• Simply put: Marginal cost/benefit

    Simply put” is an ongoing series. See the introduction for an explanation of the series and the full list of topics that have been or may be covered. Feel free to suggest other topics in that post.

    A  doctor and an economist have the following conversation:

    Doctor: There is no waste in health care. Allof care I provide my patients is valuable. Every bit improves health.

    Economist: That last little bit of care you provide costs far more than it is worth. It’s a waste of resources. You’re reducing, not increasing, welfare.

    Doctor: Reducing welfare? Ridiculous! My job is to benefit patients and the public. That’s what I do.

    Economist: Benefiting patients and the public? Don’t be so sure! My job is to point out where we can make better use resources. That’s what I do.

    What’s this argument about? And who is right? It’s about two different views of “welfare” and both the doctor and the economist are right (or could be). It all can be explained in terms of marginal benefit and marginal cost.

    Let’s start with one thing the doctor and the economist can both agree on. It’s the following intuitive idea: any good or service a person buys is worth at least as much to that person as the money that person spent on it. From this idea it follows that people will buy more of something the less they have to pay for it.

    The maximum amount of money someone will spend on a good or service is called that individual’s valuation of that good or service. We can think of it as a monetized form of the benefit (or utility, in economist speak) they’ll derive from that good or service. If you’d spend up to $3 for a cup of coffee at a coffee shop but not a penny more, then $3 is your valuation of that cup of coffee. Though you may be willing to spend $3 for the first cup, you may not be for a second, or third, or tenth. If the price is lower, say $1 per cup, you might be more willing to buy more than one cup, however.

    You’ll keep buying cups of coffee until the increase in benefit you’d get from the next cup is lower than the additional amount you’d have to spend on it. Notice those words “increase” and “additional”? Those are synonyms for another term economists use, marginal. So long as the marginal benefit exceeds the price, you’ll keep buying. This just means you keep buying something (coffee, whatever) until you no longer think it is worth it, given how much you’ve already bought (or consumed). This should be intuitive. It’s how you decide how many cups of coffee to buy at the coffee shop, or how many bananas to buy at the super market, or how much of anything to buy.

    It’s true for health care too. Now, purchasing health care is more complicated because of insurance. But the same idea applies. You’ll consume as much health care as you think worth it for the transaction price (your copayment if you’re insured). The lower the price, the more you’ll consume. You’ll keep using health services until the marginal benefit falls below the price you pay.

    Imagine you’re fully insured. (You pay no copayment.) You pay nothing for each health care service. How much will you use? Well, if it costs you $0 for a service you’ll use as much of that service until the marginal benefit is $0. So long as the service is at least providing a tiny bit of benefit (to your health, or just because you enjoy the experience for some reason), you’ll keep using it. This is illustrated in the following diagram. The vertical axis is price (that you pay out of pocket) and the horizontal axis is the quantity you’ll use. The downward sloping line is marginal benefit. It slopes downward for the reasons given above; lower price means you’ll buy more. You’ll use quantity B because that’s the quantity for which marginal benefit reaches the price you pay, $0 (because you’re fully insured).

    So long as you’re benefiting from the service, the physician is likely willing to provide it, particularly if he perceives the benefit is at least not harming your health. In other words, the physician is inclined to provide quantity B of health services too. To the physician and the patient, all of that health care is “welfare” improving in the sense that it improves your health, or doesn’t harm it, anyway. (Qualitatively, the story doesn’t change if the patient is not fully insured, but pays a copayment. In that case, the horizontal axis in the figure is not at the $0 price level, but at the copayment level.)

    The economist considers not just marginal benefit, but the (full) marginal cost. Imagine each health service costs a fixed amount, as shown by the marginal cost line in the figure. For example, each service costs $100, no matter how many are provided. (The story is not much different if marginal costs varies.) The insurance company may be paying most or all of that $100, but it is still a cost. It reflects real resources used (physician time, supplies, etc.).

    The economist notices that the marginal benefit falls below marginal cost at quantity A. All the resources used to provide B-A services cost more than they’re valued by the patient. This is termed a “welfare loss” by economists because it reflects a misuse of resources in the following sense. If the patient were handed enough cash to buy B health care services, she would not buy that many. She’d buy the amount A and use the rest of the money for something else (like coffee). The cost reflected by the blue triangle in the figure is, in this sense, “wasted.” The patient only receives a benefit reflected by the marginal benefit line and all the cost of providing care that is above that line and to the right of A (the blue triangle) is economic waste, even if it is health improving.

    Economists term the area of the blue triangle “deadweight loss.” To them it is a welfare loss even as the doctor (and patient) may perceive it as a health (or welfare in another sense) gain.

