The Economic Problem Notes

Economics Notes

The Economic Problem

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How do we sum up the basic economic problem? We all suffer from it and spend most of our lives trying to resolve it. Essentially, the economic problem stems from the fact that as humans, we have unlimited wants and needs. A need is something that can be seen as being essential to survival, such as food, water, shelter and warmth. A want is something that we would like to have but which is not essential to survival - a car, the latest version of the PlayStation, that new top you have seen in Top Shop, the mobile phone with all the latest gadgets on etc.

The problem is that the world and every individual in it have limited resources in relation to the wants and needs we have. We never have enough money to get what we 'want'. There are never enough resources to make sure the health service works properly; teachers and lecturers will always moan about how they never have enough resources to do their job properly. In recent times, we have heard much about the problems faced by the armed forces in conflict zones around the world 'not having the tools to get the job done'.

There have been plenty of news items in recent years about the lack of resources available to the military in dangerous conflict zones such as Iraq and Afghanistan. If we were to increase the number of soldiers, equipment and weapons available to the military, it would have consequences elsewhere. The government has limited funds from taxes, which have to be spent on a wide range of things - if we diverted more funds to the military, there would have to be cuts elsewhere in the government's spending programme - or a rise in taxes. Copyright: Dragon MasterGunner, from stock.xchng.

All these things are symptomatic of the tension between scarce resources and unlimited wants and needs. That is what the economic problem is all about.

At this stage, you might point to the fact that countries like the UK and the United States produce massive amounts of waste every year. You might look at the food that is wasted in restaurants, fast food outlets and even the school canteen every day to wonder why there is so much wasted food, with so many people in the world hungry and on the verge of starvation.

Part of the problem is the fact that resources are not distributed evenly between countries and societies. The terms 'wants' and 'needs' are also relative terms. 'I really, really want a Ferrari' might be the comment of an individual in the UK; 'I really, really want to be able to walk only two miles to get the daily ration of water for my household' might be the cry of an individual in the Sudan. To each individual, they are both important - we might be able to point out that the Ferrari is not really that necessary; a Smart car will do just as well!

Wants, needs and scarce resources - all part of the economic problem. Wants and needs are relative - my burning want might be very different from the wants of someone like the boy in the image above. Copyright: Luca Biagiotti from stock.xchng, Andrew Ashwin, and Luc Sesselle from stock.xchng.

Resources is a specific term used a great deal in economics. It describes all the things available at our disposal that can be used to satisfy our needs. This therefore includes things like our income, which is simply a means of acquiring a range of goods and services. Resources therefore might be the food we buy at shops, clothing, houses, cars, entertainment, metal, minerals, oil, timber, gas, plastics and so on.

In economics, these resources are normally classified into three or four categories. These are:

Land - all the natural resources of the earth. That includes the fish in the sea, all the minerals found in the earth, metals, sand, stones, rocks, timber, food from the soil and so on. Economists have a name for the reward for the income from 'land' which is rent.
Labour - all the human mental and physical effort that goes into production. This will include people who work as street cleaners, people who are interior designers, teachers, the police, doctors, bricklayers, architects and so on. The reward for labour is referred to as wages.
Capital - all the equipment, machinery and buildings that is not used for its own sake but for the contribution it makes to production. This includes things like office desks and chairs, computers, lorries, cranes, specialist machinery in a factory, the humble office coffee machine and so on. The 'price' of acquiring capital is referred to as interest.

This factory uses a large amount of capital in the production process - there are the buildings that form the factory, all the machines that are used in production and all the equipment needed to make sure the machines and the production process operates smoothly. However, what it also needs is labour, raw materials, land and enterprise to make it all work properly. Copyright: Wena, fromstock.xchng.

Enterprise - the skills needed to organise other resources into some form of production. Some people would put enterprise as a specialist skill within labour but enterprise does have some distinctive characteristics that merit its own category. The return for enterprise is called profit.

Garbage truck in the background, underneath a lighthouse, while two men sweep the street

Man about to hit a red-hot piece of metal with a hammer

Regardless of the task, the human resource of labour comes in many different forms. Labour offers its services in exchange for a reward or price - wages. Copyright: Cristina Ortigoso, Mitchell Powell, Joseph Zlomek and Francesco Pacilli, all from stock.xchng.

If we had an unlimited supply of resources at our disposal we would be able to meet any want or need. The problem is, we do not have unlimited resources at our disposal. We therefore have to make choices. Economics, could, therefore, be described as the science of choice.

Choices are made at many different levels.

You might go into a shop and see two great-looking pairs of jeans but you only have enough money (resources) to buy one of them.
A hospital manager may have 50 patients all wanting to have an operation immediately but there might only be sufficient resources (doctors, nurses, equipment, rooms, beds etc.) at that time to treat 20 of them.
A business might have received a major order for its products and wants to increase production but does not have the staff or the equipment and raw materials to meet the order in full.
An individual in Ethiopia might want a bowl of rice to eat but has to survive on whatever they can scavenge from the parched earth.

All these examples highlight the problem of scarce resources in relation to wants and needs. When we are faced with these choices, we have to go through some quite sophisticated decision making. We might not always be aware that we are making sophisticated decisions but in reality we are. Such decision making is at the heart of the subject of economics and tells us something about how humans try to tackle the economic problem.

