Principles Of

Health Economics
2nd Lecture Note:
Demand For
Health And Health
Care
Demand for Health
 The general model of human capital was originally developed by Gary Becker in his context of investment in
education (Becker, 1975) and Grossman (1972) extended 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. Individuals take several decisions regarding work, health (and non-
health) care, exercise, and the use of consumption goods and bads (such as unhealthy food, cigarettes, alcohol, or
addictive drugs).
 According to this theory:
1. It is not medical care as such that consumers want, but rather health. In seeking health, they demand medical care
inputs to produce it.
2. Consumers do not merely purchase health passively from the market. Instead, they produce health, combining time
devoted to health-improving efforts including diet and exercise with purchased medical inputs.
3. Health lasts for more than a day or a month or a year. It does not depreciate instantly, and it can be analysed
like a capital good.
4. Perhaps most importantly, health can be treated both as a consumption good and an investment good. People
desire health as a consumption good because it makes them feel and look better. As an investment good, they
desire health because it increases the number of healthy days available to work and to earn income.
Demand for Health
Figure 2.1: Investing in Human Capital

Figure 2.1 provides a simple diagram that explains the concept of health capital. It is defined as capital goods (or
“stock of capital”) like cars and refrigerators. One can conceive of a person’s stock of health capital that provides the
ultimate output of “healthy days.” One might measure the stream of health output(s) as a single dimension of healthy
days, or in several dimensions of physical health, mental health, and limited activity; for example, one can no longer
play singles in tennis, but must play (less strenuous) doubles instead.
Demand for Health
 Consumers apply sets of health inputs, which might include not only market inputs of health care, but also diet, exercise,
and time, to their physical makeup, thus making investments in health capital. These investments maintain or improve the
consumers’ stocks of health, which in turn provide them with healthy days. Over time, the health stock may grow, remain
constant, or decline (again, like a car or a refrigerator), either slowly with age, or more abruptly with illness or injury.
Furthermore, there may be many technologies available to produce health capital, using various amounts of time or
market goods. Thus, Figure 2.1 explain how the end goal of “healthy days” guides consumer decisions as to how much time
and money to invest in health stock.
 We will see that the prices of health care, the people’s wage rates, and their productivities in producing health affect how
resources are to be allocated among health capital, and other goods and services that people buy.

 For example, an individual buys market inputs (e.g., medical care, food, clothing), and combines them with her/his own
time to produce a stock of health capital that produces services that increase their utility. Then she/he uses market inputs
and personal time both to invest in her/his stock of health and to produce other things that she/he likes.
 These other items include virtually all other things that individuals do. These include time spent watching television, reading,
playing with children, preparing meals, baking
 bread, or watching the sunset, a composite of other things people does with leisure time. We shall call this composite home
good B.
Demand for Health: Grossman’s Investment Model of Health
 The principle contribution of Grossman’s model is the distinction between health as an output (i.e., a fundamental
commodity), which is a source of utility to people, and medical care as an input to the production of health. In
Grossman’s model, health is both demanded and produced by individuals.
 Health is demanded because it affects the total time available for the production of income and wealth and
because it is a source of utility itself. Ill health reduces both our happiness and our ability to earn.
 Health is modelled as being produced by individuals, using a variety of means such as diet, lifestyle choices, and
medical care. How efficient people are in the production of health depends on their knowledge and education.
Medical care is an input to the production of health.
 Each individual is modelled as starting life with a ‘stock’ of health, which has characteristics similar to capital: health
depreciates through time with age, but can also be increased through investments in time, effort, knowledge, or by
seeking health care.
 Grossman’s model captures two important insights. First, health care is but one input in generating improvements in
health: it is now widely accepted that medical care is not the major determinant of health. Second, individuals do
not demand health care for its own sake. The utility received from consuming health care is not generated from
health care, but from the improvements in health that result. Therefore, the demand for health care is a derived
demand.
Demand for Health: Grossman’s Investment Model of Health
 The investment model of health views the demand for health as being conditional on both the cost of health capital
and the rate of depreciation of the health stock. As in the investment in a car, or in any capital good that eventually
depreciates (wears out), the difference between the gross (total) and net investment depends on the rate at which
the capital good depreciates.

