Chapter 3: Cost and Benefit Analysis

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Chapter 3 Cost and Benefit Analysis
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Cost Identification Analysis

• Cost Identification Analysis measures the total
  economic cost of a given medical condition or
  type of adverse health behavior.
• Examples Cost of asthma or Alzheimers disease.
  Cost of cigarette smoking or excessive alcohol
  consumption.

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Three Types of Costs

• Direct medical costs all costs incurred by
  medical care providers when treating the
  condition. (DMC)
• Direct nonmedical costs monetary costs imposed
  on any nonmedical care personnel, including
  patients and their relatives.(DNC)
• Indirect costs opportunity cost of the time
  influenced by the illness or health behavior such
  as lost productivity because of sickness, injury,
  or loss of life. (IC)

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Three Types of Costs

• Note that Total Cost DMCDNCIC
• Do not confuse the use of opportunity cost in the
  definition of IC to mean that there are no
  opportunity costs in DMC and DNC
• In fact, ALL costs are really opportunity cost.
  IC are just often hidden or missed as we measure
  medical costs.

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Example

• Weiss, Gergen, and Hodgson (1992), New England
  Journal of Medicine
• Total annual cost of asthma in the U.S. 6.2
  billion in 1990
• Direct medical costs 3.6 billion
• Indirect costs 2.5 billion
• Lost school days 900 million
• Lost work due to illness 800 million
• Lost work because of worker death 800 million

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Limitations of Cost Identification Analysis

• While valuable because it sheds light on the
  economic impact of illnesses and adverse health
  behaviors, cost identification analysis does not
  provide information on the wastefulness of
  various medical interventions or the best or
  efficient way of saving lives.
• It ignores the benefit side of the analysis
• Cost-Benefit Analysis and Cost-Effectiveness
  Analysis do offer this type of information.

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Cost-Benefit Analysis

• The Theory of Cost-Benefit Analysis
• Maximize net social utility by looking at both
  the costs and benefits of all possible actions
• Suppose an all-knowing and benevolent
  Surgeon-General (SG) is responsible for
  maximizing the social utility or happiness of the
  population in an area.
• The SG achieves the objective by maximizing the
  total net social benefit received from each and
  every good in society.

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Theory of Cost-Benefit Analysis - continued

• For medical services, the SG faces the following
  objective
• Max TNSB(Q) TSB(Q) TSC(Q)
• Where Q identifies the action
• TSB is the total social benefit of the action
• TSC is the total social cost of the action
• Total net social benefit (TNSB) represents the
  difference between the two.

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TSB and TSC

• TSB the money value of the satisfaction
  generated from consuming medical services.
• TSB increases at a decreasing rate reflecting the
  law of diminishing marginal utility.
• TSC the money value of all the resources and
  opportunities used in the producing medical
  services.
• TSB increasing at an increasing rate indicating
  the law of diminishing marginal productivity.

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Determination of the Efficient Level
of Medical Services

TSC
TSB
Q0 occurs where the slope of the TSB equals the
slope of the TSC
A
B
Quantity of Medical Services Q
Q0
Q0 represents the efficient level of medical
services because TNSB, the vertical difference
between TCB and TSC, is the greatest.
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MSB and MSC

• Marginal social benefit
• (MSB) ?TSB/?Q or slope of TSB curve
• Marginal social cost
• (MSC) ?TSC/?Q or slope of TSC curve
• Geometric principle the distance between two
  curves is maximized when slopes are equal.

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A Marginal Perspective of the Efficient Level

MSC
A
G
E
C
F
H
MSB
B
Q0
QL
QR
Quantity of Medical Services
Q
The amount of medical services at Q0 is efficient
because MSB MSC.
QL reflects under provision because MSB MSC.
QR indicates overprovision because MSC MSB.
Triangular areas ECF and GCH reflect the
deadweight losses associated with inefficient
outcomes.
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The Net Benefit Calculus - revisited

• The SGs task can be restated as setting the net
  marginal social benefit (NMSB) of each and every
  action equal to zero, or
• NMSB(Q) MSB(Q) MSC(Q) 0
• If NMSB(Q) 0 do more.
• If NMSB(Q)

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Practical Side of C/B Analysis

• Several steps must be taken to implement C/B
  analysis in practice.
• Enumerate and quantify the benefits of the
  program or intervention, e.g.,
• Medical costs diverted because an illness is
  prevented
• Monetary value of any gains in productivity
  because death is postponed or illnesses prevented
• The monetary value associated with the utility of
  being in a state of good health

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C/B in practice - continued

• Costs must be enumerated and quantified, e.g.,
• Opportunity cost of each and every resource
  involved in the program or intervention.
• Should capture both the money (explicit) and time
  (implicit) cost of resources.

