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Chap 2 Microeconomic Tools for Health Economics
Scarcity and the Production Possibilities Frontier • The PPF is a curve drawn in a graph to illustrate the trade-offs between two categories of goods=> no free lunch • Increasing opportunity cost (see Table 2 -1) ÞThe slope of the PPF=opportunity cost ÞBowed-out shape of the PPF *An interior point in PPF means that it is inefficient.
Practice with Supply and demand • The demand curve and demand shifters 1. As long as people buy less at higher prices=> the demand curve is downward-sloping 2. implicit assumption: all other things are held constant = Demand shifter (1) Income: normal good (2) Other price: the price of other substitutable good (3) Insurance: health insurance (4) Tastes
• Supply shifters 1. Technological changes 2. Input prices 3. Prices of Production-Related Goods: orange or juice 4. Size of the industry: Immigration 5. weather • Equilibrium : demand=supply (static equilibrium in Figure 2 -3) • Comparative statistics 1. Coffee were a freeze in Brazil (Figure 2 -4 A) 2. The market for tea when the price of sugar rises (Figure 2 -4 B)
Functions and curves • Linear Functions: Y=a+bx where y=dependent variable x= independent variable a= intercept b= slope • Demand functions: Qd=a-b. P • The demand for spaghetti: Qd=f(Ps, Po, Y, Z) where Ps: price of spaghetti Po: the prices of substitute Y: income Z: taste factor Qd=500 -10*Ps+5*Po+20 Y+40 Z It is download sloping in its own price, shifting rightward (leftward) with higher price of substitutes (complements), shifting rightward (leftward) with income increases for normal (inferior) goods, and shifting rightward with a positive shift in tastes Derived demand: Demanded by consumers for a final foods or service may stimulate the providers of that service in turn to demand factors of production. E. g. health-> exercise equipment, health foods, and visits to a physician
Consumer Theory: Ideas Behind the demand curve • Utility 1. Marginal Utility (=slope of utility) 2. The slope is fatter=decreasing marginal utility • Indifference Curves 1. convex to the origin. 2. The rate at which agent want to trade off the two goods is represented by the slope of the indifference curve • Budget Constraint Changes in budget constraints due to changes in price or income (Figure 2. 8) • Consumer equilibrium: To maximize satisfaction given a budget constraint, the consumer will want to be on the highest attainable indifference curve. • Individual and market demand: Market demand is the horizontal sum of individual demands
Elasticities • Elasticity is defined as the percent change in the dependent variable resulting from a 1 percent change in dependent variable • Price elasticity: Ep=(percent change in quantity demanded)/(percent change in price) Ep is always negative • Income elasticity: Ey=(percent change in quantity demanded)/(percent change in income) Ey may be positive (if a normal good) or negative (if an inferior good) • Example (Figure 2 -12) 1. Demand is perfectly inelastic (D 1)=> tax revenue will be at a maximum but with no effect on smoking 2. Increasing elastic demand (D 2 and D 3) creates bigger reductions in smoking but at the cost of decreasing tax revenue
Production and Market Supply • The product function shows that the maximum sustainable output that can be obtained from all of the various combinations of inputs with existing technology. • The law of diminishing returns represents the idea that the marginal product of an input will eventually tend to fall as more is added. (See Figure 2 -3) • Q=f(X 1, X 2, …, Xn) • e. g. Cobb-Douglas MP and AP are shown in Table 2 -4
t • Isoquant curves: 1. combinations of inputs producing equal output lie on isoquant. 2. The negative slope to an isoquant indicates the possibilities of substituting inputs in the production process and of the positive marginal product of the input. 3. E. g. Empirical estimates reveal substantial substitution possibilities between physicians’ assistants and physicians. *Isocost curves: TC=w. L+r. K *Cost Minimization or Output Maximization determines efficient combination of labor and capital (Fig 2 -15) E. g. Hospitals may achieve cost minimization in applying hospital inputs, and home health care service may achieve cost minimization in applying home health care resources. But, for society as a whole to minimize its costs of care, we need to know which of these types of care is the most cost efficient for particular patients even the comparing quality of care.
Marginal and Average cost curves • Economics of scale: Total and average costs are related to the scale of activity. If the higher level of production leads to improved ability to take advantage of specialization proving a better division of labor; it may be possible to reduce average costs. • The long-run marginal cost curve shows the cost of producing an incremental unit when all inputs can be varied. It will go through the minimum point of the LRAC.
The firm curve under perfect competition • Assumptions: 1. A sufficient number of buyers and sellers of the good exist so that no single actor has any power over the price. 2. The good is homogeneous; that is, all producers produce the exact same good so that the market cannot be segmented on the basis of differences of goods. 3. Information is perfect. 4. no barriers to entry or exit are presented. • The above assumption ensures that the short-run market equilibrium can be represented by the price and the quantity at which demand (D=MR=P)and supply curves (p=MC) intersect. (see Figure 2 -17, MR>MC at Q 1 ; MR=MC at Q*) * positive economic profit will be attractive to potential entrants. With perfect information and no barrier to entry, other suppliers will enter the market until the prices have fallen enough to eliminate economic profit. In the long run, equilibrium profit will be zero, and price will be at the lowest point on each firm’s long-run average cost curve
Monopoly and other market structure • Firms in other market structures, unlike perfect competition, have market power, which is the ability to affect market price such as the pure monopoly, monopolistic competition, the several forms of oligopoly. E. g. In health sectors, pharmaceutical firms that control patens for certain drugs are pure monopoly. • Equilibrium for the monopolist is illustrated in Figure 2 -18. To maximize profit, the monopolist produces where MR=MC at Q 0. The corresponding price is P 0 and the total profit is the rectangle P 0 ACB. • Welfare loss: The total net gain to society from increasing output from Qm to Qc (see Figure 2 -19) is triangular area labeled ABC. Thus, a welfare loss, represented by an area under the demand curve and above the marginal cost curve, is an opportunity for mutual gains that is being foregone by the market.