 The theory of health demand starts by assuming that for simplicity, people derive utility from two goods: health (H)
and a composite of all other fundamental commodities (B), such that:
U = U(H, B)
H is a weighted sum of the number of healthy days that the person enjoys over a lifetime. These healthy days derive
from a person’s stock of health (HS), thus greater health stock will lead to a greater number of healthy days. The
health stock as a particular time (HSt) is determined by the health stock in the previous period (HSt-1) less any
depreciation in health stock that has taken place over that period (dt), plus any investment in health (It) that the person
has undertaken, such that:
HSt = HSt-1 - dt + It
Demand for Health: Grossman’s Investment Model of Health
 An increment to capital stock, such as health, is called an investment. During each period, an individual produces an
investment in health, I. Health investment I is produced by time spent improving health, TH, and market health inputs
(medical care, drugs), M. Likewise, home good B is produced with time, TB, and market-purchased goods, X.
 If, for example, we considered good B to be baking bread, the market goods might include flour, yeast, kitchen
appliances, and gas, water, and/or electricity. Thus, this individual uses money to buy health care inputs, M, or home
good inputs, X. He uses leisure time either for health care (TH) or for producing the home good (TB). Production
functions become;
I= I(M, TH)
B=B(X, TB)
These functions indicate that increased amounts of M and TH lead to increased investment I, and that increased amounts
of X and TB lead to increased home good B.
Demand for Health: Grossman’s Investment Model of Health
 It is assumed that a person will attempt to maximize his/her utility, but there are two constraints upon this—a time
budget and an expenditure budget. The time budget (T) is fixed at 365 days per year, where time is further
constrained to time spent on working (TW) and time spent being sick (TS), such that:
Total Time, 365 days= T = TH (improving health) + TB (producing home goods) + TL (lost to illness) + TW (working)
Figure 2.2. Labour-Leisure Trade-off
Demand for Health: Grossman’s Investment Model of Health
 In Figure 2.2, the x -axis represents the individual’s work and leisure time. Assume further that the number of days
lost to ill health and the number of days spent on health-enhancing activity are fixed (we relax this assumption
later).
 Variables TL and TH refer to time lost and time spent on healthy activities, respectively. The maximum amount of
time that he has available to use either for work, TW, or leisure, TB, is thus 365 − TH − TL, so:
Time Available for Work or Leisure days = 365 days - TH - TL= TB + TW
 Leisure time, TB, is measured toward the right while time spent at work, TW, is measured toward the left. Figure 2.2
shows that if the individual chooses leisure time, OA, then he has simultaneously chosen the amount of time at work
indicated by AS.
 The y -axis represents income, obtained through work. This income will then purchase either market health goods or
other market goods. Thus, if he chooses point S, he will not be able to purchase market goods because he has no
wage income. If, beginning at S, he gives up one day of leisure by spending that day at work, to point N, he will
generate income equal to 0Y1, which represents his daily wage. In economic terms, this quantity represents income
divided by days worked—that is, the daily wage. The slope of the line VS depicting the labour–leisure trade-off
reflects the wage rate (if he pays Social Security and/or taxes on his wage, then the slope reflects the after-tax
wage rate).
Demand for Health: Grossman’s Investment Model of Health
 The constraint on the expenditure budget is income, which depends on how much time is spent working and the
wage rate (W). How much is spent depends on the costs of the market goods, M and B, and it is assumed that all
income is spent, such that:
PM x M+ PB x B = TW x W
Preferences between Leisure and Income
 Consumers have preferences regarding income and leisure. In Figure 2.2, in equilibrium, the person’s trade-off of
leisure and income is the same as the market trade-off, which is the wage rate. Here, he takes amount 0A of leisure
and trades amount AS of leisure for income, 0Y2.
Demand for Health: Grossman’s Investment Model of Health
Figure 2.3 Increased Amount of Healthy Time Due to Investment

 In Figure 2.3, he has made a different choice with respect to time spent investing in health status. To illustrate,
suppose that time spent on health-producing activities, TH, is increased to 𝑇𝑇𝐻𝐻′ . Correspondingly, suppose that the
number of days lost to ill health has been reduced to 𝑇𝑇𝐿𝐿′ . On the one hand, the time he spends producing health
reduces his time available for other activities. Time spent on health investment increases health stock and, in turn,
reduces time lost to illness.
Demand for Health: Grossman’s Investment Model of Health
 If the net effect of 𝑇𝑇𝐻𝐻′ + 𝑇𝑇𝐿𝐿′ is a gain in available time, then this illustrates the pure investment aspect of health
demand. The health investments “pay off” in terms that both add to potential leisure and also increase the potential
income, shifting the income–leisure line outward from VS to RQ. The expenditure of time (and medical care, too) for
health producing activities may later improve this person’s available hours (because he is sick less) of productive
activity.
 As a result of his investment, he can increase his utility, moving from point E to point E’. Not only does investment in
health lead to his feeling better, but it also leads to more future income and may lead to more leisure, as well.
 The improvement in health status also might increase the person’s productivity at work, perhaps resulting in a higher
wage and a steeper income–leisure line.
Demand for Health: Grossman’s Investment Model of Health
The Investment/Consumption Aspects of Health
 The Grossman model describes how consumers simultaneously make choices over many periods or years. It can also
be instructive to represent a whole life span as a single period. This can show the dual nature of health as both an
investment good and a consumption good.
Production of Healthy Days
 For simplicity, we will view health as a productive good that produces a single output,

