Supply and Demand Analysis of Rising Healthcare Expenditure

Question

Japan spent a record ¥42.2 trillion on healthcare in 2017, mainly due to an ageing population, and the spending is funded through high taxes paid by a shrinking working generation. Besides, the healthcare industry is also faced with a shortage of healthcare workers.

(a) Use supply and demand analysis to explain why the abovementioned factors may have led to a record high healthcare expenditure in Japan. [10]

Answer

Total expenditure (TE) on a good is the product of its price and the quantity exchanged, $TE = P \times Q$ . The question supplies two forces — an ageing population and a shortage of healthcare workers — and the task is to trace each through the demand and supply of healthcare to show why both push total expenditure up. Because the two act on opposite sides of the market, their effects on expenditure reinforce one another.

Demand factor: the ageing population. An ageing population raises the average age of consumers, and the prevalence of chronic and acute health conditions rises with age. This is a change in a non-price determinant of demand — the willingness and ability to pay for healthcare — so the demand curve for healthcare shifts to the right, from $D_0$ to $D_1$ . At the original price a shortage opens up, and the price mechanism bids price up until a new equilibrium is reached: price rises from $P_0$ to $P_1$ and quantity exchanged rises from $Q_0$ to $Q_1$ . Since both price and quantity rise, total expenditure rises unambiguously from $P_0 Q_0$ to $P_1 Q_1$ — this is a shift of demand, not a movement along it, so the elasticity of demand does not need to be invoked to sign the change.

Rightward shift of healthcare demand from an ageing population. Demand shifts D0 to D1 along a fixed supply curve; price rises P0 to P1 and quantity rises Q0 to Q1, so total expenditure P0Q0 rises unambiguously to P1Q1.

Supply factor: the shortage of healthcare workers. Labour is the principal input to healthcare provision, and the demand for it is derived from the demand for healthcare itself. A shortage of healthcare workers means the quantity of such labour demanded exceeds the quantity supplied at the prevailing wage; the price mechanism in the labour market bids wages up. Higher wages raise the unit cost of producing healthcare services, a non-price determinant of supply, so the supply of healthcare falls, shifting from $S_0$ to $S_1$ . Here the effect on total expenditure is not automatic: a leftward supply shift raises price but lowers quantity, so the outcome turns on the price elasticity of demand. Healthcare has a high degree of necessity and few close substitutes — especially for an ageing population — so its demand is price inelastic. As applying PED to a supply shift shows, when demand is inelastic the proportionate rise in price exceeds the proportionate fall in quantity, the price effect dominates, and total expenditure rises from $P_0 Q_0$ to $P_1 Q_1$ .

Leftward shift of healthcare supply from a worker shortage, against price-inelastic demand. Supply shifts S0 to S1; the price rise P0 to P1 is more than proportionate to the quantity fall Q0 to Q1, so total expenditure rises from P0Q0 to P1Q1.

Conclusion. The two forces act on opposite sides of the market but push expenditure the same way: the ageing population raises demand, which lifts both price and quantity; the worker shortage cuts supply, which against inelastic demand lifts price more than it cuts quantity. Both channels raise $P \times Q$ , and acting together they compound, which is why Japan’s healthcare expenditure reached a record high.