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Adam Smith - Virtual Economy

Economists - Adam Smith (1723-90)

Adam Smith is often seen as the founding father of economics. He developed much of the theory about markets that we regard as standard theory now. In fact he could be seen as being to blame for much of the content of current economics courses!

Adam Smith was Scottish and after graduating from Glasgow (at the amazing age of 17!!) he was a fellow at Oxford and then he lectured back in Scotland again - first at Edinburgh and then Glasgow Universities. Surprisingly this was not in economics. In fact it was not until 10 years after leaving the Chair of Moral Philosophy at Glasgow that he wrote the book (or series of books) for which he is most famous. After Glasgow, he decided to go travelling. Almost certainly this was not backpacking and sleeping out in stations as he spent much of this time meeting the influential thinkers of the day. It was this that helped him to formulate his ideas, and once he got back to Scotland again, he started writing.

Nobel Prize Winners 2005 - Robert Aumann and Thomas Schelling

A Game

Play this game and see what happens. Get into a group; you will need some envelopes, some scrap paper and a pen. Imagine that each of you has a different amount of money that comprises your personal wealth. You are required to contribute a sum of money, however, to the common good.

Write down a sum of money, which could be from £0 upwards to the top of your wealth limit, which you are prepared to donate to the common good. Your teacher or group organiser will then double the total amount contributed and share it out equally amongst everyone in the group.

Your teacher will tell you how much each person will get at the end of the round. Now play the game again - what will your strategy be this time?

Your teacher/group leader will allow you to play the game several more times. As each round progresses, notice what happens to your behaviour and also what happens to the behaviour of those in your group.

Game Theory

This simple game reveals a great deal about human nature. For some time now, economists have been interested in game theory and its application to a wide range of situations that are highly relevant to economic analysis. Economists like to think they belong to a tradition that values scientific methodology but there is one big problem facing the subject, which is that economics is a social science and as such is dealing with human behaviour. Human behaviour is not predictable in the same way that force, momentum or light might be.

This does not stop economists looking what is called the law of large numbers and offering some considerable insight into the way in which economies work and how humans behave. The latest winners of the Nobel Prize for Economics have spent much of their lives investigating game theory and their research has some fascinating implications for policy makers and for analysis a series of economic issues.

Robert J. Aumann (left) and Thomas C. Schelling (right) received their awards for the Bank of Sweden Prize in Economic Sciences in memory of Alfred Nobel at the Stockholm Concert Hall, December 10th 2005. Copyright:Nobel Web AB 2005

Robert J. Aumann was born in Germany in 1930 and is the Emeritus Professor at the Centre for Rationality at the Hebrew University of Jerusalem. His background is in mathematics and he gained his PhD in mathematics at the Massachusetts Institute of Technology in 1955. His work has been in the field of game theory and specifically the effect of how cooperation can be of benefit, as a result of the research carried out into repeated games. In such circumstances, the short run benefits may be outweighed by the longer-term benefits of cooperation rather than individual optimisation.

Thomas C. Schelling was born in 1921 and was Emeritus Professor in the Department of Economics and School of Public Affairs at the University of Maryland. Schelling's contribution to game theory was set against the backdrop of the Cold War and the tensions between the West and the East and the nuclear arms race. His research on strategies has helped build understanding of conflict and conflict resolution in spheres as diverse as nuclear war and market structure.

Both Prize winners' ideas and research have helped provide a framework for a greater understanding of human behaviour. We see the potential for applying their ideas every day, as well as in high-profile events such as the G8 summit, the trade talks and Mr Blair's performance at the EU budget summit in December 2005.

Conflict and Strategy

When we look at human behaviour, there is a potential to think of it in terms of evolutionary biology - the survival of the fittest - and extrapolate from this an assumption that humans are selfish individuals who all act to maximise their own self-interest. Adam Smith, of course, suggested that if this were the case, then by definition the welfare of society as a whole would improve - the so-called invisible hand.

Conflict has been a feature of human life ever since humans first walked the planet. However, it is equally the case that cooperation between humans can lead to benefits to the participants that are greater than the cost of the cooperation.

In essence, therefore, every decision we make involves some potential pay-off but might also involve some sacrifice. If we are all acting as rational beings, then we might seek to maximise our pay-offs and minimise our sacrifices. The classic scenario on which this analysis is based is the 'Prisoners' Dilemma'. The following is a summary of this scenario.

The Prisoners' Dilemma

Two people are detained by the authorities on suspicion of committing a crime. The two are separated and then offered a series of choices by the authorities.

If one attributes the crime to the other but the other says nothing, then the one staying silent will get 20 years in jail but the one offering the evidence goes free. This represents a betrayal strategy.
If they both refuse to say anything then they will both receive only six months in jail due to the lack of evidence.
If both say it was the other then they will each get 10 years.

Put yourself in this situation - which choice would you make?

For Player A, select either 'confess' or 'Do not confess'. The animation will then select a response for Player B. When that response is highlighted, you will be given the result on the screen! Try again to see all the options.

(Nb. if nothing appears below you should make sure your Flash player is up to date.

If you think your colleague is also going to behave rationally, then s/he will also be seeking to maximise their outcome.
If you think your colleague will stay silent, then the best option is to betray your colleague because you will go free.
If you assume that your colleague will also seek to maximise his/her situation, then you should still betray them because the outcome will only be a 10-year term instead of a 20-year one.