 healthy days, a production function relationship illustrated in Figure 2.4. The horizontal axis measures health stock in
a given period. A larger stock of health leads to a larger number of healthy days, up to a natural maximum of
365 days. The bowed shape of the curve illustrates the law of diminishing marginal returns. That is, additional
resources have decreasing marginal impacts on the output—all of the person’s health improvement attempts serve
to increase his healthy days, but he still gets sick every once in a while. Note also the concept of a health stock
minimum shown as 𝐻𝐻𝑚𝑚𝑚𝑚𝑚𝑚 , where health stock becomes arbitrarily small. At this point, production of healthy days
drops to zero, indicating death.
Demand for Health: Grossman’s Investment Model of Health
Figure 2.4 Relation of Health Days to Health Stock
Demand for Health: Grossman’s Investment Model of Health
 Production of Health and Home Goods

Consider the possibilities for producing health, H, and home good, B, given the total amount of time available. Figure
2.5 shows the production possibilities trade-off. The curve differs from the usual production possibilities curve in several
respects.
Figure 2.5 Allocation of Production between Health and Bread
Demand for Health: Grossman’s Investment Model of Health
 First, from point A to point C, health improvements increase the amounts of the home good, B, and
health, H, attainable. It is necessary to increase health beyond Hmin in order to obtain income and
leisure time from which to produce B.
 Moving along the production possibilities curve, the person (Ed) shifts his uses of available time
and distributes his purchases of market goods. The move from E to C indicates that he has made
more time available for health and that this move has increased leisure time of production of the
home good, baking bread.
 Suppose that the person desires health solely for its effect on the ability to produce income and
the leisure time to produce the home good bread, B. This would imply that his indifference curves
between H and B are vertical lines. (it means he would not trade any B to get additional health.)
In such a case, he would maximize his utility by producing as much B as possible. The utility-
maximizing choice would be at point C, a point of tangency between indifference curve U1 and
the production possibilities curve. He produces amount B0 of the home good, and H0 of health.
 Now assume instead that this person achieves utility not only from producing B, but also directly
from health itself (he likes feeling better). In this case, his (dashed) indifference curve, U2, sloping
downward from left to right. It is more realistic to say that he values health both as a consumption
good, and as an investment in productive capacity. The consumption aspect suggests that he
enjoys feeling healthy; the investment aspect, that feeling healthy makes him more productive,
thus allows him to earn more. In general, by including the person’s “feeling healthy” in this
consumption feature of the model, he will choose a higher health stock than under the pure
investment model.
 In Figure 2.5, health stock, H1, exceeds H0. The cost of this increase in H involves foregoing some
of the home good B, such that B1 is less than B0.
Demand for Health: Grossman’s Investment Model of Health
Investment over Time
The Cost of Capital
 People make choices for the many periods over their life cycles, rather than just for one representative period. As a
beginning point for each analysis, we feature the pure investment version of the model (point C in Figure 2.5). We
then discuss the analytical changes when consumers, in addition, value health intrinsically (point D in Figure 2.5).
 We demand health capital because it helps us earn more and feel better. What does it cost? By analogy, a health
clinic purchases thousands of dollars of X-ray equipment. The return to the X-ray equipment is in the future earnings
that ownership of the equipment can provide.
 Suppose that an X-ray machine costs $200,000, and that its price does not change over time. Suppose also that the
annual income attributable to the use of the X-ray machine is $40,000. Is purchasing the machine a good
investment? Consider the alternative: Instead of purchasing the X-ray machine, the clinic could have put the
$200,000 in a savings account, at 5 percent interest, yielding the following:
Demand for Health: Grossman’s Investment Model of Health
200,000 × 1.05 = 210,000 at the end of Year 1
200,000 ×1.052 = 210,000 × 1.05 = 220,500 at the end of Year 2
200,000 ×1.053 = 220,500 × 1.05 = 231,525 at the end of Year 3
200,000 ×1.054 = 231,525 × 1.05 = 243,101 at the end of Year 4
200,000 ×1.055 = 243,101× 1.05 = 255,256 at the end of Year 5
 For the investment in an X-ray machine to be desirable by these criteria, it should provide at least $55,256 in incremental revenue over
the five years. The problem is more complicated, however, because capital goods depreciate over time. Most students will agree that a
five-year-old personal computer is worth almost nothing. Even though it may do everything it ever did, new programs may not work on it,
new equipment may not hook up to it properly, and it may be very slow compared to new machines.
 In economic terms, depreciation is the budgeting for replacement. Similarly, suppose that the clinic knows that the X-ray machine will wear
out (or depreciate), so that it will be worth only half its original value in five years. The clinic must earn enough not only to cover the
opportunity cost from the bank, but also to maintain the value of the machine. For an investment in an X-ray machine to be worthwhile,
then, it must not only earn the competitive 5 percent return each year, but it also must provide enough return to cover depreciation. This
suggests that the cost of holding this capital good for any one year, as well as over time, will equal the opportunity cost of the capital
(interest foregone) plus the depreciation (deterioration of value). In this example, the depreciation cost is $100,000, or half of the
$200,000 original cost.
The Demand for Health Capital
 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 (MEI), a demand concept that relates the return to investment
to the amount of resources invested.
Marginal Efficiency of Investment and Rate of Return
 The MEI can be described in terms of the X-ray machine example. A busy clinic may wish to own more than one X-ray machine.
But how many? The clinic management may logically consider them in sequence. The first machine purchased (if they bought only
one) would yield a return as we have discussed.
 Suppose that return each year is $40,000.

