralization as:
o Strengthening lower levels of the health system
o Local government
o Autonomous institutions
o Executive agencies
o Non-governmental providers

8.6 Argument against decentralization

- Makes stabilization policies more difficult to implement, or even destabilization of public
expenditures and debt
- Offloading of fiscal imbalances by central governments to local governments. Strong
association between decentralization and fiscal imbalances at lower levels
- Possibility that decentralization retards economic growth

8.7 Argument for decentralization

o Efficiency:
- Decisions about public expenditure on a closer level of government are more responsive and
reflect local demand more so than remote government. Also, improvement of
competitiveness of government and enhances innovation – more likely to act to satisfy the
wishes of citizens.
o Political
- Decentralization an essential part of democratization as autocratic central regimes are
replaced by elected governments

8.8 Rationale for “balanced” Decentralization – not “either-or”

- Not all functions can or should be financed and managed in decentralized way
- If national government delegates responsibilities, they usually need to retain policy and
supervisory roles
- National government creates and maintains “enabling conditions” that allow local
responsibility
- Decentralization depends on training and coordination of local government, private
enterprises, and local NGO‟s in planning, financing, and management

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8.9 SUMMARY

- Development affects health in a complex way. Its overall effect is to make more
resources available to deal with health problems.
- Development creates a range of possibilities out of which the most favorable should be
selected.
- Development changes not only level mortality but also its structure (and presumably also
in that of morbidity)
- High mortality in poor countries reflects high prevalence of communicable disease (e.g.
diarrhoea and respiratory diseases) and the interaction of these with malnutrition.
- In rich countries, mortality from these causes is highly reduced and major cause of
mortality are chronic conditions (diabetes, hypertension) and degenerative conditions
from external causes.
- Health status seems to explain an important part of economic growth.
- Poverty is a multidimensional concept, with social, economic, cultural and political
components.
- Economic indicators focus primarily on income poverty, but health indicators provide a
measure of multidimensional poverty.
- Best way to analyse poverty is to look at all the five types of capital:-human, financial,
social, physical, and natural.
- Poor people are more likely to suffer from ill health
- Poor are less likely to seek medical care even when it is urgently needed.
- Ill health generates poverty.

8.10 ACTIVITIES

1) Find key health and development indicators of in Kenya (emphasis more on health-
IMR, LEB, Morbidity etc).
2) Find out (health and development) indicators of Kenya the trend in the past 10 years,
reasons for increase/decline in indicators

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8.11 FURTHER READING

BARLOW R (1979). Health and Economic Development: A Theoretical and Emp irical
Review. In: Sirageldin I (ed) 'Research in Human Capital and Development' . Vol 1 pp 45-
75. JAI Press, Connecticut.

CUMPER G (1983). Jamaica: A Case Study in Health Development. Social Science and
Medicine vol 17 no 24 pp 1983-1993

CUMPER G (1984). Determinants of Health Levels in Developing Countries. Research

Studies Press Ltd.John Wiley & Sons Inc.

CUMPER G (1983). Chapter 2: Economic Development, Health Services and Health. In: Lee
K and Mills A (eds) 'The Economics of Health in Developing Countries'. Oxford University
Press
HARDIMAN M and MIDGLEY J (1982). Chapter 2: Poverty, Inequality and Development.
In: The Social Dimensions of Development. John Wiley and Sons

HERRICK B and KINDLEBERGER (1983). Chapter 6: Measurement and Development. In:

Economic Development. Mc Graw Hill Books

MUSGROVE P (1987). The Economic Crisis and its Impact on Health and Health Care in
Latin America and the Caribbean. International Journal of Health Services vol 17 No 3 pp
411-441

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