This is referred to as a non-zero sum game. The decision of one protagonist does not mean there can be no benefit for the other. In a zero-sum game, increasing the benefit for one would lead to a corresponding loss for the other - there is always a winner and a corresponding loser.

Schelling's work was based on the premise that the vast majority of instances of social interaction involved multiple individuals or groups with each having a mix of common interest and conflict.

Schelling identified two aspects of game theory - non-cooperative game theory and cooperative game theory.

Cooperative game theory assumes that there are a set of outcomes or agreements that is known to each player and that each player has preferences over these outcomes.
Non-cooperative game theory assumes players have a series of strategies they could use to gain an outcome and that each player has a preference over their desired outcome.

The other main concept we need at this point is that of the Nash Equilibrium. John Nash was another Nobel Prize Winner in 1994 and carried out research into strategies and solutions in game theory. A Nash Equilibrium exists if, in a non-cooperative game, there is no incentive for any player to change his or her strategy to achieve any benefit to them. There would only be a reason to change strategy if the player thought they could make some gain whilst other players kept their choices unchanged. The resulting pay-offs and the set of strategies constitutes a Nash Equilibrium.

Chicken or Hawk/Dove Games

The background to Schelling's work mentioned earlier is important. Schelling looked at the issue of bargaining - bargaining entails some form of conflict of interest but in essence each player will be looking to maximise their returns, whilst knowing at the same time that some agreement is preferable to no agreement at all. In this scenario, how does a player manage to influence the negotiations in order to move towards his or her preferred outcome without upsetting the other players and thus failing to secure any agreement - an outcome which would be disadvantageous to all concerned, including the player?

Schelling proposed that it might be in the interests of the player to worsen his or her own options in order to gain some sort of concession from another player. Mr Blair, for example, might have had a much freer hand in the EU Budget negotiations if he had not made a firm declaration earlier in the year that the issue of the rebate was not up for discussion. In making such a pronouncement he sent a clear message to the EU that he would not budge on this issue and this affects the subsequent negotiating stance of the rest of the EU members. However, in doing this Mr Blair also set himself up for considerable difficulties at home - any movement on the rebate could be seized upon by his political opponents at home as a sign of weakness.

In such cases, the other EU members would know that if Mr Blair was to move on the rebate issue then it would bring great political costs to him personally and thus by moving on this, Mr Blair might have been more likely to elicit concessions from the rest of the EU on other matters than if he had made a statement at the outset that the rebate was up for negotiation, provided he got some concessions from the others!

Where difficulties arise is if both parties to a conflict make commitments that are seen as being irreversible and incompatible. The result could be stalemate and potential serious conflict. The current dispute with Iran over its nuclear programme might be looked at in this light.

Schelling illustrated some of the dilemmas through a simple example of two countries in conflict over a piece of land. Each country could make a decision to mobilise its troops and attack the other. The alternative would be not mobilising and thus seeking some peaceful solution to the conflict. The payoff to each country if both decide to mobilise is 0. If both decide to seek a peaceful solution, the payoff will be split between the two and will be positive.

If, however, one country mobilises but the other does not, the aggressor can take complete control of the land and achieve a positive payoff that is greater than that achieved through peaceful agreement. For the other country, losing the land is bad but not as bad as all-out war - the result of both mobilising.

The optimum strategy, therefore, is mixed. One is for a country not to mobilise if it thinks the other country is going to; another is for one country to mobilise if it thinks the other country will not. The outcome might depend on the degree to which each country understands the position of the other. In most 'game' situations, the protagonists know something about the position of the other - but not everything. However, if there is any perceived chink in the armour of the other player and this is detected by the other, then there is a potential benefit to follow the hard route. This is why this sort of game is referred to as 'chicken' or 'hawk/dove'.

Deterrence

Schelling further included other complications to the analysis by looking at how the strategies of each player would change in light of threats and action. One of the key features of Cold War strategy was the use of the terms 'first strike' and 'second strike capability'. 'If you send one missile to my land, I will strike back with 20 missiles on yours'. Such a deterrence might influence decision-making - but only if it is credible. In establishing such a deterrence, Schelling also noted that there could be an impact on the perception by other players of the country's interests and intentions, i.e. is this a deterrence strategy or an intention to get a first strike capability where you act and succeed in knocking out the other country's capacity to retaliate, therefore gaining a positive payoff?

How do you interpret the build up of missiles by a prospective opponent? As a means of deterrence or the capability to launch an aggressive attack? Is Iran's work on its nuclear programme purely for energy purposes or is the country aiming to get the technology to allow it to build nuclear weapons? Knowing the intentions of your opponent may not be as straightforward as it seems. © Dave Gotisha, Stock.Xchng.

Having confidence in knowing what your opponent will do in different circumstances, therefore, is vital if some form of equilibrium outcome is to be secured. Country 1 adopts the strategy of not mobilising unless Country 2 chooses to do so. What does Country 2 now do? It knows that if it mobilises then Country 1 will also mobilise - the payoff is zero. Country 2 therefore would be better off choosing not to mobilise. Schelling referred to such a situation as 'a balance of terror'. This translated into the idea of mutually assured destruction (MAD) and inspired the establishment of a hotline between the Kremlin and the White House following the Cuban Missile Crisis.