 We also can calculate the annual rate of return, which would be $40,000 ÷ $200,000, or 20 percent per year.

 The management would buy this machine if the incremental revenue brought in > its opportunity cost of capital and the
depreciation. In terms of rates, management would choose to own the first X-ray machine as long as the rate of return, 20
percent, exceeded the interest rate (the opportunity cost of capital) plus the depreciation rate.
 If management considered owning two machines, it would discover that the rate of return on the second X-ray machine would
probably be less than the first. This is best understood by recognizing that a clinic buying only one X-ray machine would assign it
to the highest priority uses, those with the highest rate of return. If the clinic were to add a second X-ray machine, then the second
machine would have a lower rate of return than the first. The clinic would then purchase the second machine only if its rate of
return were still higher than interest plus depreciation.
The Demand for Health Capital
 Figure 2.6 Optimal Health Stock
 The marginal efficiency of capital (MEC) is a measure of
how much extra output can be produced with an extra unit
of input.
The Decreasing MEI
 Other machines probably could be added at successively
lower rates of return. In Figure 2.6, the marginal
efficiency of investment curve, MEI, describes the pattern
of rates of return, declining as the amount of investment
(measured on the horizontal axis) increases. The cost of
capital (that is, the interest rate, r, plus the depreciation
rate, δ0) is shown as the horizontal line labelled r + δ0.
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 Demand for Health Capital
 Like the marginal efficiency of investment curve in this example, the MEI curve for investments in health also would
be downward sloping. This occurs because the production function for healthy days (see Figure 2.4) exhibits
diminishing marginal returns. The cost of capital for health would similarly reflect the interest rate plus the rate of
depreciation in health. A person’s health, like any capital good, also will depreciate over time. As we age, certain
joints may wear out, certain organs may function less well than before, or we may become more forgetful. Thus, the
optimal demand for health is likewise given at the intersection of the MEI curve and the cost of capital curve (r + δ0).
 Changes in Equilibrium: Age, Wage, and Education
As we mentioned at the beginning of the lecture (see figure 2.1), an individual has chosen an equilibrium level of
health stock, by deciding how much to work, how much time to spend on health, what kind of diet, and how much
exercise to do. He allocates his resources such that every year he maintains a constant level of health stock, and this
provides him with an equilibrium level of healthy days per year. How does his investment in health change in response
to changes in age, wage, and education?
The model depicted in Figure 2.6 helps us investigate several important model implications. Consider age first.