    This is the crux of the debate between the doctor and the economist. One sees point B as providing the greatest value, the other point A. Who is right? They both are. “Waste” and “welfare” mean different things to each of them. To the right of A, marginal benefit is below marginal cost, notwithstanding any health improvements. The doctor sees providing quantity B as his job, the economist sees limiting provision to quantity A as his. If you already see how this relates to the notion of “rationing,” you’re on the right track.

    Further Reading

    Newhouse J. Pricing the Priceless: A Health Care Conundrum.

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    • I think these arguments are missing an important factor. Medical care spending is not discretionary spending like coffee, gadgets, new clothes, etc.. If you have a broken leg, you MUST purchase medical care AT ANY COST. If you do NOT have a broken leg, you are not going to purchase any medical care. You are not going to break your leg just because you have insurance and it won’t cost any money.
      Economists are fond of stating that if something is free, it will be over consumed. People will consume medical care when they get sick and for preventive services which they are told will keep them from getting sick. They will not go to the doctor to have tests and procedures just because it is free. There is a natural limit to the demand for medical care imposed by the amount of illness in the community. (The fact that doctors have been effective at promoting expensive, unproven tests and treatments is a doctor supply/demand problem, not a patient supply/demand problem.)
      Your graph is nice for iPods but doesn’t apply to medical care. If I am sick I will spend whatever it takes to get better. If I am not sick I won’t spend anything. There is no marginal cost or marginal benefit decision. There is no discretion. It’s either “I’m sick and I must get better” or “I’m well and will avoid doctors like the plague”. People do not choose to get sick and see a doctor. The get sick and must see the doctor.
      An additional complication is that there is no relationship in medical care between cost and benefit so no one can make a cost/benefit calculation. Patients get sick and do what the doctor says. It may be an expensive and risky procedure with no proven benefit. Patients will spend any amount of money if they are offered the promise that they might get better. The marginal cost/marginal benefit curve doesn’t exist in medical care.
      The Price Quantity graph is a vertical line at a point on the Quantity axis which corresponds to the amount of illness in the community (or the individual).

      • @Mark Spohr – Really? No utilization by the “healthy”? Individuals not making any choices about their health utilization? Are you sure? Personal costs don’t matter? To anybody? I don’t believe it.

        Mental health care? Wellness visits? Vaccination? Preventative care? Follow-up visits/tests, “just to be sure”? That nagging cough that’s “probably nothing”? Adherence to prescription drugs?

        What you say does not square with a lot of research. I could, with work, cite tons of studies. How about just the RAND HIE? Need I point to all the posts related to this?

        It’s just not as simple as you suggest.

      • You are wrong when people need medical care sometimes they purchase it sometimes they don’t. When people purchase medical care sometimes the need it sometimes they don’t these are facts. You apear to be suggesting that people only behave in a collectively rational manner but they behave in a personally rational manner. Also you seem to be suggesting that this is a normative argument ,it is not for the economist or the physician. But the positive arguments being made are different no politics here at all.
        If you want politics I could go on for hours I suspect.

    • I did mention preventive care in my post and all of your examples fall into that category.
      Preventive care is people maintaining their health by doing what health professionals tell them is good. This is part of the “natural demand” for health care and is not a manufactured excess demand based on low cost. The demand curve is a vertical line. People don’t consume extra medical care just because it is cheap. They see the doctor when they are sick and when they are told to see the doctor.

    • Dear Austin,
      It is not my purpose to drive you crazy (although I seem to be trying your patience). I do appreciate your efforts to explain economics to a doctor with only minimal economics training (Econ 101 and 102 at the Wharton School).
      I have done a little research and I would like to propose that I have been wrong. It appears that the demand curve is based on only those people who manage to overcome financial and logistic barriers to actually receive medical services and not on the people who are sick but can’t afford to see the doctor. In this case, demand is indeed rationed by cost to the patient and if you lower costs to the patient, you will increase demand.
      However, my point is that this is not a classical supply/demand curve for two reasons:
      1. For many illnesses, cost is not part of the decision making. You must purchase the service or suffer and maybe die. Cost information is also seldom available.
      2. The total demand for medical services has a “natural” limit set by the amount of disease naturally occurring and also by fear of disease (prevention services). It will not expand infinitely in response to lower costs. However, it can expand due to fear (i.e. get this test/procedure or you will die) which is where physician induced demand comes into the equation.


      Hope your ankle gets better… most of the time it will… stay off of it and keep it elevated with ice for the first day. An elastic bandage (not too tight) may help. If it is not better in a few days you may want to get an x-ray (not an MRI and certainly not a CT scan) to rule out a fracture. Even simple sprains can take weeks to heal.

