Indifference Curve - Application to the Health Care Industry - Term Paper Example

A Paper in Managerial Economics INDIFFERENCE CURVE: APPLICATION TO THE HEALTH CARE INDUSTRY Introduction The United s today is experiencing a rapidly increasing cost of health care that is without parallel elsewhere in the world. Both the costs of medical care and health insurance have drastically gone up, making it difficult for many Americans to cope with the alarming costs in this sector which the media has reported as having risen twice as fast as consumer prices in general. It is easy to jump to conclusions about what is wrong and what the solutions to the problems should be, but any sober-minded analyst or policy maker needs to know the facts and to analyze this current problem in a rational and objective manner in order to formulate appropriate policies. The economist with tools at his command has certain viewpoints and strategic approaches that can be used to get a good grasp at the problem and suggest solutions. One crucial angle that perhaps needs to be considered is that of demand and supply from the viewpoint of the consumer-constituency, particularly with regard to the problem of consumer choice in the face of scarcity or limited resources. It is a fact that rising prices can be traced to the inadequacy of the supply of medical goods and services as the demand for them continue to rise from year to year. It is therefore important to examine the supply side of the issue – in terms of lack of resources, funding, facilities, and manpower to service the needs of consumers in the medical and health fields. On the other hand, we also need to address the issue of demand – why demand has been growing way above average levels for economic goods and services in the country. From the viewpoint of the policy maker, such as a legislator, he needs to look into how the imbalances between supply and demand have led above-average sectoral inflation and how the issue can be addressed by empathizing with the individual, the constituent faced with the challenge of balancing his or her budget from day to day. Faced with scarce resources, a limited budget, the individual has to make a decision on how to allocate his spending money. This paper shall discuss the choice the consumer has to make between the purchase of one good relative to another good – a trade off that happens as the purchase of one good means the sacrifice of another. The decision to buy one good means that he or she has less money to buy another. Hence the concept of the budget line. The Budget Line. Economists attempt to simplify matters in order to explain something. In the case of the budget line, only two commodities are considered although in real life one does make many choices. Let us say that Lucy Jones has to make a decision on how to allocate her budget of $100 between books and movies. Books cost $5.00 whereas movie tickets cost $2.50. If she spends all on movies she will be able to have 40 tickets and no books, and if she spends it all on books she will have 20 books and no movies. In between she can have varying portions of books and movies as shown in the budget line below: Fig. 1 Clearly the budget line limits the quantity of either goods that her budget can afford to buy, and the budget line shows the combination of either goods that is affordable. Of course, Lucy may also purchase goods below the budget line and thus be able to save. Beyond the budget line, to the right, she will not be able to afford it because of her limited budget. What happens if the price of the movie ticket rises to $5? She will have half as many tickets, and the budget line shifts downward to the left. We shall encounter an analogy of this hypothetical event in the increase in the cost of medical and health services. Note, however, that if income improves, assuming all other things constant, the budget line will have to shift, as indicated by the straight black line, towards the right , as follows: Fig 2 What this indicates is that Lucy has more purchasing power as she can obtain more of the either or both goods, assuming that inflation has been contained at zero percent. The Indifference Curve. While the budget line indicates the choices available to the consumer, given her available resources and the market prices, the consumers preferences will also have to be taken into account in order to determine which combination of goods she will want to choose. There will be combinations of movie tickets and books which the consumer prefers in the above example, and some of these she will prefer compared to others. When certain quantitative combinations are preferred, she is ranking her preference; however, if mixes of these goods are equally desirable to her – that is, she is “indifferent,”- we will be able to discover her indifference curve, which contains points along which she does not care about which one she gets. The indifference curve is thus defined as a line connecting all combinations of the commodities which are equally desirable to the consumer (Baumol and Smart, 1997; Mankiw, 1998). Note that as the indifference curve shows more of one good compared to the other, the consumer will need proportionately more of the other good that has become “scarce.”, hence the peculiar shape of the curve. Fig. 3 Economists point out that there are certain characteristics of indifference curves: a) Every point in the higher indifference curve (further away from the origin) will be preferred to any point on a lower indifference curve;2) Curves never intersect. 3) Indifference curves have a negative slope, and 4) Curves are bowed in or flatten out as they extend from left to right. The slope of the indifference curve is called the marginal rate of substitution between two commodities, representing the maximum amount of one good that the consumer would be willing to sacrifice in exchange for one more unit of the other good. On the other hand, the slope of the budget line shows what the market requires a consumer to give up in order to get an additional unit of the other good while adhering to the budget limit. When we superimpose one curve on the other we would be able to obtain the point of tangency between the budget line and the indifference curve. At this point of tangency, the consumers benefits from buying the combination of goods is maximized, while the budget line shows that it is within affordable limits. Fig. 4 Relevance of Indifference Curve Analysis At the level of the individual, ones knowledge of indifference curve would help the policy maker understand the impact of inflation on the consumers choices. However, there is considerable difficulty in determining the units of goods or services in such a multi-dimensional sector as medical and health services. An attempt will have to be made nonetheless in determining what two bundles of goods or services to use in the study without overly simplifying matters. One could, for example, visits to a medical facility as one commodity, and “other goods” as the other commodity (Samuelson and Marks, 