Brinksmanship

In analysing intentions and outcome, each player will be basing their decisions on some form of probability assessment. What is the probability that your opponent will mobilise? What is the probability that your opponent will retaliate to your actions? In such cases, Schelling noted the use of 'brinkmanship' - providing your opponent with a gradually increasing probability of zero payoff. A key to successful brinkmanship is to up the ante each time by only a small step.

It pays, therefore, to keep your opponent guessing as to your intentions. This might certainly be an analysis that could be applied to the way in which Tony Blair approached the negotiations at the EU Budget meeting. At the heart of game theory is the necessity of assessing the costs and the benefits of a strategy - not too difficult a concept in essence, but extremely powerful in reality.

Schelling then turned his attention to the issue of what happens to strategic decision-making in the long term as opposed to just a short-term view. Decisions made now might have an impact on the future state of negotiations between different parties. Mr Blair suggested that getting a budget deal now was important because it helped set the scene for future negotiations about the Common Agricultural Policy (CAP).

The incentive to forge an agreement and then renege on that agreement i.e. cheat, might be strong. However, Schelling noted that parties will need to recognise that the costs to them of cheating and gaining some short term benefit (which may be much greater) is far outweighed by the costs to them in the longer term of the destruction of the trust that results from cheating. The relationships between players will need to be assessed in the context of repeated playing of the game over a period of time. Certainly, the negotiations on the EU budget have not ended with the agreement in December 2005. The issue will come up again and the parties, whilst not necessarily the same people, will remember what has gone on before and factor this into their decision making.

Schelling's Other Contributions

The work on conflict and aggression that Schelling has worked on established his reputation in the field. However, he continued to work on many other implications of his research, which had an impact on a range of different fields other than war. One such example is his analysis of 'tipping', described as the rapid movement from one equilibrium state to another.

One aspect of this is highlighted in immigration policy. Take the East End of London as an example. During the first half of the twentieth century, the East End was largely composed of white British families. The immigration of different ethnic groups and the tendency for such groups to be concentrated into a particular area meant a fairly rapid change in the social structure of the area. In the Tower Hamlets area, for example, the concentration of communities from Bangladesh, India and Pakistan is relatively high. In such circumstances, white communities can quickly find themselves in the minority and this might not be something that the white community would want.

In such circumstances there might be significant micro and macro social and economic impacts as a result of this 'tipping'. What might happen is that if there are fears that a community might end up in the minority, they seek to move quickly to get out before this happens. In such a case the impact on property prices, local businesses, how the existing area is left and what effect this has on future investment, schooling, health provision and so on as well as the knock-on effects of the movements elsewhere could be quite dramatic.

Schelling also suggested that his ideas could be applied to other areas of social policy. Take smoking for example. Smokers impose costs on the health care system and on the social security system (if they are ill and cannot work then they need support). Should the government try to put in place incentives to persuade smokers to give up - such as taxes?

If you apply strict economic theory to the issue, the answer is 'no'. The reason? Smokers tend to die younger because of their habit. In so doing, they impose less of a cost on the health system than if they did not smoke and stayed alive longer! It is a simple case of cost and benefit. The benefit to the state of people smoking in terms of the overall costs to the health and social security system is greater than the cost of them giving up.

Schelling, himself a smoker who tried to give up over a period of twenty years, argued that despite the apparent logic of this rational analysis, the government in the US should impose taxes on tobacco. His argument was based around the intrapersonal conflicts faced by humans as individuals who do things that they know is not good for them - eating too much and eating the wrong sorts of food, smoking, drinking, exercising too little and not saving enough. In this scenario we are facing a 'game' whereby we face strategic options - to smoke and receive both positive and negative payoffs, or to quit and again receive negative and positive payoffs. The analysis is equally applicable and has relevance to public policy in such circumstances as the research did to military conflict in the 1960s. Witness the current debate over the decision to ban smoking in public places.

Long-term Cooperation

Market trading can be seen as the repeated playing of financial games. © Photolibrary Group

Robert Aumann made his contribution to game theory in a slightly different way. Schelling was noted for the accessibility of his ideas; Aumann's contribution is no less valid but is rooted in a mathematical tradition and as such is not as accessible to the general public.

Aumann's most noted contribution is in the field of long-term cooperation around game theory. We have already seen how, in the prisoners' dilemma, the optimum short-term strategy for each player is to betray the other. In so doing, however, they receive a payoff that is worse than if they cooperated and said nothing. Aumann asked the question about what the equilibrium outcome would be if the game were repeated over and over again, with each prisoner trying to maximise the average payoff from each game.

In this case, Aumann showed that the equilibrium outcome was to cooperate because any cheating on the agreement in the short term would be punishable by a refusal to cooperate at some point in the future - and both players would know this. Any short-term gains, therefore, are outweighed by longer-term losses. Aumann expressed this through what he referred to as a 'supergame' - that is, looking at the collection of repeated games as a whole game in itself.

Aumann's work was extended to look at how groups of players might react in such situations. In a cartel, for example, there is always the tendency or incentive for one firm to break the cartel to seek to gain some advantage in the market. Aumann's work suggested that long-term cooperation could be 'enforced' by the many against the few who might be seeking to defect.