      • @Mark Spohr – To your points:

        1. The unavailability of prices does not change the person’s valuation. A service is worth something to a person, an amount for which they are indifferent between the cash and the service. The demand curve need not be linear and need not be the same for all conditions and services. Obviously there is only so much one can convey in one graph.

        2. My demand curve does not extend indefinitely. When marginal benefit reaches zero, no more services would be demanded.

        My ankle is fine. I know this. Given the cost in time and money (and lost opportunity), no medical attention would be worth the marginal benefit. 🙂

    • A helpful slide I marked up to encapsulate essence of discussion.

      Also, Mark, I say this tongue in cheek: Visit Boca Raton, or talk to a doc there. You know how “experts” say there is no such thing as a rising fast ball? Hitters behind the plate say hooey. Dont think folks dont like going to the doctor for no reason….

      Think again.

      PS–I trained with one of the founders of MDVIP, and am friendly with a bunch of docs there. Not an n=1 anecdote.

    • @Brad
      I like the diagram. (I think everything is more understandable when reduced to a 2×2 matrix.)
      I am most interested in the lower left box – “Moral Hazard” (Consumer Driven / Not MD Driven). The other three boxes should be addressed by fixing the payment system / perverse incentives / pay for quality, etc.
      However, most people who are trying to fix the high cost of health care seem to focus on blaming the patient and try to put in barriers to keep patients from seeking medical care. They say they are only interested in reducing “unnecessary” use of services but all of their proposals (higher deductibles, copayments, etc.) end up with the effect that people don’t get necessary health care and end up with increased morbidity and mortality.
      Your “Moral Hazard” box contains only “generic Rx” as an example. I’m not sure how this relates to moral hazard. Patient fill Rx as they are written by doctors so this would seem to be a doctor problem (or the doctor needs to educate patients on the value of generics). Most insurance charges more for brand Rx so no moral hazard there.
      Others have given the example of a patient seeing a doctor for “only a sore throat”. The worried well have always been an issue and I think that physician education should play a role here. However, the simple sore throat could be strep and should have a strep test (and Rx as necessary) so is not unnecessary care.
      I really don’t think there is much consumer driven unnecessary care. Financial deterrents to seeking care are a blunt instrument which end of denying necessary care and have health consequences.
      Numerous studies have confirmed this fact and also that most of the costs of health care are physician driven. Physicians are the problem, not the patients. Patients do not have the medical knowledge to know what care they need. They also do not have the financial knowledge to know what health care costs. They rely on their physicians to tell them when they need care and what care they need. If they are over-using the system, it is the physician’s job to tell them they don’t need the care. However, physicians are financially conflicted because in many cases, the benefit financially for delivering more care.

    • Generic = low copay, and “license” to use. PPI, allergy, as well as lifestyle medicines, etc., will amp up requests. Essentially, what might have been out of reach Rx at one point become accessible. Take away $5 copay and make them non-covered however, and folks balk. That’s moral hazard. I believe Austin laid that out last week in another post.

      Just read an interesting paper on SID:
      http://www.rwjf.org/coverage/product.jsp?id=71903

      Bottom line: nothing is simple.

      Brad

    • Thank you for your reply but I’m still not sure that I understand your reasoning for putting “Generic Rx” in the category of consumer demand /moral hazard. You mention that people are more likely to fill Rx if meds are cheaper. This is obvious but only becomes a moral hazard if it stimulates demand beyond the insurers expected necessary need (i.e. sick people who need meds). Allergy meds would seem to be an expected need. PPI (?proton pump inhibitors) also would seem to be appropriate use of medicine to treat disease. I’m not sure what you mean by “lifestyle meds” but I assume that these are recreational (non-disease Tx) drugs. Any physician writing scripts for this use should consider the ethical implications of giving patients access to non-therapeutic drugs in return for an office visit fee.
      Thanks also for the link to the RWJF report. Unfortunately, this is locked behind a paywall so I can only access the abstract which states that a minority of Medicare patients consume most of the resources and it will be difficult to cut these costs because they are really sick. … Duh.

    • Evaluating the marginal cost against the marginal benefit also provides an important way to solve problems. Simply put, businesses proceed with plans when the marginal benefit exceeds costs. John Taylor, author of “Principles of Economics” explains the market is most efficient if the marginal cost is equal amongst all producers and the marginal benefit of consuming the item is the same amongst all consumers. When these two conditions are not met, producers outsource some of its divisions to more efficient vendors and consumers sell the items to other buyers as a way to achieve equilibrium.