Consumer preferences and the relationship between health and consumption

In an ideal world, consumers' choices in relation to the incremental costs of producing goods and services would dictate what gets produced, and at what price. Choices should tell us about preferences. But it's not an ideal world and it is harder for analysts to uncover preferences when there are arbitrary, institutionally-imposed, incentives or distorted messages. In his keynote presentation at the 18th Annual Health Economics Conference, W. P. Carey Economics Professor Kerry Smith addressed the issue of how to determine whether consumers' health spending choices were the result of institutionally-imposed incentives, misleading messages, or rational behavior.

In an ideal world, consumers' choices in relation to the incremental costs of producing goods and services would dictate what gets produced, and at what price. Choices should tell us about preferences. But, of course, it's not an ideal world and it is harder for analysts to uncover preferences when there are arbitrary, institutionally-imposed, incentives or distorted messages.

In his keynote presentation at the 18th Annual Health Economics Conference, W. P. Carey Economics Professor Kerry Smith addressed the issue of how to determine whether consumers' health spending choices were the result of institutionally-imposed incentives, misleading messages, or rational behavior. The conference was hosted by the School of Health Management and Policy at the W. P. Carey School of Business.

Consumer sovereignty and how decisions are made

"In many respects, I think that health economics and environmental economics are on the front lines of challenges to consumer sovereignty," Smith. (In economics, consumer sovereignty refers to the idea that consumers know what is best for themselves.) Yet when it comes to health and the environment, consumers' behavior seems at odds with this premise - or at least what some analysts think constitutes rational behavior.

"People say they're concerned about health, yet they smoke and they're overweight," Smith said. "People say they're concerned about the environment, but SUVs are everywhere." Perhaps distorted information and incentives lead people to walk one way while talking another. "What we see people do is a function of the information that they receive and the incentives that they get," Smith said.

"Fortunately some of this landscape is changing. Our messages on the health front are getting better. They've changed over the last 25 years and continue to change." Smith cited a magazine ad from 1945 that read "More Doctors Smoke Camels Than Any Other Cigarette" and Business Week cover from 2007 with a picture of a man smoking a cigarette.

The cover admonishes "Get Healthy — Or Else." "As economists, our job is to take those messages and the actual incentives people face and translate them into economic models that allow us to accurately characterize behavior," Smith said. Given the health messages people receive and incentives they face, then, economists can evaluate whether the level of spending on health care is the result of incentives or consistent with what people want.

Building theoretical models

University of California, Berkeley Economics Professor Charles Jones — also a presenter at the Health Economics Conference and his co-author, Stanford Economics Professor Robert Hall, do just that in a recent paper, "The Value of Life and the Rise in Health Spending," published in February, 2007 in The Quarterly Journal of Economics. Smith said that the question implicit in the Jones and Hall article is, "can we rationalize growing expenditures on health? Are they the result of consumer preferences or the incentives they face?"

The question is whether, as Jones and Hall suggest, the rising share of GDP that's devoted to health spending is due to consumer preferences favoring health care over consumption as income rises or W. P. Carey as critics of Jones and Hall suggest W. P. Carey a result of the inefficient incentive structure of our health system. But Jones and Hall are not the only economists to suggest that rising health is important to consumers.

University of Chicago economics professors Kevin Murphy and Robert Topel reached a similar conclusion in a recent paper, "The Value of Health and Longevity," published in The Journal of Political Economy. In their work, Murphy and Topel found that increases in life expectancy since 1970 due to health progress against heart disease and cancer added $3.2 trillion per year to national wealth W. P. Carey about half of GDP. "That is staggering," Smith said.

Linking health and consumption: complementarity

Both analyses share an important assumption: They maintain that an individual's consumption and his health status are complementary goods. If consumption and health are complementary, then as income leads to greater consumption we should expect health expenditures to also rise.

(In economics, complementary goods are those that are consumed together W. P. Carey hamburger patties and buns, for example, or W. P. Carey as for the Hall and Jones model W. P. Carey consumption of ordinary goods and services and the health services we associate with enhancing the quality and length of our lives.) Complementarity is a reasonable way to describe the relationship between health and consumption in contributing to a person's well-being. But does this relationship hold indefinitely? The result lead to extreme outcomes, Smith said.