The work was extended in subsequent research to try to take into account the strategies players might adopt in repeated games with incomplete information. This provides an incentive to players to hide, or seek to conceal, information from their rivals. Firms are very keen to keep their costs to themselves! If one player does manage to access information about their rivals and has some form of strategic advantage therefore, what is the best way to utilise this knowledge? If this situation arose, would playing your hand to gain short-term benefit reveal that you did actually know more than you were letting on? For the player who does not have the information they would like, could they discover anything about the player's position by reviewing the strategies and decisions made by that player in the past?

Such scenarios are relevant to the world of financial markets where the issue of insider trading is always something that the authorities are keen to stamp out. The number of people with access to privileged information about market moves, business plans and strategies does mean that there is potential for many decisions that could have long-term implications for the markets and the businesses involved.

Aumann and Schelling's work has a great many applications in everyday life. Trade wars, price wars, negotiations over budgets, wage negotiations, discussions about environmental issues, merger discussions, social policy, monetary policy, fiscal policy, the work of the Competition Commission, EU fisheries debates and oligopolies are just some of the major areas where their work can be applied.

Mathematics in Business and Economics

Health Economics - Mind your Business

Mathematics in Business and Economics

Introduction

This area of Biz/ed looks at mathematics in the context of business and economics. Many students arrive at university to study either economics or business and find that a big barrier to their progress is not the understanding of the economics or business concepts themselves, but the mathematics that goes with it.

This resource is aimed at helping those who lack confidence in using mathematics for economics and business by reviewing some of the basics before moving on to look at some more involved problems.

The first thing to point out is that maths is very much about confidence and being logical. The confidence comes in knowing what to do when and why. The logical bit is ensuring you treat each part of a calculation in the correct order and laying out your answer clearly. If you struggle with maths then remembering these two points will help to ensure a greater degree of achievement and if you achieve, it helps to build your confidence in tackling more complex problems.

Mind your Business - 11 October 2004

Health Economics

The News

Health is one of the major issues on the government's agenda. It is likely to be central in the policy debates in the forthcoming general election. The issue, at its heart, is quite simple. The demands on the health service are great but the resources available are limited. The classic economic problem - unlimited wants and scarce resources!

Every week, doctors have to make difficult decisions about treatment in their hospitals. The decisions are not only based on clinical need but also on the value for money that the hospital has to provide to its 'customers'. In addition it has to think of how to allocate competing resources. If a hospital manager, for example, is working out a budget, they may have to think about how to allocate a limited sum of money amongst competing uses. Does the hospital devote resources to preventative medicines and education or to treatment? Does it spend money on kidney dialysis or hip replacement operations?

Such decisions are always difficult. Recent cases may serve to highlight the problems facing hospitals in allocating scarce resources.

The Welsh Assembly announced at the end of September 2004, that the cost of prescriptions in Welsh pharmacies was to fall from £6.40, the rate in the rest of the UK, to £5.00. In addition, the Assembly announced that it intended to move towards free prescriptions within three years.

However, there has been growing concern amongst some in Wales at the rise in the number of patients on the waiting list for treatment. The tables below highlight the problem faced by Welsh hospitals. The Conservative opposition in the Welsh Assembly claim that despite a 40% increase in funding since 1999, waiting lists have risen by 85%.

Out-patients waiting lists in Wales, 1999-2003

	1999	2000	2001	2002	2003
Total	134,364	160,844	177,647	212,740	216,370
Waiting more than:
3 months	53,424	73,745	85,547	115,480	117,413
6 months	21,828	37,991	45,757	68,834	70,120
1 year	4,947	10,360	14,603	27,501	24,606
18 months	--	1,988	5,758	12,505	8,361

In-patients and day cases waiting lists in Wales, 1999-2003

	1999	2000	2001	2002	2003
Total	65,315	79,873	65,582	70,640	74,641
Waiting more than:
3 months	--	46,688	36,405	41,313	42,292
6 months	--	29,668	22,315	26,159	27,541
1 year	7,303	11,352	9,037	10,135	11,831
18 months	2,197	4,273	4,045	4,085	5,238

Source: Welsh Assembly - Waiting lists and waiting times

There are those who would argue that the money is being channelled into the wrong area and that the £32 million it has been reported that the prescription policy will cost ought to be put into reducing waiting lists. Those who argue this point to cases where patients diagnosed with cancers have to wait to see specialists far longer than their equivalents in England. Such potentially serious diseases can be life threatening if not treated early.

Decision-making in hospitals constrained by staff accountability for their actions and decisions. © Photolibrary Group

Another case that highlights the problems centres on a baby born after only 26 weeks. For 11 months, Charlotte Wyatt has received intensive care and has never left hospital. She has severe lung and heart problems and has been already resuscitated twice by doctors. However, the doctors now say that there is no clinical benefit to offering further resuscitation to Charlotte should she stop breathing again. Charlotte's parents fought to try to overturn the doctors' judgements and wanted everything possible to be done to help Charlotte stay alive. The case went to the High Court, where a judge ruled that Charlotte should not be resuscitated if she stops breathing.

