Michael Grossman’s influential 1972 paper fundamentally reshaped the economic perspective on health, moving beyond its traditional view as a mere consumption good to conceptualize it as a durable capital stock. This innovative model proposes that individuals are born with an initial amount of health, which naturally diminishes over time due to depreciation. However, this health stock is not static; it can be actively augmented through investments made by the individual. The ultimate output of this health capital is healthy time, which is crucial for participation in both market and nonmarket activities. A distinctive aspect of the model is the idea that individuals “choose” their lifespan, as death occurs when their health stock falls below a critical minimum level.
Consumers demand health for a twofold purpose: firstly, as a consumption commodity, good health directly contributes to their utility, while illness leads to disutility. Secondly, and perhaps more innovatively, health functions as an investment commodity. By increasing one’s health stock, an individual reduces time lost to illness, thereby increasing the total time available for productive pursuits, which yields a tangible economic return.
The production of health capital occurs within the household through a household production function. Individuals combine their own time (for activities like exercise or rest) and various market goods (such as medical care, nutritious diet, recreation, and housing) to produce investments in health. An important environmental variable influencing this process is education. More educated individuals are presumed to be more efficient at producing health, meaning they can achieve a given level of health with fewer inputs. This framework implies that the demand for market goods like medical services is not an end in itself but rather a derived demand for the more fundamental commodity of “good health.”
An individual determines their optimal stock of health capital by balancing its marginal efficiency against its user cost. The marginal efficiency of health capital (MEC) represents the rate of return on an investment in health. It is typically downward-sloping, reflecting the principle of diminishing marginal productivity of health capital (e.g., as one approaches 365 healthy days in a year, additional investments yield smaller returns). The user cost of health capital, analogous to a rental price, includes three components: the forgone interest from investing in health rather than alternative assets, the rate at which the health stock depreciates, and any capital gains or losses associated with changes in the marginal cost of gross investment over time. Equilibrium is achieved when the marginal efficiency of health capital equals its user cost.
The Grossman model provides powerful predictions regarding variations in health and medical care consumption across individuals, moving beyond explanations based solely on “tastes”:
Age: As individuals age, the rate of depreciation on health capital naturally rises. This increase in depreciation directly elevates the user cost of health. Consequently, the model predicts that the quantity of health capital demanded will decline over the life cycle. However, if the demand curve for health (MEC schedule) is relatively inelastic (less than unity), individuals will attempt to offset this increased depreciation by increasing their expenditures on medical care as they age. This means that older, less healthy individuals might make larger gross investments in health than younger, healthier ones.
Wage Rate: A higher wage rate increases the monetary value of an individual’s healthy time, whether spent on market work or nonmarket activities. This higher value of healthy time effectively boosts the rate of return on health investments. Therefore, the model predicts a positive correlation between a consumer’s demand for health and medical care and their wage rate.
Education: More educated individuals are theorized to be more efficient producers of health. This increased efficiency lowers the effective cost of producing health, leading them to demand a larger optimal stock of health. However, given a relatively inelastic demand curve for health, this higher production efficiency can result in a negative correlation between medical outlays and education. This is because more efficient individuals can achieve the same or higher levels of health with fewer purchased inputs like medical care.
A key distinction of the Grossman model from other human capital theories (like those focusing on knowledge or schooling) is that health capital specifically determines the total time available for activities, rather than primarily influencing wage rates or productivity per hour. This means even individuals not in the labor force have a strong incentive to invest in their health. The model is also notable for its behavioral framework, explaining observed health differentials through economic factors affecting the supply and demand for health capital, rather than relying on unobservable differences in “tastes” for health. While the model makes some simplifying assumptions, such as constant depreciation rates or perfect foresight of death, its core principles remain foundational for understanding health economics.
Reference: Grossman, M. (1972). On the Concept of Health Capital and the Demand for Health. Journal of Political Economy, 80(2), 223–255.