Health services would never experience diminishing returns if with every year of exponential increases in consumption the marginal value of an added expenditure on health was higher due to this persistent complementarity. In Murphy and Topel's paper, complementarity is evidenced by improvements in the quality of life that enhances the value of improvements in quantity of life W. P. Carey and vice-versa. In other words, when people have better quality of life, they value additional years of life more.

Empirical evidence of complementarity

Jones and Hall and Murphy and Topel assume that health and consumption display complementarity over all ranges of consumption and health. Because this assumption is so central to their conclusions, Smith said, empirical evidence is important to substantiate that theory. Smith cited two studies that provide information about the relationship between health and consumption.

The first study that presents such empirical evidence is a 2006 stated-preference study by University of Oregon Economics Professor Trudy Cameron and UCLA Professor of Public Policy J.R. DeShazo. The study offers individuals a profile of illnesses and asks them to choose the illness they most want to avoid (keeping in mind the annual cost of avoiding that illness). Cameron and DeShazo model the survey results taking into account the actual health conditions experienced by their survey respondents.

By comparing the illness that they were being asked about hypothetically to conditions they had and were currently experiencing it was possible to gauge how their willingness to spend on activities to prolong life or reduce the risks of poor health related to their current health state. The results indicate that individuals who had experienced the illness that was presented to them would be likely to pay more W. P. Carey nearly double W. P. Carey to avoid that disease than a healthy person with no prior experience with the illness.

Their results also indicate that individuals who had not experienced the particular disease that was presented them but were ill with other diseases would pay less to avoid a life-threatening disease presented to them than either the healthy person without prior experience or the person who had experienced the particular disease. "The quality of their lives was lower, so they were less willing to pay to prolong their lives than those with higher qualities of life," Smith said.

The second set of empirical evidence comes from a revealed-preference study that Smith conducted with University of Tennessee Assistant Economics Professor Mary Evans based on a panel of older adults interviewed as part of the Health and Retirement Study. Evans and Smith considered the labor market choices of these adults in 1994. Smith said that one could use a person's willingness to accept wage compensation in exchange for increased risk on the job to evaluate the complementarity relationship between health and consumption.

The study revealed that respondents between the ages of 51 and 55 who were in excellent health required twice as high compensation to accept serious risks as those in the same age group with poorer health. "There's a 124 percent increase in the value that respondents place on reducing risk if they are in excellent health over if they're not in excellent health," Smith said. "This is clear evidence of complementarity.

Your health affects your valuation of risk." As in the Cameron and DeShazo study, the bottom line is that people who are healthy (those who have a high quality of life) are more willing to pay more to avoid serious illness than people who are not healthy (those who don't have a high quality of life). But Smith doubts that healthy individuals' willingness to pay to avoid illness will increase without limit as income increases.

At some price point individuals will no longer be willing to pay to avoid the marginal illness he suggested. That question of a limit to complementarity is central to the public policy debate about health spending. Hall and Jones, for example, suggest that health spending will account for 30 percent of GDP by 2050. But Smith wonders if such a high health share is plausible given the other consequences of this large reallocation of resources.

Determining whether there is a limit to the consumption/health complementarity, then, is key to determining whether the current increasing level of health spending will be sustained. "The question of a limit to complementarity between health and consumption is likely to influence a significant amount of research that we do in health economics. We can only hope to improve our descriptions of people s preferences through developing a better understanding of how the information and incentives that we provide people influence their choices," Smith said.

Bottom line

• There is theoretical evidence (Jones and Hall and Murphy and Topel) that rising health expenditure as a share of GDP is a rational response to consumer choices.
• Both arguments assume significant complementarity between consumption and health. In Murphy and Topel complementarity is evidenced by improvements in the quality of life that enhance the value of improvements in the length or quantity of life W. P. Carey and vice-versa.
• In Jones and Hall's work, complementarity is evidenced by increases in consumption enhancing the value of improvements in health.
• There is empirical evidence demonstrating the link between health status and willingness to pay for health care.
• The key question to explore further is whether complementarity has a limit or whether health expenditures and consumption will rise together indefinitely as income rises.