Apart from the ethical issues surrounding this case, there is an economic one also which, however distasteful it sounds, doctors have to consider. The National Institute for Clinical Excellence (NICE) estimated that the cost of intensive care unit (ICU) treatment was £1,232 per bed per day as an average in UK hospitals. That, they estimate, is six times the cost per bed per day of an individual on a general ward, and the cost per bed in a high dependency unit three times more expensive than on a general ward. (Source:NICE Appraisal Consultation Document, point 2.5).

In simple terms, therefore, we might estimate the cost of Charlotte being in the ICU of a hospital at nearly £450,000 (12 months at £1,232 per day).

Image: The high degree of technology and care needed in ICU means that it is expensive to provide. Copyright: Adam Ciesielski, stock.xchng.

Two questions then need to be asked:

Could that £450,000 be better used on another patient or a number of patients?
Is £450,000 a worthwhile figure to put on one individual's life?

Both questions are clearly extremely difficult to answer.

Hospitals, therefore, are being seen not only as places where people are treated for a range of problems, they are also business units in their own right. In addition, they are subject to a whole range of economic pressures and because they consume a relatively large amount of national income - around 17% of government spending totalling some £76.5 billion per year - there is enormous political and economic pressure to get value for money from the resources allocated.

Theory

There are a number of core concepts to investigate in relation to health:

The supply and demand for healthcare
Valuing a life
Hospitals as cost centres
Estimating value for money in the health service

The supply and demand for health care:

Health care comes in several forms. It could be based on preventative medicine - providing people with education to enable them to make healthy life choices - but such a strategy is long term in its effects and could be questionable in how effective it is. (The nation is still eating too much of the wrong foods, smoking and drinking too much and not getting enough exercise despite the repeated warnings!)

The National Health Service (NHS) is structured through a system that starts with PCTs - Primary Care Trusts. These are the first contact that people tend to have with the NHS. General Practitioners (GPs) will see a patient in the first instance. The GP may be able to treat that person without further problem but in some cases will need to refer the patient for more specialist treatment - so called secondary health care. This is likely to be at a hospital where the patient will need to see a specialist. That specialist may then recommend a course of treatment depending on the nature of the problem the patient has.

The Structure of Health Care in the UK

Source: About the NHS (http://www.nhs.uk/england/aboutTheNHS/default.cmsx). Crown Copyright, reproduced under licence.

Where and to whom the GP refers the patient is the crucial point in this section. In most economic markets, the demand and supply of goods and services are independent of each other. Suppliers may take patterns of demand into account but they cannot directly control demand and vice versa.

However, in health care the supplier of the service is also the one generating the demand. For example, I go to my doctor with a pain in my abdomen. The GP examines me and decides that I have kidney stones. Upon referral to the hospital, a specialist in renal care examines me and decides that the stones need to be removed by keyhole laser surgery. In another scenario, my pain could be diagnosed by the GP as being due to an ulcer - a different doctor and different treatment regime would be required as a result.

The point here is that the demand for the service (the doctor concerned, the treatment, the necessity of an operation, etc.) is determined by the very people who are also supplying the service. If a doctor tells me I need an endoscpy to check out my problem who am I to argue? As a patient, I am not in a position to be able to make informed choices because there is a considerable degree of imperfection in the information available to me.

The same situation exists in the case of medicines and drugs. The doctor may prescribe a particular course of drugs. As the patient, I do not know if there are other drugs available that would do the job just as well (or better), neither do I know if the drugs being prescribed are just given because they are the most effective treatment, or whether the GP/doctor is a shareholder in the company who makes them, or whether they are under pressure to get rid of stocks of drugs or to prescribe the cheapest available to save the NHS money!

Image: Who determines the demand for drugs? The doctors or the patient? Copyright: Carin Araujo,stock.xchng.

The idea therefore of bringing market forces into the health service is heavily restricted by this unusual situation.

Valuing a life:

This is a really difficult and tricky issue. We can look at the problem from a marginal cost perspective. Ask yourself this question - how much would you say a human life is worth. Or put it another way, how much extra, per year, would you be prepared to pay in taxes to save one additional human life? £10, £10,000, £1,000,000? The answer is almost impossible to answer, in part because it is so subjective (a normative proposition) and in part because most of us do not have £1,000,000 or anything like that to make the question feasible.

However, the NHS and doctors do have to find some way of making such a decision. One way would be to put an estimate on the contribution the individual might make to society - estimated in its crudest sense by their future earning capacity.

Take the example of a patient who is 45. In theory that person has another 20 years of work left in them before the normal retirement age. The average wage in the UK for all people is around £25,000 per annum. That means that this individual is worth £500,000 to society. If the treatment therefore costs less than £500,000 it could be argued it is worth treating this individual.

Other models look at the individual's willingness to pay to buy an extra year's worth of life or how much someone would be willing to pay to reduce the risk of death. There are inherent problems with all of these models but the essential basis of each of them is the fundamental concept of a 'trade off'.

One economist, Orley Ashenfelter, calculated the value of a human life based on an analysis of the effect of a rise in speed limits on US roads. The rise in the speed limit meant that drivers drove slightly faster. This 'led to' a rise in deaths on the roads by 35%. Ashenfelter then compared this to the data from areas where speed limits had not been changed. People in such areas drove slower.

The trade off occurs between the number of hours saved as a result of faster travel against the lives lost as a result. Ashenfelter found that the saving in time was about 45 million hours whereas the increase in the number of deaths was 360. Dividing the two gives an average of 125,000 hours per life. Multiply this figure by the US avarage wage and he ended up with the figure of £980,000.