The Demand for Health Capital
Age
 How does the person’s optimal stock of health vary over a lifetime? In this model the age of death is determined as
part of the model; death itself is endogenous, meaning that it doesn’t just happen! (For completeness, an outcome
determined outside of the model is called exogenous.) Here, he chooses his optimal life span, a life span that is not
infinite. By this model, all of us at some time will optimally allow our health stock to dispersed (spent) to Hmin. This
feature depends in a critical way on how the depreciation rate (a cost factor) varies with age, as well as how long
the person expects to live (and enjoy the benefits of good health).
 Looking first at costs, the person’s health stock may depreciate faster during some periods of life and more slowly
during others. Eventually, as he ages, the depreciation rate will likely increase. In other words, the health of older
people will likely deteriorate faster than the health of younger people.
 Consider then the effect of aging on his optimal health stock. Return to Figure 2.6. We assume that the wage and
other features determining the MEI are not substantially altered by this ageing. However, by hypothesis, the
depreciation rate, δ, increases with age from δ0 to δ1 and ultimately to δD. These assumptions imply that the optimal
health stock decreases with age.
The Demand for Health Capital
Age
 This situation is shown in Figure 2.6 by the fact that the optimal health at the younger age, H0, is greater than H1, the
optimal stock at the older age. Higher depreciation rates increase the cost of holding health capital stock. We
adjust to this by holding more health capital in periods when health is less costly. In old age, health depreciation
rates are extremely high, δD, and optimal health stock falls to Hmin at point B.
 This conclusion is consistent with the observation that elderly people purchase a greater amount of medical care,
even as their health deteriorates. Thus, the pure investment model generates the prediction that optimal health will
decline as the person ages. In Figure 2.6, this suggests that as the expected length of life decreases, the MEI curve
shifts to the left, because the returns from an investment will last for a shorter period of time. This will reinforce the
decrease in investment that occurs due to increased depreciation.
 The Demand for Health Capital
Wage Rate
 Figure 2.6 also illustrates the effect of a change in the wage rate on the individual’s
optimal level of investment. Increased wage rates increase the returns obtained from
healthy days (8 hours’ work will bring in $160 rather than $120 if the wage rate
increases from $15 to $20 per hour). Thus, higher wages imply a higher MEI curve,
or MEI´.
 Assume now that the original MEI curve describes the lower-wage case and yields
optimal health stock, H0. The MEI´ curve, above MEI, shows the marginal efficiency of
investment for someone with higher wages. At new equilibrium point C, the higher
wage will imply a higher optimal level of health stock, H2, in this pure investment
model. The rewards of being healthy are greater for higher-wage workers, so
increased wages will generally tend to increase the optimal capital stock.
 The model illustrates one more implication of the wage factor. Consider that when he
retires, his wage effectively drops to zero because improved health does not help
him earn more. The pure investment version implies that he would change his optimal
health stock to Hmin upon retirement. Once he retires, he would make no further
investment in health, but instead would allow health to depreciate until death.
The Demand for Health Capital
Wage Rate
 How would we amend (improve, make better) this analysis by considering the consumption aspects of health— that
good health makes people feel good?
 First, he would presumably continue to obtain utility directly from healthy days. Thus, optimal health stock would not
necessarily drop to Hmin directly upon his retirement, but it would do so only when depreciation rates became
sufficiently severe.
 Second, if retirees and those who are still working obtain utility directly from healthy days, then the only significant
change upon retirement would involve the end of the pure investment motive. Therefore, even when we include the
consumption aspects of health, we would expect people to reduce their health stock upon retirement.
The Demand for Health Capital
Education
 Education is especially interesting to those who study health demand.
Those with higher education often have better health, and most
economists believe that education may improve the efficiency with
which people can produce investments to health and the home good.
Examples of improved efficiency may include improved ability to
follow instruction regarding medicines or better knowledge of harmful
effects of obesity, or of potentially harmful activities such as smoking,
drinking, or addictive drugs, to name just a few.
 Figure 2.6 illustrates the effect of education. Here, the MEI curve
illustrates the marginal efficiency of investment for the consumer with a
low level of education (measured, for example, by years of schooling),
while the MEI´ curve illustrates the same person with a higher level of
education. This model indicates that because education raises the
marginal product of the direct inputs, it reduces the quantity of these
inputs required to produce a given amount of gross investment.
 It follows that given investments in health can be generated at less cost
for educated people, and thus they experience higher rates of return
to a given stock of health. The result, as shown, is that the more highly
educated people will choose higher optimal health stocks, H2; the less
highly educated will choose H0.
The Demand for Health Capital
Education
 This explains the widely observed correlation between health status and education. Educated people tend to be
significantly healthier. However, this explains only the correlation of health status and education from the supply side
in that it considers only the increased efficiency with which we produce health. One also might wish to explain
education from the demand side.
 Educated people most likely recognize the benefits of improved health. They may enjoy preparing and eating
nutritious food or doing physical exercise. They may recognize the dangers of smoking and the long-term problems
of overexposure to the sun. They may enjoy feeling and looking good. As such, all else equal, they would have a
greater taste for health relative to other goods.
 The demand for health due to education is difficult to separate from the supply effect of education, which implies
more productivity in producing health. Clearly, however, both exist and both are important.