1995). When a consumer has, say, a $1000 budget, she could spend make 10 visits per year with a cost per visit of $100 and none left for other goods. Or she could spend all that money for other goods and no health visits. Or she could spend a combination of visits and other goods. Her indifference curve, before time and inflation has set in, would be some point of tangency between her budget line and her indifference curve, at a certain combination of the two bundles of goods. Assuming that the cost of such visits increased by 25% - which means $125 per visit instead of $100, how would this affect his choices? Her budget line would shift leftward on the horizontal axis to 8 visits ( a reduction by 2 visits), while the budget for other goods remain constant, assuming, for the sake of simplicity, that inflation had not affected the prices of other goods. Such a shift in the budget line would be similar to the graph shown in Fig. 1 above. The indifference curve would also dip downwards and towards the left, with the purchases of other goods also affected, though a bit slightly in comparison. General consumer welfare drops. The Impact of Inflation on Consumer Choices We have seen that the consumer has to make decisions in the face of changes in her income. When inflation is higher than the increase in personal income, the consumer is worse off. When there is an imbalance in her expenditures because the cost of medical and health care has gone up disproportionately higher than other goods, the consumers budget line will shift to the left and she will have to reduce her consumption of medical and health care, and her indifference curve – which indicates the optimal combination of medical and health care vis-a-vis other goods at different levels - will likewise shift to the left, with both items slipping, indicating a drop in consumer welfare. For the elected official, this can sound an alarm of a possible reduction in support in the next elections. Let us consider actual inflation statistics. According to the U.S. Bureau of Labor Statistics, U.S. Inflation rate was 2.85 per cent in 2007, rising to 3.9 per cent on an annual basis in April 2008. During the latter period, medical care costs were up 3.9 per cent. Discounting the high (5.0 per cent) increase in food and beverages and and of energy (15.9 per cent), the general inflation rate should have been only 2.3 per cent. This means that medical care costs only rose 86.6 higher than the consumer price index. Because medical and health services are partly government supervised, inflation in this sector cannot be expected to rise uncontrolled; only the private sector can subject their services to the market forces of supply and demand. If we assume that the individual consumers income has not kept pace with inflation, she would have a lower purchasing power generally than the year before. Her budget line will move to the left to that extent. At the same time, because medical care costs had risen nearly twice the inflation rate, her “visits” to the medical doctor or hospital would be constrained more severely than other purchases. Aside from the budget line shifting slightly to the left, the “visits” on the horizontal axis would also shift to the left. This is shown by the following graph. Fig 5 Consequently, her indifference curve would (I1) would also shift to the left, to I2. Note that the point of tangency between her new indifference curve and the post-inflation budget line would also fall. This indicates that consumer welfare has dropped. When combined with supply-and-demand analysis, indifference curve analysis as an analytical tool is useful to the policy maker in resolving that some new policy or policies are required to address the issue, and in determining the nature and form such initiatives. Conclusion Against the backdrop of high inflation rates for medical and health care compared to the overall consumer price index, the first step that the policy maker may take in order to contain or reduce inflation in this sector is to analyze both supply and demand in that sector. On the supply side, there may be inadequacy in the the governments budget for the health sector, so that the patients had to bear the brunt of rising costs. There might be a need for more hospitals and hospital beds, more doctors and nurses, more and cheaper medicines, and more and adequate health insurance coverage with government support. Such scarcity relative to demand can be studied with assiduous diligence so that a health development strategy that addresses all issues can be developed for the medium and long-term future. On the demand side, the government might need more, strictly enforced measures and incentives to reduce the incidence and frequency of hospital treatment. The case of health care for senior may have to be specially addressed, as the growth of medical costs in this segment has grown significantly in 2007. Measures that the Senator might address in a draft legislation which addresses the demand side would be, among others: 1) Enforcement measures to limit tobacco smoking and elimination of drug abuse for all levels of population, 2) Health awareness with regard to food consumption which can be undertaken through the regulation of eateries,restaurants, and other food establishments, through information dissemination to consumers about the harmful consequences of certain food consumption behaviors, 3) Emphasis on exercise and physical activity particularly for the middle-aged and senior population, 4) Reduction of environmental pollution in every respect, and 5) Tighter regulation of the medical industry to ensure safe procedures for the protection of patients. While the above suggestions are limited in character, what they emphasize is that medical and health care costs can be controlled if the government takes the initiative to study the supply and demand relationships in the health sector. With the control of price increases of goods and services, the welfare of consumers in the nation would be promoted and safeguarded. The indifference curve, which we just explained, would then show not a shift of the budget line downward to the left – indicating a worsening of the level of welfare of the constituency – but should remain stable, and, if possible, show a shift towards the right if increasing personal incomes outstrip the inflation rate. REFERENCES Baumol, W.J. & Blinder, A.S. (1997). Microeconomics: Principles and policy (7th ed.). Orlando, FL: The Dryden Press. Folland, S., Goodman, A.C., & Stano, M. (1997). The Economics of health and health care (2nd ed.). Upper Saddle River, NJ: Prentice Hall. Mankiw, N. G. (1998). Principles of economics. Orlando, FL: The Dryden Press Samuelson, W.F. & Mark, S.G. (1995). Managerial economics (2nd ed.). Orlando, FL: The Dryden Press. Truett, L. J. & Truett, D. B. (2004). Managerial economics:Analysis, problems, cases (8th ed.). Hoboken, NJ: John Wiley and Sons U.S. Inflation data. Retrieved June 14, 2008, from http://inflationdata.com/inflation/Consumer_Price_Index/CurrentCPI.asp Read More