One problem with such calculations is that it might assume that everyone's life is of equal value. Treatment given to a 98 year old may be valued differently compared to a 25 year old. The question then arises, where do you draw the line? When does someone beceome too old to treat? Already there have been cases where doctors have refused to treat patients who have smoked and drank heavily despite repeated warnings because they feel they have brought the problems onto themselves and that the use of public money to treat such people is misdirected.

Image: What price human life? Does age, behaviour and personal habit make a difference? Copyright: John Pring, stock.xchng.

Hospitals as cost centres:

Cost centres are important concepts in business. A cost centre is a point in a business organisation where costs can be specifically attributed. For example, in a hospital, the X-ray department will incur various costs in carrying out its work. How much this cost is, over a period, can be calculated fairly accurately. Cost centres are important in that knowledge of them can help a business in analysing and controlling costs within the business. If, for example, the X-ray department's costs rose dramatically from one year to the next as a proportion of the costs of the hospital concerned, investigations can be undertaken to discover whether this was due to increased use or whether there was some element of the unit that was inefficient in some way.

Image: A machine such as this may do work for a number of departments in a hospital. How do you account for the cost of it? Copyright: Adam Ciesielski, stock.xchng.

Some cost centres are easy to idenitfy, others are not. For example, in a hospital, the work of the catering department is spread across all the different departments of the hospital. In such cases, the costs of catering may have to be allocated to each department based on an evaluation of the proportion of use that department makes of catering.

Estimating value for money in the health service:

Value for money essentially looks at what you get in return for every unit of currency spent. For most purchases in life, we are able to make an informed estimate as to the value of something to us as individuals when purchasing. With health care, the benefits are not so clear.

Part of the reason for this is that the outcomes of health treatment are not always what we might imagine. Some illnesses and treatments can lead to the patient being able to live a completely 'normal' life; other treatments may result in us being better than we were before but not able to live completely 'normal' lives. The definition of the term 'normal' is the tricky part. A woman who has had to have a breast removed following diagnosis of breast cancer may be able to carry out all the normal functions of living but mentally might be scarred by what has happened and by the surgery. The feeling that they are not a 'complete woman' is not unusual amongst such patients.

One method that has been designed to try to come to terms with this is a unit of measurement of the outcome of treatment called quality adjusted life years (QALYs). The concept was developed by health economics researchers at the University of York in the UK. A QALY gives a measure of the extra quality of life and the number of years of extra life resulting from a treatment.

To create a scale (the measure of health state) that covers the range of outcomes of a treatment (or intervention as it is called), researchers went from 1, the best possible state of health where all normal functions were at the disposal of the patient, to 0, the worst possible health state. Between these two scales (and it may seem rather bizarre) was 'death' - in other words, an intervention could be carried out that results in the death of the patient.

What could be worse than death? This is very much a normative issue but it may be possible to imagine a state of health that exists where a patient suffers intolerable physical and mental pain. Doctors, for example in the case of Charolte Wyatt, maintained that Charlotte was in a state where 'her quality of life was both terrible and permanent' and that 'she had no feelings other than continuing pain'.

Another example might be the state of the young man, Tony Bland who, in 1989, suffered severe brain damage after being crushed at the Hillsborough Stadium disaster. He existed in a permanent vegetative state, a condition where the patient loses cognitive functioning - the ability to process information, be aware of the environment and what is happening to them and around them - but is still able to breath and survive through artificial nutrition and hydration. Mr Bland survived in this state for 3 years before the High Court agreed that his life support should be switched off. The relatives of Mr Bland were reportedly 'relieved' at the judgement. Clearly in such tragic situations, some might view the quality of life as being worse than being dead.

The researchers drew up the grades within this scale based on responses from patients about their preferences for different states of health. The grades within the scale, therefore, allow the user to be able calculate the number of QALYs gained from a treatment. If treatment of a condition of a 50 year old patient restores the person to full health and that person's life expectancy is 76, then the treatment will have resulted in 26 QALYs. If the treatment restores the person to a reasonable state of health but with some disabilities, such as some limitations to walking, breathing, sight, hearing or other problems rated on the scale as 0.75, then the number of QALYs would be 0.75 x 26 = 19.5 QALYs.

Having got some indication of an outcome, the cost of providing that outcome can be identified and as a result some measure of the value for money provided by healthcare treatment can be identified. For example:

The average cost of a primary hip replacement is £4,160.
The average cost of a heart transplant is £16,500.
The average cost of treating a patient with an open lower limb fracture or dislocation is £2,521 per fracture.

Let us assume that the following outcomes are possible after treating a 40 year old patient:

Treatment	Cost per patient	Measure of health state	Additional life expectancy	QALY	Cost per QALY
Hip Replacement	£4160	0.95	15	14.25	£291.92
Heart Transplant	£16,500	0.83	10	8.3	£1,987.95
Fracture	£2,521	1.00	35	35	£72.03

Predictably the fracture comes out as providing the best value for money because of the amount of years of 'good health' it provides after treatment. We can also deduce from this that the opportunity cost of treating one person with a heart transplant is 6.8 people that could have been given a hip replacement and achieving the same cost per QALY - in other words the cost per outcome.