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Discounting Costs and Benefits

• Discounting considers the time value of goods and
  services. In general, people prefer receiving
  goods and services today than in the future.
• Stated in financial terms, a dollar received
  today is worth more than a dollar received
  tomorrow.

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Discounting Costs and Benefits - continued

• Since a medical intervention typically yields a
  stream of future benefits and costs, discounting
  of values is necessary to state all values in
  present day terms for comparability. For example,
  the present value of 1 received at the end of
  the year when the discount rate is 5 is
• PV 1/(1.05) .95

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Discounting Costs and Benefits - continued

• In general, if there are N periods for which the
  medical intervention generates benefits and/or
  cost and the discount rate is represented by r,
  we can write
• PV B1-C1 B2-C2 . . . BN-CN
• (1r)1 (1r)2 (1r)N
  
• N
• Or PV ? Bi-Ci
• i (1r)i
• Notice, increasing r will lower PV, while
  decreasing r raises PV, and higher r makes future
  values much less in PV calculation

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Discounting Costs and Benefits - continued

• Careful consideration must be given to the choice
  of the discount rate. The discount rate should
  reflect societys time preference for goods and
  services.
• If the chosen rate is higher than the true rate,
  short-term interventions will be chosen over
  long-term interventions.
• The T-bill rate is often used and studies
  normally examine the sensitivity of the results
  to different discount rates.

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The Value of a Human Life

• To properly estimate the benefits of a medical
  intervention, it is often necessary to put a
  value on a human life. Two approaches.
• Human Capital Approach equate the value of a
  persons life to the market value, in present
  value terms, of the output produced by an
  individual over the remaining years of that
  persons life.
• For example, suppose a life-saving treatment, if
  implemented today, provides an estimated 2
  additional years of life for an estimated 10,000
  adult males, each with his human capital worth
  1,500 for those 2 years. The benefit, in terms
  of the value of life years saved, would be 15
  million.

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Human Capital Approach - continued

• Although widely accepted and used, human capital
  values may be understated because of gender and
  racial discrimination in the labor market.
• Additionally, the human capital approach would
  assign a zero value of life for someone who is
  chronically unemployed.

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Willingness to Pay Approach

• Willingness to pay approach assigns a value of
  life based upon someones willingness to pay for
  a small reduction in the probability of dying.
• This kind of information is revealed when people
  purchase safety equipment or are compensated for
  working in risky environments, for example.

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Willingness to Pay Approach - continued

• To understand the logic, consider a person who is
  deciding to purchase a device that can reduce the
  probability of dying by Pr. Using the
  cost-benefit principle, the person with a value
  of life equal to V would be indifferent about
  buying the device of cost, C, if
• Pr V C
• (or expected marginal benefit equals marginal
  cost.)

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Willingness to Pay - continued

• Rewriting
• V C/Pr
• Thus, if society is willing to pay 100 per
  person per year for some device that improves
  environmental quality, thus reducing the
  probability of dying by 1 in 10,000, the imputed
  value of a life equals at least 1 million (100
  divided by 1/10,000

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Willingness to Pay Approach - continued

• For figures based on various types of regulations
  see Table 7-2 in text.
• Viscusi (1993) JEL found willingness to pay
  estimates to range between 3 million and 7
  million in 1990 based on labor market studies
  where workers must be compensated for undertaking
  risky jobs. Note the figure for wage premiums for
  dangerous factory jobs in Table 7-2.
• Viscusi and others point out the willingness to
  pay numbers greatly exceed human capital
  estimates by a sizeable margin.

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Willingness to Pay Approach - continued

• Advantage measures the total value of life,
  both job market value and leisure time..
• Disadvantage difficult to develop precise,
  reliable data about how much people value safety.

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The Game of Life

• Bon Chance!

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Determining the Value of Your Life

• We begin with a pool of 10,000 people.
• Each person is asked to play a game, if willing.
  
• Each person must determine the fee that he or she
  will accept or be paid to participate in the
  game.
• The fee is based on each persons own values and
  the expected level of competition.
• One thousand of the 10,000 lucky people with the
  lowest fees will be chosen to play the game. The
  assumption is that competition among the 1,000
  individuals will keep fees close to actual
  willingness to play the game.

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Determining the Value of Your Life

• One of the 1,000 players will be selected at
  random and executed.
• The rest will receive their fees and are allowed
  to withdraw from the game.
• How much will you charge to play the game?

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Calculations

• Fee probability of dying times value of life
  (i.e., MB MC)
• Value of life Fee/probability of dying
• Value of Life 1000 X Fee
• Major Point The value of our lives is revealed
  by our acceptance or avoidance of risk.

