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Economics of Public Health blog number 3

10 January 2012

Key economic principles: opportunity cost and marginal analysis

Having critiqued other ways of managing scarcity and having tried to make the case for economic evaluation to be applied to population health initiatives, we now need to go back to some basic principles from which we can then (re) build.

Opportunity cost and marginal analysis

An economic approach to priority setting has to adhere to two key economic concepts; ‘opportunity cost’ and ‘the margin’. Opportunity cost refers to having to make choices within the constraint of limited resources; opportunities will be taken up while others must be forgone, the benefits of the latter being opportunity costs. Thus, we need to know the costs and benefits from various activities. Marginal analysis refers to the focus on the benefit gained from the next unit of resources, or benefit lost from having one unit less. If the marginal benefit per £ spent from, say, an elective heart operation programme is greater than that for an elective hip replacement, then resources should be taken from hips and  given to hearts. But where does this allocation process stop? Do we wipe out the hips programme completely?

This is best answered by use of the sequence of diagrams in the following sections (click here to download a copy of the full sequence). For now, let us assume we can measure both costs and benefits (i.e. health gains) from treating hearts and hips in terms of money, as on the vertical axis (see Diagram a). 

 

graph a

 

 

 

 

 

 

 

 

 

 

This makes the following arguments easier to explain, but they would still hold even when using a non-monetary measure of health gain. A further assumption is that these programmes and all others are operating at maximum ‘technical efficiency’ – i.e. there is no waste in the system, as achieved by approaches such as ‘lean thinking’. Minimisation of technical inefficiencies would obviously be a desirable first step, but is set aside for now for purposes of illustration. First, we invoke the standard economic principle of diminishing marginal benefit, where patients differ in their ability to benefit from treatment; and then make the reasonable assumption that health professionals prioritise patients according to potential to benefit. Thus, those who gain most from a heart operation will be treated first (as in b). 

Graph b

 

 

 

 

 

 

 

 

 

 

 

Accordingly, if we increase the number of patients that are treated over a set period of time, we are adding patients that benefit less and less from the procedure, leading to the downward sloping marginal benefit (MB) line for hearts (c and d) and a corresponding one for hips; although note the hips line has a different slope (e).

Graph c

 

Graph d

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Graph d

 

 

 

 

 

 

 

 

 

 

 

 

If we also assume that the cost of each procedure is constant and equal for all patients receiving either procedure (f), then cutting back on hips from its starting point (g) will increase its ratio of marginal benefit per £ spent, whilst expanding hearts will diminish its equivalent ratio (i.e. we will get less and less return in terms of health gain for each additional £ invested in hearts). 

 

Graph dGraph d

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

To maximise total patient benefit derived from the combined budgets of the two programmes, the process of reallocation should continue until the ratios of marginal benefit to marginal cost for the programmes are equal (h).

Graph d

 

 

 

 

 

 

 

 

 

 

 

Thus, service elimination is never really considered, although it remains a possibility. Rather, through examining changes ‘at the margin’, the application of economics becomes about the balance of services

Operationalising opportunity cost: an economic framework for needs assessment

A framework for operationalising these two basic principles is outlined below:

An economic approach to needs assessment (five questions)

PBMA addresses priorities from the perspective of resources:

1. What resources are available in total?

2. In what ways are these resources currently spent?

3. What are the main candidates for more resources and what would be their effectiveness?

4. Are there any areas of care within the programme which could be provided to the same level of effectiveness but with less resources, so releasing those resources to fund candidates from (3)?

5. Are there areas of care which, despite being effective, should have less resources because a proposal (or proposals) from 3. is (are) more effective for the resources spent?

The framework provides a structured approach to planning service delivery either at the (micro) level of a programme (such as diabetes) or services for a whole population (a more ‘macro’ approach). In public health language, we might refer to this as ‘an economic approach to needs assessment’, although it is often known by the more-cumbersome term of programme budgeting and marginal analysis (PBMA). Note that the starting point here is resources, not need, the latter being the natural starting point for many health professionals. The nice result to emerge from this process of thinking, however, is that need met from available resources will be maximised! Indeed, the wider the range of services covered (e.g. with health and social services under one budget), the nicer the result!

Programme budgeting comprises the first two questions, while the last three pertain to marginal analysis. The underlying premise of programme budgeting is that we cannot know where we are going if we do not know where we are. If our budget is fixed, opportunity cost is accounted for by recognising that the candidates for more resources (question 3 in the process) can be funded only by taking resources from elsewhere (questions 4 and 5). Resources can be obtained from elsewhere by being more technically efficient (e.g. doing things differently so we achieve the same health outcomes at less cost, as addressed by question 4) or more allocatively efficient (e.g. doing entirely different things for different people to achieve a greater health outcome at the same cost, as addressed by question 5). Possibilities under question 4 are more desirable, whilst question 5 is more difficult to address because it involves taking resources from some groups of patients to give to others (literally robbing Peter to pay Paul). However, the key is that all of this can be done 'at the margin' by considering the amounts of different services provided. Although, in reality, quantitative data on marginal benefits is often lacking in many areas of health care, it is the clear and logical way of thinking underpinning the framework that is of prime importance. The more technical ways of estimating costs and benefits are outlined later in the series.

Although some readers may think that top priorities for service development could always be funded from annual resource increases from government, such increased funds are unlikely to cover all proposed growth areas (i.e. scarcity still exists). Thus, the principles of the economic approach to needs assessment actually apply in principle to the whole base budget spent on health in the NHS and elsewhere in the public sector, an issue which will be increasingly recognised in forthcoming years.

For population health the principles remain the same – it is about managing scarcity. Specific to upstream interventions: funding for interventions is often required from different sources; and health may not be the main objective of some funders. A response to this is that the thinking underlying the theory can be just as easily applied at the societal level – indeed economics should take a societal approach. At least then we can work out what is socially optimal before deciding whether it is feasible to work across budgets to implement multi-sectoral solutions. Issues of perspective will be discussed in more detail in later blogs.

As ever, we are willing to accept any comments on the above. More specifically, in managing scarcity of resources, is there an alternative to the five questions portrayed as an economic approach to needs assessment?

 

Cam Donaldson

Kenny Lawson

Helen Mason

Emma McIntosh

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About the author

Prof Cam Donaldson NIHR Senior Investigator and Yunus Chair in Social Business & Health

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Cam Donaldson holds the Yunus Chair in Social Business & Health at Glasgow Caledonian University. He has worked as an academic health economist for nearly 30 years, mainly on development and implementation of methods of economic evaluation of health interventions.

Read all blog posts by Prof Cam Donaldson

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