This system therefore provides the health professionals with some form of measure of the outcome of treatment, its associated cost, comparisons between hospitals and departments and thus the basis for decision making.

Data / Facts / Figures

Details of the costs of providing a range of treatments on the NHS(http://www.dh.gov.uk/assetRoot/04/07/01/16/04070116.xls)

Questions

A kidney transplant costs around £20,000 per patient, a liver transplant £18,500, whilst a lung transplant costs £23,000 per patient. The health care states following the operations are estimated to be 0.92, 0.91 and 0.84 respectively. Write a short 500 word report targeted at a health service manager justifying on which type of care the hospital should focus its treatment regime.
You are the health care manager. What other factors would you take into account when deciding on the allocation of resources?
Does the fact that supply and demand for healthcare is different than a normal market structure mean that market forces cannot be introduced into the health service?
Critically analyse the issues involved in assessing the value of a human life.
What other cost benefit analysis techniques could the health service use to measure efficiency, value for money and to improve its accountability?

Related Web sites for Research

An outline of the cost effectiveness of transplants - from the NHS (http://www.uktransplant.org.uk/ukt/newsroom/fact_sheets
/cost_effectiveness_of_transplantation.jsp)
The economic benefits of speed cameras - view from the Cleveland Safety Camera partnership (http://www.clevelandsafetycameras.co.uk/index2.html)
Article on the approaches to valuing human life by Richard P. Morin (http://www.brown.edu/Administration/George_Street_Journal/value.html)
A more detailed analysis estimating the value of a human life by J.K. Vrijling and P.H.A.J.M. van Gelder(http://www.waterbouw.tudelft.nl/public/gelder/paper58.pdf)
Summary of Ashenfelter's work - from the Daily Princetonian (http://www.dailyprincetonian.com/archives/2002/10/09/news/5646.shtml)
BBC news article on Charlotte Wyatt's case - note this is an on going case and is likely to change (http://news.bbc.co.uk/1/hi/health/3706770.stm)
A spreadsheet showing the NHS Reference Costs for different treatments (FCE stands for 'Finished Consultant Episodes') (http://www.dh.gov.uk/assetRoot/04/07/01/16/04070116.xls)
US question and answer site on transplant surgery (http://www.transweb.org/subindex/azindex/azindexa.html)
Department of Health (http://www.dh.gov.uk/Home/fs/en)
Guide to foundation hospitals - from the Department of Health (http://www.dh.gov.uk/PolicyAndGuidance/OrganisationPolicy/
SecondaryCare/NHSFoundationTrust/fs/en)

Mark Scheme

A kidney transplant costs around £20,000 per patient, a liver transplant £18,500, whilst a lung transplant costs £23,000 per patient. The health care states following the operations are estimated to be 0.92, 0.91 and 0.84 respectively. Write a short 500 word report targeted at a health service manager justifying on which type of care the hospital should focus its treatment regime.
For this question, you will need to use the QALY method to estimate the value for money of treating patients. The one with the best value for money could, you might argue, be the area that the hospital should focus on. Some hospitals do 'specialise' in certain types of health care - in building up a specialisation they may gain further benefits - a sort of health economy of scale! Your report should show how you arrived at the figures and any assumptions you may have made - life expectancy, age of patient and so on. You can get some idea of the life expectancy for various transplant surgeries for example (see the suggested links), which will add some support to your argument.
You are the health care manager. What other factors would you take into account when deciding on the allocation of resources?
This is a follow on from the last question. You can use the QALY method but, of course, this does not take into account lots of moral and ethical questions raised by looking at a 'value for money' measure. Who, for example, will tell the patient with heart problems that they may not be treated as quickly as they could (or not at all) because the hospital is choosing to allocate resources to kidney transplants because that represents better use of tax payers money? You might need to also consider the number of patients, the skills and availability of the consultants and surgeons, the availability of specialist nurses, the range of competing health care areas and so on. You might need to begin with a clear statement of what the hospital's main aim is - value for money or the 'best' health care possible. Beware though, the term 'best' is also equally subjective.
Does the fact that supply and demand for healthcare is different than a normal market structure mean that market forces cannot be introduced into the health service?
Since the Tory Government of the 1980s, the notion of introducing market forces into health care has been topical. Attempts to make hospitals compete for patients, improving information for patients and GPs on the cost and efficiency of different hospitals' allocation of funds based on how many patients and how quickly they are treated and now the notion of foundation hospitals have all, arguably, been based on increasing choice in health provision based on some form of market principle. Is health care something you can expose to market forces especially given the fact that supply and demand are so closely linked to the same group of people?
Critically analyse the issues involved in assessing the value of a human life.
A review of the information about valuing human life and the links provided that give more details will be the basis for your answer here. A 'critical analysis' means that you have to consider the advantages and disadvantages and to arrive at some form of judgement about which measure might be the most appropriate and why.
What other cost benefit analysis techniques could the health service use to measure efficiency, value for money and to improve its accountability?
The article What are the more popular measures of benefits in the health sector and why? by Nasima Begum and Monika Rahman at Queen Mary, University of London, will help you to work through this question. It looks at the issues raised in this Mind Your Business.

Thursday, August 11, 2011

Monday, January 17, 2011

Sunday, January 16, 2011

Economics Notes