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End of Game

• I hope you won!
• Do we ever see games like this? Where?
• Hint Risky behavior

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SKIP Reconciling the Human Capital and
Willingness to Pay Approaches

• Keeler (2001) JHE
• Points out that standard economic models of labor
  supply assume that the value of leisure time at
  the margin is equal to the marginal wage rate
  (i.e., marginal cost equals marginal benefit of
  working).
• If we assume the value of all time is equal to
  the wage rate (no diminishing returns due to
  leisure if so a lower bound estimate), we can
  calculate the value of life by multiplying the
  wage rate by total discounted hours of life time
  remaining.

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SKIP Reconciliation - continued

• Makes these assumptions
• Workers stay employed for 5 years after we first
  observe them working.
• After the initial period they revert to the 1990
  participation rates 92 of 25-54 year old mean
  remain employed 70 of men 55-64 16 of men 65
  and over 75 of 25-54 year old women 46 of
  women 55-64 9 of women 65 and older.
• Hour wage rate given by the 1990 median weekly
  earnings for full-time wage and salary workers in
  their age-sex category divided by 40.
• Workers work 2000 hours per year, if employed.
• Workers live up to age 40 and then follow average
  US 1992 mortality rates.
• Discount rate is 3.

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Value of life based on value of work and leisure
time
NOTE how value of life decreases as age increases.
Keeler, 2001, JHE
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SKIP Reconciliation - continued

• Keeler concludes by writing (p. 142)
• Neither the estimates of value of life in the
  literature nor these estimates of value of
  lifetime remaining are very precise, but it is
  amusing that they are so close to each other.
  Maybe people really do make these calculations
  implicitly in choosing a job, or answering a
  survey.

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C/B Analysis some applications

• See page 191 in text and surrounding discussion
  concerning Vaccination of College Students
  against Meningococcal Disease.
• Cutler and McClellan (2001) Health Affairs, Is
  Technological Change in Medicine Worth It?

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Cutler and McClellan

• Most analysts agree that technological change has
  accounted for the bulk of medical care cost
  increases over time. But do the benefits outweigh
  the added costs?
• The average newborn could expect to spend 8,000
  in present value terms on medical care over his
  or her lifetime.
• An infant born in 1990 had a life expectancy that
  was 7 years greater than one born in 1950 and
  lower disability but faced costs of 45,000 on
  medical care during his or her lifetime.
• Do the benefits outweigh the costs?

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Cutler and McClellan

• Cutler and McClellan focus on the costs and
  benefits of medical technology improvements at
  the disease level to get more precise estimates.
  Focus on
• Heart Attacks
• Low-birthweight infants
• Depression
• Cataracts
• Breast Cancer

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Cutler and McClellan

• Authors point out that new technologies have
• treatment substitution effect (use new
  treatments over old) and
• treatment expansion effect (more care in total)
• Authors assume a 3 discount rate and the value
  of a year of life in the absence of disease at
  100,000.

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Cutler and McClellan - continued

• Authors conclude
• The benefits from lower infant mortality and
  better treatment of heart attacks have been
  sufficiently great that they alone are about
  equal to the rise in medical care costs over
  time. Recognizing other benefits, medical
  spending is clearly worth the costs.
• Quality adjusted medical prices may actually have
  declined over time in contrast to standard
  figures showing rising prices for medical
  services.

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Cost Effectiveness Analysis

• Instead of measuring if various medical
  intervention are wasteful or not, CEA seeks to
  answer the question What is the least cost way
  of achieving a given objective?
• Objective may be number of life years saved or
  reduced cholesterol levels or blood pressure, for
  example.

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CEA Analysis - continued

• Cost of a life year saved
• Cost of Intervention
• Number of life years saved
• Costs would include both direct medical costs and
  direct nonmedical costs. The number of life years
  saved may also be multiplied by a quality of life
  index ranging from zero (death) to one (perfect
  health) to measure quality-adjusted live years
  saved.

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CEA Analysis - continued

• With a limited budget, CEA allows one to choose
  the largest payoff for dollars spent
• Practiced in Oregon for Medicaid spending
• Ranked treatments by CEA based on quality
  adjusted life years saved (QALY)
• QALY uses responses to understand how many years
  or money a person would give up to avoid an
  ailment.
• CEA said spend more money on prenatal and
  childhood illnesses, less on late-life
  intervention

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• Lifesaving Costs
• Median cost of a year of life saved by various
  interventions
• 
  COST
• Childhood immunizations Less than
  zero
• Prenatal care Less than
  zero
• Flu shots
  600
• Water chlorination
  4,000
• Pneumonia vaccination
  12,000
• Breast cancer screening
  17,000
• Construction safety rules
  38,000
• Home radon control
  141,000
• Asbestos controls 1.9 million
  
• Radiation controls 27.4 million
• Source Harvard Lifesaving Study

Health Prevention may be costlier than a cure
Wall Street Journal New York Jul 6, 1994
Stipp, David