The price elasticity of demand: the concept and examples in health
Economist and candidate for a Master's in Economics
Health Economics Area Director
The price elasticity of demand for a good or service makes it possible to determine how and to what extent consumers of that good or service respond to changes in prices. The concept is of great utility and interest in health as it makes it possible to estimate how effective public policies related to the consumption of health goods can be or whose consumption affects health and on which side of the market, supply or demand, supports the greater part of the changes in health consumption. In this blog post we explain the concept of price elasticity of demand and offer a couple of examples in the healthcare sector.
The demand for a good or service depends on the tastes or preferences of consumers for that good or service, its price and the prices of other goods, the income of consumers, and a broad set of other factors. However, in economics we abstract these elements and say that the demand for a good or service is fundamentally a function of its own price. With this, it is possible to study the behavior of consumers by differentiating how their consumption responds to changes in prices and to changes in other factors, so that we can individualize and quantify the magnitude and direction of these changes and how they interact with each other, estimating the influence of each of these changes on the final net effect. Furthermore, our daily experience shows us that if the price of a good or service increases, then the quantity demanded for it decreases, assuming that the other factors that intervene in the demand for that good do not vary. The question is, how much does the quantity consumed of a good decrease as a consequence of an increase in its price (or, conversely, how much does the quantity consumed of a good increase in response to a reduction in the price of that good).
A measure of the response to variations in the quantities consumed of a good as a consequence of variations in its own price is the price elasticity of demand (EPD), which is calculated as the ratio between the percentage change in the quantity demanded of the good ( which we call Q) and the percentage change in price (which we call P), that is,
EPD = (% variation in Q) / (% variation in P) = (AQ / Q) / (AP / P)
- If the EPD> 1, the demand for the good is said to be elastic and an increase of 10% in the price generates a reduction greater than 10% (more than proportional) in the quantity consumed. Thus, an EPD = 2 means that an increase in the price of 10% produces a reduction in the consumption of that good of 20%.
- If the EPD <1, the demand for the good is said to be inelastic and an increase of 10% in the price generates a reduction of less than 10% (less than proportional) in the quantity consumed. Thus, an EPD = 0.5 means that an increase in the price of 10% produces a reduction in the consumption of that good of 5%.
- If the EPD = 1, it is said that the demand for the good has unit elasticity and an increase of 10% in the price generates a reduction of 10% in the quantity consumed.
Whether the EPD of a good is elastic or inelastic depends on the nature of that good. Goods considered necessary or whose consumption cannot be easily substituted by others tend to have inelastic demands. This is the case for health in general: since the RAND Corporation health insurance experiment was carried out, most health services, including pharmaceuticals, are considered inelastic price, with EPD around –0.20 according to different studies carried out for developed countries (Yeung et al. 2016). In Colombia, intramolecular, brand and generic EPD was investigated for three tracer pathologies (hypertension, diabetes and hyperlipidemia), in the ethical and private Colombian market, which concluded that both brand name and generic drugs are inelastic in the face of changes in their price, in In particular, brand-name drugs are more inelastic than generic drugs (Vásquez et al., 2013).
The question is what implications the fact that goods and services have elastic or inelastic EPD has on health outcomes. There are several and we will mention two of great relevance.
1. Estimate the impact that tax policies have on mass consumer goods that put health at risk.
Tobacco use is a major risk factor for disease and an underlying cause of poor health, preventable death, and disability. It is estimated to kill more than 7 million people each year worldwide, representing more deaths each year than HIV / AIDS, tuberculosis and malaria combined and the total economic damage from smoking (including productivity losses). by death and disability) has been estimated at more than US$ 1.400 billion per year, equivalent to 1.8% of global annual GDP (World Bank, 2018). The aggregate EPD of cigarettes in Colombia is –0.78, which indicates that, in Colombia, an increase of 10% in the relative price of cigarettes reduces aggregate demand by 7.8% (Maldonado et al. 2016). This implies that there is room to achieve public health objectives by reducing consumption and simultaneously increasing tax revenues through taxation through a tax on the consumption of cigarettes. The cigarette tax is estimated to prevent approximately 2,300 deaths and generate around $500 billion in revenue from 2018.
2. Evaluate how and through what mechanisms drug prices constitute a barrier to access health services in general or to specific population groups.
When the Deficit Reduction Act of 2005 was passed in the United States, Congress inadvertently increased the prices of oral contraceptives by factors of 3 to 5 times the initial price at university health centers in that country. This implied a reduction in contraceptive methods of between 2% and 4% among university women in general. However, among university students who did not have insurance, the reduction in contraceptive use was between 6% and 16% and induced in them the substitution of standard contraception for emergency contraception and other forms of non-prescription birth control and induced that a significant part reduced the frequency of sexual encounters (Collins & Hershbein, 2011). Thus, a specific group of women (young university students) who already had access barriers to contraceptive methods due to lack of insurance, experienced a greater inability to obtain drugs due to higher prices in the price increases of these drugs.
3. Determine market power in drug markets.
According to the World Health Organization (WHO), depression is a disorder that affects 4.7% of the population in Colombia and constitutes a growing public health problem. Cadena-Lozano et al. (2017) estimated the EPD of a “type” drug used for the treatment of depression and obtained an EPD of 0.35 %, that is, changes in price do not generate the expected response in demand, which makes this drug one highly inelastic. This suggests the existence of high market power and the ability of the company that manufactures it to exercise that market power in the relevant market, which shows the need to regulate prices in some way for this class of drugs.
Finally, it must be said that, despite the simplicity of the concept, in practice it is not easy to calculate the EPD of a good or service. It is necessary to estimate a demand function of a market using econometric techniques, some of them very complex and sophisticated.
Cadena-Lozano, J., Ariza-Garzón, M., & Pulido-Cruz, C. (2017). Elasticities of demand for an antidepressant drug in Colombia as a strategy to evaluate market power. Management And Health Policies, 15 (31).
Collins, EM and Hershbein, B. The Impact of Subsidized Birth Control for College Women: Evidence from the Deficit Reduction Act. Population Studies Center Research Report 11-737, May 2011.
Maldonado N, Llorente B, Deaza J. Taxes and demand for cigarettes in Colombia. Rev Panam Salud Publica. 2016; 40 (4): 229–36.
Vásquez J., Gómez K., Castaño E., Cadavid JV., Ramírez A. (2011). Elasticity of the demand for medicines in the private pharmaceutical market in Colombia. 17 (37), 142-172.
Kai Yeung K., Basu A., Hansen RN. And Sullivan D. (2016). Price elasticities of pharmaceuticals in a value-based-formulary setting. National Bureau of Economic Research, Working Paper 22308.